Reveals functional relation between factors of input and output. PRODUCTION FUNCTION Reveals functional relation between factors of input and output.

The Technology of Production The Production Process Combining inputs or factors of production to achieve an output Categories of Inputs (factors of production) Land Capital Labor Entrepreneur

The Technology of Production Production Function: Indicates the highest output that a firm can produce for every specified combination of inputs given the state of technology. Shows what is technically feasible when the firm operates efficiently.

The Technology of Production The production function for two inputs: Q = F(K,L) Q = Output, K = Capital, L = Labor For a given technology

Short Run vs Long Run S-R is the period of time during which at least one factor of production is fixed - cannot be increased. L-R is the period of time during which all factors of production can be varied.

The Short Run / Law of Variable proportions Stages Law of increasing returns Law of diminishing returns Law of negative returns

Production with One Variable Input (Labor) Amount Amount Total Average Marginal of Labor (L) of Capital (K) Output (Q) Product Product 0 10 0 --- --- 1 10 10 10 10 2 10 30 15 20 3 10 60 20 30 4 10 80 20 20 5 10 95 19 15 6 10 108 18 13 7 10 112 16 4 8 10 112 14 0 9 10 108 12 -4 10 10 100 10 -8

Production with One Variable Input (Labor) Observations: The average product of labor (AP), or output per worker, increases and then decreases.

Production with One Variable Input (Labor) Observations: The marginal product of labor (MP), or output of the additional worker, increases rapidly initially and then decreases and becomes negative..

Production with One Variable Input (Labor) Output per Month A B C D 112 Total Product B increase at increasing rate B to D incr at diminishing rate D max prd. n then decline in TP 60 1 2 3 4 5 6 7 8 9 10 Labor per Month

Production with One Variable Input (Labor) Output per Month E Marginal Product Observations: Left of E: MP > AP & AP is increasing Right of E: MP < AP & AP is decreasing E: MP = AP & AP is at its maximum 30 20 Average Product 10 1 2 3 4 5 6 7 8 9 10 Labor per Month

Production with One Variable Input (Labor) Observations: When MP = 0, TP is at its maximum When MP > AP, AP is increasing and TP is increasing at increasing rate. When MP < AP, AP is decreasing and TP is increasing at diminishing rate. When MP = AP, AP and TP are at maximum

Production with One Variable Input (Labor) AP = slope of line from origin to a point on TP, lines b, & c. MP = slope of a tangent to any point on the TP line, lines a & c. Output per Month Output per Month D 112 30 C E 20 60 B 10 A Labor per Month Labor per Month 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Law of variable output Stage I Stage II Stage III TP in increasing at increasing rate, MP is increasing (reaches it max and then declines somewhere in this stage) and AP is also increasing but less than MP. Stage II TP in increasing at diminishing rate, MP is declining and AP is declining and is higher than MP. Stage III TP reaches its max and then start to decline, MP is ZERO when TP is max and AP is declining.

The Law of Diminishing Marginal Returns Stage of operation The Law of Diminishing Marginal Returns As the use of an input increases in equal increments, a point will be reached at which the resulting additions to output decreases (i.e. MP declines).

Long Run Production Function Returns to Scale Measuring the relationship between the scale (size) of a firm and output 1) Increasing returns to scale: output more than doubles when all inputs are doubled Utilizing Economies of Scale

Returns to Scale Measuring the relationship between the scale (size) of a firm and output Constant returns to scale: output doubles when all inputs are doubled Moving towards Optimum

Returns to Scale Measuring the relationship between the scale (size) of a firm and output 3) Decreasing returns to scale: output less than doubles when all inputs are doubled Decreasing efficiency with large size Reduction of entrepreneurial abilities Diseconomies of scale