Production theory

Provides framework for economics of production of firm

What is production

Production refers to transformation of inputs or resources into outputs of goods and services

Inputs = resources used in production of goods (fixed and variable) Output = end result

Basic production decision

1.How much of commodity to produce 2.How much inputs should be used To answer these questions, the firm a. Requires engineering data on production possibilities b. Economic data on input and output prices

Production function

Production is a function that transforms inputs into output Q = f (L, N, KT)

Factors affecting production are 1.Technology 2.Inputs (land, labour etc) 3.Time period (short run vz long run)

Production function with one variable input

1) Total Product: TP = Q = f(L)

TP 2) Average Product: APL = L TP 3) Marginal Product: MPL = L

Concepts of production
Total Product :This is amount of total output produced by a given amount of factor, other factors held constant. Average Product: This is total output produced per unit of factor employed AP =TP/no. of units of factor employed

Marginal Product: This is addition to total production by employment of extra unit of factor

Law of variable proportions or law of diminishing returns

As more and more of one factor input is employed, all other input quantities held constant, a point will be reached where additional quantities of varying input will yield diminishing marginal contribution to total product Short run law Some factors fixed, other factors variable State of technology fixed and unchanged Possibility of varying proportion of factors

Production function with one variable input

Total, Marginal, and Average Product of Labor, and Output Elasticity

L 0 1 2 3 4 5 6

Q 0 3 8 12 14 14 12

MPL 3 5 4 2 0 -2

APL 3 4 4 3.5 2.8 2

EL 1 1.25 1 0.57 0 -1

Production function with one variable input

Stages of return
Stage 1:Increasing returns. MP increasing, AP increasing, TP increases till G at increasing rate, after that at decreasing rate. G= point of inflexion Stage 2:Diminishing returns. MP decreasing and falls till zero, AP decreasing, TP increases at a decreasing rate Stage 3:Negative returns. MP negative, AP decreasing, TP is also falling

Contd..
Stage of operations stage2 Stage 1 fixed factor too much for variable factor. Fixed factor is more intensively utilised Stage 3- variable factor too much in relation to fixed factor

Applications agriculture, studying

Production with two variable inputs

Isoquants show combinations of two inputs that can produce the same level of 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.

Isoquant

An isoquant is a curve representing various combinations of 2 inputs that produce the same level of output

ISO+QUANT= same + quantity

Production with two variable inputs

Isoquants

Production with two variable inputs

Marginal Rate of Technical Substitution

MRTS = K/L = MPL/MPK

Marginal rate of substitution

The marginal rate of technical substitution of L for K (MRTSLK ) is the amount of K a firm will give up for increasing the amount of L used by 1 unit and remain on same isoquant
MPL = w MPK r

MRTSLK =

Production With Two Variable Inputs

MRTS = (-2.5/1) = 2.5

Optimal combination of inputs

Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost.
C wL rK
C w K L r r
C Total Cost w Wage Rate of Labor ( L) r Cost of Capital ( K )

Isocost

An isocost shows all different combinations of labor and capital that a firm can purchase, given the total outlay (TO) of firm and factor prices. The slope of an isocost is Pl. Pk

Producers equilibrium

An producer is in equilibrium when he maximises output for total outlay. i.produces given output at minimum cost ii. Produces maximum output at given level of cost Equilibrium = isocost tangent to isoquant Here, MRTS lk = MPl /MPk = w/r i.e.At equilibrium, MPl = MPk Pl Pk

Optimal combination of inputs

MRTS = w/r

Returns to Scale- Change in all inputs

Production Function Q = f(L, K)
Q = f(hL, hK) If = h, then f has constant returns to scale. If > h, then f has increasing returns to scale. If < h, the f has decreasing returns to scale.

Stages of return Returns to scale

The percentage increase in output when all inputs vary in same proportion is known as returns to scale 1.Constant returns to scale Output increases in same proportion as increase in input 2.Increasing returns to scale-Output increases by greater proportion as increase in input 3. Decreasing returns to scale Output increases by lesser proportion as increase in input

Returns to Scale
Constant Returns to Scale Increasing Returns to Scale Decreasing Returns to Scale

Reasons
Causes of increasing returns Specialisation in large scale production. In some industries, small scale production is not possible

Causes of decreasing returns Coordination and control maybe difficult. Information maybe lost or distorted when transmitted