VIEWS: 21 PAGES: 41 CATEGORY: Business POSTED ON: 11/19/2011
Production theory Provides framework for economics of production of firm The Organization of Production Inputs Labor, Capital, Land Fixed Inputs Variable Inputs Short Run At least one input is fixed Long Run All inputs are variable What is production Production refers to transformation of inputs or resources into outputs of goods and services Inputs = resources used in production of goods (fixed and variable) Output = end result Basic production decision 1.How much of commodity to produce 2.How much inputs should be used To answer these questions, the firm a. Requires engineering data on production possibilities b. Economic data on input and output prices Production function Production is a function that transforms inputs into output Q = f (L, N, K……T) Factors affecting production are 1.Technology 2.Inputs (land, labour etc) 3.Time period (short run vz long run) Production function with 2 inputs Q = f(L, K) K Q 6 10 24 31 36 40 39 5 12 28 36 40 42 40 4 12 28 36 40 40 36 3 10 23 33 36 36 33 2 7 18 28 30 30 28 1 3 8 12 14 14 12 1 2 3 4 5 6 L Production Function With Two Inputs Discrete Production Surface Production Function With Two Inputs Continuous Production Surface Production function with one variable input 1) Total Product: TP = Q = f(L) TP 2) Average Product: APL = L TP 3) Marginal Product: MPL = L 4) Production or MPL Output Elasticity: EL = AP L Concepts of production Total Product :This is amount of total output produced by a given amount of factor, other factors held constant. Average Product:This is total output produced per unit of factor employed AP =TP/no.of units of factor employed Marginal Product:This is addition to total production by employment of extra unit of factor Production function with one variable input Total, Marginal, and Average Product of Labor, and Output Elasticity L Q MPL APL EL 0 0 - - - 1 3 3 3 1 2 8 5 4 1.25 3 12 4 4 1 4 14 2 3.5 0.57 5 14 0 2.8 0 6 12 -2 2 -1 Law of variable proportions or law of diminishing returns As more and more of one factor input is employed, all other input quantities held constant, a point will be reached where additional quantities of varying input will yield diminishing marginal contribution to total product Short run law Some factors fixed, other factors variable State of technology fixed and unchanged Possibility of varying proportion of factors Production function with one variable input Stages of return Stage 1:Increasing returns. MP increasing, AP increasing, TP increases till G at increasing rate, after that at decreasing rate. G= point of inflexion Stage 2:Diminishing returns. MP decreasing and falls till zero, AP decreasing, TP increases at a decreasing rate Stage 3:Negative returns. MP negative, AP decreasing, TP is also falling Contd.. Stage of operations –stage2 Stage 1 – fixed factor too much for variable factor. Fixed factor is more intensively utilised Stage 3- variable factor too much in relation to fixed factor Applications – agriculture, studying Optimal use of variable input Marginal Revenue MRPL = (MPL)(MR) Product of Labor Marginal Resource TC MRCL = Cost of Labor L Optimal Use of Labor MRPL = MRCL Optimal use of variable input Use of Labor is Optimal When L = 3.50 L MPL MR = P MRPL MRCL 2.50 4 $10 $40 $20 3.00 3 10 30 20 3.50 2 10 20 20 4.00 1 10 10 20 4.50 0 10 0 20 Optimal use of variable input Efficient Resource Utilisation Firm maximises production for a given rupee outlay on labor and capital Minimise rupee outlay on labor and capital inputs necessary to produce a specified rate of output Produce the output rate that maximises profit To solve these problems, production isoquants and isocosts are used Production with two variable inputs Isoquants show combinations of two inputs that can produce the same level of output. Firms will only use combinations of two inputs that are in the economic region of production, which is defined by the portion of each isoquant that is negatively sloped. Isoquant An isoquant is a curve representing various combinations of 2 inputs that produce the same level of output ISO+QUANT= same + quantity Production with two variable inputs Isoquants Production with two variable inputs Economic Region of Production Production with two variable inputs Marginal Rate of Technical Substitution MRTS = -K/L = MPL/MPK Marginal rate of substitution The marginal rate of technical substitution of L for K (MRTS lk) is the amount of K a firm will give up for increasing the amount of L used by 1 unit and remain on same isoquant MRTS lk = MP l = w MP k r Production With Two Variable Inputs MRTS = (-2.5/1) = 2.5 Production with two variable inputs Perfect Substitutes Perfect Complements Optimal combination of inputs Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost. C wL rK C Total Cost w Wage Rate of Labor ( L) C w K L r Cost of Capital ( K ) r r Isocost An isocost shows all different combinations of labor and capital that a firm can purchase, given the total outlay (TO) of firm and factor prices. The slope of an isocost is – Pl. Pk Producer’s equilibrium An producer is in equilibrium when he maximises output for total outlay. i.produces given output at minimum cost ii. Produces maximum output at given level of cost Equilibrium = isocost tangent to isoquant Here, MRTS lk = MPl /MPk = w/r i.e.At equilibrium, MPl = MPk Pl Pk Optimal combination of inputs MRTS = w/r Returns to Scale- Change in all inputs Production Function Q = f(L, K) Q = f(hL, hK) If = h, then f has constant returns to scale. If > h, then f has increasing returns to scale. If < h, the f has decreasing returns to scale. Stages of return – Returns to scale The percentage increase in output when all inputs vary in same proportion is known as returns to scale 1.Constant returns to scale – Output increases in same proportion as increase in input 2.Increasing returns to scale-Output increases by greater proportion as increase in input 3. Decreasing returns to scale – Output increases by lesser proportion as increase in input Returns to Scale Constant Increasing Decreasing Returns to Returns to Returns to Scale Scale Scale Reasons Causes of increasing returns Specialisation in large scale production. In some industries, small scale production is not possible Causes of decreasing returns Coordination and control maybe difficult. Information maybe lost or distorted when transmitted Production data of Silicone chip firm L K % inc L, K Q % inc TP Returns 1 100 - 100 0 increase 2 200 100 220 120 increase 3 300 50 350 59 increase 4 400 33.33 500 42.9 increase 5 500 25 625 25 constant 6 600 20 750 20 constant 7 700 16.66 860 14.66 decrease 8 800 14.29 940 9.3 decrease 9 900 12.5 1000 6.4 decrease Empirical production function Cobb-Douglas Production Function Q = AKaLb b + a = 1 (constant returns) Estimated using Natural Logarithms ln Q = ln A + a ln K + b ln L Effect of technology What is the effect of technology on production? How do isoquants change? Innovations, Global Competition Product Innovation Process Innovation Product Cycle Model Just-In-Time Production System Competitive Benchmarking Computer-Aided Design (CAD) Computer-Aided Manufacturing (CAM) Elasticity of Substitution When price of a factor falls, the equilibrium position will be disturbed. The producer will substitute the cheaper factor for other factor. The degree of substitutability of factor L for factor K, resulting exclusively from change in relative factor prices, is called elasticity of technical substitution. E subs = Δ(K/L)/(K/L) Δ(MRTS)/(MRTS)