CHAPTER 5

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

2. 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.

3. TOPICS TO BE DISCUSSED

4. 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. What do we mean by Production?

5. The Production Process T OUTPUTS INPUTS GOODS & SERVICES FACTORS OF PRODUCTION

6. TOPICS TO BE DISCUSSED

7. 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. Meaning of Production

8. 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 Mathematical Representation

9. The production function for two inputs: Q = F(K,L) Q = Output, K = Capital, L = Labour In case of two inputs

10. An important tool to study production function in detail. WHAT ARE ISOQUANTS ? ISOQUANTS SHOW ALL POSSIBLE COMBINATIONS OF INPUTS THAT YILED THE SAME OUTPUT. ISOQUANTS

11. Assumptions The producer has two inputs: Labour (L) & Capital (K) Assumptions of Isoquant Analysis

12. Production Function for Food Labour Input Capital Input 1 2 3 4 5 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

13. Production with Two Variable Inputs (L,K) Capital per year The Isoquant Map E 5 4 The isoquants are derived from the production function for output of of 55, 75, and 90. 3 A B C 2 Q3 = 90 D Q2 = 75 1 Q1 = 55 1 2 3 4 5 Labour per year

14. The isoquants emphasize how different input combinations can be used to produce the same output. This information allows the producer to respond efficientlyto changes in the markets for inputs. What does the Isoquant emphasizes? Input Flexibility

15. TOPICS TO BE DISCUSSED

16. 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 Run

17. Production in the Short Run • When discussing production in the short run, three definitions are important. • Total Product • Marginal Product • Average Product

18. Total product (TP) is another name for output in the short run. TOTAL PRODUCT (TP)

19. Marginal product tells us how output changes as we change the level of the input by one unit. For example MARGINAL PRODUCT (MP)

20. Average product tells us, on average, how many units of output are produced per unit of input used. For example AVERAGE PRODUCT (AP)

21. Production withOne Variable Input (Labour) Amount Amount Total Average Marginal of Labour (L) of Capital (K) Output (Q) Product Product 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

22. With additional workers, output (Q) increases, reaches a maximum, and then decreases. The average product of labor (AP), or output per worker, increases and then decreases. The marginal product of labour (MP), increases rapidly initially and then decreases and becomes negative OBSERVATIONS

23. D Total Product C A: slope of tangent = MP (20) B: slope of OB = AP (20) C: slope of OC= MP & AP B A Production withOne Variable Input (Labour) Output per Month 112 60 Labour per Month 0 1 2 3 4 5 6 7 8 9 10

24. Observations: Left of E: MP > AP & AP is increasing Right of E: MP < AP & AP is decreasing E: MP = AP & AP is at its maximum Marginal Product E Average Product Production withOne Variable Input (Labour) Output per Month 30 20 10 Labour per Month 0 1 2 3 4 5 6 7 8 9 10

25. To summarize MP = 0 TP is at its maximum MP > AP AP is increasing MP < AP AP is decreasing MP = AP • AP is at its maximum

26. Why such a relationship?

27. TOPICS TO BE DISCUSSED

28. The Law of Diminishing Marginal Returns • 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.

29. RECALL SLIDE 21 Amount Amount Total Average Marginal of Labor (L) of Capital (K) Output (Q) Product Product 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

30. Increasing Returns Teamwork and Specialization MP Diminishing Returns Begins Fewer opportunities for teamwork and specialization X MP The Law of Diminishing Returns • Reasons

31. TOPICS TO BE DISCUSSED

32. Production in the Long Run • 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.

33. 3 things can happen • 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)

34. 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

35. Increasing Returns: The isoquants move closer together A 4 30 20 2 10 0 5 10 IRTS Capital (machine hours) Labour (hours)

36. 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

37. A 6 30 4 20 2 10 0 5 10 15 CRTS Capital (machine hours) Constant Returns: Isoquants are equally spaced Labour (hours)

38. 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

39. A 4 30 2 20 10 0 5 10 DRTS Capital (machine hours) Decreasing Returns: Isoquants get further apart Labour (hours)

40. Returns to Scale One way to measure returns to scale is to use a coefficient of output elasticity: • If E>1 then IRTS • If E=1 then CRTS • If E<1 then DRTS

41. TOPICS TO BE DISCUSSED

42. 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. Meaning

43. TOPICS TO BE DISCUSSED

44. 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. How useful is production function to managers?

45. CASELET:13 CALL CENTERS APPLYING PRODUCTION FUNCTION TO A SERVICE Managerial Economics: Keat & Young, pg. 299

46. 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 The Genesis Q= f (X,Y)

47. Possibility of IRTS Although smaller in size, quality is high and cost is low (?) Application of returns to scale