1. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 1 Theory of Production 6 CHAPTER

2. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 2 Production is the process of transforming inputs into outputs. DEFINITION OF PRODUCTION Processing INPUTS Input refers to the factors of production that a firm uses in the production process OUTPUTS Refers to what we get at the end of the production process, that is, finished products.

3. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 3 CLASSIFICATION OF FACTORS OF PRODUCTION CLASSIFICATION OF FACTORS OF PRODUCTION LAND LABOUR Physical or mental activities of human beings A person who combines the different factors of production, and initiates the process of production and also bears the risk ENTREPRENEUR All natural resources or gifts of nature CAPITAL Part of man-made wealth used for further production

4. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 4 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

5. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 5 SHORT RUN PRODUCTION 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) WhereQ=Output L =Labour K=Capital (fixed)

6. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 6 SHORT RUN PRODUCTION 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.

7. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 7 MARGINAL PRODUCT (MP)Change in the total product of that input corresponding toan 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 MARGINAL PRODUCT (MP)Change in the total product of that input corresponding toan 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 RUN PRODUCTION FUNCTION (CON’T)

8. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 8 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 RUN PRODUCTION FUNCTION (CON’T)

9. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 9 STAGES OF PRODUCTION SHORT RUN PRODUCTION 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.

10. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 10 SHORT RUN PRODUCTION FUNCTION (CON’T) -10 0 10 20 30 40 50 60 012345678910 TP MPMP AP STAGE I STAGE II AP MAX; AP=MP STAGE III MP= 0 TP MAX

11. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 11 LONG-RUN PRODUCTION FUNCTION In the long-run a firm can produce its output in various ways by adjusting the amount of labour and capital.

12. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 12 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-RUN PRODUCTION FUNCTION (CON’T)

13. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 13 Isoquant Table LONG-RUN PRODUCTION FUNCTION (CON’T) 1250450 550 700 800 2450650 800 900 950 3600800 95010501100 4700900105011501200 5800950110012001250 12345 CAPITAL LABOUR

14. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 14 LONG-RUN PRODUCTION 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.

15. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 15 LONG-RUN PRODUCTION FUNCTION (CON’T) Isoquant Curve

16. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 16 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

17. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 17 MICROECONOMICS17 ISOQUANT MAP (CON’T)

18. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 18 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.

19. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 19 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 SCALE All the factors of production are increased in a given proportion, and output would increase by a greater proportion.

20. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 20 In Cobb Douglas function, the return to scale is determined by the coefficient of labour and capital. Production Function: Q = AK a L b 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)

21. All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 6– 21 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)