Theory of Production

Chapter 6:

Terms to Remember:• Marginal Product – additional product brought about adding an

additional resource output.• Diminishing Returns – the point where marginal product decreases

despite an increase to resource input.• Isoquant – combination of resource input that produce the same level

of output.• Isocost – combination of production resources that a given budget can

buy.• Productivity – the ratio o output over input• Returns to Scale – measures how an output changes relative to

resource inputs.

Production The process of transformation of resources (like land, labour,

capital and entrepreneurship) into goods and services of utility to consumers and/or producers.

Theory of production is an analysis of output-input relationship.

Production Function

A production function is a table or a mathematical equation showing the maximum amount of output that can be produced from any specified set of inputs, given the existing technology. The total product curve for different technology is given below:

Q

x

Q = output x = inputs

Production FunctionAlso termed as law of variable proportion It is the short term production function Total product is a function of labour:

Average Product (AP) is total product per unit of variable input

Marginal Product (MP) is the addition in total output per unit change in variable input

Marginal Product is defined as the product due to additional or lost unit of the variable resource input and measured as follows

As the quantity of the variable factor is increased with other fixed factors, MP and AP of the variable factor will eventually decline.

Therefore law of variable proportions is also called as law of diminishing marginal returns.

Average Product is output per unit of the variable resource input and measured as follows:

EXAMPLE :

The decline of TP at the last stage obviously decreases AP but only to the level of zero. There is no such thing as negative output, although a negative MP only shows decrease in output.

Law of Diminishing Returns

States that production function shows that stretching the use of variable resources against the limits of fixed resources decreases the marginal product.

Furthermore having too much of one resource and too little of one another can even result in a resource imbalance that decreases production capacity with a negative marginal product.

Lessons of Law of Diminishing Returns The size of the resource

should not g beyond its product-maximizing point.

Capacity can only increase with more resources combined with unless technology changes.

Resources are basically complementary.

Isoquant-Isocost ModelIllustrates more dynamically how different resource combinations determine different levels of resource efficiency and capacity.There are infinite combinations of resource inputs which determine the same capacity, these combinations form the product indifference curve or ISOQUANTMarginal Rate of Substitution (MRS) – how much of one resource is given up in order to use an additional unit of other, given a fixed capacity.

Where:K- Capital L- Labor

The table shows that less and less of capital inputs (K) are given up in order to use an additional unit of labor (L) as MRS decreases down.

The graph shows the downward pointing arrow as the capital and rightward pointing arrow as the labor.

The shortening vertical arrow decreases as the ratio of the horizontal arrow which is the trend of the MRS as L substitutes K.This trend shapes that the isoquant as convex to the graph’s point of origin.

• It is an array of isoquants which corresponds to different level of resource inputs.

• All points of Q1 move upward to form a higher isoquant which is the Q2 as more capital and labor increases capacity.

• This overall change is actually the upward and rightward shift in the production function curve.

• There is an infinite number of isoquants as there are infinite levels of the capacity in the hierarchy.

Heirarchy of Isoquants• This means that any point in

the graph is a resource combination of an isoquant.

Isocost and Its Heirarchy

• There are infinite combinations of production resources that a given budget can buy.

• These combination form isocost curve.

• The table and the graph illustrates the isocost curve with capital and labor as resource inputs

• Between one point and another along the curve, one resource is given up in exchange for other because of a fixed budget.

Returns to Scale

Constant Returns to Scale : When a proportional increase in all inputs yields an equal proportional increase in output

Increasing Returns to Scale : When a proportional increase in all inputs yields a more than proportional increase in output

Decreasing Returns to Scale : When a proportional increase in all inputs yields a less than proportional increase in output

Returns to Scale show the degree by which the level of output changes in response to a given change in all the inputs in a production system.

Return to ScalesMeasures how output changes relative to resource

inputs in the long run and indicates how overall resource efficiency changes:

Where:Q – outputI – Resource Input

Stages of Law of Production

Second Stage: Diminishing return TP increase but at diminishing rate and it reach at highest at the end of the

stage. AP and MP are decreasing but both are positive. MP become zero when TP is at Maximum, at the end of the stage MP<AP.Third Stage: Negative return TP decrease and TP Curve slopes downward As TP is decrease MP is negative. AP is decreasing but positive.

First Stage: Increasing return TP increase at increasing rate until the end of the stage. AP also increase and reaches at highest point at the end of the stage. MP also increase at it become equal to AP at the end of the stage. MP>AP