1. Chapter 5 Slide 1 CHAPTER 5 THEORY OF PRODUCTION Dr. Vasudev P. Iyer

2. Chapter 5 Slide 2 INTRODUCTION Our focus is the supply side. We will consider the conceptual issues related to production. We will also consider production in the short-run and in the long-run period.

3. Chapter 5 Slide 3  Meaning of production  Meaning of production function  Short-run production function  The Law of Diminishing Returns  The long-run production function and returns to scale  The economies of scale  Production functions and managerial decision making

4. Chapter 5 Slide 4 What do we mean by Production? The Production Process – Combining inputs or factors of production to achieve an output Categories of Inputs (factors of production) – Land – Labour – Capital Thus, in simple words, production means transforming inputs into outputs.

5. Chapter 5 Slide 5 INPUTS OUTPUTS FACTORS OF PRODUCTION GOODS & SERVICES T The Production Process

6. Chapter 5 Slide 6  Meaning of production  Meaning of production function  Short-run production function  The Law of Diminishing Returns  The long-run production function and returns to scale  The economies of scale  Production functions and managerial decision making

7. Chapter 5 Slide 7 Meaning of Production A production function defines the relationship between inputs and the maximum amount that can be produced within a given time period with a given technology.

8. Chapter 5 Slide 8 Mathematical Representation Mathematically, the production function can be expressed as Q=f(X 1,X 2,...,X k ) Q is the level of output X 1,X 2,...,X k are the levels of the inputs in the production process f( ) represents the production technology

9. Chapter 5 Slide 9 In case of two inputs The production function for two inputs: Q = F(K,L) Q = Output, K = Capital, L = Labour

10. Chapter 5 Slide 10 ISOQUANTS An important tool to study production function in detail. WHAT ARE ISOQUANTS ? ISOQUANTS SHOW ALL POSSIBLE COMBINATIONS OF INPUTS THAT YILED THE SAME OUTPUT.

11. Chapter 5 Slide 11 Assumptions of Isoquant Analysis Assumptions –The producer has two inputs: Labour (L) & Capital (K)

12. Chapter 5 Slide 12 Production Function for Food 12040556575 24060758590 3557590100105 46585100110115 57590105115120 Capital Input12345 Labour Input

13. Chapter 5 Slide 13 Production with Two Variable Inputs (L,K) Labour per year 1 2 3 4 12345 5 Q 1 = 55 The isoquants are derived from the production function for output of of 55, 75, and 90. A D B Q 2 = 75 Q 3 = 90 C E Capital per year The Isoquant Map

14. Chapter 5 Slide 14 What does the Isoquant emphasizes? The isoquants emphasize how different input combinations can be used to produce the same output. This information allows the producer to respond efficiently to changes in the markets for inputs. Input Flexibility

15. Chapter 5 Slide 15  Meaning of production  Meaning of production function  Short-run production function  The Law of Diminishing Returns  The long-run production function and returns to scale  The economies of scale  Production functions and managerial decision making

16. Chapter 5 Slide 16 Short-run: – Period of time in which quantities of one or more production factors cannot be changed. – These inputs are called fixed inputs. Long-run – Amount of time needed to make all production inputs variable. The Short Run versus the Long Run

17. Chapter 5 Slide 17 Production in the Short Run When discussing production in the short run, three definitions are important. Total Product Marginal Product Average Product

18. Chapter 5 Slide 18 TOTAL PRODUCT (TP) Total product (TP) is another name for output in the short run.

19. Chapter 5 Slide 19 MARGINAL PRODUCT (MP) Marginal product tells us how output changes as we change the level of the input by one unit. For example

20. Chapter 5 Slide 20 AVERAGE PRODUCT (AP) Average product tells us, on average, how many units of output are produced per unit of input used. For example

21. Chapter 5 Slide 21 AmountAmountTotalAverage Marginal of Labour (L)of Capital (K)Output (Q)ProductProduct Production with One Variable Input (Labour) 0100------ 110101010 210301520 310602030 410802020 510951915 6101081813 710112164 810112140 91010812-4 101010010-8

22. Chapter 5 Slide 22 OBSERVATIONS 1.With additional workers, output (Q) increases, reaches a maximum, and then decreases. 2.The average product of labor (AP), or output per worker, increases and then decreases. 3.The marginal product of labour (MP), increases rapidly initially and then decreases and becomes negative

23. Chapter 5 Slide 23 Total Product A: slope of tangent = MP (20) B: slope of OB = AP (20) C: slope of OC= MP & AP Labour per Month Output per Month 60 112 023456789101 A B C D Production with One Variable Input (Labour)

24. Chapter 5 Slide 24 Average Product Production with One Variable Input (Labour) 8 10 20 Outpu t per Month 02345679101 Labour 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

25. Chapter 5 Slide 25 MP = 0 TP is at its maximum MP > AP MP < AP MP = AP AP is decreasing AP is at its maximum AP is increasing To summarize

26. Chapter 5 Slide 26

27. Chapter 5 Slide 27  Meaning of production  Meaning of production function  Short-run production function  The Law of Diminishing Returns  The long-run production function and returns to scale  The economies of scale  Production functions and managerial decision making

28. Chapter 5 Slide 28 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). When the labour input is small, MP increases due to specialization. When the labour input is large, MP decreases due to inefficiencies. The Law of Diminishing Marginal Returns

29. Chapter 5 Slide 29 AmountAmountTotalAverage Marginal of Labor (L)of Capital (K)Output (Q)ProductProduct RECALL SLIDE 21 0100------ 110101010 210301520 310602030 410802020 510951915 6101081813 710112164 810112140 91010812-4 101010010-8

30. Chapter 5 Slide 30 The Law of Diminishing Returns Reasons X MP Increasing Returns Teamwork and Specialization Diminishing Returns Begins Fewer opportunities for teamwork and specialization MP

31. Chapter 5 Slide 31  Meaning of production  Meaning of production function  Short-run production function  The Law of Diminishing Returns  The long-run production function and returns to scale  The economies of scale  Production functions and managerial decision making

32. Chapter 5 Slide 32 In the long run, all inputs are variable. The long run production process is described by the concept of returns to scale. Returns to scale describes what happens to total output if all of the inputs are changed by the same proportion. Production in the Long Run

33. Chapter 5 Slide 33 If all inputs into the production process are doubled, three things can happen: –output can more than double increasing returns to scale (IRTS) –output can exactly double constant returns to scale (CRTS) –output can less than double decreasing returns to scale (DRTS) 3 things can happen

34. Chapter 5 Slide 34 INCREASING RETURNS TO SCALE output more than doubles when all inputs are doubled Larger output associated with lower cost (autos) One firm is more efficient than many (utilities) The isoquants get closer together

35. Chapter 5 Slide 35 IRTS Labour (hours) Capital (machine hours) 10 20 30 Increasing Returns: The isoquants move closer together 510 2 4 0 A

36. Chapter 5 Slide 36 Constant Returns to Scale output doubles when all inputs are doubled Size does not affect productivity May have a large number of producers Isoquants are equidistant apart

37. Chapter 5 Slide 37 CRTS Labour (hours) Capital (machine hours) Constant Returns: Isoquants are equally spaced 10 20 30 15510 2 4 0 A 6

38. Chapter 5 Slide 38 Decreasing Returns to Scale output less than doubles when all inputs are doubled Decreasing efficiency with large size Reduction of entrepreneurial abilities Isoquants become farther apart

39. Chapter 5 Slide 39 DRTS Labour (hours) Capital (machine hours) Decreasing Returns: Isoquants get further apart 10 20 30 510 2 4 0 A

40. Chapter 5 Slide 40 Returns to Scale If E>1 then IRTS If E=1 then CRTS If E<1 then DRTS One way to measure returns to scale is to use a coefficient of output elasticity:

41. Chapter 5 Slide 41  Meaning of production  Meaning of production function  Short-run production function  The Law of Diminishing Returns  The long-run production function and returns to scale  The economies of scale  Production functions and managerial decision making

42. Chapter 5 Slide 42 Meaning When doubling the output results in a less than double increase in costs, we can say that a firm is enjoying economies of scale. Types of economies of scale –Internal –External Internal economies include: specialization, technical, purchasing, transportation, marketing etc.

43. Chapter 5 Slide 43  Meaning of production  Meaning of production function  Short-run production function  The Law of Diminishing Returns  The long-run production function and returns to scale  The economies of scale  Production functions and managerial decision making

44. Chapter 5 Slide 44 How useful is production function to managers? It is the foundation for cost analysis (Chap. 6) In allocation of a firm’s scarce resources in short-run and long-run Production planning. –Operate at a stage from were AP is max. to MP=zero. But production levels depend on how much customers want to buy.

45. Chapter 5 Slide 45 CASELET:13 CALL CENTERS APPLYING PRODUCTION FUNCTION TO A SERVICE Managerial Economics: Keat & Young, pg. 299

46. Chapter 5 Slide 46 The Genesis Output (Q)= the number of calls handled by customer representatives Input: Labour= the call center representative Thus, we have: Where, Q is the output X is the variable input Y is the fixed input Q= f (X,Y)

47. Chapter 5 Slide 47 Application of returns to scale Possibility of IRTS Although smaller in size, quality is high and cost is low (?)