Theory of Production

Production Theory
Production theory describes efficient combinations of inputs (L,K) which contribute maximum output (Q) or with least cost combination. The firms production function relates its output Q to labor L, capital K, and other inputs. If L and K are the main inputs Q=F(L,K). In the short run firms find it costly to change capital stock so Q depends mostly on L, the more flexible input.

Table 1 Measures of Production With Fixed Capital

Types of Production Function

There
It

are two types with respect to time Short Run Production Function
is that production function in which one input is fixed (K) and other is variable (L)

Long
It

Run Production Function

is that production function in which both inputs (K) and (L) are variable

Types of Production function with respect to category

Simple Cobb CES

Production Function

Douglas Production Function

( Constant Elasticity of Substitution) Production Function

Simple and Cobb- Douglas production functions

It means that production function in which there is no effect of efficiency of Q = f ( K , L, R, S , , ) inputs and no effect of technology has been introduced. In Cobb Douglas both parameters have been taken Care.

Q =A * LK

Average and Marginal Product of Labor

Table

1 includes two derived production concepts where K=8. Definition

The

marginal product of labor is defined as

(1 ) M L P Q = L

Definition
The

average product of labor is defined as

(1 ) APL = Q L

APL and MPL Curves

Figure 1 displays the average and marginal product of labor from table 1 in a graph. Holding capital constant, the marginal product of labor eventually diminishes. This is the Law of Diminishing Marginal Returns As long as MPL>APL however, the average product of labor is rising.

Laws of Returns ( Short Run Analysis of theory of Production)

Law of Increasing Return If each additional unit of labor with fixed capital gives more production as compare to previous unit, it means that production follows Law of Increasing Return Law of Constant Return If each additional unit of labor with fixed capital gives same production as compare to previous unit, it means that production follows Law of Constant Return Law of Diminishing Return If each additional unit of labor with fixed capital gives less output as compare to previous unit of labor, it means that production follows Law of Diminishing Return

 Rationale
(3) (1) Marginal Product Units of the (MP), (2) Variable Resource Total Product Change in (2)/ (Labor) Change in (1) (TP) 0 1 2 3 4 5 6 7 8 0 10 25 45 60 70 75 75 70

Tabular

Example

(3) Average Product (AP), (2)/(1) 10.00 12.50 15.00 15.00 14.00 12.50 10.71 8.75

] ] ] ] ] ] ] ]

10 15 20 15 10 5 0 -5

Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns

 Graphical
Total Product, TP 30 20 10 0 Marginal Product, MP

Portrayal
TP

Increasing Marginal 20 Returns

Diminishing Marginal Returns

Negative Marginal Returns

10 1 2 3 4 5 6 7

AP 8 9 MP

Figure 1 Production with Variable Labor and Fixed Capital Stage

-1 Stage -2 S t a g e 3

Labor and Capital Both Variable

In

the long run the adjustment costs of capital loom less large and capital becomes a variable input. Table 2 illustrates this situation. Notice that as L and K increase in equal proportion along the diagonal, Q increases in the same proportion. This is Constant Returns to Scale, CRS.

Table 2Production with Both Inputs Variable

Labor and Capital Both Variable

You

can have both CRS and diminishing returns for the same production functionlike table 2. Hold K=4 and you get diminishing returns to labor. Vary L and K in proportion along the diagonal and you get CRS.

The Returns to Scale ( Long Run Analysis of Production Theory

If

both inputs are variable then with an increase in both inputs at what proportion the output is increasing, It depends upon Laws of Returns to scale Types of Laws of Returns to Scale
Law of Increasing Return to scale Law of Diminishing Return to scale Law of constant Return to scale

Equilibrium in Theory of Production

ISO Quant ISO Cost

ISO Quant It is an aggregation of those combinations of inputs (K,L) which are giving same level of output ISO Cost It means that combination of inputs (K,L) on which same cost has been occurred

Properties of ISO Quant

Downward

Sloping DMRTS( Diminishing Marginal Rate of Technical Substitution Higher is better Never intersect each other

Slope of the Isoquant

The

slope of the isoquant is the additional capital K required per unit of labor L given up that maintains output. We call this slope the marginal rate of technical substitution or MRTS. This varies along the isoquant.

Figure 6--Marginal Rate of Technical Substitution Along an Isoquant

Marginal Rate of Technical Substitution (MRTS)

Definition:

The MRTS is the slope of the isoquant or trade-off between two inputs, holding output constant.

In terms of Figure 6,
(1 ) K MRTS = , L

This is the units of capital required per unit of labor sacrificed along the isoquant.

Derivation of the MRTS

Q=F(L,K)

is the production function. Since Q=Q0 along an isoquant we have Q=Q0=F(L,K).

Now

differentiate Q0=F(L,K). The result

(1 ) F F Q1= 1= L + K L K

is

Derivation of the MRTS

The

ratio terms in (4) are the marginal products of each input, which hold the other input constant. Thus,
(1 )
Inserting

F F MP , MP L K L K

(5) into (4) we reach,

1 MPL L + MPK K =
Lecture 7, Chapter 7

(1 )

Derivation of the MRTS

Solving

(6) for the change in K

(1 ) MP K = L L MP K

Then

dividing (7) by the change in P,

(1 ) MPL K MRTS = = L MPK

MRTS

(8).

is the expression on the right of

Equilibrium Condition

Slope of ISO Quant must be equal to slope of ISO Cost OR = W/R

MRTS