Chapter 5 Slide 1 CHAPTER 5 THEORY OF PRODUCTION Dr. Vasudev P. Iyer

Slide 1Chapter 5

CHAPTER 5THEORY OF

PRODUCTIONTHEORY OF

PRODUCTION

Dr. Vasudev P. Iyer

Slide 2Chapter 5

INTRODUCTION

• Our focus is the supply side.

• We will consider the conceptual issues related to production.

• We will also consider production in the short-run and in the long-run period.

Slide 3Chapter 5

Meaning of production

Meaning of production function

Short-run production function

The Law of Diminishing Returns

The long-run production function and returns to scale

The economies of scale

Production functions and managerial decision making

Slide 4Chapter 5

What do we mean by Production?

• The Production Process– Combining inputs or factors of production to

achieve an output

• Categories of Inputs (factors of production)– Land– Labour– Capital

• Thus, in simple words, production means transforming inputs into outputs.

Slide 5Chapter 5

INPUTS OUTPUTS

FACTORS OFPRODUCTION

GOODS &SERVICES

T

The Production Process

Slide 6Chapter 5








Slide 7Chapter 5

Meaning of Production

•A production function defines the relationship between inputs and the maximum amount that can be produced within a given time period with a given technology.

Slide 8Chapter 5

Mathematical Representation

• Mathematically, the production function can be expressed as

Q=f(X1,X2,...,Xk)

• Q is the level of output

• X1,X2,...,Xk are the levels of the inputs in the production process

• f( ) represents the production technology

Slide 9Chapter 5

In case of two inputs

• The production function for two inputs:

Q = F(K,L)

Q = Output, K = Capital, L = Labour

Slide 10Chapter 5

ISOQUANTS

• An important tool to study production function in detail.

• WHAT ARE ISOQUANTS ?

• ISOQUANTS SHOW ALL POSSIBLE COMBINATIONS OF INPUTS THAT YILED THE SAME OUTPUT.

Slide 11Chapter 5

Assumptions of Isoquant Analysis

• Assumptions

–The producer has two inputs:

•Labour (L) &

•Capital (K)

Slide 12Chapter 5

Production Function for Food

1 20 40 55 65 75

2 40 60 75 85 90

3 55 75 90 100 105

4 65 85 100 110 115

5 75 90 105 115 120

Capital Input 1 2 3 4 5

Labour Input

Slide 13Chapter 5

Production with Two Variable Inputs (L,K)

Labour per year

1

2

3

4

1 2 3 4 5

5

Q1 = 55

The isoquants are derivedfrom the production

function for output ofof 55, 75, and 90.A

D

B

Q2 = 75

Q3 = 90

C

ECapitalper year The Isoquant MapThe Isoquant Map

Slide 14Chapter 5

What does the Isoquant emphasizes?

• 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.

Input FlexibilityInput Flexibility

Slide 15Chapter 5








Slide 16Chapter 5

• Short-run:

– Period of time in which quantities of one or more production factors cannot be changed.

– These inputs are called fixed inputs.

• Long-run– Amount of time needed to make all production

inputs variable.

The Short Run versus the Long RunThe Short Run versus the Long Run

Slide 17Chapter 5

Production in the Short Run

• When discussing production in the short run, three definitions are important.

•Total Product

•Marginal Product

•Average Product

Slide 18Chapter 5

TOTAL PRODUCT (TP)

• Total product (TP) is another name for output in the short run.

Slide 19Chapter 5

MARGINAL PRODUCT (MP)

• Marginal product tells us how output changes as we change the level of the input by one unit.

• For example

L

Q

Input Labor

Output MP L

Slide 20Chapter 5

AVERAGE PRODUCT (AP)

• Average product tells us, on average, how many units of output are produced per unit of input used.

• For example

L

Q

Input Labor

Output AP

Slide 21Chapter 5

Amount Amount Total Average Marginalof Labour (L) of Capital (K) Output (Q) Product Product

Production withOne Variable Input (Labour)

0 10 0 --- ---

1 10 10 10 10

2 10 30 15 20

3 10 60 20 30

4 10 80 20 20

5 10 95 19 15

6 10 108 18 13

7 10 112 16 4

8 10 112 14 0

9 10 108 12 -4

10 10 100 10 -8

Slide 22Chapter 5

OBSERVATIONS

1. With additional workers, output (Q) increases, reaches a maximum, and then decreases.

2. The average product of labor (AP), or output per worker, increases and then decreases.

3. The marginal product of labour (MP), increases rapidly initially and then decreases and becomes negative

Slide 23Chapter 5

Total Product

A: slope of tangent = MP (20)B: slope of OB = AP (20)C: slope of OC= MP & AP

Labour per Month

Outputper

Month

60

112

0 2 3 4 5 6 7 8 9 101

A

B

C

D


Slide 24Chapter 5

Average Product


8

10

20

Output

per Month

0 2 3 4 5 6 7 9 101 Labour per Month

30

E

Marginal Product

Observations:Left of E: MP > AP & AP is increasingRight of E: MP < AP & AP is decreasingE: MP = AP & AP is at its maximum

Slide 25Chapter 5

MP = 0 TP is at its maximum

MP > AP

MP < AP

MP = AP

AP is decreasing

AP is at its maximum

AP is increasing

To summarize

Slide 26Chapter 5

Slide 27Chapter 5








Slide 28Chapter 5

• As the use of an input increases in equal increments, a point will be reached at which the resulting additions to output decreases (i.e. MP declines).

• When the labour input is small, MP increases due to specialization.

• When the labour input is large, MP decreases due to inefficiencies.

The Law of Diminishing Marginal ReturnsThe Law of Diminishing Marginal Returns

Slide 29Chapter 5

Amount Amount Total Average Marginalof Labor (L) of Capital (K) Output (Q) Product Product

RECALL SLIDE 21

0 10 0 --- ---

1 10 10 10 10

2 10 30 15 20

3 10 60 20 30

4 10 80 20 20

5 10 95 19 15

6 10 108 18 13

7 10 112 16 4

8 10 112 14 0

9 10 108 12 -4

10 10 100 10 -8

Slide 30Chapter 5


• Reasons

X

MP

Increasing ReturnsTeamwork and Specialization

Diminishing Returns BeginsFewer opportunities for teamwork and specialization

MP

Slide 31Chapter 5








Slide 32Chapter 5

• In the long run, all inputs are variable.

• The long run production process is described by the concept of returns to scale.

• Returns to scale describes what happens to total output if all of the inputs are changed by the same proportion.

Production in the Long Run

Slide 33Chapter 5

• If all inputs into the production process are doubled, three things can happen:– output can more than double

• increasing returns to scale (IRTS)

– output can exactly double• constant returns to scale (CRTS)

– output can less than double• decreasing returns to scale (DRTS)

3 things can happen

Slide 34Chapter 5

INCREASING RETURNS TO SCALE

• output more than doubles when all inputs are doubled

• Larger output associated with lower cost (autos)

• One firm is more efficient than many (utilities)

• The isoquants get closer together

Slide 35Chapter 5

IRTS

Labour (hours)

Capital(machine

hours)

10

20

30

Increasing Returns:The isoquants move closer together

5 10

2

4

0

A

Slide 36Chapter 5

Constant Returns to Scale

• output doubles when all inputs are doubled

• Size does not affect productivity

• May have a large number of producers

• Isoquants are equidistant apart

Slide 37Chapter 5

CRTS

Labour (hours)

Capital(machine

hours)

Constant Returns:Isoquants are equally spaced

10

20

30

155 10

2

4

0

A

6

Slide 38Chapter 5

Decreasing Returns to Scale

• output less than doubles when all inputs are doubled

• Decreasing efficiency with large size

• Reduction of entrepreneurial abilities

• Isoquants become farther apart

Slide 39Chapter 5

DRTS

Labour (hours)

Capital(machine

hours)

Decreasing Returns:Isoquants get further apart

1020

30

5 10

2

4

0

A

Slide 40Chapter 5

Returns to Scale

• If E>1 then IRTS• If E=1 then CRTS• If E<1 then DRTS

inputsallinchangePercentage

QinchangePercentageQE

One way to measure returns to scale is to use a coefficient of output elasticity:

Slide 41Chapter 5








Slide 42Chapter 5

Meaning• When doubling the output results in a less than

double increase in costs, we can say that a firm is enjoying economies of scale.

• Types of economies of scale– Internal – External

• Internal economies include: specialization, technical, purchasing, transportation, marketing etc.

Slide 43Chapter 5








Slide 44Chapter 5

How useful is production function to managers?

• It is the foundation for cost analysis (Chap. 6)

• In allocation of a firm’s scarce resources in short-run and long-run

• Production planning.– Operate at a stage from were AP is

max. to MP=zero.

• But production levels depend on how much customers want to buy.

Slide 45Chapter 5

CASELET:13

CALL CENTERS

APPLYING PRODUCTION FUNCTION TO A SERVICE

Managerial Economics: Keat & Young, pg. 299

Slide 46Chapter 5

The Genesis

• Output (Q)= the number of calls handled by customer representatives

• Input: Labour= the call center representative

• Thus, we have:

• Where, Q is the output

X is the variable input

Y is the fixed input

Q= f (X,Y)

Slide 47Chapter 5

Application of returns to scale

• Possibility of IRTS

• Although smaller in size, quality is high and cost is low (?)

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Chapter 5 Slide 1 CHAPTER 5 THEORY OF PRODUCTION Dr. Vasudev P. Iyer