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SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION
• Profits and the aims of the firm
• Long-run and short-run production: – fixed and variable factors
• The law of diminishing returns
• The short-run production function:– total physical product (TPP)
– average physical product (APP)
– marginal physical product (MPP)
– the graphical relationship between TPP, APP and MPP
• Profits and the aims of the firm
• Long-run and short-run production: – fixed and variable factors
• The law of diminishing returns
• The short-run production function:– total physical product (TPP)
– average physical product (APP)
– marginal physical product (MPP)
– the graphical relationship between TPP, APP and MPP
Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Number of farm workers
To
nne
s o
f wh
eat
pro
du
ced
pe
r ye
ar
Number of workers
012345678
TPP 0 310243640424240
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
To
nne
s o
f wh
eat
pro
du
ced
pe
r ye
ar TPP
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
To
nne
s o
f wh
eat
pro
du
ced
pe
r ye
ar TPP
a
b
Diminishing returnsset in here
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
To
nne
s o
f wh
eat
pro
du
ced
pe
r ye
ar TPP
a
b
d
Maximum output
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Number offarm workers (L)
Ton
nes
of w
heat
per
yea
r
TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
Number offarm workers (L)
TPP = 7
L = 1
MPP = TPP / L = 7
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
MPP
Number offarm workers (L)
Number offarm workers (L)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
APP
MPP
APP = TPP / L
Number offarm workers (L)
Number offarm workers (L)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
Diminishing returnsset in here
Number offarm workers (L)
Number offarm workers (L)
b
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
d
d
Number offarm workers (L)
Number offarm workers (L)
Maximumoutputb
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
b
d
d
Number offarm workers (L)
Number offarm workers (L)
Slope = TPP / L= APP
c
c
LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION
• Economies of scale– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
– economies of scope
• Economies of scale– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
– economies of scope
LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION
• Diseconomies of scale
• External economies and diseconomies of scale
• Optimum combination of factorsMPPa/Pa = MPPb/Pb ... = MPPn/Pn
• Diseconomies of scale
• External economies and diseconomies of scale
• Optimum combination of factorsMPPa/Pa = MPPb/Pb ... = MPPn/Pn
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
– slope and position of the isocost
– shifts in the isocost
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
– slope and position of the isocost
– shifts in the isocost
Unitsof K402010 6 4
Unitsof L 512203050
Point ondiagram
abcde
a
Units of labour (L)
Un
its o
f ca
pita
l (K
)An isoquantAn isoquant
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
Unitsof K402010 6 4
Unitsof L 512203050
Point ondiagram
abcde
a
b
Units of labour (L)
Un
its o
f ca
pita
l (K
)An isoquantAn isoquant
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
An isoquantAn isoquant
Unitsof K402010 6 4
Unitsof L 512203050
Point ondiagram
abcde
a
b
c
de
Units of labour (L)
Un
its o
f ca
pita
l (K
)
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14 16 18 20
Un
its o
f ca
pita
l (K
)
Units of labour (L)
g
hK = 2
L = 1
isoquant
MRS = 2 MRS = K / L
Diminishing marginal rate of factor substitutionDiminishing marginal rate of factor substitution
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14 16 18 20
Un
its o
f ca
pita
l (K
)
Units of labour (L)
g
h
j
k
K = 2
L = 1
K = 1
L = 1
Diminishing marginal rate of factor substitutionDiminishing marginal rate of factor substitution
isoquant
MRS = 2
MRS = 1
MRS = K / L
0
10
20
30
0 10 20
An isoquant mapAn isoquant mapU
nits
of c
ap
ital (
K)
Units of labour (L)
I1
0
10
20
30
0 10 20
I2
Un
its o
f ca
pita
l (K
)
Units of labour (L)
An isoquant mapAn isoquant map
I1
0
10
20
30
0 10 20
I2
I3
Un
its o
f ca
pita
l (K
)
Units of labour (L)
An isoquant mapAn isoquant map
I1
0
10
20
30
0 10 20
I2
I3
I4
Un
its o
f ca
pita
l (K
)
Units of labour (L)
An isoquant mapAn isoquant map
I1
0
10
20
30
0 10 20
I1I2
I3
I4
I5
Un
its o
f ca
pita
l (K
)
Units of labour (L)
An isoquant mapAn isoquant map
0
5
10
15
20
25
30
0 5 10 15 20 25 30 35 40
An isocostAn isocost
Units of labour (L)
Un
its o
f ca
pita
l (K
)
Assumptions
PK = £20 000 W = £10 000
TC = £300 000
TC = £300 000
a
0
5
10
15
20
25
30
0 5 10 15 20 25 30 35 40
Units of labour (L)
Un
its o
f ca
pita
l (K
)
TC = £300 000
a
b
Assumptions
PK = £20 000 W = £10 000
TC = £300 000
An isocostAn isocost
0
5
10
15
20
25
30
0 5 10 15 20 25 30 35 40
Units of labour (L)
Un
its o
f ca
pita
l (K
)
TC = £300 000
a
b
c
Assumptions
PK = £20 000 W = £10 000
TC = £300 000
An isocostAn isocost
0
5
10
15
20
25
30
0 5 10 15 20 25 30 35 40
Units of labour (L)
Un
its o
f ca
pita
l (K
)
TC = £300 000
a
b
c
d
Assumptions
PK = £20 000 W = £10 000
TC = £300 000
An isocostAn isocost
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Least-cost combination of factors for a given output
– point of tangency
– comparison with marginal productivity approach
• Highest output for a given cost of production
• Least-cost combination of factors for a given output
– point of tangency
– comparison with marginal productivity approach
• Highest output for a given cost of production
0
5
10
15
20
25
30
35
0 10 20 30 40 50
Finding the least-cost method of productionFinding the least-cost method of production
Units of labour (L)
Un
its o
f ca
pita
l (K
)
Assumptions
PK = £20 000W = £10 000
TC = £200 000
TC = £300 000
TC = £400 000
TC = £500 000
0
5
10
15
20
25
30
35
0 10 20 30 40 50
Units of labour (L)
Un
its o
f ca
pita
l (K
)Finding the least-cost method of productionFinding the least-cost method of production
TPP1
0
5
10
15
20
25
30
35
0 10 20 30 40 50
Units of labour (L)
Un
its o
f ca
pita
l (K
)Finding the least-cost method of productionFinding the least-cost method of production
TC = £400 000r
TPP1
0
5
10
15
20
25
30
35
0 10 20 30 40 50
Units of labour (L)
Un
its o
f ca
pita
l (K
)Finding the least-cost method of productionFinding the least-cost method of production
TC = £400 000
TC = £500 000s
r
tTPP1
Finding the maximum output for a given total costFinding the maximum output for a given total cost
TPP1TPP2
TPP3
TPP4
TPP5
Un
its o
f ca
pita
l (K
)
Units of labour (L)
O
O
Isocost
Un
its o
f ca
pita
l (K
)
Units of labour (L)
TPP1TPP2
TPP3
TPP4
TPP5
Finding the maximum output for a given total costFinding the maximum output for a given total cost
O
r
v
Un
its o
f ca
pita
l (K
)
Units of labour (L)
TPP1TPP2
TPP3
TPP4
TPP5
Finding the maximum output for a given total costFinding the maximum output for a given total cost
O
s
u
Un
its o
f ca
pita
l (K
)
Units of labour (L)
TPP1TPP2
TPP3
TPP4
TPP5
r
v
Finding the maximum output for a given total costFinding the maximum output for a given total cost
O
t
Un
its o
f ca
pita
l (K
)
Units of labour (L)
TPP1TPP2
TPP3
TPP4
TPP5
r
v
s
u
Finding the maximum output for a given total costFinding the maximum output for a given total cost
O
K1
L1
Un
its o
f ca
pita
l (K
)
Units of labour (L)
TPP1TPP2
TPP3
TPP4
TPP5
r
v
s
u
t
Finding the maximum output for a given total costFinding the maximum output for a given total cost
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