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1 PRODUCTION FUNCTION Reveals functional relation between factors of input and output.

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2 The Technology of Production The Production Process – Combining inputs or factors of production to achieve an output Categories of Inputs (factors of production) – Land – Capital – Labor – Entrepreneur

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3 The Technology of Production Production Function: – Indicates the highest output that a firm can produce for every specified combination of inputs given the state of technology. – Shows what is technically feasible when the firm operates efficiently.

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4 The Technology of Production The production function for two inputs: Q = F(K,L) Q = Output, K = Capital, L = Labor For a given technology

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5 Short Run vs Long Run – S-R is the period of time during which at least one factor of production is fixed - cannot be increased. – L-R is the period of time during which all factors of production can be varied.

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6 The Short Run / Law of Variable proportions Stages Law of increasing returns Law of diminishing returns Law of negative returns

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7 AmountAmountTotalAverage Marginal of Labor (L)of Capital (K)Output (Q)ProductProduct Production with One Variable Input (Labor)

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8 Observations: The average product of labor (AP), or output per worker, increases and thendecreases. Production with One Variable Input (Labor)

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9 Observations: The marginal product of labor (MP), or output of the additional worker, increases rapidly initially and then decreases and becomes negative.. Production with One Variable Input (Labor)

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10 Total Product B increase at increasing rate B to D incr at diminishing rate D max prd. n then decline in TP Labor per Month Output per Month A B C D Production with One Variable Input (Labor)

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11 Average Product Production with One Variable Input (Labor) Output per Month Labor per Month 30 E Marginal Product 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

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12 Observations: – When MP = 0, TP is at its maximum – When MP > AP, AP is increasing and TP is increasing at increasing rate. – When MP < AP, AP is decreasing and TP is increasing at diminishing rate. – When MP = AP, AP and TP are at maximum Production with One Variable Input (Labor)

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13 Production with One Variable Input (Labor) Labor per Month Output per Month A B C D 8 20 E Output per Month Labor per Month AP = slope of line from origin to a point on TP, lines b, & c. MP = slope of a tangent to any point on the TP line, lines a & c.

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14 Law of variable output Stage I – TP in increasing at increasing rate, MP is increasing (reaches it max and then declines somewhere in this stage) and AP is also increasing but less than MP. Stage II – TP in increasing at diminishing rate, MP is declining and AP is declining and is higher than MP. Stage III – TP reaches its max and then start to decline, MP is ZERO when TP is max and AP is declining.

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15 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). Stage of operation The Law of Diminishing Marginal Returns

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16 Long Run Production Function Returns to Scale Measuring the relationship between the scale (size) of a firm and output 1)Increasing returns to scale: output more than doubles when all inputs are doubled Utilizing Economies of Scale

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17 Returns to Scale Measuring the relationship between the scale (size) of a firm and output 2)Constant returns to scale: output doubles when all inputs are doubled – Moving towards Optimum

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18 Returns to Scale Measuring the relationship between the scale (size) of a firm and output 3)Decreasing returns to scale: output less than doubles when all inputs are doubled Decreasing efficiency with large size Reduction of entrepreneurial abilities Diseconomies of scale

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