1. 1 Part 2 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Introduction into the Theory of Production Introduction into the Theory of Production Factors of Production Factors of Production Production Function Production Function Short Run & Long Run Short Run & Long Run Isoquants Isoquants Production in Short Run Production in Short Run Total Product, Average and Marginal Product of Labor Total Product, Average and Marginal Product of Labor Law of Diminishing Returns Law of Diminishing Returns Production in Long Run Production in Long Run Isoquants Isoquants Marginal Rate of Technical Substitution Marginal Rate of Technical Substitution Returns to Scale Returns to Scale

2. 2 Production ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Inputs Output Production Process is combining inputs (factors of production) to achieve an output

3. 3 Production ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Labor (L) Labor (L) Inputs (Factors of Production) are inputs required for any type of production Capital (K) Capital (K) Land Land

4. 4 Production ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Production Function PF is a technical relationship between a certain level of inputs and the corresponding level of output PF indicates the highest output that a firm can produce for every specified combination of inputs given by the state of technology Q = f (K, L) Q…output K…capital L…labor

5. 5 Production ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Short-run period Only some factors of production may vary in quantity, all other factors of production are fixed in quantity Q = f (K 0, L) Long-run period All factors of production are variable K…fixed input L…variable input Q = f (K, L) K…variable input L…variable input

6. 6 Production ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Isoquants Curves showing all possible combinations of inputs that yield the same output Q1Q1 Q2Q2 L K Q3Q3 The isoquants emphasize how different input combinations can be used to produce the same output This information allows the producer to respond efficiently to changes in the markets for inputs

7. 7 Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Total Product (TP) Total output produced using given quantity of input Average Product of Labor (APL) Output per unit of input Marginal Product of Labor (MPL) Change of the output per the unit change of input

8. 8 Example – TP, APL, MPL Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union

9. 9 Example – TP, APL, MPL Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union TP APL MPL

10. 10 Example – TP, APL, MPL Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union MPL=0 Max TP

11. 11 Example – TP, APL, MPL Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union MPL>APL APL is increasing

12. 12 Example – TP, APL, MPL Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union MPL<APL APL is decreasing

13. 13 Example – TP, APL, MPL Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union MPL=APL Max APL

14. 14 Law of Diminishing Returns Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union

15. 15 Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union MPL begins to decrease Law of Diminishing Returns

16. 16 Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Example: The table below contains a hypothetical firm’s total production data for cars during a certain short period of time. Calculate total, marginal and average product from the production function. Graph the TP curve.

17. 17 Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union L TP APL MPL Solution : With the addition of what worker do diminishing returns first occur?

18. 18 Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union

19. 19 Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Example: Hypothetical firm’s production function is Q=10L+6L 2 -L 3. Determine Determine 1)TP, APL and MPL 2)TP, if the firm employes 3 workers 3)MPL, if the firm employes 2 workers 4)With the addition of what worker do diminishing returns first occur?

20. 20 Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Solution: 1)TP=Q=10L+6L 2 -L 3, APL=10+6L-L 2, MPL=10+12L-3L 2 2) TP(L=3)=10*3+6*9-27=57 3) MPL(L=2)=10+12*2-3*4=22 4) diminishing returns first occur when MPL achieves maximum d(MPL)=12-6L=0…L=2. d(MPL)=12-6L=0…L=2.

21. 21 Production in Short Run ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Law of Diminishing Returns Small Labor Input MPL increases due to specialization Large Labor Input MPL decreases due to inefficiencies (capital-labor ratio declines)

22. 22 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Long Run Period Production in Long Run All factors of production are variable Q1Q1 Q2Q2 L K Q3Q3 Isoquants analyze and compare the different combinations of K & L and output Law of diminishing returns is valid for both L and K

23. 23 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Production in Long Run Isoquant - example Q=KL Q=4

24. 24 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Production in Long Run Example: The table below contains a hypothetical firm’s total production data for goods during a certain period of time. Does the table describe the short or the long run? Why?

25. 25 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Production in Long Run Example: Use the production function Q = 4L 2 K 3. What is the output when labour is 5 units and capital is 7 units? Draw the relevant isoquant using other different combinations of L and K that brings the same output. Q=4*5 2 *7 3 =34 300 units

26. 26 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Substitution of Inputs Production in Long Run Managers want to determine what combination of inputs to use They must deal with the trade-off between inputs The slope of each isoquant gives the trade-off between two inputs while keeping output constant

27. 27 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Marginal Rate of Technical Substitution Production in Long Run

28. 28 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Marginal Rate of Technical Substitution Production in Long Run Q=KL Q=4 MRTS=2 MRTS=? MRTS decreases

29. 29 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Isoquants - properties Production in Long Run 1) Negative slope Using more of one input to produce the same level of output must imply using less of the other input 2) Convex to the origin MRTS is diminishing 3) The further the isoquant from the origin, the higher the level of output Using more of both inputs must increase output

30. 30 Change in output caused by the change in capital ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Marginal Rate & Marginal Productivity Production in Long Run Change in output Change in output caused by the change in labor

31. 31 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Marginal Rate & Marginal Productivity Production in Long Run Output is constant along the isoquant

32. 32 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Marginal Rate & Marginal Productivity Production in Long Run The marginal rate of technical substitution between two inputs is equal to the ratio of the marginal products of the inputs

33. 33 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Isoquants - types Production in Long Run MRTS is constant MRTS is 0 or infinity

34. 34 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Returns to Scale Production in Long Run What happens to output when all inputs are increased by a given percentage? 1) Increasing Returns output increases by a larger percentage than inputs 2) Constant Returns output increases by the same percentage as inputs 3) Decreasing Returns output increases by a smaller percentage than inputs

35. 35 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Increasing Returns to Scale Production in Long Run Isoquants get closer together L K Q=10 Q=20 Q=30 Q=40

36. 36 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Constant Returns to Scale Production in Long Run Isoquants are equidistant apart L K Q=10 Q=20 Q=30 Q=40

37. 37 ___________________________________________________________________________ ___________________________________________________________________________ This project is co-financed by the European Union Decreasing Returns to Scale Production in Long Run Isoquants become father apart L K Q=10 Q=20 Q=30 Q=40