Introduction to Economics Theory of Production Lecture#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 capital Organisation Labour Land Consists of all natural resources like agricultural plots , forests water reserves like rivers and oceans etc Consists of all produced means of production like machinery, buildings etc Enterprises which assumes the responsibility of risk bearing,organising the business activity, Consists of all working people in economy such as carpenters laborers, clerks etc

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 proportions Units of Labor TP Marginal Product ∆Q/ ∆L Average product Q/ L 1 10 2 25 15 12.5 Zone I MP> AP 3 45 20 4 60 15 ZoneII MP=AP 5 70 14 6 75 12.5 7 10.7 8 72 -3 9 ZoneIII MP< AP 9 63 -9

d c Slope = TPP / L = APP Maximum output b b Zone I Zone II Zone III c Total Product b Number of workers (L) b Zone I Zone II Zone III c Average and Marginal Products APL d Number of workers (L) MPL

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 a Output is I000 meter clothes Units of K 40 20 10 6 4 of L 5 12 20 30 50 Point on diagram a b c d e Units of capital (K) b I000 meter I000 meter c d I000 meter e Units of labour (L)

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

An isoquant map Units of capital (K) I5 I4 I3 I2 I1 Units of labour (L)

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

Marginal rate of Technical substitution MRTS = 2 MRTS = DK / DL DK = 2 h DL = 1 Units of capital (K) isoquant Units of labour (L)

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

Diminishing marginal rate of technical substitution MRS = 2 MRTS = DK / DL DK = 2 h DL = 1 Units of capital (K) j MRS = 1 DK = 1 k DL = 1 isoquant Units of labour (L)

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

An isocost Assumptions PK = £20 000 W = £10 000 TC = £300 000 Units of capital (K) b TC = £300 000 Units of labour (L)

Finding the maximum level of output maximum level of output will be there when highest ISO quant will touch the lowest Iso cost line s TC = £500 000 Units of capital (K) TC = £400 000 r MRTS=w/r t TPP1 Units of labour (L)