Review

Risk: expected value and standard deviation Risk averse, risk loving and risk neutral Risk premium Ways to reduce risks:
diversication insurance collect more information

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Lecture 8: Production (chapter 6)

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Production

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Production

The theory of the rm describes how a rm makes cost-minimizing production decisions and how the rms resulting cost varies with its output. The production decisions of rms are analogous to the purchasing decisions of consumers, and can likewise be understood in three steps:
1. Production Technology 2. Cost Constraints 3. Input Choices

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Production Function

Factors of production: Inputs into the production process (e.g., labor, capital, and materials). Production Function: q = F (K , L) Production Function shows the highest output that a rm can produce for every specied combination of inputs. Production functions describe what is technically feasible when the rm operates eciently.

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The technology of production

The short run versus the long run Short Run
Period of time in which quantities of one or more production factors cannot be changed. eg. Wahaha Spring Water deciding production plan in November.

Long Run
Amount of time needed to make all production inputs variable. eg. Wahaha Spring Water to open a new plant next year.

The length of time required for the long run varies from sector to sector.
In the nuclear power industry for example, it can take many years to commission new nuclear power plant and capacity.

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Production Function with One variable input

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Average and Marginal Product

Average Product: Output per unit of a particular input.

Average product of labor = Output/labor input = q/L

Marginal Product: Additional output produced as an input is increased by one unit.

Marginal product of labor = Change in output/change in labor input = q /L

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Production curve with one variable input

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Production curve with one variable input

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Production curve with one variable input: Labor

Law of Diminishing Marginal Returns Principle that as the use of an input increases with other inputs xed, the resulting additions to output will eventually decrease.

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Malthus and Food Crisis

The law of diminishing marginal returns was central to the thinking of political economist Thomas Malthus (1766-1834). Malthus believed that the worlds limited amount of land would not be able to supply enough food as the population grew.
Population grows exponentially. Production grows less than linearly.

He predicted that as both the marginal and average productivity of labor fell, mass hunger and starvation would result. Fortunately, Malthus was wrong(although he was right about the diminishing marginal returns to labor).

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Malthus and Food Crisis

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Labor Productivity

Labor Productivity Average product of labor for an entire industry or for the economy as a whole. Factors that my aect labor productivity:
stock of capital: total amount of capital available for use in production. technological change: development of new technologies allowing factors of production to be used more eectively.

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Labor Productivity: Data

The level of output per employed person in the United States in 2006 was higher than in other industrial countries. Until the 1990s, productivity in the United States grew on average less rapidly than productivity in most other developed nations. Productivity growth during 1974-2006 was much lower in all developed countries than it had been in the past.
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Isoquant
Isoquant Curve showing all possible combinations of inputs that yield the same output.

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Isoquant Map

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Isoquant: Diminishing Marginal Returns

Holding the amount of capital xed at a particular levelsay 3, we can see that each additional unit of labor generates less and less additional output.

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Marginal Rate of Technical Substitution (MRTS)

MRTS: Amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant.

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Production Function: Two special cases

Isoquants When Inputs Are Perfect Substitutes. The MRTS is constant.

Fixed-proportions production function Production function with L-shaped isoquants, so that only one combination of labor and capital can be used to produce each Production 20/24

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Return to Scales
Returns to Scale Rate at which output increases as inputs are increased proportionately. F (2K , 2L) Increasing returns to scale: Situation in which output more than doubles when all inputs are doubled. F (2K , 2L) > 2F (K , L) Constant returns to scale: Situation in which output doubles when all inputs are doubled. F (2K , 2L) = 2F (K , L) Decreasing returns to scale: Situation in which output less than doubles when all inputs are doubled. F (2K , 2L) < 2F (K , L)

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Return to Scale

Notice: Dierentiate return to scale and diminishing marginal returns.

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Describing Return to Scale

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Examples for return to scale

Consolidation of small-scale coal mines Productivity vs. company size

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