VIDYA BHARTI EDUCATIONAL INSTITUTIONS

PRODUCTION FUNCTIONhttp://vidyabharti.in/

PRODUCTION AND FIRM Production:

Is the process of using the factors of production to produce goods and services.

In other words, it can be stated as the “transformation of inputs into outputs”.

Usually, by firm

Firm: An output producing organization Demand production factors from

input market Maximize profit (rational assumption)

COST & PROFIT ECONOMICS & ACCOUNTING CONCEPTS

Accounting Cost (Explicit Cost) Considered as “normal” cost (or profit) What was paid out (in money) Example: wages or rental

Economics Cost (Implicit Cost) Reflex the opportunity cost The 2nd best alternative lost Considered as implicit cost Example: Owner time/effort or using own

building

Accounting Profits A firm’s total revenue minus

its explicit costs. Formula:

Economics Profits A firm’s total revenue minus

its explicit and implicit costs.

licitTR exp

)(exp implicitlicitTR

Explicit Cost: What was paid out (in money)Implicit Cost: The opportunity Cost

THE PRODUCTION DECISION All firms must make several basic decisions

to achieve what we assume to be their primary objective—maximum profits.

1.How muchoutput to

supply

2.Which production

technologyto use

3.How much ofeach input to

demand

THE THREE DECISIONS THAT ALL FIRMS MUST MAKE

Market price Techniques Prices of inputs

q = f (K, L, M…)

THE PRODUCTION PROCESS

Input:Raw Material

Input:Capital

Input:Labour Output

Technology

Input decision:>>How many>>Which types

Cost decision Selling price

Production Function: Refers to the relationship between

inputs and outputs. It can be represented in the form of a

mathematical equation such as: Q=f(K,L,M…)

Marginal Product (MP): Additional output that can be produced

by adding one more unit of a particular input, ceteris paribus.

MP slopping down reflex the law of diminishing marginal returns

Formula: ∆ TP / ∆L Average Product of labor (AP):

Average amount produced by each unit of a variable factor (e.g. labor)

Formula: TP / L

PRODUCTION THEORY Short run – Period of time which

quantities of one or more inputs cannot be changed and firm is operating under fixed scale, firms can neither enter nor exit an industry.

Long run – Period of time which quantities of all inputs can be varied (no fixed input). Firms can change the scale of production (increase/decrease).

QUANTITY OF

WORKERS

OUTPUT MP AP COST OF FACTORY

COST OF WORKERS

TOTAL COST

012345678

0259

1214151514

-2343210-1

-2

2.533

2.82.52.11.8

$303030303030303030

$01020304050607080

$30405060708090

100110

A PRODUCTION FUNCTION AND TOTAL COST FOR HUNGRY HELEN’S COOKIE

FACTORY

02468

101214161820

0 1 2 3 4 5 6 7 8Number of Workers Hired

Quantity of output

TP

HUNGRY HELEN’S PRODUCTION FUNCTION

11

Relationship between TP& MP

When MP is increasing, TP will increase at an increasing rate. (stage 1)

When MP is decreasing, TP will increase at a decreasing rate. (stage 2)

When MP is zero, TP is at its maximum When MP is negative, TP declines. (stage 3)

Stage 1

Stage 2 Stage 3

Relationship between MP& AP

When MP is above AP, AP is increasing When MP is below AP, AP is decreasing When MP equals to AP, AP is at maximum.

LAW OF DIMINISHING MARGINAL RETURN

Definition

This law explains the behavior of production functions in the short run, when at least one of the inputs must be fixed.

The law of diminishing marginal returns states that as more of variable inputs is used, while other inputs are fixed, the marginal product of the variable input will eventually declines.

12

STAGE OF PRODUCTION

Increasing Marginal Returns (Stage 1: A to B) The marginal product (MP) of a variable resource

increases as each additional unit of that resource is employed.

TP increase at an increasing rate (specialization) Diminishing Marginal Returns (Stage 2: B to C)

As more of a variable resources is added to a given amount of another resource, marginal product (MP) eventually declines.

TP increases at a decreasing rate (less efficient / abundant)

Negative Marginal Returns (Stage 3: After C) The marginal product (MP) of a variable resource

turn to negative as each additional unit of that resource is employed

TP decreases (overcrowded).

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Labor

Labor

TP

AP, MP

Stage 1 Stage 2 Stage 3

TP

AP

MP

STAGES OF PRODUCTION

B

CA

15

INCREASING MARGINAL RETURNS

Tota

l Pro

duct

, TP

Quantity of Labor

Aver

age

Prod

uct,

AP,

and

Mar

gina

l Pro

duct

, MP

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

IncreasingMarginalReturns

16

DIMINISHING MARGINAL RETURNS

Tota

l Pro

duct

, TP

Quantity of Labor

Aver

age

Prod

uct,

AP,

and

Mar

gina

l Pro

duct

, MP

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

DiminishingMarginalReturns

17

NEGATIVE MARGINAL RETURNS

Tota

l Pro

duct

Quantity of Labor

Aver

age

Prod

uct,

and

Mar

gina

l Pro

duct

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

NegativeMarginalReturns

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