Lecture 6 Producer Theory Theory of Firm

The main objective of firm is to maximize profit Firms engage in production process. To maximize profit firms want maximize production with its available inputs and technology. In the production process firms objective is to efficiently produce output and minimize cost.

Factor of Production The factors of production are : – Land Price paid to acquire land = Rent – Labour – all physical and mental human effort involved in production Price paid to labour = Wages – Capital – buildings, machinery and equipment used for production Price paid for capital = Interest

Production Function It shows the maximum amount of output that can be efficiently produced by given inputs and technology. Production function is expressed as Q = f (K, L, La) Output (Q) is dependent upon the amount of capital (K), Land (La) and Labour (L) used

Total product (TP) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc) The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant.

Production Function of a Rice Farmer Units of L Total Product (Q L or TP L ) Marginal Product (MP L)

Marginal Product Observe that the marginal product initially increases, reaches a maximum level, and beyond this point, the marginal product declines, reaches zero, and subsequently becomes negative. The law of diminishing returns states that "as the use of an input increases (with other inputs fixed), the marginal product will initially increase but eventually there will be a point from which the marginal product will decrease."

Average Product (AP) Average product is a concept commonly associated with efficiency. The average product measures the total output per unit of input used. – The "productivity" of an input is usually expressed in terms of its average product. – The greater the value of average product, the higher the efficiency in physical terms. Formula:

TABLE 5.2. Average product of labor. Labor (L) Total product of labor (TP L ) Average product of labor (AP L )

Comparison In Consumer Theory, the indifference curve shows combinations of goods giving the same utility The slope of the indifference curve was the marginal rate of substitution In Production Theory, there is a similar concept known as isoquant curve which shows the combinations of inputs that give the same amount of production

Isoquant: It is a curve that shows all possible combinations of inputs that can produce the same level of output. All the isoquants to the right of a given isoquant show higher level of production. All the isoquants to the left of a given isoquant show lower level of production.

Labor Capital 0 K2K K1K1 L2L2 L1L1

Marginal Rate of Technical Substitution The slope of isoquant is called Marginal Rate of Technical Substitution ( MRTS) Definition: The marginal rate of technical substitution (labor for capital) measures the amount of an input, K, the firm the firm could give up in exchange for a little more of another input, L, in order to just be able to produce the same output as before. The formula of MRTS is MRTS L,K =  K/  L

In the following figure, the slope (ΔK/ΔL) of isoquant is Marginal Rate of Technical Substitution ( MRTS) which shows the way the producer substitute capital ( decreases the use of capital from k1 to k2) with labor ( increases the use of labor from L1 to L2) so that he remains in the same isoquant (that means the level of output remains the same)