1.
Micro EconomicsMicro Economics
Lecture 07Lecture 07
THEORY OF PRODUCTIONTHEORY OF PRODUCTION
Lecturer -J.D.T.MadhusankaLecturer -J.D.T.Madhusanka
2.
Lecture OutlineLecture Outline
Theory of Production –Short-run
Law of Diminishing Returns
Total Average and Marginal Product
Stages of Production
3.
THEORY OFTHEORY OF
PRODUCTIONPRODUCTION
Production
Production refers to the transformation of
inputs or resources into outputs of goods and
services
Fixed Cost
Cost incurred with resources, which takes a
considerable time to adjust
Variable Cost
Cost incurred with resources, which can quickly
be varied to increase or decrease the level of
output
4.
Short-run
The time period during, which at least one
input is fixed
Long-run
The time period during, which all the inputs
are variable
Production Function
Production function shows the relationship
between inputs and the maximum attainable
output under given technology.
Q = f (L, K, M)
5.
THE PRODUCTION FUNCTIONTHE PRODUCTION FUNCTION
Out put can be increased
by increasing the use of
the variable input only
There is a possibility to
substitute one input for
the other though they
are complements
6.
Properties of a ProductionProperties of a Production
FunctionFunction
There is a limit to extra production that can
be achieved when more of one input is used
while other inputs are held constant.
There is some complementarily among
inputs, but it is possible to substitute the
use of one input for another without
reducing production.
7.
Production with One Variable input – Short-Production with One Variable input – Short-
run Productionrun Production
Short-run Production Function
Q = f (L )
Total Product of a Variable Input
The amount of output produced where a
given amount of that input is used along some
fixed inputs.
9.
The Average Product of a Variable Input (AP)
AP is the total product of the variable input divided
by the amount of that input used.
APL
= TPL
/ L
Marginal Product of a Variable Input (MP)
MP is the change of the TP of that input
corresponding to one unit change in its use.
MPL
= ∆ TPL
/∆ L
10.
MARGINAL & AVERAGE PRODUCT CURVESMARGINAL & AVERAGE PRODUCT CURVES
11.
Relationship Among TP, AP and MPRelationship Among TP, AP and MP
TP
L
L
AP &
MP
0
0
MP
AP
12.
Stages of Production
AP
MP
TP
L
MP &
AP
TP
L0
0
13.
Cont’d…Cont’d…
Stages ProductionStages Production
Stage 01
MP > AP; AP is Rising
Stage 02
0< MP < AP
Stage 03
MP < 0
14.
The Law of Diminishing ReturnsThe Law of Diminishing Returns
The law states that MP of the variable input will
decline as the proportion of the variable input is
increased with the constant level of fixed input
There is a limit that the amount of output can be
produced in a productive facility of a given size
15.
Optimal Use of a Variable InputOptimal Use of a Variable Input
MPL= PL = Wage (w)
0
MPL
L
MPL
w
16.
Theory of Production – Long-runTheory of Production – Long-run
◦ Introduction
◦ Isoquants
◦ Marginal rate of technical substitution
◦ Isocost
◦ Producer equilibrium
◦ Production expansion path
17.
Production with Two Variable InputsProduction with Two Variable Inputs
Long-run AnalysisLong-run Analysis
In the long-run, all the inputs are
variable
Long-run Production Function
Q = F (K,L) = aK + bL
Both capital (K) and labor(L) inputs are variable
18.
Use of Calculus to Derive MP of Capital and LabourUse of Calculus to Derive MP of Capital and Labour
b
L
Q
MPL =
∂
∂
= a
K
Q
MPK =
∂
∂
=
19.
IsoquantIsoquant
An Isoquant shows all different
combinations of L & K that can be used to
produce a given level of output
20.
Properties of IsoquantsProperties of Isoquants
Very powerful tool for non-technical
exposition of production theory
Application is similar to indifference
curves
Convex t the origin
Downward sloping
Do not intersect
Further from the origin represent
greater output levels
21.
An Isoquant MapAn Isoquant Map
convex to the origin
downward sloping
do not intersect
farther from the
origin represents
greater output levels
22.
Marginal Rate of Technical Substitution (MRTS)Marginal Rate of Technical Substitution (MRTS)
MRTS - The slope of an Isoqunat is the rate at
which a producer can substitute between two
inputs and maintain the same level of output
MRTS = ∆K / ∆ L OR ,
MRTS (K, L) = MPL
/MPK
23.
MRTS and Marginal ProductsMRTS and Marginal Products
The Marginal Rate of Technical
Substitution is equal to the Ratio of
Marginal Products
MPL . ∆L + MPK . ∆K = 0
MPL
. ∆L = - MPK
. ∆K
∆K = MPL
∆ L MPK
24.
Law of Diminishing MRTSLaw of Diminishing MRTS
A property of a
production
function
stating that as
less of one
input is used,
increasing
amounts of
another input
must be
employed to
produce
25.
Perfect Substitutes and Complementary InputsPerfect Substitutes and Complementary Inputs
0
4 8 12
6
4
2
Capital Capital
Labour
0
6
4
2
2 4 6
2k
1L
Perfectly Substitutable Inputs- An isoquant is a straight line (so
that its absolute slope or MRTS is constant) ), and downward
sloping.
Complementary Inputs- An isoquant is right angled and
efficient production can take place only with a specific ratio of
inputs.
26.
IsocostIsocost
Isocost is a line that represents combinations of
inputs that will cost the producer the same
amount of money.
wL + rK = C
The equation above in slope/intercept
form:
K = C – w L
r r
Slope of the isocost line is –w/r
Intercept is C/r
28.
A Shift in an IsocostA Shift in an Isocost
Iso-costs
further away
from the origin
are associated
with higher
costs.
K
L
C1
C0
29.
A Rotation in an IsocostA Rotation in an Isocost
Changes in input
prices change
the slope of the
isocost line,
changing the
relevant
intercept
(Intercept of the
labor axis)
L
K
A new isocost line for a
decrease in wages (Price of
labor)
30.
Producer Equilibrium – Long-runProducer Equilibrium – Long-run
(K*,L*) where isocost
and isoquant are
tangent
The slope of the
isoquant is equal to
the slope of the
isocost line
MPL
/MPK
= w/r
MPL
/w = MPK
/r
31.
Producer EquilibriumProducer Equilibrium
Cost
minimization;
Given an output
constraint entails
finding the isocost
that is closest to the
origin meeting the
output constraint
32.
Production Expansion PathProduction Expansion Path
This joins the
tangency points of
isoquant curves and
the isocost lines
At this equilibrium
point, the ratio of
marginal product of
the two inputs is
equal to the price
ratio of the two
products
Views
Actions
Embeds 0
Report content