Principles of Economics

1. Principles of Economics Session 4

2. Topics To Be Covered • Factors of Production • Production Function • Productivity • Isoquant • Isocost • Minimum Cost Rule • Returns to Scale • Managing Lock-In

3. Production Production is the process that combines inputs or factors of production to achieve an output

4. Factors of Production • Capital (Physical Capital) • Labor (Human Capital) • Land (Natural Resources) • Technological Knowledge

5. Physical Capital Physical capital is the stock of equipment and structures that are used to produce goods and services. • Tools used to build or repair automobiles. • Tools used to build furniture. • Office buildings, schools, etc.

6. Human Capital Human capital is the economic term for the knowledge and skills that workers acquire through education, training, and experience. • Like physical capital, human capital raises a nation’s ability to produce goods and services.

7. Natural Resources Natural resources are inputs used in production that are provided by nature, such as land, rivers, and mineral deposits. • Renewable resources include trees and forests. • Nonrenewable resources include petroleum and coal.

8. Natural Resources Natural resources can be important but are not necessary for an economy to be highly productive in producing goods and services.

9. Technological Knowledge Technological knowledge is the understanding of the best ways to produce goods and services.

10. The Production Function The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

11. The Production Function Q = quantity of output A = available production technology L = quantity of labor K = quantity of capital N = quantity of natural resources Q= A F(L, K, N)

12. Production Function for Two Inputs Q = F(K,L) Q = OutputK = CapitalL = Labor

13. Production with One Variable Input (Labor) 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

14. Total Product With additional workers, output or total product (Q, TP) increases, reaches a maximum, and then decreases.

15. Maximum Product ● Total Product Maximum Product Output per Month 112 60 Labor per Month 0 1 2 3 4 5 6 7 8 9 10

16. Average Product The average product of labor (AP), or output per worker, increases and then decreases. AP = slope of line from origin to a point on TP

17. Total Product A' ● Maximum AP A ● Average Product AP and TP Output per Month 112 60 Labor per Month 0 1 2 3 4 5 6 7 8 9

18. Marginal Product The marginal product of labor (MP), or output of the additional worker, increases rapidly initially and then decreases and becomes negative. MP = slope of tangent to a point on TP

19. B' ● Total Product A' ● MP=0 Maximum MP A ● B ● Marginal Product MP and TP Output per Month 112 60 Labor per Month 0 1 2 3 4 5 6 7 8 9

20. The Law of Diminishing Marginal Product • The Law of Diminishing Marginal Product states that the marginal product (MP) of an input declines as the quantity of the input increases. • When the input is small, MP increases due to specialization. • When the input is large, MP decreases due to inefficiencies.

21. Marginal Product E Average Product MP and AP Output per Month E: MP = AP and AP is at its maximum Left of E: MP > AP and AP is increasing Right of E: MP < AP and AP is decreasing 30 20 10 Labor per Month 0 1 2 3 4 5 6 7 8 9 10

22. Total Product C' ● B' ● A' ● A B ● ● Average Product ● C Marginal Product TP, AP, and MP Output per Month 112 When MP = 0, TP is at maximum When MP > AP, AP is increasing When MP < AP, AP is decreasing When MP = AP, AP is at maximum 60 Labor per Month 0 1 2 3 4 5 6 7 9

23. Labor productivity can increase if there are improvements in technology, even though any given production process exhibits diminishing returns to labor. C B O3 A O2 O1 The Effect ofTechnological Improvement Output per time period 100 50 Labor per time period 0 1 2 3 4 5 6 7 8 9 10

24. Productivity Productivityis the amount of goods and services produced from each hour of a worker’s time. Higher productivity ð Higher standard of living

25. Malthus and the Food Crisis • Malthus predicted mass hunger and starvation as diminishing returns limited agricultural output and the population continued to grow. • Why did Malthus’ prediction fail?

26. Index of World FoodConsumption Per Capita Year Index 1948-1952 100 1960 115 1970 123 1980 128 1990 137 1995 135 1998 140

27. Malthus and the Food Crisis • The data show that production increases have exceeded population growth. • Malthus did not take into consideration the potential impact of technology which has allowed the supply of food to grow faster than demand. • Technology has created surpluses and driven the price down.

28. Labor Productivity

29. Isoquants • There is a relationship between production and productivity. • Long-run production K& L are variable. • Isoquants analyze and compare the different combinations of K & L and output.

30. Isoquants Isoquants are curves that show all possible combinations of inputs that yield the same output

31. Isoquants Labor Input 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 Capital 1 2 3 4 5 Input

32. The Isoquant Map Capital per year E 5 The isoquants are derived from the production function for output of of 55, 75, and 90. 4 3 A B C 2 Q3 = 90 D Q2 = 75 1 Q1 = 55 1 2 3 4 5 Labor per year

33. Isoquants • The isoquants emphasize how different input combinations can be used to produce the same output. • This information allows the producer to respond efficiently to changes in the markets for inputs.

34. Substituting among Inputs • Managers want to determine what combination if inputs to use. • They must deal with the trade-off between inputs. • The slope of each isoquant gives the trade-off between two inputs while keeping output constant.

35. Marginal Rate of Technical Substitution MRTS is the rate at which one input is substituted for another along an isoquant.

36. 2 1 1 1 Q3 =90 2/3 1 1/3 Q2 =75 1 Q1 =55 Marginal Rate ofTechnical Substitution Capital per year 5 Isoquants are downward sloping and convex like indifference curves. 4 3 2 1 Labor per month 1 2 3 4 5

37. Diminishing MRTS • Increasing labor in one unit increments from 1 to 5 results in a decreasing MRTS from 1 to 1/2. • Diminishing MRTS occurs because of diminishing returns and implies isoquants are convex.

38. MRTS and Marginal Productivity • The change in output from a change in labor equals: • The change in output from a change in capital equals:

39. MRTS and Marginal Productivity If output is constant and labor is increased, then:

40. A B C Q1 Q2 Q3 Isoquants When Inputs are Perfectly Substitutable Capital per month Labor per month

41. Perfect Substitutes • When inputs are perfectly substitutable, the MRTS is constant at all points on the isoquant. • For a given output, any combination of inputs an be chosen (A, B, or C) to generate the same level of output.

42. Q3 C Q2 B Q1 K1 A L1 Fixed-ProportionsProduction Function Capital per month Labor per month

43. Fixed Proportions Production • When inputs must be in a fixed-proportion, each output requires a specific amount of each input (e.g. labor and jackhammers). • To increase output requires more labor and capital proportionately.

44. Isocost Line The isocost line is one that shows all combinations of inputs that can be purchased for the same cost.

45. Isocost Line Assume inputs are labor (L) and capital (K) and wage and capital price are w and r respectively, then:

46. A Isocost Line: K= 40 – 0.5L B D E G Isocost Line Capital (units) r= $2 w = $1 C = $80 (C/r) = 40 30 20 10 Labor (units) 0 20 40 60 80 = (C/w)

47. K2 A K1 K3 Q1 C0 C1 C2 L2 L1 L3 Isocosts and Isoquants Capital per year For output Q1, point A is of least cost Labor per year

48. B K2 C2 L2 Isocosts and Isoquants Capital per year If the price of labor increases, the isocost curve becomes steeper due to the change in the slope: -(w/r). To maintain Q1, the minimum cost point shifts from A to B, which requires more cost than C1. A K1 Q1 C1 Labor per year L1

49. Minimum Cost Combination

50. Minimum Cost Rule The minimum cost rule states that the cost of producing a specific level of output is minimized when the ratio of the marginal product of each input to the price of that input is the same for all inputs.