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o First, in the short run, to choose the optimal quantity of each input
o Second, in the long run, to choose the optimal size of the firm or the
production capacity that minimizes the cost
The manager will be able to tackle these targets only if he has enough
and accurate knowledge concerning the production function or the input
output relationships, and that is the focus of this chapter.
The first part of the chapter introduces the production function in short
run and long run, while the second part of the chapter is concerned with
the estimation of the production function.
Total Product:
In the short run, the total production curve shows the maximum
output produced using a certain set of variable inputs (as labor and
row materials) in addition to one or more of fixed inputs (as the
size of the plant, equipments, area of land).
The total product curve shows how total product changes with the
quantity of labor employed
The area below TP curve is attainable at every level of labor, while the
area are above TP is unattainable.
Example:
To understand the nature of the relation between the different
measures of production in the short run, let us take a simple example
of a small farm where capital (area of the farm, water well, and
equipments) is fixed, and the number of workers is the only variable
input.
Total
Marginal
Average product of
Workers
Product
Product of labor
labor
(L)
(TP)
(MPL)
(APL)
0
1
2
3
4
5
6
0
8
18
29
39
47
52
--------8
10
11
10
8
5
--------8
9
9.67
9.75
9.4
8.67
7
8
56
52
4
-4
8
6.5
From the table above, you may notice that total product increases as more
workers are hired. First, total product increases at high speed making big
jumps, then it slows down but still in creasing as it approach its maximum,
then total product starts to decrease as more labor are employed.
In scientific terms we may describe the behavior of the total product in the
short run by saying that, TP increases first at an increasing rate to reach an
infliction (turning) point, after that it keeps increasing but at a decreasing
rate until it reaches its maximum level, then it starts to fall.
TP
Stage I
TP_, AP_,
MP_ then_,
MP > AP
a
Stage
II
Stage III
TP_, AP_,
MP_,
MP < AP
MP > 0
TP_, AP_,
MP_,
MP < AP
MP < 0
TP
AP
L
0
L1
L2
MPL
The marginal product of labor (MPL) is the change in output (or Total
Product) that results from a one-unit change in the variable input
(quantity of labor employed), or one additional hour of work, with all
other inputs remaining the same.
MP =
L
As you see in the graph above, the slope of the TP curve starts very
close to zero at the origin, then increases (production speeds up) to
reach its
maximum at the infliction (turning) point (point a) on the TP curve, where
MPL curve reaches its maximum. The slope of TP curve decreases
gradually (production slows down) to reach zero at L 2 as MPL falls to
intersects the L axis. Total product starts to fall from there on as the slope
of the MPL curve become negative.
From the above table notice how the Marginal product of labor increases
to reach its maximum of 11, then falls after that to take a negative value
where total product starts to fall.
Increasing
marginal
returns
arise
from
increased
It is important to keep in mind that all units of the variable input are assumed
of equal productivity, and the only reason for variations in its marginal
product (productivity) can be attributed to its order in utilization in the
production process.
Referring to our previous example, at some early stage you may notice
increasing returns, where the MP curve has a positive slope. The reason
here is clear because the larger the number of workers is the higher the
productivity of individual workers due to specialization and teamwork
privileges.
As more workers are added to the same quantity of the fixed input, at some
point diminishing returns will be in effect due to crowdness in the work place,
and inadequacy of the fixed input, as the number of workers increase each
worker will have less fixed input.
In general:
o
o
The average product of labor (AP L) refers to the share of each worker in
the total production.
TP
L
L =
Q
L
The point that TP change its pace from increasing at increasing rate to
increasing at decreasing rate (i.e., the point where DMR start its course) is
called the turning point. When TPL is at its turning point MPL is at its
maximum,
1. If MPL is increasing and positive, TPL is increasing at increasing rate
2. If MPL is decreasing and positive, TPL is increasing at decreasing rate
3. If MPL = 0, TPL is at its maximum
4. If MPL < 0, TPL is decreasing
The relationship between TP, MP, and AP can be used to divide the SR
production function into three stages of production.
Stage I:
o
o
o
Stage II:
higher costs to hire more workers; while the total revenue is falling
as TP decreases.
At which stage should the firm operate?
Firm uses more of its variable inputs to produce less output. Fixed
input is over utilized or overused inefficient use of resources
Given that Stage II is the best for profit-maximizing firm, then what is the
optimal level of variable input should the firm use? In other words, at
which point on production function should the firm operate?
The answer depends upon: how many units of output the firm can sell, the
price/ of the product, and the monetary costs of employing the variable
input.
The Optimal quantity of the variable input is the quantity that allows
the firm to maximize its profits.
The question facing the manager is: what is the optimal number of workers?
To make things easy, let us assume that the firm buys its inputs and sell its
products in competitive markets, which means, it can hire any number of
workers at the market going wage (W) and sell any quantity of its product
at the market going price (P).
Now we may present the firm profit function in the following form:
= TR TC = PXQ (FC + WL)
Where: P is the Price of the good which is assumed constant, Q is the total
product, FC is the fixed input cost, W is the labor wage which is assumed
constant, and L is the number of workers.
Now, the question is: how many workers the firm should hire in order to
maximize its profits?
P * MP = W
Which says that, the optimal number of workers is that number at which the
value of the marginal product of labor is equal to the market wage rate; or
at which the marginal revenue product of labor (MRPL) equals the
marginal labor cost (MLC).
Total revenue product (TRP) refers to the market value of the firms
output, computed by multiplying the total product by the market price (Q * P)
Total labor cost (TLC) refers to the total cost of using the variable input,
labor, computed by multiplying the wage rate (which assumed to be fixed)
by the number of variable input employed (W * L)
Marginal labor cost (MLC) is the change in total labor cost resulting from
one unit change in the number of workers used
As you may notice here again we are comparing marginal revenues and
marginal cost. Therefore, the decision rule is to hire more workers as long as
the value of the production contributed by the additional worker (P*MPL)
exceeds the cost of hiring an additional unit of labor which is equal to the
wage (W) paid to worker, under competition in the labor market.
Suppose the firm production function has more than one variable input in
the short run. In order to maximize profits, the manager has to choose the
quantities of each input that will minimize cost.
Let CX is the cost of X and CY be the cost of Y, while PQ is the price of the
firm output.
For simplicity let us assume that the firm buys its inputs and sell its product
in competitive markets, where the firm can buy or sell any quantities at a
constant price.
MPx = MPy
Cx
Cy
Thus, the optimal condition for a profit-maximizing firm employing two variable
inputs X and Y is attained where the ratio of the marginal products of the variable
inputs is equal the ratio of their costs. Or, the marginal product of X to its cost
must be equal to the marginal product of Y to its cost.
In other words, the marginal product per the amount of money spent on X
must be equal to the marginal product per the amount of money spent on Y.
Example:
o Suppose you are the production manager of a company that makes
computer parts in Malaysia and Algeria.
o
At the current production levels and inputs utilization you found that:
Malaysian marginal product of labor (MPM ) =18 Units
Algerian marginal product of labor (MPA ) = 6 Units
Wage rate in Malaysia Wm = $ 6/hr
Wage rate in Algeria WA = $ 3/hr
Looking at the wage rates you might be tempted to hire more workers
and expand production in Algeria, where wages are relatively lower.
However, production theory suggests that the firm should not only look at
inputs cost but also to the MP of each input relative to the cost.
By examining the marginal product per dollar in each country, you will
find that:
MPM = 18 = 3 > MPA = 6 = 2 ;
$6
$3
W
W
M
Example:
o
Suppose labor and capital are both variable inputs and some other input
such as land is fixed, and suppose that
MPL = 12 units, MPk =24, w =$6 and r = $8,
Solution
o
So use more capital and less labor since capital is cheaper per dollar
spent than labor (capital is more productive)
o Bur, as more capital is used its MP_, and as less labor is used its MP_. o
This will continue until the two ratios are equal.
o
As you know by now, the long run is a period of time long enough to allow
the firm to change all its inputs. Effectively, all inputs are variable.
As the firm increases all its inputs in the long run, it actually changes the
scale of its production activity.
If all inputs into the production process are doubled, three things can
happen:
1. Output can be more than double, increasing returns to scale.
A larger scale of production allows the firm to divide tasks into more
specialized activities, thereby increasing labor productivity. It also
enables the firm to justify the purchase of more sophisticated (hence,
more productive) machinery. These factors help in explaining why
the firm can experience increasing returns to scale.
2. Output can exactly double, constant returns to scale.
3. Output can be less than double, decreasing returns to scale.
IRTS
CRTS
Q
X,Y
DRTS
Q
X,Y
% Q
% in all inputs
Example:
Q = 50X + 50Y +100
X = 1, Y = 1 Q 50(1) + 50 (1) +100 = 200 If X
=2, Y = 2 Q 50(2) + 50 (2) +100 = 300 %UQ =
(300 - 200)/200 = 50%
%U in all inputs = 100%
EQ = 50%/100% = 0.5 < 1 DRTS
Although the manager may be well informed about the three stages of
production for his firm, in the short rum, he might realize that the market
demand is consistently lower than expected.
Capacity Planning: refers to the planning the amount of fixed inputs that
will be used along with the variable inputs. Good capacity planning
requires:
o
Suppose the firm is forced to produce in the first stage as a result of the
inadequate demand in the short run. In this case the firm is underutilizing
its capacity or its fixed inputs, in other words, the firm would have excess or
idle capacity. Fixed costs are the cost of fixed inputs, that part of the firm
total cost, which is independent of the level of production. A firm producing
in stage one with some idle capacity, would have high average cost (per
unit cost), and therefore, will not maximize profits.
In the long run, such firm should consider reducing its production
capacity to the optimal size that enables it to maximize profits
By the same token, a firm facing a growing demand beyond its production
capacity should consider expanding its capacity in the long run to meet
the market demand while producing in the rational range that would allow
maximum profits.