Production Theory and Estimation
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Aqib ArshadProduction Theory and Estimation
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Aqib ArshadChapter 6
Production Theory
and Estimation
Production: refers to the transformation of
inputs or resources into output of G & S .
Inputs: are the resources used in the
production of G & S. e.g. Labour, capital, land
or natural resources
Fixed Inputs: are those that cannot be readily
changed during the time period under
consideration e.g plant
Variable Inputs: are those that can be varied
easily and on a very short notice e.g raw
material
Short Run
◦ At least one input is fixed
Long Run
◦ All inputs are variable
A production function can be an equation,
table or graph presenting the maximum
amount of a commodity that a firm can
produce from a given set of inputs during a
period of time.
If we assume , only one type of commodity
produce and use only 2 inputs, L, K
Q = ƒ (L, K)
Where Q, as above, is the output, L and K are
the quantities of labour and capital and
ƒ shows the functional relation between the
inputs and output.
Short run production Function: shows the
maximum quantity of G & S that can be
produced by a set of inputs, assuming the
amount of at least one of the inputs used
remains unchanged.
Long run production function: shows the
maximum quantity of G & S that can be
produced by a set of inputs, assuming the
firm is free to vary the amount of all the
inputs being used.
Total Product TP = Q = f(L)
TP
Marginal Product MPL =
L
Average Product TP
APL =
L
As the proportion of one factor (L) in a
combination of factor(land) increases , after a
point the average and marginal product of
that factor will diminish.
L Q MPL APL EL
0 0 - - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1
Stage-1 Increasing return to
scale: (0-2) MP increases, AP
increases, TP increases
Stage-11(3-5) decreasing return
to scale: MP decreases, AP
decreases, TP increases and
constant
Stage-111 negative return to
scale(5-6): MP negative, AP
decreases, TP decreases
Rational firms should only be
operating in stage11.
Why not stage-111 because TP
decreases
Why not stage-1 underutilization
of resources
Presented by iso quant and iso cost approach:
Production Isoquant: shows combinations of two
inputs(L,K) that can produce the same level of output.
Higher iso quant, large output
Lower iso quant, lower output
Firms will only use combinations of two inputs that are in
the economic region of production, which is defined by
the portion of each isoquant that is negatively sloped.
Isoquants
Slope of Iso Quant is: Marginal Rate of
Technical Substitution (MRTS)
MRTS = -K/L = MPL/MPK
Prepared by Robert F.
Brooker, Ph.D. Copyright
©2004 by South-Western, a
division of Thomson Learning.
All rights reserved.
Slide 12
Isocost lines represent all combinations of two inputs
that a firm can purchase with the same total cost.
C=wL +rK C Total Cost
If c=100 w Wage Rate of Labor ( L)
W=10 r Cost of Capital ( K )
r= 10
C=wL +rK
100 = 10L + 10K so firm could either hire 10L or 10K or
any
Slope of iso cost is= w/r
Isocost Lines
AB C = $100, w = r = $10
A’B’ C = $140, w = r = $10
A’’B’’ C = $80, w = r = $10
AB* C = $100, w = $5, r = $10
1, 3, 4, 5
