Theory of production and cost

Rajneesh Mishra
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Module- 2

The Theory of Production

Relationship between factors of production and the output of goods and services

How output changes when inputs change

Based on short run

Producers only change variable inputs

Long run
Period long enough for all inputs to vary
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Production Function

States the relationship between inputs and outputs 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

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Production Function

Mathematical representation of the relationship: Q = f (K, L,) Output (Q) is dependent upon the amount of capital (K), labour (L)

Analysis of Production Function: Short Run

In the short run at least one factor fixed in supply but all other factors 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 effectively.

Analysis of Production Function: Short Run

In times of rising sales (demand) firms can increase labour and capital but only up to a certain level they will be limited by the amount of space. In this example, land is the fixed factor which cannot be altered in the short run.

Analysis of Production Function: Short Run

If demand slows down, the firm can reduce its variable factors in this example it reduces its labour and capital but again, land is the factor which stays fixed.

Analysis of Production Function: Short Run

If demand slows down, the firm can reduce its variable factors in this example, it reduces its labour and capital but again, land is the factor which stays fixed.

Analysing the 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 not just short term capacity Associated with a change in the scale of production The period of time varies according to the firm and the industry In electricity supply, the time taken to build new capacity could be many years; for a market stall holder, the long run could be as little as a few weeks or months!
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Analysis of Production Function: Long Run

In the long run, the firm can change all its factors of production thus increasing its total capacity. In this example it has doubled its capacity.
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Law of Variable Proportions

Output will change as one input is varied

Other inputs are held constant

Examples

Farming and using fertilizer too much of a good thing is a bad thing

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SHORT-RUN THEORY OF PRODUCTION

The short-run production function:

total product (TP) average product (AP)

AP = TP/L
marginal product (MP)

MP = TP/L
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Wheat production per year from a particular farm

Number of Workers (L) (a) 0 1 2 (b) 3 (c) 4 5 6 (d) 7 42 6 -2
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TP 0 3 10 24 36 40 42

AP (=TP/L) -

MP (=TP/L)

3 3 7 5 14 8 12 9 4 8 2 7 0

Wheat production per year from a particular farm

Number of Workers (L) (a) 0 1 2 (b) 3 (c) 4 5 6 (d) 7 42 6 -2
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TP 0 3 10 24 36 40 42

AP (=TP/L) -

MP (=TP/L)

3 3 7 5 14 8 12 9 4 8 2 7 0

Wheat production per year from a particular farm

Number of Workers (L) (a) 0 1 2 (b) 3 (c) 4 5 6 (d) 7 42 6 -2
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TP 0 3 10 24 36 40 42

AP (=TP/L) -

MP (=TP/L)

3 3 7 5 14 8 12 9 4 8 2 7 0

Three Stages of Production

Stage I: Increasing Returns

Each input contributes more than the previous Total output rises at a faster rate Total production is growing

Stage II: Diminishing Returns

But by smaller amounts

Known as principle of diminishing returns

Total production is decreasing

Stage III: Negative Returns

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Wheat production per year from a particular farm d

Tonnes of wheat produced per year
40

TP
Maximum output

30

Diminishing returns set in here

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10

0 0 1 2 3 4 5 6 7 8

Number of farm workers

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Tonnes of wheat per year

Wheat production per year from a particular farm

40

TP

30

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Diminishing returns set in here

Number of farm workers (L)

10

0 0 1 2

Tonnes of wheat per year

14 12 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7

AP
Number of farm workers (L)

MP8

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Wheat production per year from a particular d farm

Tonnes of wheat per year
40

TP
Maximum output

30

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10

0 0 1 2 3 4 5 6 7 8

Tonnes of wheat per year

14 12 10 8 6 4 2 0 -2 0 1 2

Number of farm workers (L)

AP
d
3 4 5 6 7 8

MP

Number of farm workers (L)

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Average and Marginal Product Curves

AP curve slopes upward when it is below MP AP slopes downward when it is above MP AP is flat where the two curve cross
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Production with Two Variable Inputs

Most production processes use many variable inputs: labor, capital, materials, and land Capital inputs include assets such as physical plant, machinery, and vehicles Consider a firm that uses two inputs in the long run:

Labor (L) and capital (K) Each of these inputs is homogeneous Firms production function is Q = F(L,K)

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Production with Two Variable Inputs

When a firm has more than one variable input it can produce a given amount of output with many different combinations of inputs

E.g., by substituting K for L

Productive Inputs Principle:

Increasing the amounts of all inputs strictly increases the amount of output the firm can produce
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Isoquants

An isoquant identifies all input combinations that efficiently produce a given level of output

Note the close parallel to indifference curves Can think of isoquants as contour lines for the hill created by the production function

Firms family of isoquants consists of the isoquants for all of its possible output levels
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Isoquant Example

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Properties of Isoquants

Do not slope upward The boundary between input combinations that produce more and less than a given amount of output Isoquants from the same technology do not cross Higher-level isoquants lie farther from the origin
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Substitution Between Inputs

Rate that one input can be substituted for another is an important factor for managers in choosing best mix of inputs Shape of isoquant captures information about input substitution

Points on an isoquant have same output but different input mix Rate of substitution for labor with capital is equal to negative the slope

Marginal Rate of Technical Substitution for input X with input Y: the rate as which a firm must replace units of X with units of Y to keep output unchanged starting at a
given input combination
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MRTS and Marginal Product

Recall the relationship between MRS and marginal utility Parallel relationship exists between MRTS and marginal product

MRTS LK

MPL MPK

The more productive labor is relative to capital, the more capital we must add to make up for any reduction in labor; the larger the MRTS
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Declining MRTS

Often assume declining MRTS Here MRTS declines as we move along the isoquant, increasing input X and decreasing input Y

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Isocost curves
Various combinations of inputs that a firm can buy with the same level of expenditure
PLL + PKK = M where M is a given money outlay.
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Capital

Isocost curves

M/PK

Slope = -PK /PL

M/PL

Labor

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Maximization of output for given cost

Capital

300 200
100

Labor

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MPL/PL = MPK/PK
Capital

300 200
100

Labor
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Expansion Path

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Returns to scale
If the firm increases the amount of all inputs by the same proportion: Increasing returns means that output increases by a larger proportion Decreasing returns means that output increases by a smaller proportion Constant returns means that output increases by the same proportion
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Output elasticity
The percentage change in output resulting from 1 percent increase in all inputs.

e > 1 ==> increasing returns e < 1 ==> decreasing returns e = 1 ==> constant returns

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Returns to Scale
Types of Returns to Scale Proportional change in ALL inputs yields Same proportional change in output Greater than proportional change in output Less than proportional change in output What happens when all inputs are doubled?

Constant
Increasing Decreasing

Output doubles
Output more than doubles Output less than doubles

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Returns to Scale

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