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Thory of production

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  • 1. Production Theory
  • 2. Production
    • The process of transformation of resources (like land, labour, capital and entrepreneurship) into goods and services of utility to consumers and/or producers.
    • Goods includes all tangible items such as furniture, house, machine, food, car, television etc
    • Services include all intangible items, like banking, education, management, consultancy, transportation.
  • 3. Types of Inputs
    • Technology
    • determines the type, quantity and proportion of inputs.
    • also determines the maximum limit of total output from a given combination of inputs.
    • at any point of time, technology will be given; impact of technology can be seen only over a period of time.
    • Fixed and Variable Inputs
    • Variable input : that can be made to vary in the short run, e.g. raw material, unskilled/semi skilled labour, etc.
    • Fixed input: that cannot be varied in the short run, e.g. land, machine, technology, skill set, etc.
  • 4. Factors of Production
    • Land
      • Anything which is gift of nature and not the result of human effort, e.g. soil, water, forests, minerals
      • Reward is called as rent
    • Labour
      • Physical or mental effort of human beings that undertakes the production process. Skilled as well as unskilled.
      • Reward is called as wages/ salary
    • Capital
      • Wealth which is used for further production as machine/ equipment/intermediary good
      • It is outcome of human efforts
      • Reward is called as interest
    • Enterprise
      • The ability and action to take risk of collecting, coordinating, and utilizing all the factors of production for the purpose of uncertain economic gains
      • Reward is called as profit
  • 5. Production Function
    • A technological relationship between physical inputs and physical outputs over a given period of time.
    • shows the maximum quantity of the commodity that can be produced per unit of time for each set of alternative inputs, and with a given level of production technology.
    • Normally a production function is written as:
    • Q = f (L,K,I,R,E)
    • where Q is the maximum quantity of output of a good being produced, and L=labour; K=capital; l=land; R=raw material; E= efficiency parameter.
  • 6. Production Function with One Variable Input
    • Also termed as variable proportion production function
    • It is the short term production function
    • Shows the maximum output a firm can produce when only one of its inputs can be varied, other inputs remaining fixed:
    • where Q = output, L = labour and K = fixed amount of capital
    • Total product is a function of labour:
      • Average Product (AP) is total product per unit of variable input
      • Marginal Product (MP) is the addition in total output per unit change in variable input
  • 7. Law of Variable Proportions
    • As the quantity of the variable factor is increased with other fixed factors, MP and AP of the variable factor will eventually decline.
    • Therefore law of variable proportions is also called as law of diminishing marginal returns.
    11.1 -30 100 9 Negative returns 16.3 -20 130 8 21.5 0 150 7 25 10 150 6 28 20 140 5 Diminishing returns 30 30 120 4 30 40 90 3 25 30 50 2 Increasing returns 20 - 20 1 Stages AP MP Total Product (’000 tonnes)‏ Labour (’00 units)‏
  • 8.
    • First stage
      • Increasing Returns to the Variable Factor
      • MP>0 and MP>AP
    • Second stage
      • Diminishing Returns to a Variable Factor
      • MP>0 and MP<AP
    • Third Stage
      • Negative Returns
      • MP<0 while AP is falling but positive
      • Technically inefficient stage of production
      • A rational firm will never operate in this stage
    Law of Variable Proportions Labour Total Output O MP L AP L Labour Total Output O TP L A* A Stage I B * B Stage II C C* Stage III
  • 9. Production Function with Two Variable Inputs
    • All inputs are variable in long run and only two inputs are used
    • Firm has the opportunity to select that combination of inputs which maximizes returns
    • Curves showing such production function are called isoquants or iso-product curves .
    • An isoquant is the locus of all technically efficient combinations of two inputs for producing a given level of output
    10 8 9 12 8 18 7 28 6 40 Labour (’00 units)‏ Capital (Rs. crore)‏
  • 10. Characteristics of Isoquants
    • Downward sloping
    • Convex to the origin
    • A higher isoquant represents a higher output
    • Two isoquants do not intersect
    O Labour Capital Q 0 B Q 1 A C Q 2 B Q 1 O Labour Capital C Q 2 A
  • 11. Marginal Rate of Technical Substitution
    • Measures the reduction in one input, due to unit increase in the other input that is just sufficient to maintain the same level of output .
    • It is also equal to the ratio of the marginal product of one input to the marginal product of other input
  • 12. Isocost Lines
    • The isocost line represents the locus of points of all the different combinations of two inputs that a firm can procure, given the total cost and prices of the inputs.
    Total Cost is sum of Labour cost and Capital cost The (absolute) slope of this line is equal to the ratio of the input prices. B 1 A 1 B 2 A 2 Labour Capital O B A
  • 13. Producer’s Equilibrium C D Necessary condition for equilibrium Slope of isoquant = Slope of isocost line Maximization of output subject to cost constraint
    • AB is the isocost line
    • Any point below AB is feasible but not desirable
    • E is the point of tangency of Q 2 with isocost line AB
      • Corresponds to the highest level of output with given cost function.
    • Firm would employ L* and K* units of labour and capital
    • Q 3 is beyond reach of the firm
    • Points C and D are also on the same isocost line, but they are on isoquant Q 1 , which is lower to Q 2 . Hence show lower output.
    • E is preferred to C and D, which is on the highest feasible isoquant.
    Labour Capital O A B Q 2 Q 3 Q 0 Q 1 E L* K*
  • 14. Producer’s Equilibrium Minimization of cost for a given level of output
    • Firm has decided the level output to be produced shown by the isoquant Q
      • Will be indifferent between output combinations shown by R, S, E on isquant Q.
    • Has to ascertain that combination of inputs Labour and Capital which minimizes the cost of production
    • Hence a map of isocost lines will be prepared
    • The isocost lines are parallel to each other because price of the inputs is given.
    • A 1 B 1 line is not feasible
    • It will use OK and OL of capital and labour respectively, at point E which is also on AB, the lowest possible isocost line.
    • R, S are not desirable because they are on higher cost line A 2 B 2 .
    Necessary condition for equilibrium Slope of isoquant = Slope of isocost line B 2 A 2 B A B 1 A 1 L K O Labour Capital Q E R S
  • 15. Expansion Path
    • Line formed by joining the tangency points between various isocost lines and the corresponding highest attainable isoquants is known as Expansion Path.
    • For homogeneous production function and given factor prices (and hence factor ratio):
      • expansion path is a straight line through the origin.
    • For non- homogeneous production function:
      • optimal expansion path is non linear.
    E 2 E 1 Expansion Path O Labour Capital
  • 16. Returns to Scale
    • Constant Returns to Scale : When a proportional increase in all inputs yields an equal proportional increase in output
    • Increasing Returns to Scale : When a proportional increase in all inputs yields a more than proportional increase in output
    • Decreasing Returns to Scale : When a proportional increase in all inputs yields a less than proportional increase in output
    • Returns to Scale show the degree by which the level of output changes in response to a given change in all the inputs in a production system.
  • 17. Technical Progress
    • Refers to research and development and investments made to manage technical know how
    • Technical change may be
      • Embodied or investment specific, where new capital is used in the production apparatus, which requires investment to take place; or
      • Disembodied or investment neutral, where output increases without any increase in investment but by an innovation through research and knowledge.
  • 18. Technical Progress
    • Types of Technical Progress (Hicks)‏
      • Neutral Technical Progress: changes in the marginal product of labour (MPL) and capital (MPK) are same
      • Labour augmenting Technical Progress : MPL increases faster than the MPK
      • Capital augmenting Technical Progress : MPK increases faster than MPL