Production

Asmita Verma
IIM Visakhapatnam
28th July/ 2nd Aug 2022
Introduction
• The economy includes thousands of firms that produce the goods and services
you enjoy every day.
• Some firms are large; they employ thousands of workers and have thousands of
stockholders who share the firms’ profits.
• Other firms, such as the local general store, barbershop, or café, are small; they
employ only a few workers and are owned by a single person or family.
• Firm behaviour-Theory of the firm: Explanation of how a firm makes cost-
minimizing production decisions and how its cost varies with its output.
• E.g., If the Ford Motor company wants to increase production, should it hire more workers,
construct new plants or both, how much labour should it employ in its new automobile
plants, how should it estimate its costs, etc.
• This topic will give you a better understanding of the decisions behind the
supply curve
The production decisions of a firm
Best understood in three steps (just like consumer theory):
1. Production Technology
• How inputs can be transformed into outputs.
2. Cost Constraints
• Prices of inputs have to be taken into account.
3. Input Choices
• Given the former two, the firm has to decide how much of each input to
use in producing its output.
1. Production Technology
• Itrefers to the transformation of inputs/factors of production or
resources into outputs of goods and services.
• Factors of production include labour, capital, land and entrepreneurship.

• E.g., IBM hires workers to use machinery parts and raw materials in
factories to produce personal computers.

• The output of a firm can be final product or service.

• Production refers to all activities involved in the production of goods
and services.
Production Function
• Production functions shows the relationship between outputs and inputs.

• Both inputs and outputs are measured in physical units rather than in
monetary units. Simply, we assume that a firm produces one type of
commodity with two inputs, labour (L) and capital (K) (technology is
assumed to be constant).

• The general equation of production function is: Q = f (L,K)

Time period
• Short run: The time period during which at least one input is fixed is
called short run time period.

In the short run, a firm can increase its output only by using more of variable inputs
together with fixed inputs.
Variable inputs: These can be varied easily e.g.,raw materials, unskilled labourers..
Fixed inputs: Production factors that cannot be varied., e.g., plant and equipment..

• Long run: The time period during which all inputs are variable is called
long run time period.
In the long run, the output increase happens efficiently by expanding firm’s
production facilities (plant and equipment).
Production with One Variable Input (Labor).
Short Run Production

AVERAGE PRODUC MARGINAL PRODUCT
AMOUNT OF LABOR (L)​ AMOUNT OF CAPITAL (K)​ TOTAL OUTPUT (q)​
T (q/L)​ (∆q/∆L)​

0​ 10​ 0​ —​ —​
1​ 10​ 15​ 15​ 15​
2​ 10​ 40​ 20​ 25​
3​ 10​ 69​ 23​ 29​
4​ 10​ 96​ 24​ 27​
5​ 10​ 120​ 24​ 24​
6​ 10​ 138​ 23​ 18​
7​ 10​ 147​ 21​ 9​
 
8​ 10​ 152​ 19​ 5​
9​ 10​ 153​ 17​ 1​
10​ 10​ 150​ 15​ -3​
11​ 10​ 143​ 13​ -7​
12​ 10​ 133​ 11.08​ -10​
Total, Average and Marginal Product
• Total product (TP) is the total quantity of a particular good
or service produced.

• Average product (AP) is output per unit of input. AP is

also called productivity.

• Marginal product (MP) is the extra output or added product

associated with adding a unit of a variable resource.
The slopes of the product curve
The Relationship Between The Average And
Marginal Products

When the marginal product of labor is greater than the average

product, the average product of labor increases.

When the marginal product of labor is less than the average

product, the average product of labor decreases.

When the marginal product of labor is equal to the average product, the
average product of labor is at its maximum.
Law of diminishing returns and stages of
production for labor (variable input)
• Law of Diminishing Returns
As we use more and more units of the variable input with a given amount of the
fixed input, after a point, we get diminishing returns (marginal product) from the
variable input.
• Stage I of Production
Range from the origin to the point where 𝐴𝑃 𝐿 is maximum.
• Stage II of Production
Range from point where 𝐴𝑃 𝐿 is maximum to the point where 𝑀 𝑃 𝐿 = 0.
• Stage III of Production
Range over which 𝑀 𝑃 𝐿 < 0.
https://www.youtube.com/watch?v=rnEFtyMzjOo&ab_channel=mjmfoodie
1 2 3
A Production Function For Health Care

Do increases in health care expenditures reflect

increases in output or do they reflect
inefficiencies in the production process?

Points A, B, and C represent points at which

inputs are efficiently utilized, although
there are diminishing returns when moving
from B to C.

Point D is a point of input inefficiency.

Output Elasticity of Labour
• Production or output elasticity of labour (EL) measures the percentage
change in output divided by the percentage change in the quantity of
labour used.
Labor Productivity
• Labor productivity is the average product of labor for an entire
industry or for the economy as a whole. It determines the real
standard of living that a country can achieve for its citizens.

• The most important source of growth in labor productivity is

growth in the stock of capital, followed by technological change.

• Stock of capital is the total amount of capital available for use in

production.
 Pop Quiz
1. The marginal product of labor is equal to
  A) the additional labor required to produce one more unit of output.
  B) average product when average product is at a minimum.
  C) the additional output produced by hiring one more unit of labor.
  D) the slope of a ray drawn from the origin to a point on the total product curve.

2. The average product of labor is equal to

  A) the additional labor required to produce one more unit of output.
  B) marginal product when average product is at a minimum.
  C) the additional output produced by hiring one more unit of labor.
D) the slope of a ray drawn from the origin to a point on the total product
 
curve.
 Production with Two Variable Inputs
(Long Run Production)

Isoquants: the curves showing

all possible combinations of
inputs that yield the same
output.

• Isoquant map is a graph

combining a number of
isoquants, used to describe a
production function.
Marginal rate of technical substitution
(MRTS)
Amount by which the quantity of one input can be reduced when one extra
unit of another input is used, so that output remains constant.

MRTS = −Change in capital input/change in labor input

= − ∆𝐾 / ∆𝐿(for a fixed level of q)

• MRTS = (MPL/ MPK)

Declining Marginal Rate Of Technical
Substitution
The slope of the isoquant at any
point measures the marginal rate
of technical substitution—the
ability of the firm to replace
capital with labour while
maintaining the same level of
output.

On isoquant q2, the MRTS falls

from 2 to 1 to 2/3 to 1/3.
Isoquants When Inputs Are Perfect Substitutes
When the isoquants are straight
lines, the MRTS is constant.
Thus, the rate at which capital
and labor can be substituted for
each other is the same no
matter what level of inputs is
being used.
Points A, B, and C represent
three different capital-labor
combinations that generate the
same output q3.
Isoquants When Inputs Are Perfect Compliments
FIXED-PROPORTIONS
PRODUCTION FUNCTION
When the isoquants are L-
shaped, only one combination of
labor and capital can be used to
produce a given output (as at
point A on isoquant q1, point B
on isoquant q2, and point C on
isoquant q3). Adding more labor
alone does not increase output,
nor does adding more capital
alone.
A Production
Function for
Wheat
•Food grown on large farms in the
United States is usually produced
with a capital-intensive technology.
Most farms in the United States and
Canada, where labor is relatively
expensive, operate in the range of
production in which the MRTS is
relatively high (with a high capital-
to-labor ratio).

•Farms in developing countries, in

which labor is cheap, operate with a
lower MRTS (and a lower capital-to-
labor ratio).
Returns to Scale
Rate at which output increases as inputs are increased proportionately.
INCREASING RETURNS TO SCALE
Situation in which output more than doubles when all inputs are doubled.
CONSTANT RETURNS TO SCALE
Situation in which output doubles when all inputs are doubled.
DECREASING RETURNS TO SCALE
Situation in which output less than doubles when all inputs are doubled.
Returns to Scale
Q=f(L,K)
If L and K both increase by a factor of h, then what happens to Q?
• f(hL, hK)>hf(L,K)- Increasing Returns to Scale
• f(hL, hK)<hf(L,K)- Decreasing Returns to Scale
• f(hL, hK)=hf(L,K)- Constant Returns to Scale
When a firm’s production process exhibits
constant returns to scale as shown by a
movement along line 0A in part (a), the
isoquants are equally spaced as output
increases proportionally.
However, when there are increasing returns to
scale as shown in (b), the isoquants move
closer together as inputs are increased along
the line.
Returns to Scale in the Real World
Case Study: Returns to Scale in the Carpet
Industry
Innovations have reduced costs and greatly increased carpet
production. Innovation along with competition have worked
together to reduce real carpet prices.
Carpet production is capital intensive. Over time, the major
carpet manufacturers have increased the scale of their
operations by putting larger and more efficient tufting machines
into larger plants. At the same time, the use of labor in these
plants has also increased significantly. The result? Proportional
increases in inputs have resulted in a more than proportional
increase in output for these larger plants.
Most smaller carpet manufacturers have found that small
changes in scale have little or no effect on output.
We can therefore characterize the carpet industry as one in
which there are constant returns to scale for relatively small
plants but increasing returns to scale for larger plants.
Exercise 1

If production function is Q = L0.1 K 0.5, find out

output elasticity of labour and capital.
Exercise 2: Fill in the blanks
Quantity of Total output Marginal Average
variable input product of product of
variable input variable input
0 0
1 225
2 300
3 300
4 1140
5 225
6 225