PRODUCTION THEORY AND ANALYSIS- I (ONE VARIABLE INPUT)

PRODUCTION
Transformation of I/Ps or resources into O/P of goods and services

FACTORS AFFECTING PRODUCTION

Technology Inputs

Time period of production

FACTORS OF PRODUCTION INPUTS

FACTOR INPUTS NON-FACTOR INPUTS
Raw materials and other goods from other producing units

Land
Inelastic Immobile Heteroge neous

Labor
Active Mobile Variable Producti vity

Capital Enterprise
Structures Equipment Innovative Risk Decision making

SECONDARY INPUTS

PRIMARY INPUTS

INPUT CLASSIFICATION
Fixed input: qty can not be readily changed Example: Building, Plant, Machinery Variable input: quantity can be changed Example: Labour, raw material

PRODUCTION FUNCTION
When analyzing production, it is important to distinguish between two time frames

Short-run production function assumes that at least one of the inputs is fixed Long-run production function assumes that all inputs adjust

LEVEL & SCALE OF PRODUCTION

Level of production can be altered changing the proportion of variable inputs

Output = Fixed inputs + Variable inputs

Scale of production can be altered by changing the supply of all the inputs only in the long run Output = Total inputs (variable inputs)

PRODUCTION FUNCTION

Technological relationship showing diff combinations of I/Ps that can produce max O/P within a given time period with a given technology

PRODUCTION FUNCTION
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

PRODUCTION FUNCTION
For simplicity, consider a production function of two inputs:

Q=f (L,K)
Q is output L is Labor K is Capital

 Variable proportions production: O/P can be changed by changing the I/Ps i.e. same O/P can be produced using diff combinations of I/Ps Fixed proportions production: combination of I/Ps to produce a given O/P fixed

HYPOTHETICAL PRODUCTION FUNCTION

LABOUR 6 5 4 3 2 1 46 50 45 35 15 5 1 61 65 60 50 30 20 2 OUTPUT 80 85 80 70 50 40 3 88 95 90 80 60 50 4 CAPITAL 95 100 96 85 65 55 5 86 90 85 75 55 45 6

 Technical efficiency: maximum amount of O/P with a given combination of inputs Economic efficiency: Producing a given O/P at the lowest possible cost.

SHORT RUN ANALYSIS OF PRODUCTION FUNCTION- ONE VARIABLE INPUT

PRODUCTION FUNCTION
Q = f (L,K)
Firm has chosen the level of capital so K is fixed in amount

CONCEPT OF PRODUCT
Total Product - total volume of O/P resulting from use of different quantities of I/Ps Average Product - the per unit product of a variable factor Marginal Product - the rate at which total product changes/ change in TP resulting from a unit change in quantity of variable factor

CONCEPT OF PRODUCT

Total Product Marginal Product Average Product Production or Output Elasticity

TP = Q = f(L)

TP MPL = L
TP APL = L MPL EL = AP L

HYPOTHETICAL PRODUCTION FUNCTION

LABOUR 6 5 4 3 2 1 46 50 45 35 15 5 1 61 65 60 50 30 20 2 80 85 80 70 50 40 3 OUTPUT 88 95 90 80 60 50 4 CAPITAL 95 100 96 85 65 55 5 86 90 85 75 55 45 6

EXCERCISE
Variable Input Total Product (X) (Q or TP) 0 0 1 8 2 18 3 29 4 39 5 47 6 52 7 56 8 52

Calculate values of MP & AP

CALCULATION OF MARGINAL PRODUCT

Variable Marginal Input Total Product Product (X) (Q or TP) (MP) 0 0 8 1 8 10 2 18 11 3 29 10 4 39 8 Q 5 5 47 X=1 Q=5 5 X 1 6 52 4 7 56 -4 8 52

CALCULATION OF AVERAGE PRODUCT

Variable Total Average Input Product Product (X) (Q or TP) (AP) 0 0 --1 8 8 2 18 9 3 29 9.67 4 39 9.75 5 47 9.4 6 52 8.67 7 56 8 8 52 6.5

DO YOURSELF- EXERCISE II
Find Marginal Product, Average Product & Output Elasticity of labour

L 0 1 2 3 4 5 6

Q 0 3 8 12 14 14 12

MPL 3 5 4 2 0 -2

AP 3 4 4 3. 2. 2

SOLUTION
L Q MPL APL EL

0
1 2

0
3 8

3 5

3 4

1 1.25

3
4 5 6

12
14 14 12

4
2 0 -2

4
3.5 2.8 2

1
0.57 0 -1

LAW OF VARIABLE PROPORTIONS

As more & more units of some factors of production are employed with some fixed factor then initially TP increases at an increasing rate, then at a decreasing rate & finally decreases

EXAMPLE
VARIABLE I/P (L) 0 1 2 3 4 5 TP 0 5 15 35 45 50 MP 5 10 20 10 5 AP 5 7.5 11.67 11.25 10

45

-5

7.5

THE LAW OF DIMINISHING RETURNS & STAGES OF PRODUCTION

Total 16 Product
14

C
12 10 8 6 4 2

TP
B

Marginal & Average Product

0 6 5 4 3 2 1 0 -1 -2 -3

Labor

B A

D E F

AP
0 1 2 3 4 5 6 7

MP

Labor

THE LAW OF DIMINISHING RETURNS & STAGES OF PRODUCTION

Total Product
16 14 12 10 8 6 4 2 0 1 2 3 4 5 6

TP

Marginal & Average Product

6 5 4 3 2 1 0 -1 -2 -3 0

Stage I

Stage II

Stage III

Labor7

AP
1 2 3 4 5 6 7

MP

Labor

THE LAW OF DIMINISHING RETURNS

Why does MP eventually decline?

Due to the law of diminishing return or as additional units of a variable input are combined with a fixed input, at some point the additional output (i.e., marginal product) starts to diminish.

RELATIONSHIP B/W AP & MP

If MP > AP then AP is rising. If MP < AP then AP is falling. MP=AP when AP is maximum

RELATIONSHIP B/W TP & MP

If MP is positive then TP is increasing. If MP is negative then TP is decreasing. TP reaches a maximum when MP=0 (Maximization Condition!)

Max

STAGES OF PRODUCTION
Q
Increasing Marginal Returns

Diminishing Marginal Returns

Negative Marginal Returns

Q=F(K,L)

MP

AP L

THREE STAGES OF PRODUCTION

Stage I (increasing returns) From zero units of the variable input to where AP is maximized Stage II (diminishing returns) From the maximum AP to where MP=0 Stage III (negative returns) From where MP=0 on where MP < 0

THREE STAGES OF PRODUCTION

In the short run, rational firms should only be operating in Stage II. Why Stage II? Why not Stage I? Under utilising fixed capacity Why not Stage III? Over utilising fixed capacity

OPTIMAL USE OF THE VARIABLE INPUT

Marginal Revenue Product of Labor Marginal Resource Cost of Labor

MRPL = (MPL)(MR) TC = W MRCL = L

Optimal Use of Labor MRPL = MRCL

EXERCISE: FINDING OPTIMAL VARIABLE I/P

L MPL MR MRCL

2.50
3 3.50 4 4.50

4
3 2 1 0

10
10 10 10 10

20
20 20 20 20

Assumption : Firm hires additional units of labor at constant wage rate

SOLUTION

L 2.50 3.00 3.50 4.00 4.50

MP L 4 3 2 1 0

MR = P 10 10 10 10 10

MRP L 40 30 20 10 0

MRC L 20 20 20 20 20

Use of Labor is Optimal When L = 3.50

EXERCISE
Production function for Global electronics: Q = 2 K 0.5 L 0.5 Assume that capital stock is fixed at 9 units, price of output is Rs 6 per unit & wage rate is Rs 2 per unit (a) determine the optimal labour to be hired. (b) What labour rate is optimal if the wage rate is increased to Rs 3 per unit.

SOLUTION
(a) Rule: MRPL = MRCL = w MRPL = (MPL)(MR) = 18/L

W=2
So L = 81 (b) L = 36

As the wage rate increase, L employment falls.