Today Content • Production • Factors of production in SR & LR; • Production function-Short run analysis • Law of variable proportions • Returns to Scale Production Decisions of a Firm 1. Production Technology: Production: Inputs are transformed to Output 2. Cost Constraints: Input price 3. Input Choices:
Theory of the firm
Explanation of how a firm makes cost-minimizing production decisions and how its cost varies with its output. Factors of Production Fixed and Variable factors of production
Fixed: not varying at each unit of output
Variable: varying at each unit of output
The Short Run versus the Long Run Short Run: Long Run: Period of time in Amount of time which quantities of one or more needed to make all production production factors cannot be inputs variable. changed.
period in which firms can Period sufficiently long that all factors adjust production by changing (both fixed and variable) can be variable factors. adjusted. The Production function Production function Functional relationship between Input and output
q = F(K, L) Returns
Returns to a factor Returns to scale Returns to Scale Concepts in production analysis Total product Total amount of output produced (measured in physical units)
Average product Output per unit of input. (Total output divided by total units of input) Average product of labor = Output/labor input = q/L
𝚫𝒒 Marginal product ( ) 𝚫𝑳 Additional output produced as an input is increased by one unit. or Extra output produced by 1 additional unit of that input while other inputs are held constant. or Addition made to total product when one more unit of input is employed. PRODUCTION WITH ONE VARIABLE INPUT (LABOR) The Law of Diminishing Returns
The law of diminishing marginal
returns Principle that as the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease. • Average Product diminishes after the point where, Marginal Product = Average Product.
• Why? PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
The Effect of Technological Improvement
2015 Figure 6.2 Labor productivity (output 1955 per unit of labor) can increase if there are improvements in technology, 1900 even though any given production process exhibits diminishing returns to labor. As we move from point A on curve O1 to B on curve O2 to C on curve O3 over time, labor productivity increases. Labor Productivity
Labor productivity Average Causes of labor productivity growth
product of labor for an entire industry or for the economy as Stock of capital Total amount of capital available a whole. for use in production.
Technological change Development of new technologies allowing factors of production to be used more effectively. Production with Two Variable Inputs Isoquants
Figure 6.8
Isoquant Describing the
Production of Wheat A wheat output of 13,800 bushels per year can be produced with different combinations of labor and capital. The more capital-intensive production process is shown as point A, the more labor- intensive process as point B. The marginal rate of technical substitution between A and B is 10/260 = 0.04. Isoquant Curve showing all possible combinations of inputs that yield the same output. Input Flexibility Managers can usually obtain a particular output by substituting one input for another.
Diminishing Marginal Returns
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.
Diminishing MRTS (MPL ) / (MPK ) = −(K / L) = MRTS TABLE 6.4 Production with Two Variable Inputs Labour Input Capital Input 1 2 3 4 5 1 20 40 55 65 75 2 40 60 75 85 90 3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120
PRODUCTION WITH TWO VARIABLE INPUTS • Substitution Among Inputs ● 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. Figure 6.5 MRTS = − Change in capital input/change in labor input Marginal Rate of Technical = − ΔK/ΔL (for a fixed level of q) Substitution
Isoquants are downward sloping
and convex. The slope of the isoquant at any point measures the marginal rate of technical substitution—the ability of the firm to replace capital with labor while maintaining the same level of output. On isoquant q2, the MRTS falls from 2 to 1 to 2/3 to 1/3.
(MPL ) / (MPK ) = −(K / L) = MRTS (6.2)
Production Functions—Two Special Cases Fixed-proportions production function Production function with L-shaped isoquants, so that only one combination of labor and capital can be used to produce each level of output. Returns to Scale Returns to Scale When all inputs are doubled then Output ● Increasing returns to scale Situation in which output increases more than proportionately when all inputs are increased in a More than doubles certain proportion.
● constant returns to scale
Situation in which output changes in the same Doubles proportion as the change in inputs.
● decreasing returns to scale
Situation in which output increases less than proportionately when all inputs are increased in a Less than doubles certain proportion. Problems
