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All Rights ReservedMicroeconomics© Oxford University Press Malaysia, 2008

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Theory of Production

6CHAPTER


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Production is the process of transforming inputs into outputs.

DEFINITION OF PRODUCTION

Processing

INPUTSInput refers to the factors of production that a firm uses in the production process

OUTPUTSRefers to what we get at the end of the production process, that is, finished products.


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CLASSIFICATION OF FACTORS OF PRODUCTION

CLASSIFICATIONOF FACTORS

OF PRODUCTION

LAND LABOUR

Physical or mentalactivities of human beings

A person who combinesthe different factors of

production, and initiatesthe process of

production and also bears the risk

ENTREPRENEUR

All natural resourcesor gifts of nature

CAPITALPart of man-made

wealth used for furtherproduction


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The production function is a statement of the functional relationship between inputs and outputs, where the maximum output that can be produced is shown with given inputs.

Q = (K, L)

Where Q = Output K = Capital L = Labour

THE PRODUCTION FUNCTION


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SHORT RUNPRODUCTION FUNCTION

In the short run, we assume that at least one inputs is fixed, that is, capital.In the short run, the production function can written as:

Q = ( K , L)

Where Q = OutputL = LabourK = Capital (fixed)


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SHORT RUNPRODUCTION FUNCTION (CON’T)

Average Product (AP) = Total Product

Total Labour

AP = TP/ L

AVERAGE PRODUCT (AP)

Divide the total product by the amount of that input used in the production.

TOTAL PRODUCT (TP) The amount of output produced when a given amount

of that input is used along with fixed inputs.


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MARGINAL PRODUCT (MP) Change in the total product of that input corresponding to an additional unit change in its labour assumingother factors, that is, capital fixed.

Marginal Product (MP) = Change in Total Product

Change in Total Labour

MP = TP/ L



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LAW OF DIMINISHING MARGINAL RETURNS

It states that if the quantities of certain factors are increased while the quantities of one or more factors are held constant, beyond a certain level of production, the rate of increase in output will decrease.



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STAGES OF PRODUCTION


Stage I • Proportion of fixed factors are greater

than variable factors.• Under utilization of fixed factors.• Operation involves a waste of resources

Stage II • Called law of diminishing returns. • The most efficient stage of production• because the combinations of inputs are fully

utilized.

Stage III • Proportion of fixed factors is lower than • variable factors.• Increase in variable factors decline TP because overcrowding. • A producer would not like to operate at this stage.


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-10

0

10

20

30

40

50

60

0 1 2 3 4 5 6 7 8 9 10

TP

MP

AP

STAGE I STAGE II

APMAX;

AP=MP

STAGE III

MP= 0

TPMAX


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LONG-RUNPRODUCTION FUNCTION

In the long-run a firm can produce its output in various ways by adjusting the amount

of labour and capital.


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Isoquant

• Isoquant represents all possible combinations of variable inputs that are used to generate the same level of output (total product).

• Isoquant analysis illustrates that there are various ways to generate a given quantity of output in one time period.

LONG-RUNPRODUCTION FUNCTION (CON’T)


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Isoquant Table


1 250 450 550 700 800

2 450 650 800 900 950

3 600 800 950 1050 1100

4 700 900 1050 1150 1200

5 800 950 1100 1200 1250

1 2 3 4 5CAPITAL

LABOUR


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There are various combinations of capital and labour. Different combination of inputs can yield diffrerent outputs.

For example, using 2 units of capital and 2 units of labur, total output would be 650 units.


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Output

0

1

2

3

4

5

6

1 2 3 5

Labour

Ca

pit

al

Output


Isoquant Curve


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Isoquant Map• A number of isoquants that are combined in a

single graph can be used to estimate the maximum attainable output from different combinations of inputs.

• A higher isoquant curve represents a higher level of output.

ISOQUANT MAP


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Is o q u an t m ap

Q =800

Q =6000

1

2

3

4

5

6

1 2 3 4 5

Cap

ital

ISOQUANT MAP(CON’T)


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MARGINAL RATE OF TECHNICAL SUBSTITUTION ( MRTS)

MRTS = Change in Capital

Change in Labour

MRTS = – K/ L

Marginal Rate of Technical Substitution (MRTS)

The technique to estimate the amount of capital input to be replaced by labour input without increasing or

decreasing output.


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SCALES OF PRODUCTION

DECREASING RETURNS TO SCALE All the factors of production are increased in a given proportion, and output

would increase by a smaller proportion.

CONSTANT RETURNS TO SCALE All the factors of production are increased in a given proportion, and output

would increase by the same proportion.

INCREASING RETURNS TO SCALEAll the factors of production are increased in a given proportion, and output

would increase by a greater proportion.


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In Cobb Douglas function, the return to scale is determined by the coefficient of labour and capital.

Production Function: Q = AKaLb

If,

a + b > 1, Increasing Returns to Scale

a + b < 1, Decreasing Returns to Scale

a + b = 1, Constant Returns to Scale

SCALES OF PRODUCTION (CON’T)


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In linear production function, the returns to scale is determined by substituting the labour and capital values.

Production Function: Q = 2L + 2KL + 4K

Let us assume L = 1 and K = 1, then substitute these values into the equation.

Q = 2(1) + 2(1)(1) + 4(1) = 8

Let us assume L and K are increased by two times

Q = 2(2) + 2(2)(2) + 4(2) = 20

The new output (20 units) is more than double of the old output (8 units), so it is increasing returns to scale.

SCALES OF PRODUCTION (CON’T)

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Documents

total output

level of output total

fixed inputs

total product total

efficient stage of production

variable factors

total labour mp

maximum output