Understanding concept of

PRODUCTION &BUSINESS
ORGANIZATION

Chapter 05
MISS KIRAN SHEIKH
 Glossary
• aggregate production function
• the process whereby an economy as a whole turns
economic inputs such as human capital, physical
capital, and technology into output measured as
GDP per capita
• compound growth
• rate the rate of growth when multiplied by a base
that includes past GDP growth
• human capital the accumulated skills and education
of workers
• Innovation putting advances in knowledge to use in
a new product or service
•
 Glossary
 Invention advances in knowledge
 labor productivity the value of what is produced per
worker, or per hour worked (sometimes called worker
productivity)
 production function the process whereby a firm
turns economic inputs like labor, machinery, and raw
materials into outputs like goods and services used by
consumers
 technological change a combination of invention—
advances in knowledge—and innovation
 Short run – where one factor of production (e.g.
capital) is fixed.
 This is a time period of fewer than six months.
 Long run – where all factors of production of a
firm are variable (e.g. a firm can build a bigger
factory)
 A time period of greater than six months/one year
 Very long run –Where all factors of production
are variable
additional factors outside the control of firm can
change
e.g. technology, government policy. Several years.
 gross domestic product (GDP) n [singular] the total
 value of goods and services produced in a country’s
 economy, not including income from abroad
 gross domestic product per capita n [singular] the
 total value of goods and services produced in a country
 divided by the number of people living there
 PRODUCTION
 Everything that we see around us is the result of
production.
 Every GOOD, PRODUCT or SERVICE is the consequence of
production.
 We can observe, as we delve further into the
 study of economics, that much of its ideas revolve around the concept
of production.
PRODUCTION
 We have studied the basic economic
problem — that of scarcity — and with
people’s unlimited wants and needs,
that would indeed be a problem.
Lecture objectives
 THE PRODUCTION FUNCTION
 TOTAL ,AVERAGE AND MARGINAL PRODUCT
 THE LAW OF DIMINISHING RETURNS
 SHORT RUN &LONG RUN
 PRODUCTIVITY AND
AGGREGATEPRODUCTION FUNCTION
 THE NATURE OF BUSINESS FIRM
 THE SCOPE OF SIZE OF THE BUSINESS
The production function specifies the maximum
output that can be produced with a given quantity of
inputs. It is defined for a given state of engineering
and technical knowledge.
Example
input – land , labor
Output – wheat, toothpaste
 The production function for generating electricity.
Visualize it as a book with technical specifications for different
kinds of plants.
 Gas turbines, showing their inputs (initial capital cost, fuel
consumption
 The amount of labor needed to run the turbine)
 Their outputs (amount of electricity generated)
 THEproduction
The PRODUCTION function FUNCTION
can be mathematically
written as:
 What is Production Function?
Q = f(L, K, T…..n)
 The basic relationship between the factors of production and the
Where,
output
Qis = output
referred to as a Production Function.
LThe
= firm’s
laborproduction function for a particular good (q) shows the
Kmaximum
= capital amount of the good that can be produced using alternative
 combinations of capital (K) and labor (L)
T = level of technology
 q = f(K,L)
n = other inputs employed in
production
 Important facts about production
function
 A Production function is expressed with reference to a particular
period of time.
 It expresses a physical relation because both inputs and outputs are
expressed in physical terms.
 Production function describes a purely technological relation because
 what can be produced from a given amount of inputs depends upon the
state of technology
Lecture objectives
 THE PRODUCTION FUNCTION
 TOTAL, AVERAGE AND MARGINAL
PRODUCT
 THE LAW OF DIMINISHING RETURNS
 SHORT RUN &LONG RUN
 PRODUCTIVITY AND
AGGREGATEPRODUCTION FUNCTION
 THE NATURE OF BUSINESS FIRM
 THE SCOPE OF SIZE OF THE BUSINESS
 Total, Average, and Marginal Product
 Starting with a firm’s production function, we can calculate three
important production concepts:
 Total product (TP) Total Product total amount of outputs produce
 Average product (AP) total output divided by total units of input
 Marginal product (MP) (of an input) the extra output produced by one
additional unit of that input while other factors are held constant
 Marginal Product and Average Product
 Marginal product is the additional output that can be
produced by adding one more unit of a specific input, ceteris
paribus.

change in total product

marginal product of labor =
change in units of labor used

• Average product is the average amount

produced by each unit of a variable factor of
production.
total product
average product of labor =
total units of labor
 Total product (TP)
 Total Product Function (TP) Represents the relationship between the
number of workers (L) and the TOTAL number of units of output
produced (Q) holding all other factors of production (the plant size)
constant.
 EXAMPLE
Bushels of wheat
Number of sneakers.
 For a coffee shop, output would be measured in “number of coffee cups a
day”
 For a steel mill, output would be measured in “tons of steel produced a
day”
 Marginal Product (MP)
 The additional output that can be produced by adding one more worker
while holding plant size constant.
 The marginal product of an input is the extra output produced
by 1 additional unit of that input while other inputs are held constant.
 Example Assume that we are holding
 land, machinery, and all other inputs constant.
 labor’s marginal product is the extra output
obtained by adding 1 unit of labor.
Average Product (AP)
 Represents the amount of output produced by each worker on
average.
 Or
 Output per worker
 The final concept is the average product, which
equals total output divided by total units of input.
 the average product of labor as 2000 units per worker with one
worker,
 1500 units per worker with two workers, and so forth.
Total Product
(TP)
Sum

Average Product
(AP)
TP/Q

Marginal Product table shows the total product that can be produced
(MP) for different inputs of labor when other inputs (capital,
TPn - TPn-1
land, etc.) and the state of technical knowledge are
unchanged. From total product, we can derive
important
concepts of marginal and average products.
 Production Function for Sandwiches
45
40
Production Function 35

Total product
30
(2) (3) (4) 25
(1) TOTAL PRODUCT MARGINAL AVERAGE
20
LABOR UNITS (SANDWICHES PRODUCT OF PRODUCT
(EMPLOYEES) PER HOUR) LABOR OF LABOR 15
10
0 0 - - 5
0
1 10 10 10.0 0 1 2 3 4 5 6 7
2 25 15 12.5 Number of employees
15

Marginal Product
3 35 10 11.7
10
4 40 5 10.0
5 42 2 8.4 5

6 42 0 7.0
0
0 1 2 3 4 5 6 7
Number of employees
Lecture objectives
 THE PRODUCTION FUNCTION
 TOTAL ,AVERAGE AND MARGINAL PRODUCT
 THE LAW OF DIMINISHING RETURNS
 SHORT RUN &LONG RUN
 PRODUCTIVITY AND
AGGREGATEPRODUCTION FUNCTION
 THE NATURE OF BUSINESS FIRM
 THE SCOPE OF SIZE OF THE BUSINESS
 The Law of Diminishing Returns
 Under the law of diminishing returns, a firm will
 Get less and less extra output when it adds additional
 units of an input while holding other inputs fixed.
 In other words, the marginal product of each unit
 of input will decline as the amount of that input
 increases, holding all other inputs constant.
The Law of Diminishing
Marginal Returns
 The law of diminishing marginal
returns states that:
When additional units of a variable input
are added to fixed inputs, the marginal
product of the variable input declines.
The law of diminishing returns expresses a very
basic relationship.
 An input such as labor is added to a fixed
amount of land, machinery
inputs, the labor has less and less of the other
factors to work with.
 The land gets more crowded
the machinery is overworked
 the marginal product of labor declines.
 It states that:
If one factor is used more & more ,keeping the other factors
constant.
The total output will increase at an increasing rate in the
beginning and then at
diminishing rate and eventually decreases absolutely.
ASSUMPTIONS :
 Constant Technology
Short run
 Homogeneous Factors
Variable Input Ratio
 As the production of one factor in the combination of
factor
 is increased after a point the average & MP of that factor
will
 diminishing.

 Reasons:
 Scarcity of fixed factors
 Indivisibility of fixed factor
 Lack of perfect substitution of factor
of production
Lecture objectives
 THE PRODUCTION FUNCTION
 TOTAL ,AVERAGE AND MARGINAL PRODUCT
 THE LAW OF DIMINISHING RETURNS
 SHORT RUN &LONG RUN
 PRODUCTIVITY AND
AGGREGATEPRODUCTION FUNCTION
 THE NATURE OF BUSINESS FIRM
 THE SCOPE OF SIZE OF THE BUSINESS
 SHORT RUN AND LONG RUN
 Efficient production requires time as well as conventional inputs like
labor.
 We therefore distinguish between two different time periods in
production and cost analysis.
 short run is the period of time in which only some inputs, the
variable inputs, can be adjusted.
In the short run, fixed factors, such as plant and equipment, cannot be
fully modified or adjusted.
 long run is the period in which all factors employed by the firm,
including capital, can be changed.
 SHORT RUN &LONG RUN

Types
Short –Run Long – Run

Inputs kept (Varying all

 constant inputs

One input Law of returns

(Labor) is varied to scale
Law of variable
proportion
 SHORT RUN AND LONG RUN
 Production requires not only labor and land but also time.
 To account for the role of time in production and costs, we
distinguished between two different time periods:
 Short Run – period in which a firm can adjust production by
changing variable factors
 (i.e., materials & labor) but cannot change fixed factors (i.e.,
capital)
 Long Run – period sufficiently long that all factors including capital
can be adjusted.
SHORT RUN AND LONG RUN
 Two different time periods in production and cost analysis:
 Short Run – period of time in which some inputs (the
variable inputs) can be adjusted
 Long Run – period in which all factors employed by the
firm (including the capital) can be change
 PRODUCTIVITY AND THE AGGREGATE
PRODUCTION FUNCTION
 Productivity is a concept measuring the ratio of total output to a
weighted average of inputs.
Two important variants are
1) labor
2) productivity,
 which calculates the amount of output
per unit of labor,
total factor productivity, which measures output per unit of total
inputs
(typically of capital and labor).
PRODUCTIVITY AND THE AGGREGATE
PRODUCTION FUNCTION
 Productivity grows because of economies of scale and
because of technological change.

 technology might ideally allow constant or increasing

returns to scale, the need for management and supervision
may eventually lead to decreasing returns to scale in giant
firms.
 Aggregate Production Function – relate total output to the
quantity of inputs (like labor, capital and land) and to total
productivity
Productivity Growth from Economies of
Scale and Scope
 A central concept in economics is productivity, a term
denoting the ratio of output to inputs
 output is growing faster than inputs, this represents
productivity growth
 Most production processes are many times larger than they
were during the nineteenth century.
 A large ship in the mid-nineteenth century could carry 2000
tons of goods, while the largest supertankers today carry
over 1 million tons of oil.
 THE NATURE OF THE FIRM
Business firms are specialized organizations devoted to managing
the production of production .
 Among their important functions are exploiting economies of mass
production, raising funds and organizing factors of production
 Production is organized in firms because efficiency generally
requires large-scale production
, the raising of significant financial resources
careful management and coordination of ongoing activities.
 THE NATURE OF THE FIRM
Individual Proprietorship
 classic small businesses often called “mom-and-pop stores”
 might do a few hundred dollars of business per day
 barely provide a minimum wage for the owner’s efforts.
Partnership
 : combination of talents. Partnerships pose disadvantages that make
them impractical for large businesses.
 The major disadvantage is unlimited liability. General partners are
liable without limit for all debts contracted by the partnership.
The Corporation
 : a separate legal entity that may on its own behalf buy, sell, borrow
money, produce goods and services, and enter into contract
 PROBLEMS
Labor Total Product Marginal product
1 20 -----
2 46
3 75
4 92
5 100
6 96

a. Complete the table.

b. b. At what use of labor does diminishing returns set in?
 Circle the correct answer.
1. The major distinction between the short run and the long run
is:
 a. fixed factors.
 b. variable factors.
 c. the number of days
2. The marginal product can be:
 a. increasing or decreasing.
 b. positive or negative
 . c. zero. d. all of the above.
 . d. the opinion of economists.
 Find the law of diminishing returns.
a. As a fixed factor is added to variable factors, eventually the marginal
product increases.
b. As variable factors are added to fixed factors, eventually the marginal
product increases.
c. As fixed factors are added to variable factors, eventually the marginal
product decreases.
d. As variable factors are added to fixed factors, eventually the marginal
product decreases.
Find the situation where the law of diminishing returns fails to
apply.
a. The chef is given more pots and pans
. b. More workers are hired in more factories.
c. More fertilizer is added to the garden
. d. More painters are hired to paint the house.
question
 As five units of variable input are applied one at a time to a
productive process, the total product is 6, 10, 17, 20, and 22
respectively. What is the marginal product of the third unit of
input
 ? a. 7
 b. 10
 c. 16
 d. 17