MICROECONOMICS

THEORY OF PRODUCTION WITH ONE VARIABLE INPUT

TOPICS TO BE DISCUSSED The production function How output varies with the application of productive inputs in both the short-run and the long-run. Total, Marginal and Average Products The Significance of the Average-Marginal Distinction

PRODUCTION FUNCTION The amount of output produced depends upon the inputs used in the production process The production function specifies the maximum amount of output which can be produced with specific level of inputs, given the level of existing technological know-how In general form, a production function may be expressed as: Q = F(K,L) where Q is output quantity K is capital L is labour

The Production Function Inputs – the factors of production classified as: Land – all natural resources of the earth Price paid to acquire land = Rent Labour – all physical and mental human effort involved in production Price paid to labour = Wages Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to production Price paid for capital = Interest

The Input-Output Relationship Production is the creation of output that creates utility. Production requires inputs : land, labour, capital, technology, energy, etc. The production function involves the transformation of inputs into output.

Fixed and Variable Inputs Variable Input : one whose quantity may be varied in the short run and the long run. Fixed Input : one whose quantity may not be varied in the short run, but may be varied in the long run.

ANALYSIS OF PRODUCTION FUNCTION Short Run : production function with one variable input, during which at least one of the inputs used in the production process cannot be altered. Long Run : production function with all variable inputs, during which all the inputs can be altered.

Analysis of Production Function: Short Run In the short run at least one factor is fixed in supply but all other factors are capable of being changed Reflects ways in which firms respond to changes in output (demand) Can increase or decrease output using more or less of some factors but some likely to be easier to change than others Increase in total capacity only possible in the long run

Short-Run Production Function Fig illustrates several properties commonly found in short run production functions : No variable input  no output. Output initially increases at an increasing rate as the variable input increases, thereafter it increases at a decreasing rate. Eventually output may decline as variable inputs are increased. These properties are not universal.

Analysis of Production Function: Long Run The long run is defined as the period of time taken to vary all factors of production By doing this, the firm is able to increase its total capacity Associated with a change in the scale of production - to study the returns to scale The period of time varies according to the firm and the industry The returns to scale are due to internal and external economies and diseconomies of scale of production

Total, Marginal and Average Products Total Product : total output produced for a given amount of variable input. Marginal Product : the change in total product as a result of a unit change in the variable input (ceteris paribus). MPL = ∆Q/∆L

Total, Marginal and Average Products The marginal product concept is vital in running an enterprise, as it plays a pivotal role in the calculation of the firms output level. Average Product : APL = Q/L Average product is known as labour productivity when the variable input is labour.

The Relationships among Total, Marginal, and Average Product Curves

STAGES OF PRODUCTION Fig. illustrates In stage 1 TP increases upto point A at increasing rate, after that it increases at diminishing rates. This stage is stage of increasing returns because average product of the variable factor increases. In stage 2 TP continues to increase at diminishing rates upto point C. This stage is stage of diminishing returns as both the average and marginal product of the variable factor diminishes. In stage 3 TP declines , average product also declines and marginal product becomes negative.

The Relationships among Total, Marginal, and Average Product Curves When the marginal product curve lies above the average product curve, the average product curve must be rising When the marginal product curve lies below the average product curve, the average product curve must be falling. The two curves intersect at the maximum value of the average product curve.

The Practical Significance of the Average-Marginal Distinction The general rule for allocating inputs efficiently is to allocate the next unit of input to the production activity where its marginal product is highest. A rational producer will seek to produce in stage 2 Stage 1 and 3 represent non-economic region in production function DO NOT allocate resources to the activity with the highest average product!!!

Prepared by Anuradha Mittal Associate Professor Department of Economics PG Government College, Sector 11, Chandigarh