Theory of Production

How to convert inputs into output: Theory of the firm

How a firm makes cost-minimizing production decisions How cost varies with output Characteristics of market supply Issues of business regulation

Production Decisions of a Firm

Production Technology - Combining inputs or factors of production to achieve an output
Constraints how much to produce to minimise costs and maximise revenues
Cost Input

Choices labor, capital, materials

Production Technology
Production Function - Indicates the highest output that a firm can produce for every specified combination of inputs given the state of technology.

Shows what is technically feasible when the firm operates efficiently. Q=f(k,l) for two inputs labor (l) and capital (k)

Assumptions: 1)two homogenous inputs, capital & labor 2)The amount of capital and labor used per year to produce an unit of output per year are all flow concepts

Efficient use of inputs

Production

function shows the amount of output that can be produced with a given technology
With

advanced technology, more output can be produced with same inputs

Efficient

use of inputs so that there is no wastage

Short-run & Long-run

In
In

the short run, at least one input is constant

the long run, all inputs can be varied

Production with One Variable Input (Labor)

The average product of labor (AP), or output per worker: Labor Productivity

Output Q AP Labor Input L

Production with One Variable Input Labor)

The marginal product of labor (MP), or output of the additional worker:

Output Q MP L Labor Input L

Production with One Variable Input (Labor) L 0 1 2 3 4 5 6 7 8 9 10 K 10 10 10 10 10 10 10 10 10 10 10 Q 0 10 30 60 80 95 108 112 112 108 100 AP 10 15 20 20 19 18 16 14 12 10 MP 10 20 30 20 15 13 4 0 -4 -8

The Law of Diminishing Marginal Returns

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 labor input is small, MP increases due to specialization. When the labor input is large, MP decreases due to inefficiencies.

The Law of Diminishing Marginal Returns (contd)

Can be used for long-run decisions to evaluate the trade-offs of different plant configurations

Assumes the quality of the variable input is constant Explains a declining MP, not necessarily a negative one Assumes a constant technology

Total Product
Output per Month

112

C 60

Total Product

B
A

0 1

2 3

5 6

7 8

10 Labor per Month

Production with One Variable Input (Labor)

AP = slope of line from origin to a point on TP, lines b, & c. MP = slope of a tangent to any point on the TP line, lines a & c.
Output per Month 112 C 60 A 0 1 2 3 4 5 6 7 8 9 10
Labor per Month

Output per Month

30
E

20
10
0 1 2 3 4 5 6 7 8 9 10 per Month
Labor

Average Product
Output per Month 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

30
Marginal Product E

20

Average Product

10

0 1

2 3

5 6

7 8

10 Labor per Month

Observations
When MP = 0, TP is at its maximum When MP > AP, AP is increasing When MP < AP, AP is decreasing When MP = AP, AP is at its maximum

The Effect of Technological Improvement

Output per time period

100 O3

A
50 O1
Labor per time period