Department of Business Administration

FALL 2010-11
Production Theory and Estimation

by Assoc. Prof. Sami Fethi

Ch 6 Production Theory

The Production Function

Production refers to the transformation of inputs or resources into outputs of goods and services. In other words, production refers to all of the activities involved in the production of goods and services, from borrowing to set up or expand production facilities, to hiring workers, purchasing row materials, running quality control, cost accounting, and so on, rather than referring merely to the physical transformation of inputs into outputs of goods and services.

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Ch 6 Production Theory

For example

A computer company hires workers to use machinery, parts, and raw materials in factories to produce personal computers. The output of a firm can either be a final commodity or an intermediate product such as computer and semiconductor respectively. The output can also be a service rather than a good such as education, medicine, banking etc.

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Ch 6 Production Theory

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

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Ch 6 Production Theory

The Organization of Production

Inputs: are the sources used in the production of goods and services and can be broadly classified into labour, capital, land, natural resources, and entrepreneurial talent. Fixed input: are those that cannot be readily changed during the time period under consideration such as a firms plant and specialized equipment.

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Ch 6 Production Theory

The Organization of Production

Variables Inputs: are those can be varied easily and on very short notice such as raw materials and unskilled labour. The time period during which at least one input is fixed called the short-run and if all inputs are variable, we are in the long-run.

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Ch 6 Production Theory

The Production Function

A production function is an equation, tables, or graph showing the maximum output of a commodity that a firm can produce per period of time with each set of inputs. Both inputs and outputs are measured in physical rather than in monetary units. Here technology is assumed to remain constant during the period of the analysis.

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Ch 6 Production Theory

The Production Function

The general equation of the production function of a firm using labour (L) and capital (K) to produce a good or service (Q) or shows the maximum amount of output (Q) that can be produced within a given time period with each combination of (L) and (K). This can be defined as follows:

Q= f (L,K)

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Ch 6 Production Theory

Production Function With Two Inputs

K 6 5 4 3 2 1

Q = f(L, K)
10 12 12 10 7 3 1 24 28 28 23 18 8 2 31 36 36 33 28 12 3 36 40 40 36 30 14 4 40 42 40 36 30 14 5

Q The table shows 39 40 36 33 28 12 6 L

that by using 1 unit of labour (1L) and 1 unit of capital (1K), the firm would produce 3 units of o/p (3Q).
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Ch 6 Production Theory

Production Function With Two Inputs

Discrete Production Surface

The previous table are shown graphically in this figure. The height of bars refers to the max o/p that can be produced with each combination of labour and capital shown on the axes.

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Ch 6 Production Theory

Production Function With Two Inputs

Continuous Production Surface

In this figure, If we assume that i/ps and o/ps are continuously divisibly, we would have the continuous production surface. This indicates that by increasing L2 with K1 of capital, the firm produces the o/p by height of cross section K1AB. Increasing L1 with K2, we have cross section K2CD.
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Ch 6 Production Theory

Production Function With One Variable Input

When discussing production in the short run, three definitions are important: Total product Marginal product Average product

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Ch 6 Production Theory

Production Function With One Variable Input

Total Product Marginal Product Average Product

TP = Q = f(L) TP MPL = L TP APL = L

Production or Output Elasticity

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MPL EL = AP L
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Ch 6 Production Theory

Total Product

Total product (TP) is another name for output in the short run.

TP = Q = f (L)

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Ch 6 Production Theory

Marginal Product

The marginal product (MP) of a variable input is the change in output (or TP) resulting from a one unit change in the input. MP tells us how output changes as we change the level of the input by one unit. Consider the two input production function Q=f (L,K) in which input L is variable and input K is fixed at some level. The marginal product of input L is defined as holding input K constant.

TP MPL = L
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Ch 6 Production Theory

Average Product

The average product (AP) of an input is the total product divided by the level of the input. AP tells us, on average, how many units of output are produced per unit of input used. The average product of input L is defined as holding input K constant.

TP APL = L
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Ch 6 Production Theory

Production Function With One Variable Input-Example

Total, Marginal, and Average Product of Labor, and Output Elasticity

L 0 1 2 3 4 5 6

Q 0 3 8 12 14 14 12

MPL 3 5 4 2 0 -2

APL 3 4 4 3.5 2.8 2

EL 1 1.25 1 0.57 0 -1

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Ch 6 Production Theory

Production Function With One Variable Input

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Ch 6 Production Theory

The Law of Diminishing Returns

As additional units of a variable

input are combined with a fixed input, after a point the additional output (marginal product) starts to diminish. This is the principle that after a point, the marginal product of a variable input declines.

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Ch 6 Production Theory

The Law of Diminishing Returns

Increasing Returns
MP Diminishing Returns Begins

X MP
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Ch 6 Production Theory

The Three Stages of Production

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Ch 6 Production Theory

The Three Stages of Production

Stage I: The range of increasing average product of the variable input. From zero units of the variable input to where AP is maximized Stage II: The range from the point of maximum AP of the variable i/p to the point at which the MP of i/p is zero. From the maximum AP to where MP=0 Stage III: The range of negative marginal product of the variable input. From where MP=0 and MP is negative.
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Ch 6 Production Theory

The Three Stages of Production

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Ch 6 Production Theory

The Three Stages of Production

In the short run, rational firms should only be operating in Stage II. Why Stage II? Why not Stage I and III? In Stage III- MPLis negative In Stage I- MPK is negative In Stage II- MPL and MPK are both positive but decline
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Ch 6 Production Theory

The Three Stages of Production-Example

Labor Total Average Marginal Unit Product Product Product (L) (Q or TP) (AP) (MP) 0 0 1 10,000 10,000 10,000 2 25,000 12,500 15,000 3 45,000 15,000 20,000 4 60,000 15,000 15,000 5 70,000 14,000 10,000 6 75,000 12,500 5,000 7 78,000 11,143 3,000 8 80,000 10,000 2,000
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Stage II

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Ch 6 Production Theory

The Three Stages of Production-Example

What level of input usage within Stage II is best for the firm? Is there a precise point.
The answer depends upon how many

units of output the firm can sell, the price of the product, and the monetary costs of employing the variable input.

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Ch 6 Production Theory

Optimal Use of the Variable Input

How much labor or the variable input should the firm use in order to maximize profit. The firm should employ an additional unit of labor as long as the extra revenue genereted until the extra revenue equals the extra cost. Where MRP=MLC.

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Ch 6 Production Theory

Optimal Use of the Variable Input

Marginal Revenue Product of Labor Marginal Resource Cost of Labor

MRPL = (MPL)(MR)

TC MRCL = L MRPL = MRCL

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Optimal Use of Labor

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Ch 6 Production Theory

Optimal Use of the Variable Input-Example

Use of Labor is Optimal When L = 3.50

L 2.50 3.00 3.50 4.00 4.50 MPL 4 3 2 1 0 MR = P $10 10 10 10 10 MRPL $40 30 20 10 0 MRCL $20 20 20 20 20

MRPL=MRxMPL--------MRC=W
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Ch 6 Production Theory

Optimal Use of the Variable Input

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Ch 6 Production Theory

Production With Two Variable Inputs -In the long run, all inputs are variable.

Isoquants show combinations of two inputs that can produce the same level of output.
-In other words, Production isoquant shows the various combination of two inputs that the firm can use to produce a specific 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. -A higher isoquant refers to a larger output, while a lower isoquant refers to a smaller output.
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Ch 6 Production Theory

Production With Two Variable Inputs

Isoquants

K 6 5 4 3 2 1

Q 10 12 12 10 7 3 1 24 28 28 23 18 8 2 31 36 36 33 28 12 3 36 40 40 36 30 14 4 40 42 40 36 30 14 5 39 40 36 33 28 12 6 L

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Ch 6 Production Theory

Production Isoquant

Economic region of production: Negatively sloped portions of the isoquants within the ridge lines represents the relevant economic region of production. Ridge lines: The lines that separate the relevant (i.e., negatively sloped) from the irrelevant ( or positively sloped) portions of the isoquant. This refers to stage II where the MPLand MPK are both positive but declining and producers never want to operate outside this region.
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Ch 6 Production Theory

Production With Two Variable Inputs Economic Region of Production

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Ch 6 Production Theory

Production With Two Variable Inputs

Substitution among inputs Marginal Rate of Technical Substitution: The absolute value of the slope of the isoquant. It equals the ratio the marginal products of the two inputs. Slope of isoquant indicates the quantity of one input that can be traded for another input, while keeping output constant.

MRTS = -K/L = MPL/MPK

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Ch 6 Production Theory

Production With Two Variable Inputs

MRTS = -(-2.5/1) = 2.5

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Ch 6 Production Theory

Production With Two Variable Inputs

Perfect Substitutes

Perfect Complements

When an isoquant is straight line or MRTS is constant, inputs are perfect substitutes whilst an isoquant is right angled, inputs are perfect complements.
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Ch 6 Production Theory

Optimal Combination of Inputs

To determine the optimal combination of labor and capital, we also need an isocost line.

Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost.

C wL rK
Vertical intercept of isocost

C Total Cost w Wage Rate of Labor ( L) r Cost of Capital ( K )

Slope of isocost
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C w K L r r
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Ch 6 Production Theory

Optimal Combination of Inputs

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Ch 6 Production Theory

Example: Isocost Lines

AB Total Cost = c = $100 w=r=$10 c/r = $100/$10 = $10k (vertical intercept) -w/r = -$10/$10 = -1(slope) AB Total Cost = c = $140 w=r=$10 c/r = $140/$10 = $14k -w/r = -$10/$10 = -1

AB* C = $100, w = $5, r = $10 c/r = $100/$10 =$10k -w/r = -$10/$5 = -1/2

MRTS = w/r;
AB Total Cost = c = $80 w=r=$10 c/r = $80/$10 = $8k -w/r = -$10/$10 = -1

since MRTS = MPL/ MPK, condition for optimal combination of inputs as MPL/ MPK= w/r
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Ch 6 Production Theory

Expansion Path

Expansion path: joinning points of tangency of isoquants and isocost of optimal input combination. The optimal input combination required to minimize the cost of producing a given level of maximum output that the firm can produce at the tangency of an isoquant and an isocost.
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Ch 6 Production Theory

Optimal Combination of Inputs If the price of an input declines, the firm will substitute the cheaper input for another inputs in production in order to reach a new optimal input combination.

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Ch 6 Production Theory

Returns to Scale How does output vary with the scale of production?

Returns to scale describes what happens to total output as all of the inputs are changed by the same proportion.

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.

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Ch 6 Production Theory

Returns to Scale

Graphically, the returns to scale concept can be illustrated using the following graphs. The long run production process is described by the concept of returns to scale.

IRTS

DRTS Q

CRTS

X,Y
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X,Y

X,Y
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Ch 6 Production Theory

Returns to Scale

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)

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Ch 6 Production Theory

Returns to Scale

Constant Returns to Scale

Increasing Returns to Scale

Decreasing Returns to Scale

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Ch 6 Production Theory

Empirical Production Functions

Several Useful Properties : 1. The Marginal Product of capital and the marginal Product of labor depend on both the quantity of capital and the quantity of labor used in production, as is often the case in the real world. 2. K and L are represents the output elasticity of labor and capital and the sum of these exponents gives the returns on scale. a + b = 1 Constant return to scale a + b > 1 Increasing return to scale a + b <1 Decreasing return to scale
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Ch 6 Production Theory

Empirical Production Functions

Cobb-Douglas Production Function Q = AKaLb

Estimated using Natural Logarithms

ln Q = ln A + a ln K + b ln L

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Ch 6 Production Theory

Empirical Production Functions-Example A bus ltd in a district has estimated the following Cobb-Douglas production function using monthly observations for the past four years: ln Q = ln A + a ln K + b ln L+ c Ln G Ln Q = 2.303+ 0.40 ln K + 0.60 Ln L+ 0.20 ln G (3.40) R2=0.94 DW=2.20 (4.15) F= 25.6 (3.05)

Q is the number of bus miles driven, K is the number of buses the firm operates, L is the number of bus drives it employes each day, and G is the gallons of gasoline it uses.
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Ch 6 Production Theory

Innovations and Global Competitiveness

Product Innovation Process Innovation Product Cycle Model Just-In-Time Production System Competitive Benchmarking Computer-Aided Design (CAD) Computer-Aided Manufacturing (CAM)

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Ch 6 Production Theory

The End

Thanks

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