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- 1. CHAPTER 6 Theory of Production Microeconomics All Rights Reserved © Oxford University Press Malaysia, 2008 6– 1
- 2. DEFINITION OF PRODUCTIONProduction is the process oftransforming inputs into outputs. INPUTS OUTPUTS Input refers to Refers to what we the factors of Processing get at the end of production the production that a firm uses in process, that is, the production finished products. processMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 2
- 3. CLASSIFICATION OF FACTORS OF PRODUCTION LAND LABOUR All natural resources Physical or mental or gifts of nature activities of human beings CLASSIFICATION OF FACTORS ENTREPRENEUR OF PRODUCTION A person who combines CAPITAL the different factors of Part of man-made production, and initiates wealth used for further the process of production production and also bears the riskMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 3
- 4. THE PRODUCTION FUNCTION The production function is a statement of the functional relationship between inputs and outputs, where the maximum output that can be produced is shown with given inputs. Q = (K, L) Where Q = Output K = Capital L = LabourMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 4
- 5. SHORT RUN PRODUCTION FUNCTION In the short run, we assume that at least one inputs is fixed, that is, capital. In the short run, the production function can written as: Q = ( K , L) Where Q = Output L = Labour K = Capital (fixed)Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 5
- 6. SHORT RUNPRODUCTION FUNCTION (CON’T) TOTAL PRODUCT (TP) The amount of output produced when a given amount of that input is used along with fixed inputs. AVERAGE PRODUCT (AP) Divide the total product by the amount of that input used in the production. Average Product (AP) = Total Product Total Labour AP = TP/ LMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 6
- 7. SHORT RUNPRODUCTION FUNCTION (CON’T) MARGINAL PRODUCT (MP) Change in the total product of that input corresponding to an additional unit change in its labour assuming other factors, that is, capital fixed. Marginal Product (MP) = Change in Total Product Change in Total Labour MP = TP/ LMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 7
- 8. SHORT RUNPRODUCTION FUNCTION (CON’T)LAW OF DIMINISHING MARGINAL RETURNSIt states that if the quantities of certain factorsare increased while the quantities of one ormore factors are held constant, beyond acertain level of production, the rate of increasein output will decrease.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 8
- 9. SHORT RUNPRODUCTION FUNCTION (CON’T) Stage I Stage II • Proportion of fixed factors are greater •Called law of diminishing returns. than variable factors. •The most efficient stage of production • Under utilization of fixed factors. •because the combinations of inputs are fully • Operation involves a waste of resources utilized. STAGES OF PRODUCTION Stage III • Proportion of fixed factors is lower than • variable factors. • Increase in variable factors decline TP because overcrowding. • A producer would not like to operate at this stage.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 9
- 10. SHORT RUNPRODUCTION FUNCTION (CON’T) 60 TPMAX STAGE I STAGE II STAGE III 50 40 30 TP MP 20 APMAX; AP AP=MP 10 MP= 0 0 0 1 2 3 4 5 6 7 8 9 10 -10Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 10
- 11. LONG-RUN PRODUCTION FUNCTION In the long-run a firm can produce its output in various ways by adjusting the amount of labour and capital.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 11
- 12. LONG-RUN PRODUCTION FUNCTION (CON’T) Isoquant • Isoquant represents all possible combinations of variable inputs that are used to generate the same level of output (total product). • Isoquant analysis illustrates that there are various ways to generate a given quantity of output in one time period.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 12
- 13. LONG-RUN PRODUCTION FUNCTION (CON’T) Isoquant Table LABOUR CAPITAL 1 2 3 4 5 1 250 450 550 700 800 2 450 650 800 900 950 3 600 800 950 1050 1100 4 700 900 1050 1150 1200 5 800 950 1100 1200 1250Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 13
- 14. LONG-RUN PRODUCTION FUNCTION (CON’T) There are various combinations of capital and labour. Different combination of inputs can yield diffrerent outputs. For example, using 2 units of capital and 2 units of labur, total output would be 650 units.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 14
- 15. LONG-RUN PRODUCTION FUNCTION (CON’T) Isoquant Curve Output 6 5 4 Capital 3 2 Output 1 0 1 2 3 5 LabourMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 15
- 16. ISOQUANT MAP Isoquant Map • A number of isoquants that are combined in a single graph can be used to estimate the maximum attainable output from different combinations of inputs. • A higher isoquant curve represents a higher level of output.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 16
- 17. ISOQUANT MAP(CON’T) Is oquant map 6 5 4 C apital 3 2 Q =800 1 0 Q =600 1 2 3 4 5Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 MICROECONOMICS 17 6– 17
- 18. MARGINAL RATE OF TECHNICAL SUBSTITUTION ( MRTS) Marginal Rate of Technical Substitution (MRTS) The technique to estimate the amount of capital input to be replaced by labour input without increasing or decreasing output. MRTS = Change in Capital Change in Labour MRTS = – K/ LMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 18
- 19. SCALES OF PRODUCTION DECREASING RETURNS TO SCALE All the factors of production are increased in a given proportion, and output would increase by a smaller proportion. CONSTANT RETURNS TO SCALE All the factors of production are increased in a given proportion, and output would increase by the same proportion. INCREASING RETURNS TO SCALE All the factors of production are increased in a given proportion, and output would increase by a greater proportion.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 19
- 20. SCALES OF PRODUCTION (CON’T) In Cobb Douglas function, the return to scale is determined by the coefficient of labour and capital. Production Function: Q = AKaLb If, a + b > 1, Increasing Returns to Scale a + b < 1, Decreasing Returns to Scale a + b = 1, Constant Returns to ScaleMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 20
- 21. SCALES OF PRODUCTION (CON’T) In linear production function, the returns to scale is determined by substituting the labour and capital values. Production Function: Q = 2L + 2KL + 4K Let us assume L = 1 and K = 1, then substitute these values into the equation. Q = 2(1) + 2(1)(1) + 4(1) = 8 Let us assume L and K are increased by two times Q = 2(2) + 2(2)(2) + 4(2) = 20 The new output (20 units) is more than double of the old output (8 units), so it is increasing returns to scale.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 6– 21

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