Chapter 5 Theory of Production

Chapter 5 Prof. Dr. Mohamed I. Migdad Mohamed I. Migdad Professor of Economics 2015

Main Questions Production decisions concentrate on the following questions: 1. What goods to produce; 2. How to produce them; that include the technology. 3. For whom to produce, that determine the quality and price. 4. The costs of production;

Assumptions We assume all firms to try to produce efficiently at the lowest cost. Or they try to produce the maximum level of output for a given level of inputs. We also assume firms to try to maximize economic profits.

Definition A firm is an organization that comes into reality when a person or a group of people decide to produce a good or a service in order to meet a perceived demand. Most firms exist to make a profit but production is not limited to firms; many important differences exist between firms.

Production Process Production is simply the conversion of inputs to outputs. It is an economic process that uses resources to create commodities that are suitable for exchange. Some economists define production broadly as "the act of making things, creating things, producing things, and, in particular, the act of making products that will be traded or sold commercially".

Continue For those economists, this can include manufacturing, storing, shipping, and packaging. They see every commercial activity, other than the final purchase, as some form of production.

Production technology (PT) (P.T) refers to the quantitative relationship between inputs and outputs. The production technology could be a labor- intensive technology or a capital intensive one. A labor-intensive technology relies heavily on human labor instead of capital, while A capital-intensive technology relies heavily on capital instead of human labor.

Production function (PF) (P.F) explain that Production quantity is a function of factors-of-production. In the short run, it is a function of the variable FoP while in the long run, it is a function of the total (FoP). Q = F (L, C, M, E, R ….. N)

Technological Change (TC) Economic history records that total output in the US has grown more than tenfold over the last century. Part of that gain has come from increased inputs such as labor and machinery. Much of the increase of the output has come from the technological changes which improve productivity and raises living standards.

Technological change

Productive activities A farm takes fertilizer, seed, land, water & labor and tern them into wheat or corn. Factories takes energy, raw materials, machinery & labor and tern them into tractors or TVs. An airline takes airplanes, fuel, labor & computerized reservation system and provide passengers with the ability to travel quickly.

continue An accounting firms takes pencils, papers, computers, office space & labor and produce audits reports or tax returns for clients. We assume that all firms try to produce efficiently, that is, at lowest cost. Or they try to produce the maximum level of output for a given does of inputs. We assume that firms try to maximize economic profits.

The Production Process Production technology refers to the quantitative relationship between inputs and outputs. A labor-intensive technology relies heavily on human labor instead of capital. A capital-intensive technology relies heavily on capital instead of human labor.

Technological change Economic history record that total output in the US has grown more than tenfold over the last century. Part of that gain has come from increased inputs such as labor and machinery. Much of the increase of the output has come from the technological change which improve productivity and raises living standards.

Examples Fiber optics that have lowered cost and improved reliability in telecommunications. Improvement in computer technologies that have increased computational power by more than 1000 times in three decades. When the firm adjust the production process to reduce waste and increase outputs.

Profits and Economic Costs Profit (economic profit) is the difference between total revenue and total economic cost.

Total revenue Total revenue is the amount received from the sale of the product:

Profits and Economic Costs Total cost (total economic cost) is the total of 1.Out of pocket costs, 2.Normal rate of return on capital, and 3.Opportunity cost of each factor of production.

Profits and Economic Costs The rate of return, often referred to as the yield of the investment, is the annual flow of net income generated by an investment expressed as a percentage of the total investment.

Short-Run Versus Long-Run Decisions The short run is a period of time for which two conditions hold: 1.The firm is operating under a fixed scale (or fixed factor) of production, and 2.Firms can neither enter nor exit the industry.

Short-Run Versus Long-Run Decisions The long run is a period of time for which there are no fixed factors of production. Firms can increase or decrease scale of operation, and new firms can enter and existing, firms can exit the industry.

The Production Function The production function or total product function is a numerical or mathematical expression of a relationship between inputs and outputs. It shows units of total product as a function of units of inputs.

Marginal Product Marginal product is the additional output that can be produced by adding one more unit of a specific input, ceteris paribus.

MPL

The Law of Diminishing Marginal Returns The law of diminishing marginal returns states that: When additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines.

Average Product Average product is the average amount produced by each unit of a variable factor of production.

APL

Production Schedule 7 (1) LABOR UNITS (EMPLOYEES) (2) TP TOTAL PRODUCT (SANDWICHES PER HOUR) (3) MPL MARGINAL PRODUCT OF LABOR (4) APL AVERAGE PRODUCT OF LABOR 00 

The relation between TP, MP & AP

Total, Average, and Marginal Product Marginal product is the slope of the total product function. At point C, total product is maximum, the slope of the total product function is zero, and marginal product intersects the horizontal axis. At point A, the slope of the total product function is highest; thus, marginal product is highest.

Total, Average, and Marginal Product

When average product is maximum, average product and marginal product are equal. Then, average product falls to the left and right of point B.

Total, Average, and Marginal Product Remember that: As long as marginal product rises, average product rises. When average product is maximum, marginal product equals average product. When average product falls, marginal product is less than average product.

Appendix: Isoquants and Isocosts An isoquant is a graph that shows all the combinations of capital and labor that can be used to produce a given amount of output.

Appendix: Isoquants and Isocosts Alternative Combinations of Capital (K) and Labor (L) Required to Produce 50, 100, and 150 Units of Output q x = 50q x = 100q x = 150 KLKLKL A B C D E

Appendix: Isoquants and Isocosts The slope of an isoquant is called the marginal rate of technical substitution. Along an isoquant:

Appendix: Isoquants and Isocosts An isocost line is a graph that shows all the combinations of capital and labor that are available for a given total cost. The equation of the isocost line is:

Appendix: Isoquants and Isocosts Slope of the isocost line:

Appendix: Isoquants and Isocosts By setting the slopes of the isoquant and isocost curves equal to each other, we derive the firm’s cost- minimizing equilibrium condition is found

Appendix: Isoquants and Isocosts Plotting a series of cost-minimizing combinations of inputs (at points A, B, and C), yields a cost curve.