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Thory of production

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Thory of production

1. 1. ProductionProduction TheoryTheory
2. 2. ProductionProduction  The process of transformation of resourcesThe process of transformation of resources (like land, labour, capital and(like land, labour, capital and entrepreneurship) into goods and servicesentrepreneurship) into goods and services of utility to consumers and/or producers.of utility to consumers and/or producers.  Goods includes all tangible items such asGoods includes all tangible items such as furniture, house, machine, food, car,furniture, house, machine, food, car, television etctelevision etc  Services include all intangible items, likeServices include all intangible items, like banking, education, management,banking, education, management, consultancy, transportation.consultancy, transportation.
3. 3. Types of InputsTypes of Inputs TechnologyTechnology  determines the type, quantity and proportion ofdetermines the type, quantity and proportion of inputs.inputs.  also determines the maximum limit of total outputalso determines the maximum limit of total output from a given combination of inputs.from a given combination of inputs.  at anyat any pointpoint of time, technology will be given; impactof time, technology will be given; impact of technology can be seen only over aof technology can be seen only over a periodperiod ofof time.time. Fixed and Variable InputsFixed and Variable Inputs  Variable inputVariable input : that can be made to vary in the short run,: that can be made to vary in the short run, e.g. raw material, unskilled/semi skilled labour, etc.e.g. raw material, unskilled/semi skilled labour, etc.  Fixed input:Fixed input: that cannot be varied in the short run, e.g. land,that cannot be varied in the short run, e.g. land, machine, technology, skill set, etc.machine, technology, skill set, etc.
4. 4. Factors of ProductionFactors of Production  LandLand  Anything which is gift of nature and not the result of human effort,Anything which is gift of nature and not the result of human effort, e.g. soil, water, forests, mineralse.g. soil, water, forests, minerals  Reward is called asReward is called as rentrent  LabourLabour  Physical or mental effort of human beings that undertakes thePhysical or mental effort of human beings that undertakes the production process. Skilled as well as unskilled.production process. Skilled as well as unskilled.  Reward is called asReward is called as wages/ salarywages/ salary  CapitalCapital  Wealth which is used for further production as machine/Wealth which is used for further production as machine/ equipment/intermediary goodequipment/intermediary good  It is outcome of human effortsIt is outcome of human efforts  Reward is called asReward is called as interestinterest  EnterpriseEnterprise  The ability and action to take risk of collecting, coordinating, andThe ability and action to take risk of collecting, coordinating, and utilizing all the factors of production for the purpose of uncertainutilizing all the factors of production for the purpose of uncertain economic gainseconomic gains  Reward is called asReward is called as profitprofit
5. 5. Production FunctionProduction Function  A technological relationship between physicalA technological relationship between physical inputs and physical outputs over a given periodinputs and physical outputs over a given period of time.of time.  shows theshows the maximummaximum quantity of the commodityquantity of the commodity that can be produced per unit of time for each setthat can be produced per unit of time for each set of alternative inputs, and with a given level ofof alternative inputs, and with a given level of production technology.production technology.  Normally a production function is written as:Normally a production function is written as: Q = f (L,K,I,R,E)Q = f (L,K,I,R,E)  where Q is the maximum quantity of output of awhere Q is the maximum quantity of output of a good being produced, and L=labour; K=capital;good being produced, and L=labour; K=capital; l=land; R=raw material; E= efficiency parameter.l=land; R=raw material; E= efficiency parameter.
6. 6. Production Function with OneProduction Function with One Variable InputVariable Input  Also termed asAlso termed as variable proportion productionvariable proportion production functionfunction  It is the short term production functionIt is the short term production function  Shows the maximum output a firm can produce whenShows the maximum output a firm can produce when only one of its inputs can be varied, other inputsonly one of its inputs can be varied, other inputs remaining fixed:remaining fixed: where Q = output, L = labour and K = fixed amount ofwhere Q = output, L = labour and K = fixed amount of capitalcapital  Total product is a function of labour:Total product is a function of labour:  Average Product (AP) is total product per unit of variableAverage Product (AP) is total product per unit of variable inputinput  Marginal Product (MP) is the addition in total output perMarginal Product (MP) is the addition in total output per unit change in variable inputunit change in variable input ),( KLfQ = ),( LKfTPL = L TP APL = L TP MPL ∆ ∆ =
7. 7. 11.1-301009 Negative returns 16.3-201308 21.501507 25101506 28201405 Diminishing returns 30301204 3040903 2530502 Increasing returns 20-201 StagesAPMPTotal Product (’000 tonnes) Labour (’00 units) -50 0 50 100 150 200 1 2 3 4 5 6 7 8 9 Labour Output Total Product (’000 tonnes) Marginal Product Average Product 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.
8. 8. Labour Total Output O MPL APL Labour Total Output O TPL A* A Stage I B* B Stage II C C* Stage III 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
9. 9. Production Function with Two VariableProduction Function with Two Variable InputsInputs  All inputs are variable in longAll inputs are variable in long run and only two inputs arerun and only two inputs are usedused  Firm has the opportunity toFirm has the opportunity to select that combination of inputsselect that combination of inputs which maximizes returnswhich maximizes returns  Curves showing suchCurves showing such production function are calledproduction function are called isoquantsisoquants oror iso-product curvesiso-product curves..  AnAn isoquantisoquant is the locus of allis the locus of all technically efficienttechnically efficient combinations of two inputs forcombinations of two inputs for producing a given level ofproducing a given level of outputoutput 108 912 818 728 640 Labour (’00 units) Capital (Rs. crore) 0 5 10 15 20 25 30 35 40 45 6 7 8 9 10 Labour ('00 units) Capital(Rs.Crore)
10. 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 Q0 B Q1 A C Q2 B Q1 O Labour Capital C Q2 A
11. 11. Marginal Rate of TechnicalMarginal Rate of Technical SubstitutionSubstitution  Measures the reduction in one input, dueMeasures the reduction in one input, due to unit increase in the other input that isto unit increase in the other input that is just sufficient to maintain the same leveljust sufficient to maintain the same level of outputof output..  It is also equal to the ratio of the marginalIt is also equal to the ratio of the marginal product of one input to the marginalproduct of one input to the marginal product of other inputproduct of other input L K MRTSLK ∆ ∆ −= L K MP MPMRTS K L LK ∆ ∆ −==
12. 12. Isocost LinesIsocost 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. B1 A1 B2 A2 Labour Capital O B A
13. 13. Producer’s EquilibriumProducer’s Equilibrium Labour Capital O A B Q2 Q3 Q0 Q1 C E L* K* 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 Q2 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  Q3 is beyond reach of the firm  Points C and D are also on the same isocost line, but they are on isoquant Q1, which is lower to Q2. Hence show lower output.  E is preferred to C and D, which is on the highest feasible isoquant.
14. 14. Producer’s EquilibriumProducer’s Equilibrium B2 A2 B A B1 A1 L K O Labour Capital Q 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.  A1B1 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 A2 B2. Necessary condition for equilibrium Slope of isoquant = Slope of isocost line E R S
15. 15. Expansion Path E2 E1 Expansion Path O Labour Capital 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.
16. 16. Returns to ScaleReturns to Scale  Constant Returns to ScaleConstant Returns to Scale :: When aWhen a proportional increase in all inputs yields an equalproportional increase in all inputs yields an equal proportional increase in outputproportional increase in output  Increasing Returns to ScaleIncreasing Returns to Scale :: When aWhen a proportional increase in all inputs yields a moreproportional increase in all inputs yields a more than proportional increase in outputthan proportional increase in output  Decreasing Returns to ScaleDecreasing Returns to Scale :: When aWhen a proportional increase in all inputs yields a lessproportional increase in all inputs yields a less than proportional increase in outputthan 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. 17. Technical ProgressTechnical Progress  Refers to research and development andRefers to research and development and investments made to manage technicalinvestments made to manage technical know howknow how  Technical change may beTechnical change may be  Embodied or investment specific,Embodied or investment specific, wherewhere new capital is used in the productionnew capital is used in the production apparatus, which requires investment toapparatus, which requires investment to take place; ortake place; or  Disembodied or investment neutral,Disembodied or investment neutral, wherewhere output increases without anyoutput increases without any increase in investment but by anincrease in investment but by an innovation through research andinnovation through research and
18. 18. Technical ProgressTechnical Progress  Types of Technical Progress (Hicks)Types of Technical Progress (Hicks)  Neutral Technical Progress:Neutral Technical Progress: changeschanges in the marginal product of labour (MPL)in the marginal product of labour (MPL) and capital (MPK) are sameand capital (MPK) are same  Labour augmenting TechnicalLabour augmenting Technical ProgressProgress: MPL increases faster than the: MPL increases faster than the MPKMPK  Capital augmenting TechnicalCapital augmenting Technical ProgressProgress : MPK increases faster than: MPK increases faster than MPLMPL