Written by: Edmund Quek

CHAPTER 5 THE THEORY OF PRODUCTION

LECTURE OUTLINE 1 2 2.1 2.2 2.3 2.4 2.5 2.6 3 3.1 3.2 3.3 INTRODUCTION SHORT-RUN THEORY OF PRODUCTION Definition of short run Law of diminishing marginal returns Total product Marginal product Average product Relationship between marginal product and average product LONG-RUN THEORY OF PRODUCTION Definition of long run Least-cost combination of factor inputs Returns to scale

References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

2011 Economics Cafe All rights reserved.

Page 1

Written by: Edmund Quek

INTRODUCTION

Production is the process by which factor inputs are transformed into output. An increase in the quantity of factor inputs will lead to an increase in output. The theory of production is the study of how the output level changes as the quantity of factor inputs changes. This chapter gives an exposition of the theory of production.

2 2.1

SHORT-RUN THEORY OF PRODUCTION Definition of short run

If a firm wants to increase output, it can almost immediately employ more labour. However, it will not be able to employ more capital in the same time frame as acquisition of capital takes time. In economics, we distinguish between two types of factor input: variable factor input and fixed factor input. Variable factor inputs are factor inputs whose quantities can be changed in the short run. An example is labour. Fixed factor inputs are factor inputs whose quantities are fixed in the short run. An example is capital. The short run is the time period during which at least one of the factor inputs used in the production process is fixed. It does not correspond to any specific number of weeks, months or years because it varies from firm to firm and from industry to industry. For instance, a firm such as a home-based 'dot.com' company may take only a few weeks or even days to enlarge their capacity, i.e. to purchase and set up a new server. However, for firms in capital-intensive industries such as those involved in petroleum refining, steel manufacturing and car manufacturing, they may take many years to increase their capacity.

2.2

Law of diminishing marginal returns (LDMR)

The law of diminishing marginal returns (LDMR) states that if an increasing quantity of a variable factor input is used with a given quantity of a fixed factor input, a point will be reached beyond which each additional unit of the variable factor input will add less to total output than the previous additional unit. To understand the LDMR, we will consider the example of a manufacturing firm which employs two factor inputs: capital and labour. In this instance, the fixed factor input is capital and the variable factor input is labour. As the quantity of capital is fixed in the short run, the firm can only increase total output by employing more labour. Labour is assumed to be homogeneous which means that all workers are equally productive.

2011 Economics Cafe All rights reserved.

Page 2

Written by: Edmund Quek

Example Capital 5 5 5 5 5 5 5 5 5 5

Labour 0 1 2 3 4 5 6 7 8 9

Total output 0 3 7 12 18 22 24 24 23 20

Additional output --3 4 5 6 4 2 0 -1 -3

From the first unit of labour to the fourth, each additional unit of labour is adding more to total output than the previous additional unit. We say that the firm is experiencing increasing marginal returns and this is due to under-utilisation of capital. However, from the fifth unit of labour onwards, each additional unit of labour is adding less to total output than the previous additional unit. We say that the firm is experiencing diminishing marginal returns and this is due to over-utilisation of capital. From the table above, diminishing marginal returns sets in when the fifth unit of labour is employed. Furthermore, the seventh unit of labour is actually redundant. Total output even falls when the eighth unit of labour is employed.

Note: From the table above, we can see that total output changes as the firm employs more labour with a given quantity of capital. As a result, the ratio of the fixed factor input to the variable factor input falls as total output increases. Production in this case is said to have taken place under variable proportions. Therefore, the LDMR is also known as the law of variable proportions.

2011 Economics Cafe All rights reserved.

Page 3

Written by: Edmund Quek

2.3

Total product

Total product (TP) is an economic term for total output. The total product curve shows how total output changes as an increasing quantity of labour is used with a given quantity of capital. The total product curve is S-shaped as illustrated in the diagram below. TP Curve

In the above diagram, the TP curve shows how total output varies with the quantity of labour, given the quantity of capital. From the first unit of labour to QL0, the firm is experiencing increasing marginal returns. The TP curve becomes steeper as more labour is employed. After QL0, the firm is experiencing diminishing marginal returns. The TP curve becomes flatter as more labour is employed. After QL2, the problem of diminishing marginal returns becomes so severe that additional workers actually decrease the total output. The slope of the TP curve is negative.

2011 Economics Cafe All rights reserved.

Page 4

Written by: Edmund Quek

2.4

Marginal product

Marginal product (MP) is the additional output resulting from employing one more unit of labour. Mathematically, TP MP -------QL Therefore, marginal product is the slope of the TP curve. MP Curve

In the above diagram, from the first unit of labour to QL0, the firm is experiencing increasing marginal returns. The slope of the TP curve is increasing and hence the MP curve is rising. At QL0, the slope of the TP curve is the largest and hence the MP curve is at its maximum. After QL0, the slope of the TP curve is decreasing and hence the MP curve is falling. After QL2, the slope of the TP curve is negative and hence the MP curve is below the horizontal axis.

2011 Economics Cafe All rights reserved.

Page 5

Written by: Edmund Quek

2.5

Average product

Average product (AP) is the output per unit of labour. Mathematically, TP AP ------QL Therefore, average product is the slope of the line from the origin to the TP curve. AP Curve

In the above diagram, from the first unit of labour to QL1, since the slope of the line from the origin to the TP curve is increasing, the AP curve is rising. At QL1, the slope of the line from the origin to the TP curve is largest and hence the AP curve is at its maximum. After QL1, since the slope of the line from the origin to the TP curve is decreasing, the AP curve is falling.

2011 Economics Cafe All rights reserved.

Page 6

Written by: Edmund Quek

2.6

Relationship between marginal product and average product

The relationship between average and marginal values can be illustrated with the following example. Let the average height of a particular class of 20 pupils be 1.6m. If one more student, who is 1.7m tall joins the class, the average height of the class will increase. Conversely, if the height of the additional student is less than the average height of the class, the average height of the class will decrease. Therefore, when the marginal value is higher than the average value, the latter will increase. Conversely if the marginal value is lower than the average value, the latter will decrease. This relationship can be applied to average product and marginal product.

In the above diagram, from the first unit of labour to QL0, the MP curve is rising, and is falling thereafter. From the first unit of labour to QL1, the MP curve is higher than the AP curve and hence the AP curve is rising. After QL1, the MP curve is lower than the AP curve and hence the AP curve is falling. Therefore, the MP curve cuts the AP curve at the maximum point.

2011 Economics Cafe All rights reserved.

Page 7

Written by: Edmund Quek

3 3.1

LONG-RUN THEORY OF PRODUCTION Definition of the long run

The long run is the time period after which all the factor inputs used in the production process are variable. In the long run, if a firm wants to increase output, not only can it employ more labour, but it can also employ more capital whose quantity is fixed in the short run. Like the short run, the long run does not correspond to a specific number of weeks, months or years because it varies from firm to firm and from industry to industry.

3.2

Least-cost combination of factor inputs

The least-cost combination of factor inputs is used when the last dollar of each factor input employed produces the same additional output. If a firm employs two factor inputs, labour (L) and capital (K), the least-cost condition can be expressed mathematically as MPL/PL = MPK/PK, where MP denotes marginal product and P denotes price. To understand the least-cost condition, consider what will happen if MPL/PL MPK/PK. In other words, the additional output produced by the last dollar of labour employed is greater than the additional output produced by the last dollar of capital employed. When MPL/PL, the additional output resulting from employing the last dollar of labour, is greater than MPK/PK, the additional output resulting from employing the last dollar of capital, the firm can reduce the total cost of producing the same amount of output by employing more labour and less capital. Suppose that MPL/PL = 10 and MPK/PK = 5. In this instance, if the firm employs one more dollar of labour and two dollars less of capital, although total cost will fall by one dollar, total output will remain unchanged which will lead to a fall in the total cost of producing the same amount of output. However, as more labour is employed, MPL will fall due to diminishing marginal returns. Similarly, as less capital is employed, MPK will increase. This process will continue until the additional output resulting from employing the last dollar of labour is equal to the additional output resulting from employing the last dollar of capital (i.e. the last dollar of each factor input employed produces the same additional output).

2011 Economics Cafe All rights reserved.

Page 8

Written by: Edmund Quek

3.3

Returns to scale

When the quantities of all the factor inputs used in the production process are increased by the same proportion in the long run, the scale of production expands. When the scale of production expands, three things could happen: increasing returns to scale, constant returns to scale and decreasing returns to scale. Increasing returns to scale occurs when the same percentage increase in the quantities of all the factor inputs used in the production process leads to a larger percentage increase in total output. Constant returns to scale occurs when the same percentage increase in the quantities of all the factor inputs used in the production process leads to the same percentage increase in total output. Decreasing returns to scale occurs when the same percentage increase in the quantities of all the factor inputs used in the production process leads to a smaller percentage increase in total output. Example % increase in Capital Labour the quantities all factor inputs 20 4 --40 8 100 60 12 50 80 16 33.33 100 20 25 120 24 20 Total output 100 250 420 560 672 780 % increase in total output --150 68 33.33 20 16 Returns to scale --IRS IRS CRS DRS DRS

From the output level 100 to the output level 420, the firm is experiencing increasing returns to scale. From the output level 420 to the output level 560, the firm is experiencing constant returns to scale. From the output level 560 to the output level 780, the firm is experiencing decreasing returns to scale.

2011 Economics Cafe All rights reserved.

Page 9