Introduction to Economics

Theory of ProductionLecture#7

Theory of Production

• It deals with the supply side of the market

• It explains the behavior of the producers

• Shows how firms can produce efficiently, and how cost of production changes with the change in input prices and level of production

Factors of Production

• A factor of production is any aspect of environment which has influence on production

• Economics classified the factors of production into four broad categories

Labour

Consists of all working people in economy such as carpenters laborers, clerks etc

Land

Consists of all natural resources like agricultural plots , forests water reserves like rivers and oceans etc

capital

Consists of all produced means of production like machinery, buildings etc

Organisation

Enterprises which assumes the responsibility of risk bearing,organising the business activity,

The Firm• The firm may be defined as the business enterprise involved in

producing goods and services• It is a technical unit in which inputs are converted into output

for sale to consumers, other business firms and government at different levels

• The main objective of the firm is to maximize its profit which may be defined as the difference between its revenue and its costs

• Π=TR-TC• Thus in order to maximize the profit, the firm will have to

make this difference as large as possible

Production Periods

• The short run is defined as a situation in which the firm has at least one fixed factor of production. The short run is such that the firm does not have sufficient time to vary all its inputs

• The Long Run is the time period during which the firm is able to vary all its factor inputs. There are no fixed productive factors in long run

The production Function

• The Production function shows the maximum level of output that can be produced from all specific combinations of inputs, given the state of technology.

Alternative Input

Combinations

Different Quantities of Output

Production Function

The Short Run Production function

• If we assume that a firm uses capital (K) and labour (L) to produce output(Q) Than the production function will be

• Q=F(K,L)• It means production depends on capital and labour• As one factor of production is fixed in short run, suppose

its capital than production function will be• Q=f(L)• It shows how output varies as units are labor are added to

fixed amount of capital its relationship will also be known as law of variable propotions

Important Concepts

• Total Product

TP refers to the total output of the firm per period of time.

• Marginal product=∆Q/ ∆L

MP is the change in total product resulting from using an additional unit of variable factor

• Average Product= Q/ L

Average product is the total product divided by the number of units of variable factor. This is simply total output per unit of variable factor

Law of variable proportionsUnits of Labor

TP Marginal Product∆Q/ ∆L

Average product Q/ L

1 10 10 10

2 25 15 12.5 Zone I MP> AP

3 45 20 15

4 60 15 15 ZoneII MP=AP

5 70 10 14

6 75 5 12.5

7 75 0 10.7

8 72 -3 9 ZoneIII MP< AP

9 63 -9 7

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Tota

l Pro

duct

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Aver

age

and

Mar

gina

l Pro

duct

s

APL

MPL

b

b

d

d

Number of workers (L)

Number of workers (L)

Slope = TPP / L= APP

c

c

Maximumoutput

Zone I Zone IIZone III

Relations between MP & AP• When the marginal product is rising the total product increases

at the increasing rate till the point b• When the marginal product is positive the total product is

increasing. As it means that every additional worker would positively contribute in total output. TP is increasing till the point d.

• When the marginal product is negative the total product falls. It means every additional worker is negatively contributing in total product

• When the marginal product is zero the TP neither rises nor falls means reaches at its maximum. It is the point when seven workers are being employed

Relations between MP & AP• When MP is greater than AP, Average product

will rise till the four workers• When marginal product is less than average

product, AP will fall after the employment of fifth worker

• When MP=AP average product is at its maximum

Three Stages/zones of production• Stage 1 is characterized by rising APL. this is the stage of increasing

returns• Stage 2 is characterized by the equal APL And MPL. It is known as

constant returns • Stage 3 is characterized by the fall in both APL & MPL. This is known as

diminishing returns• Analyzing this situation economists argue that first stage is not suitable for

production as total productivity is increasing and still has the more potential to increase by using additional workers

• Third stage is also not suitable as its showing the diminishing returns duet o decrease in total productivity

• Thus second zone is quite suitable for production as TP is maximum and AP & MP are also equal here.

Long Run Production Function

• In LR both K and L are variable• For LR production function we use ISO quant

curve and ISO cost line for analysis• An Iso quant curve is the curve that shows the

various combinations of inputs that will produce the same amount of output

An isoquant

Unitsof K402010 6 4

Unitsof L 512203050

Point ondiagramabcde

a

b

c

de

Units of labour (L)

Uni

ts o

f cap

ital (

K)

0

5

10

15

20

25

30

35

40

45

0 5 10 15 20 25 30 35 40 45 50

Output is I000 meter clothes

I000 meter

I000 meter

I000 meter

ISO Quant Map

• ISO quant map contains infinite number of ISO quant curves representing different level of output.

• ISO quant record successively higher levels of output, the farther away they are from the origin.

• A typical ISO quant curve is convex to origin or in northeasterly direction

0

10

20

30

0 10 20

I1I2

I3

I4

I5

Uni

ts o

f cap

ital (

K)

Units of labour (L)

An isoquant map

Slope of ISO quant Curve

• The slope of ISO Quant curve is called the Marginal Rate of Technical Substitution (MRTS).

• MRTS is the amount by which the quantity of one input can be reduced when one more unit of another input is added while holding the output constant

• MRTS of labor for capital is the amount by which the capital input can be reduced, holding the output constant, while using one more unit of labor

0

2

4

6

8

10

12

14

0 2 4 6 8 10 12 14 16 18 20 22

Uni

ts o

f cap

ital (

K)

Units of labour (L)

g

hDK = 2

DL = 1

isoquant

MRTS = 2 MRTS = DK / DL

Marginal rate of Technical substitution

Diminishing MRTS

• Along any ISO quant the slope becomes flatter and the MRTS diminishes

• When relatively large amount of capital is used the producer will forgo less amount of labor for production

0

2

4

6

8

10

12

14

0 2 4 6 8 10 12 14 16 18 20

Uni

ts o

f cap

ital (

K)

Units of labour (L)

g

h

j

k

DK = 2

DL = 1

DK = 1

DL = 1

Diminishing marginal rate of technical substitution

isoquant

MRS = 2

MRS = 1

MRTS = DK / DL

Production Functions---- Two Special cases

• Two extreme cases of production function shows the possible range of input substitution in the production process

• If the two inputs are perfect substitutes for each other ,here the MRTS is constant at all points than ISO will be linear

• If one unit of output can be produced with fixed proportion of inputs than the ISO quant curve will be L-shaped

Returns to Scale• Returns to scale is the rate at which output increases

as inputs are increased proportionately• Increasing Returns to scale happens if output is more

than doubled , when inputs are doubled • Constant returns to scale means output is doubled if

inputs are doubled• Decreasing returns to scale applies when output is

less than doubled when inputs are doubled

ISO Cost line

• ISO cost line shows the budget constraint of the producer

• ISO cost line shows the different combination of two inputs that producer can purchase within the given cost.

• The budget constraint of producer can be shown as :LPL+ KPK=C

• The slope of Iso cost line is defined as price of both inputs symbolized as w/r

0

5

10

15

20

25

30

0 5 10 15 20 25 30 35 40

Units of labour (L)

Uni

ts o

f cap

ital (

K)

TC = £300 000

a

b

Assumptions

PK = £20 000 W = £10 000TC = £300 000

An isocost

0

5

10

15

20

25

30

35

0 10 20 30 40 50

Units of labour (L)

Uni

ts o

f cap

ital (

K)Finding the maximum level of output

maximum level of output will be there when highest ISO quant will touch the lowest Iso cost line

TC = £400 000

TC = £500 000s

r

tTPP1

MRTS=w/r