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ECONOMICS PRODUCTION CONCEPT

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- 1. ©2005 South-Western Publishing Production Economics Managers must decide not only what to produce for the market, but also how to produce it in the most efficient or least cost manner. Economics offers widely accepted tools for judging whether the production choices are least cost. A production function relates the most that can be produced from a given set of inputs.
- 2. The Production Function A Production Function is the maximum quantity from any amounts of inputs If L is labor and K is capital, one popular functional form is known as the Cobb- Douglas Production Function. The number of inputs is often large. But economists simplify by suggesting some, like materials or labor, is variable, whereas plant and equipment is fairly fixed in the short run.
- 3. Average Product output per labor Marginal Product output attributable to last unit of labor applied. Similar to profit functions, the Peak of MP occurs before the Peak of average product.
- 4. Short Run Production Function Numerical Example L Q MP AP 0 0 --- --- 1 20 20 20 2 46 26 23 3 4 5 70 92 110 24 22 18 23.33 23 22 Marginal Product L 1 2 3 4 5 Average Product Labor Elasticity is greater then one, for labor use up through L = 3 units
- 5. When MP > AP, then AP is RISING IF YOUR MARGINAL GRADE IN THIS CLASS IS HIGHER THAN YOUR GRADE POINT AVERAGE, THEN YOUR G.P.A. IS RISING When MP < AP, then AP is FALLING IF YOUR MARGINAL BATTING AVERAGE IS LESS THAN THAT OF THE NEW YORK YANKEES, YOUR ADDITION TO THE TEAM WOULD LOWER THE YANKEE’S TEAM BATTING AVERAGE When MP = AP, then AP is at its MAX IF THE NEW HIRE IS JUST AS EFFICIENT AS THE AVERAGE EMPLOYEE, THEN AVERAGE PRODUCTIVITY DOESN’T CHANGE
- 6. Law of Diminishing Returns INCREASES IN ONE FACTOR OF PRODUCTION, HOLDING ONE OR OTHER FACTORS FIXED, AFTER SOME POINT, MARGINAL PRODUCT DIMINISHES. A SHORT RUN LAW point of diminishing returns Variable input MP
- 7. Figure 7.4 on Page 306 Three stages of production Stage 1: average product rising. Stage 2: average product declining (but marginal product positive). Stage 3: marginal product is negative, or total product is declining. L Total Output Stage 1 Stage 2 Stage 3
- 8. Isoquants & LR Production Functions In the LONG RUN, ALL factors are variable Q = f ( K, L ) ISOQUANTS -- locus of input combinations which produces the same output (A & B or on the same isoquant) SLOPE of ISOQUANT is ratio of Marginal Products, called the MRTS, the marginal rate of technical substitution ISOQUANT MAP B A C Q1 Q2 Q3 K L
- 9. Cobb-Douglas Production Functions Q = A • Kα • Lβ is a Cobb-Douglas Production Function IMPLIES: Can be CRS, DRS, or IRS if α + β = 1, then constant returns to scale if α + β < 1, then decreasing returns to scale if α + β > 1, then increasing returns to scale Coefficients are elasticities α is the capital elasticity of output, often about .67 β is the labor elasticity of output, often about .33 which are EK and EL Most firms have some slight increasing returns to scale

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