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1. 1. Micro EconomicsMicro Economics Lecture 07Lecture 07 THEORY OF PRODUCTIONTHEORY OF PRODUCTION Lecturer -J.D.T.MadhusankaLecturer -J.D.T.Madhusanka
2. 2. Lecture OutlineLecture Outline Theory of Production –Short-run Law of Diminishing Returns Total Average and Marginal Product Stages of Production
3. 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. 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. 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. 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. 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.
8. 8. TOTAL PRODUCT CURVETOTAL PRODUCT CURVE
9. 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. 10. MARGINAL & AVERAGE PRODUCT CURVESMARGINAL & AVERAGE PRODUCT CURVES
11. 11. Relationship Among TP, AP and MPRelationship Among TP, AP and MP  TP L L AP & MP 0 0 MP AP
12. 12. Stages of Production AP MP TP L MP & AP TP L0 0
13. 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. 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. 15. Optimal Use of a Variable InputOptimal Use of a Variable Input  MPL= PL = Wage (w) 0 MPL L MPL w
16. 16. Theory of Production – Long-runTheory of Production – Long-run ◦ Introduction ◦ Isoquants ◦ Marginal rate of technical substitution ◦ Isocost ◦ Producer equilibrium ◦ Production expansion path
17. 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. 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. 19. IsoquantIsoquant An Isoquant shows all different combinations of L & K that can be used to produce a given level of output
20. 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. 21. An Isoquant MapAn Isoquant Map convex to the origin downward sloping do not intersect farther from the origin represents greater output levels
22. 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. 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. 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. 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. 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
27. 27. An Isocost LineAn Isocost Line
28. 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. 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. 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. 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. 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
33. 33. End of the Session