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4.0 Production

This document discusses production theory and production functions. It covers: 1. The production function which shows the maximum output from given inputs of capital and labor. It discusses linear and Cobb-Douglas production functions. 2. Input-output tables which show output levels corresponding to combinations of labor and capital inputs. 3. Concepts like total product, marginal product, average product and their relationships which are used to analyze production with one variable input. 4. Optimal input use which occurs when marginal revenue product equals marginal factor cost to maximize profits.

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NotYGurLz
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252 views

4.0 Production

This document discusses production theory and production functions. It covers: 1. The production function which shows the maximum output from given inputs of capital and labor. It discusses linear and Cobb-Douglas production functions. 2. Input-output tables which show output levels corresponding to combinations of labor and capital inputs. 3. Concepts like total product, marginal product, average product and their relationships which are used to analyze production with one variable input. 4. Optimal input use which occurs when marginal revenue product equals marginal factor cost to maximize profits.

Uploaded by

NotYGurLz
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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4.

0 PRODUCTION THEORY
PRODUCTION FUNCTION
Output=f (Input)
Q=f(K,L)
input or factors capital (K) and labor(L)
Production function-shows the maximum
rate of output (Q) obtained from a given
rate of capital and labor input
Two types of production function:
a)Linear function Q = KL +2KL +L2
b) Cobb Douglas Production function
Q = 100K0.5L0.5
1% change in K will change Q by 0.5%
1% change in L will change Q by 0.5%
1

INPUT-OUTPUT TABLE (PRODUCTION TABLE)


e.g Q= 4L + 3LK + K2
Labor

Capital

15

22

14

24

34

22

35

48

PRODUCTION FUNCTION WITH ONE


VARIABLE
INPUT IN SHORT RUN
Short run- at least one factor is fixed
Long run-all inputs are variable
Production functions
1.Total Product (TP) or Output
-maximum output from combining different rates of
labor input with a fixed capital input

TP=f(K,L)
2

Marginal Product (MP)- change in output per


one unit change in variable input
MP of Labor =dQ/dL
MP of capital=dQ/dL

2.

3.

Average Product(AP)= Total product per unit


of variable input
AP of labor=Q/L
AP of capital=Q/K
Relationships among the product functions

TP

II

TP

III
Q

AP, MP
AP
DMR
MP

MP and TP
1. TP increases at increasing rate-MP
increases
2. TP increases at decreasing rate-MP
decreases
3. TP increases at maximum-MP = 0
4. TP decreases -MP is negative
MP and AP
5. MP > AP-----------AP increases
6. MP = AP-----------AP maximum
7. MP < AP-----------AP decreases
Output elasticity of labor = % change in Q
% change in L
= MP L
AP L
=d Q x L
dL Q
4

OPTIMAL EMPLOYMENT OF A
FACTOR OF PRODUCTION
To maximize profit, a firm should hire labor as
long as the additional revenue associated
with hiring another unit of labor exceeds
the cost of employing that unit
Marginal Revenue Product=Marginal Factor
Cost
MRP= wage (w)
MRP= cost of capital (r)
Note: MRP= MP x Product Price
MFC= wage rate or cost of capital

Production with two variable input.


If labor & capital are variable.
Production Isoquant
lsoquant the set of all combination of capital
and labor that yield a given output level.
-Output rate corresponding to every
combination of input rate.
Q =f(K,L)
Combination of K & L that satisfy this
equation define the isoquant for output rate.
Slope of isoquant -MRTS (marg. rate of
technical substitution)

Most production function isoquant is


convex to the origin
-MRTS decreases as one input is substituted
for another.
-Takes more and more workers to replace one
machine
Slope of isoquant, MRS = -MPL/MPK
MRS= K/L
Q= MPLxL
Q= MPKxK
-MPK x K = MPLx L
AK/AL = -MPL/MPK = slope of isoquant = (MRS)

The Production Isocost.


-cost information.
Total expenditure (C) on K & L.
C=rK+wL
r= - price of capital per unit
w= price of labor
For any given cost, C , the isocost line
defines all combination of capital & labor
inputs that can be purchased for certain
constant cost expenditure
7

K= Co- w L
r r
Slope of isocost = -w/r
e.g w=2,r=3, C=40
Isocost line : 40= 3K+2L
K=40/32/3 L
K=13. 33-2/3L

K
13.33

CHANGES IN ISOCOST LINE


A) Changes in budget

) Isocost lines will have parallel


shift due to changes in budget
-Shift to the right for an
increase in budget

B) If input prices changes:


Co = $40 w=5
K =40/r5/r L
lf r increases from RM 2 to RM3
K =40/2 -5/2 L
K=40/3-5/3 L
i) If there is a change in price of capital (r)
K

If r increases

ii) If there is a change in price of labor(w)


K

If w increases:

L
10

OPTIMAL EMPLOYMENT OF TWO INPUTS


a)
Minimize cost of a given rate of output
K
b

Q= 20
Q=10

Optimal input combinations


Tangency point (a) where isoquant is tangent to isocost
line
Slope of isoquant =slope of isocost
MRTS = Price of labor
Price of capital
MRTS = -w/r
MPL = w or MPk = r
MPK r
MPL w
MPL = MPK
w r

11

b) To maximize output given a budget


constraint
Optimal point: tangency between isoquant
and isocost
MRTS =-w/r
Efficient Resource allocation or efficient
Employment of K and L
Isoquant tangent to isocost line
Slope of lsoquant= Slope of isocost
MRTS=- w/r
-MPL= - w
MPK r
MPL = MPK
w
r
Marginal product per dollar of cost of input
must be the same for both inputs
If MPL < MPK
w
r
Employ more capital and less labor.
12

c) To Maximize Profit
Both inputs must be employed until Marginal
revenue product equals marginal factor cost
of inputs for both capital and labor
Marginal revenue product = Marginal factor
of labor
cost of labor
MRPL = w
Marginal revenue product = Marginal factor
of capital
cost of capital
MRPK= r
Note:
MRPL=MP Lx Product Price
MRPK =MP Kx Product Price
MFCL = price of labor or wage rate
MFCK= price of capital or rate of capital
To maximize profit, firm should also fulfill
the efficient combination of input
13

EXPANSION PATH
If output increases, how much K and L will
be hired?
Firm expands by moving from tangency
(efficient production point) to another
These efficient points represents expansion
path
A set of combinations of K and L that meet
efficiency condition:
e.g Expansion path: K=0.8 L
Expansion path indicates the optimal input
combination but not the specific output
associated with that rate of input use
K
K=0.8L
Q1

Q3
Q2

L
14

RETURNS TO SCALE
The change in output in relation to a change
in the scale of production (or the change in
inputs)
1. Increasing returns to scale
-Proportion increase in output > increase
in input
2. Decreasing returns to scale
-Proportion increase in output < increase
in input
3. Constant returns to scale
-Proportion increase in output = increase
in input
RULE:

a) Linear production function


e.g Q= 20 L + 4L2 +3KL
i) Increasing returns to scale(IRS)-If we
double the input proportion,output is more
than double
ii) Decreasing returns to scale(DRS)-If we double the
input proportion,output is less than double
15

iii) Constant returns to scale(CRS)-If we


double the input proportion,output is also
double
b) Cobb Douglas Production function
e.g Q= I00KaLb
i)IRS: a +b > 1
e.g Q= 100K0.5L0.7
0.5+ 0.7=1.2
ii) DRS: a +b < 1
e.g Q= 100K0.5L0.3
0.5+ 0.3=0.8
iii) CRS: a +b = 1
e.g Q= 100K0.5L0.5
0.5+ 0.5=1
Reasons for IRS
1. Higher level of technology
2. Labor specialization
3. Managerial specialization
Reasons for DRS
1. Inefficient management
16

Production function: Lagrangian Model


-To maximize output given cost constraint
Example 1: Q =50 K 0.5 L 0.5
10L + 15K =RM 4000
LQ= 50K 0.5 L 0.5 - (10L + 15K -4000)
Solution: L=20 K=13.3
Q=815.5
Example 2: Q =100 K 0.5 L 0.5
w=5 r=4
Cost constraint= RM 2000
Solution: L=200
K=250
=11.2
RM 1 increase in cost constraint will increase
in output by 11.2 units

17

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