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PRODUCTION
Production theory forms the foundation for
the theory of supply
Managerial decision making involves four
types of production decisions:
1. Whether to produce or to shut down
2. How much output to produce
3. What input combination to use
4. What type of technology to use
Production involves transformation of
inputs such as capital, equipment, labor,
and land into output - goods and services
Production theory can be divided into
short run theory or long run theory.
Long run and short run:
The Long Run is distinguished from the short run
by being a period of time long enough for all
inputs, or factors of production, to be variable as
far as an individual firm is concerned
The Short Run, on the other hand, is a period so
brief that the amount of at least one input is fixed
The length of time necessary for all inputs to be
variable may differ according to the nature of the
industry and the structure of a firm
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
Q = output
x = inputs
x
Production Function continued
where
Q = output
X1, …, Xk = inputs
Q = f(L, K)
DEFINITIONS:
In the short run, capital is held constant.
Average product is total product divided by
the number of units of the input
Marginal product is the addition to total
product attributable to one unit of variable
input to the production process fixed input
remaining unchanged.
MP = TPN – TPN-1
Short run
labour Total product Average Marginal
product product
1 10 10 10
2 24 12 14
3 39 13 15
4 52 13 13
5 61 12.2 9
6 66 11 5
7 66 9.4 0
8 64 8 -2
Marginal and Average product:
Marginal product at any point is the slope of
the total product curve
Average product is the slope of the line
joining the point on the total product curve to
the origin.
When Average product is maximum, the
slope of the line joining the point to the origin
is also tangent to it.
P: Maximum Average Product
Q & R : Same Average Product
Both AP and MP first rise, reach a maximum
and then fall.
MP = AP when AP is maximum.
MP may be negative if Variable input is used
too intensively.
Law of diminishing marginal
productivity states that in the short run if
one input is fixed, the marginal product of the
variable input eventually starts falling
Law of Diminishing Returns
(Diminishing Marginal Product)
APX
MPX X
Section 2:
10 20 c
25 6 30 d
20
4 50 e
b
15
10
c
5
d
0
0 5 10 15 20 25 30 35 40 45 50
fig
MPL w
MRTS LK = =
MPK r
Minimizing Cost subject to given Output
Expansion Path
If we imagine a set of isoquants representing
each possible rate of output, and given the
relative cost of resources, we can then draw
isocost lines to determine the optimal
combination of resources for producing each rate
of output
Expansion Path leads to Total Cost Curve
An expansion path is a long-run concept
(because all inputs can change)
Each point on the expansion path
represents a cost-minimizing combination
of inputs
Given input prices, each point represents
a total cost of producing a given level of
output when the entrepreneur can choose
any input combination he or she want
Expansion Path
If the relative prices of resources change, the
least-cost resource combination will also change
the firm’s expansion path will change
2
b 500
1
400
a
0 300
0 1 2 3
200
fig
600
2
b
500
1
400
a
0 300
0 1 2 3
200
fig
2
b
1
400
a
0 300
0 1 2 3
200
fig
If α+ β=
1 , we have CRS
> 1 , we have IRS
< 1, we have DRS
Check Q = L2K2