Production Economics

Introduction

Production Economics

Introduction

Decisions of Managers Managers make resource allocation decisions about production operations marketing nancing and personnel Decisions of Managers Production decisions determine the types and amounts of inputs such as land labor raw and processed materials factories, machinery, equipment, to be used in the production of a desired quantity of output.
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Decisions of Managers Managers must decide not only what to produce for the market but also how to produce it in the most efcient or least cost manner Therefore, managers objective is to minimize cost for a given output or to maximize output for a given input budget. Economic Theory of Production consists of a conceptual framework to assist managers in deciding how to combine most efciently the various inputs needed to produce the desired output given the existing technology.

Production Economics

Production Function

Production Economics

Production Function

Production Function The theory of production centers around the concept of a production function A production function relates the most that can be produced from a given set of inputs A Production Function is the maximum quantity from any amounts of inputs Production functions allow measures of the marginal product of each input Cobb-Douglas Production Function If L is labor and K is capital, Cobb-Douglas Production Function is Q = L1 K 2 where , 1 and 2 are constants.
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Production Economics

Production Function

Production Economics

Production Function

Fixed and Variable Inputs In deciding how to combine the various inputs (L and K ) to produce the desired output, inputs are usually classied as being either xed or variable A xed input is required in the production process but its quantity employed is constant over a given period of time regardless of the quantity of output produced A variable input quantity employed in the process changes with the desired quantity of output The short run corresponds to the period of time in which one (or more) of the inputs is xed The number of inputs is often larger than just K & L. But economists simplify by suggesting
materials or labor, is variable whereas plant and equipment is fairly xed in the short run
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The Short Run Production Function In the short run, because some of the inputs are xed, only a subset of the total possible input combinations is available to the rm To increase output, rm must employ more of the variable input(s) with the given quantity of xed input(s) Q = f (X1 , X2 , X3 , X4 , . . .) where say X1 and X2 are variable inputs and the rest are xed. Q = f (K , L) is the two input case where the capital, K , is xed input A Production Function with only one variable input, labor ,L, is easily analyzed.

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Production Economics

Production Function

Production Economics

Production Function

Total, Average, Marginal Production Functions Once the total product function is given the marginal and average product functions can be derived Average Product is dened as the ratio of total output to the amount of the variable input used in producing the output Average Product of Labor is dened as Q APL = L The marginal product is dened as the incremental change in total output Q that can be produced by the use of one more unit of the variable input L, while K remains xed. The marginal product is dened as Q Q MPL = = L L is the output attributable to last unit of labor applied
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Average and Marginal Production Functions Similar to prot functions, the Peak of MP occurs before the Peak of AP When MP = AP, we are at the peak of the AP curve
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Production Economics

Production Function

Production Economics

Production Function

The Law of Diminishing Marginal Returns 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

increases in one variable factor of production holding all other factors xed, after some point, marginal product diminishes Consider the variable factor of Labor. Why we observe Diminishing Marginal Returns? After a point, each additional worker introduces crowding effects With enough additional workers, the marginal product of labor may become zero or even negative Some work is just more difcult to accomplish when superuous personnel are present This is a short run law

When MP < AP, then AP is falling

When MP = AP, then AP is at its MAX

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Production Economics

Production Function

Production Economics

Production Function

Relationship between Total, Marginal and Average Prot Figure illustrates a production function total value added or total product (TP) with a single variable input Increasing returns region: TP function is increasing at an increasing rate
Marginal product (MP) curve measures the slope of the TP curve (MP = Q ), L MP curve is increasing up to L1

Decreasing returns region: TP function is increasing at a decreasing rate

Negative returns region: TP function is decreasing

An inection point occurs at L1

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Production Economics

Optimal Use of the Variable Output

Production Economics

Optimal Use of the Variable Output

Optimal Use of the Variable Output With one of the inputs (K ) xed in the short run, the producer must determine the optimal quantity of the variable input (L) to employ in the production process Should consider output prices and labor costs Marginal Revenue Product Marginal revenue product (MRPL ) is dened as the amount that an additional unit of the variable input adds to total revenue TR MRPL = L and MRPL is equal to the marginal product of L (MPL ) times the marginal revenue (MRQ ) resulting from the increase in output obtained: MRPL = MPL MRQ
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Marginal Factor Cost Marginal factor cost (MFCL ) is dened as the amount that an additional unit of the variable input adds to total cost MFCL = TC L

where TC is the change in cost Optimal Input Level we can compute the optimal amount of the variable input to use in the production process For the short-run production decision the optimal level of the variable input occurs where MRPL = MFCL

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Production Economics

Optimal Use of the Variable Output

Production Economics

Optimal Use of the Variable Output

Wage MRPL

MPL W=MFC Labor

Optimal Labor

HIRE, if you get more revenue than cost HIRE if the marginal revenue product > marginal factor cost At optimum: MRPL = MFCL = W
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Production Economics

Optimal Use of the Variable Output

Production Economics

Optimal Use of the Variable Output

Production Isoquants Long Run Production Functions All input factors are variable Q = f (K , L) is two input example MP of capital and MP of labor are the derivatives of the production function MPL = MPK = Q L Q K A production function with two variable inputs can be represented graphically by a set of two-dimensional production isoquants Production isoquant is either a geometric curve or an algebraic function representing all the various combinations of the two inputs that can be used in producing a given level of output

MP of labor declines as more labor is applied. Also the MP of capital declines as more capital is applied

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Production Economics

Optimal Use of the Variable Output

Production Economics

Optimal Use of the Variable Output

The Marginal Rate of Technical Substitution Isoquant also indicates the rate at which one input may be substituted for another input in producing the given quantity of output slope of Isoquant is ratio of Marginal Products, called the MRTS, the marginal rate of technical substitution MRTS is given by the slope of the curve relating K to L Marginal rate of technical substitution (MRTS): the amount by which one input can be reduced when one more unit of another input is added while holding output constant Example: it is the rate that capital can be reduced, holding output constant, while using one more unit of labor

The Marginal Rate of Technical Substitution For the production function of two variable inputs: Q = f (X1 , X2 ) dQ = dX2 dX1 = Q Q dX1 + dX2 = 0 X1 X2 Q/X1 MP1 = = MRTS2,1 > 0 Q/X2 MP2

MRTS21 is the rate of substitution of X2 for X1 if MRTSLK = 2, it means that 1 unit of capital can replace 2 units of labour while output remains the same this is possible if capital is twice as productive as labour

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Production Economics

Optimal Use of the Variable Output

Production Economics

Optimal Use of the Variable Output

Optimal Combination of Inputs a given level of output can be produced using any of a large number of possible combinations of two inputs Firm needs to determine which combination will minimize the total costs for producing the desired output The objective is to minimize cost for a given output Isocost Lines Total cost of each possible input combination is a function of the market prices of these inputs Let CL and CK be the per-unit prices of inputs L and K Total cost (C) of any given input combination is C = CL L + CK K Isocost lines are the combination of inputs for a given cost, C0 , C0 = CL L + CK K
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Production Economics

Optimal Use of the Variable Output

Production Economics

Optimal Use of the Variable Output

Minimizing Cost Subject to an Output Constraint Director of operations desires to release to production a number of orders for at least Q (2) units of output Solution should be in the feasible region containing the input combinations that lie either on the Q (2) isoquant or on isoquants that fall above The total cost of producing the required output is minimized by nding the input combinations within this region that lie on the lowest cost isocost line Combination D on the C (2) isocost line satises this condition Combinations E and F , which also lie on the Q (2) isoquant, yield higher total costs because they fall on the C (3) isocost line Thus, the use of L1 units of input L and K1 units of input K will yield a (constrained) minimum cost solution of C (2) dollars

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Production Economics

Optimal Use of the Variable Output

Production Economics

Optimal Use of the Variable Output

Minimizing Cost Subject to an Output Constraint At the optimal input combination, the slope of the given isoquant must equal the slope of the C (2) lowest isocost line The slope of an isoquant is equal to dK /dL The slope of isocost is equal to dK /dL = CL /CK dK dL MPL MPK MPL CL = MRTS = = = CL CK MPK CK MPL CL = MPK CK

In Class Work Is the following rm efcient? MPL = 30 MPK = 50 W = 10 (cost of labor) R = 25 (cost of capital) If your answer is NO, what should the rm do?

MPL MPK =3= =2 CL CK Firm is inefcient!. A dollar spent on labor produces 3, and a dollar spent on capital produces 2. Shift to more labor until the equimarginal condition holds.
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This condition is known as equimarginal criterion Marginal product per dollar input cost of one factor must be equal to the marginal product per dollar input cost of the other factor
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