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# THEORY OF PRODUCTION

## ECONOMIC THEORY OF PRODUCTION

consists of a formal framework to assist the manager in deciding how to combine most efficiently the various inputs needed to produce the desired output (product of service), given the existing technology. this theory is centered around the concept of a production function.

PRODUCTION
Transformation of I/Ps or resources into O/P of goods and services. The creation of any good or service that has economic value to either consumers or other producers.

and so forth)

Production Function

Relates to the maximum quantity of output that can be produced from given amounts of various inputs for a given technology. This can be expressed in the form of a mathematical model, Schedule (table) , or graph Mathematical model: Q = f (X,Y)
The function f incorporates the existing state of technology in producing Q from X and Y.

The general function f can take may different forms. e.g. Q = L1K2, where L is the amount of labor and K is the amount of capital used in the production process (,1, and 2 are constants).

## Total Output - Table Ore- Mining Example

Capital Input, Y (horsepower) Labor Input, X (number of workers) 1 2 3 4 5 6 7 8 9 10 250 1 2 4 6 16 29 44 50 55 52 500 3 6 16 29 43 55 58 60 59 56 750 6 16 29 44 55 60 62 62 61 59 1,000 10 24 44 55 60 62 63 63 63 62 1,250 16 29 55 58 61 63 64 64 64 64 1,500 16 29 55 60 62 63 64 65 65 65 1,750 16 44 55 60 62 63 64 65 66 66 2,000 13 44 50 55 60 62 64 65 66 67

## Ore-Mining Production Function

Out put Q (t ons of ore)
64 65 64 66 65 67 66 66 65 62 63 62 63 64 63 60 62 63 63 62 61 59 62 62 60 62 55 60 56 60 59 60 60 55 58 50 55 55 52 55 55 55 44 44 44 44 44 50 65 65

29 29 13 24 16 16 16 10 16 4 6 4 2 16 29 29

2,000 1,750 6 1,500 1,000 750 500 Capital input Y 250 (horsepower)

6 3 1

10

## Labor input X (no. of workers)

Production Function
Classification of inputs (X and Y): 1. Fixed input one required in the production process but whose quantity employed in the process is constant over a given period of time regardless of the quantity of output produced. 2. Variable input one whose quantity employed in the process changes, depending on the desired quantity of output to be produced.

Production Function
Short

run the period of time in which one (or more) of the inputs is fixed or incapable of being varied; Long run period of time in which all inputs or resources employed in a production process are variable or can be varied

## Total Product Function

identifies what outputs are possible using various levels of the variable input total volume of outputs resulting from use of different quantities of inputs

## Marginal and Average Product Functions

Marginal product the incremental change in total output that can be produced by the use of one or more unit of the variable input in the production process MPx= Q X Average product the ratio of the total output to the amount of the variable input used in producing the output. APx= Q X

## Total Product, 0 (=Q) TPx (tons of ore) 6 16 29 44 55 60 62 62 61 59

Marginal Product Average Product of Labor, MPx of Labor, APx --(Q X) (Q X) +6 6 +10 +13 +15 +11 +5 +2 0 - 1 - 2 11 11 10 8.86 7.75 6.78 5.90 8 9.67

Elasticity, Ex -(MPx APx) 1.0 1.25 1.34 1.36 1.0 .50 .23 0.0 - .15 - .34

Production Elasticity
The percentage change in output Q resulting from a given percentage change in the amount of the variable input X employed in the production process with Y remaining constant Indicates the responsiveness of output to changes in the given input Ex= %Q = Q/Q = Q/X %X X/X Q/X Since MPx= Q/X and APx = Q/X: Ex = MPx APx

## Law of Diminishing Marginal Returns

Also known as the diminishing marginal productivity law or law of variable options; Given that the amount of all other productive factors remains unchanged, the use of increasing amounts of a variable factor in the production process beyond some point will eventually result in diminishing marginal increases in total output.

## Total Product, 0 (=Q) TPx (tons of ore) 6 16 29 44 55 60 62 62 61 59

Marginal Product Average Product of Labor, MPx of Labor, APx --(Q X) (Q X) +6 6 +10 +13 +15 +11 +5 +2 0 - 1 - 2 11 11 10 8.86 7.75 6.78 5.90 8 9.67

Elasticity, Ex -(MPx APx) 1.0 1.25 1.34 1.36 1.0 .50 .23 0.0 - .15 - .34

## Relationship among Total, Average, and Marginal Product Curves

Stage I Ep>1 Q3 Stage II 0<Ep<1 Stage III Ep<0

O ut pu t Q (u nit s)

Ep = 0

TP

Negative returns

AP X1 X2 X3 MP

## Three Stages of Production

Stage I the range of X over which the average product is increasing. Stage II rage of X from the point at which the average product is a maximum (X2) to the point where the marginal product (MP) declines to zero (X3). Stage III the range of X over which the total product is declining or, equivalently, the marginal product is negative.

## Marginal Revenue Product (MRPx)

The amount that an additional unit of the variable input adds to total revenue: MRPx = TR X where TR is the change in total revenue associated with the given change (X) in the variable input. MRPx is equal to the marginal product of X(MPx) times the marginal revenue (MRQ) resulting from the increase in output obtained: MRPx = MPxMRQ

## Marginal Factor Cost

The amount that an additional unit of the variable input adds to total cost: MFCx = TC

X where TC is the change in cost associated with the given change (X) in the variable input

## Marginal Revenue Product and Marginal Factor Cost Ore-Mining Example

Labor Total Marginal Input Product Product of X (number Q= (TPx) Labor of workers) (tons of ore) MPx (tons per worker) 0 1 2 3 4 5 6* 7 8 0 6 16 29 44 55 60 62 62 6 10 13 15 11 5 2 0 Total Revenue TR= PQ (\$) Marginal Revenue MRQ=TR Q (\$/ton) 10 10 10 10 10 10 10 10 Marginal Revenue Product MRPx=MPxM RQ (\$/worker) 60 100 130 150 110 50 20 0 Marginal Factor Cost MFCx (\$/worker)

## 0 60 160 290 440 550 600 620 620

50 50 50 50 50 50 50 50

## Optimal Input Level

The optimal level occurs at the point where the marginal benefits are equal to the marginal costs For the short-run production decision, the optimal level of the variable input occurs where: MRPx = MFCx

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