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All Rights ReservedMicroeconomics© Oxford University Press Malaysia, 2008
6– 1
Theory of Production
6CHAPTER
All Rights ReservedMicroeconomics© Oxford University Press Malaysia, 2008
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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
SHORT RUNPRODUCTION FUNCTION (CON’T)
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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.
SHORT RUNPRODUCTION FUNCTION (CON’T)
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STAGES OF PRODUCTION
SHORT RUNPRODUCTION FUNCTION (CON’T)
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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SHORT RUNPRODUCTION FUNCTION (CON’T)
-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
LONG-RUNPRODUCTION FUNCTION (CON’T)
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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LONG-RUNPRODUCTION FUNCTION (CON’T)
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
LONG-RUNPRODUCTION FUNCTION (CON’T)
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
All Rights ReservedMicroeconomics© Oxford University Press Malaysia, 2008
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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)