PRODUCTION

Production is a transformation of resources or

input into goods and services.
It allocates certain resources or input (raw
material, labour, machinery) to produce a final
good (table).

Input
Land Transformation
Output
Capital process Finished good
Labour Operation Services
Raw Materials Value added
Technology
Slide 1
 PRODUCTION

There are 2 types of inputs in the production process:

1. Fixed input is an input whose quantity can not be
changed as output changes in the short run. For e.g.
capital, machine, vehicles, land, building & so on.

2. Variable input is an input whose quantity can be

changed as output changes in the short run. For e.g.
raw materials and labour.

Slide 2
 PRODUCTION
Managersmustdecidenotonlywhattoproduceforthe
market,butalsohowtoproduceitinthemostefficient
orleastcostmanner.
Economicsoffersawidelyacceptedtoolforjudging
whetherornottheproductionchoicesareleastcostand
efficient.
Aproductionfunctionrelatesthemostthatcanbe
producedfromagivensetofinputs.Thisallowsthe
managertomeasurethemarginalproductofeachinput.

Slide 3
 PRODUCTION
The Production Function
The production function shows the relationship
between quantity of inputs used to make a good and
the quantity of output of that good.

Factor of Production (Inputs):

- Land (N) - Labour (L) - Technology (T)
- Capital (K) - Entrepreneur (E)
Production Function:
QP f ( N , K , L, E , T )
Slide 4
1. Production In the Short Run
Short Run
In short run, a manager needs fixed capital inputs (land & machinery)
and variable inputs (labour & raw materials) in production
So it comprises of variable inputs and fixed inputs in short run
production.

Fixed input is an input whose quantity can not be

changed as output changes in the short run.
Variable input is an input whose quantity can be changed
as output changes in the short run
Slide 5
 1. Production In the Short Run

We will begin looking at the short run when only

number of labour can be varied.
We assume capital is fixed and labor is variable
Output can only be increased by increasing labor
Must know how output changes as the amount of
labor is changed
In short run, manager will not increase or decrease
capital as it is a fixed input.

Slide 6
1. Production In the Short Run

Short Run Production Functions:

As we assume that, if there is only two inputs which are labour
(L) and capital (K), the production function in short run:

Q = f ( K, L)
for two input case, where K as Fixed in short run

Slide 7
 Average Product of Labor (AP)

Manager can evaluate his labour efficiency of

production by using AP. Where the number of
output produced by each labor.
Measures the productivity of a firms labor in terms
of how much, on average, each worker can produce

Output q
AP
Labor Input L
Slide 8
 Marginal Product of Labor
In order to evaluate the efficiency or productivity of labour,
manager should refer Marginal Product of labour (MP).
Additional output produced when labor increases by one person.
From MP, we can see how many of labour should be employed to
reach the maximum productivity.
Change in output divided by the change in labor

Output q
MPL
Labor Input L
Slide 9
The data shows number of labour, total output produced
and amount of capital used:

Slide 10
 Many manager will look at the total product/output to
evaluate the productivity of labour but it is inaccurate
because total output ofcourse will increase when
more labour employed.
From the table, we can see the number of labour
increases and the total output increase as well.
Besides, many managers will also refer the average
product of labour but it is also less accurate because it
creates bias and we cant identify which labour is
productive and which labour is unproductive.
From the table, we just can see how much products
are produced by each labour.
Slide 11
 However, Marginal Product is the best indicator to
evaluate the efficiency of labour as we can see when the
manager employed one more labour, and the increment of
labour could bring how much productivity in production.
From the table, we can see when the manager employed
from one to three labours in production, the production
increases rapidly and greater.
However, the production becomes slow down and
unproductive after more than 3 labours are employed.

Slide 12
 We can see that as we increase labor the additional output
produced declines
Law of Diminishing Marginal Returns:
As the use of one labour increases with fixed capital, the resulting
additions to output will eventually decrease after use of 3 labours.
(This implied that the number of labour is many does not create
any high productivity and in fact they could create problem in
production such as laziness, delay, less efficient and interruption)
For example, lets imagine that there are more than 30 staffs in
one 7-eleven shop.

Slide 13
 In short,
When the labor input is small and capital is fixed,
output increases considerably since workers can
begin to specialize and MP of labor increases
When the labor input is large, some workers
become less efficient and MP of labor decreases
As the manager has realised the MP is
decreasing, he must do some actions to avoid the
inefficient production.

Slide 14
 What manager could do to increase
the labours productivity?
1. Employee Performance Evaluation System
2. Supervision and Management Control
3. Staff Disciplinary Control
4. Reward and Punishment System
5. Training Program
6. Total Quality Management (TQM)

Slide 15
Graph explanation: Total Product Curve

Output per
Month
D
112

C Total Product
At point D, output is
60 maximized.
B

A
Labor per Month
c 1 2 3 4 5 6 7 8 9 10

Slide 16
Average Product and Marginal Product
Left of E: MP > AP & AP is increasing
Output Right of E: MP < AP & AP is decreasing
per At E: MP = AP & AP is at APs maximum
At 8 units, MP is zero and total output is max
Worker
30
Marginal Product
E
20 Average Product

10

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

Slide 17
 Law of Diminishing Returns
INCREASES IN ONE FACTOR OF PRODUCTION,
HOLDING ONE OR OTHER FACTORS FIXED,
AFTER SOME POINT,
MARGINAL PRODUCT DIMINISHES.
MP

A SHORT
point of
RUN LAW
diminishing
returns
Variable input
Slide 18
 Threestagesofproduction
Stage1: averageproduct Total Output Stage2
rising.
Stage2: averageproduct
Stage1
declining(butmarginal
productpositive).
Stage3: marginal
productisnegative,or Stage3
totalproductis
declining.
L

Slide 19
The calculus method

= 100/L + 32 + 10L L^2

Slide 20
 The calculus method

The total product reached the

maximum level where there
are 8 labours in production.
Slide 21
 The Effect of Technological Improvement
Changes in technology will cause shifts in the total product
curve
More output can be produced with same inputs
Labor productivity can increase if there are improvements
in technology, even though any given production process
exhibits diminishing returns to labor.
Managers should adopt the advanced technology such as
advanced machine, knowledge and skills in production.

Slide 22
The Effect of Technological Improvement
Output
As move from A to B to
100 C labor productivity is
C increasing over time

O3
B

A
O2
50

O1

Labor per
time period
0 1 2 3 4 5 6 7 8 9 10
Slide 23
 2. Long Run Production Functions
All inputs become variable and no fixed input. For
e.g. Firms will shift his building or land to bigger
plant size after few years (long term).
Q = f ( K, L )
In the long-run, capital and labour are both variable.
We can look at the output we can achieve with different
combinations of capital and labour.
ISOQUANTS curve -- usually used to show all possible
combinations of inputs that yield the same output level.

Slide 24
 Isoquant Curve
Capital
per year (K)
5
55 units of output (Q)
can be produced with
3K & 1L (point A)
4 OR
1K & 3L (point D)
3
A B C

2
Q3 = 90
D Q2 = 75
1
Q1 = 55
1 2 3 4 5 Labor per year (L)

Slide 25
 Isoquant Curve
Capital 5 Increasing labor
per year holding capital
constant (A, B, C)
4 OR
Increasing capital
holding labor constant
3 (E, D, C
A B C
D
2
q3 = 90

1 E q2 = 75
q1 = 55
1 2 3 4 5 Labor per year

26 Slide 26
Cobb-Douglas Production Functions:
It measures the impact of changes in the inputs
(labour & capital), the relevant efficiencies, and
the yields of a production activity.

Q = A K L
Q = Quantity produced from inputs L and K
L = Amount of labour,
K = Amount of capital input,
A = Total factor productivity (change of technology)
= the capital elasticity of output
= the labor elasticity of output

Slide 27
Cobb-Douglas Production Functions:
Can be IRS, DRS or CRS:
if + 1, then Constant Return to Scale
Output increases by that same proportional change

if + < 1, then Decreasing Return to Scale

Output increases by less than that proportional change

if + > 1, then Increasing Return to Scale

Output increases by more than that proportion change

Slide 28
 Questions
Suppose: Q = 1.4 L .70 K .35
Is the function homogeneous ( + 1) ?
Is the production function constant returns to
scale?
What is the labor elasticity of output?
What is the capital elasticity of output?
What happens to total output (Q), if L increases
3% and capital is cut 10%?

Slide 29
 Answers
Increases in all inputs by , increase output
by 1.05
Increasing Returns to Scale
.70
.35
%Q= EQL %L+ EQK %K = .7(+3%)
+ .35(-10%) = 2.1% -3.5% = -1.4%

Slide 30
 Returns to Scale
In addition to discussing the tradeoff between
inputs to keep production the same

How does a firm decide, in the long run, the

best way to increase output
Can change the scale of production by increasing
all inputs in proportion
If double inputs, output will most likely increase
but by how much?

Slide 31
 Returns to Scale
Rate at which output increases as inputs are
increased proportionately

Increasing returns to scale

Constant returns to scale
Decreasing returns to scale

Slide 32
 Increasing Returns to Scale
Increasing returns to scale: output more
than doubles when all inputs are doubled

Larger output associated with lower cost (cars)

One firm is more efficient than many (utilities)
The isoquants get closer together

Slide 33
 Increasing Returns to Scale
A
Capital
(machine
hours)
Output more
than doubles
4 when all inputs
are doubled
30

2 20

10
Labor (hours)
5 10

Slide 34
 REASONS FOR
Increasing Returns to Scale
Specializationintheuseofcapitalandlabor.Labor
becomesmoreskilledattasks,ortheequipmentis
morespecialized,less"ajackofalltrades,"asscale
increases.

Otheradvantagesinclude:avoidinherentlumpiness
inthesizeofequipment,quantitydiscounts,
technicalefficienciesinbuildinglargervolume
equipment.
Slide 35
 Decreasing Returns to Scale
Decreasing returns to scale: output less
than doubles when all inputs are doubled

Decreasing efficiency with large size

Reduction of entrepreneurial abilities
Isoquants become farther apart

Slide 36
 Decreasing Returns to Scale
A

Capital 30
(machine
hours)

4 20

Output less than

2 doubles when all
10 inputs are doubled

5 10 Labor (hours

Slide 37
 REASONS FOR

DECREASING RETURNS TO SCALE

Problemsofcoordinationandcontrolasitishard
tosendandreceiveinformationasthescalerises.
Otherdisadvantagesoflargesize:
slowdecisionladder
inflexibility
capacity limitations on entrepreneurial skills
(there are diminishing returns to the C.E.O.
whichcannotbecompletelydelegated).

Slide 38
 Constant Returns to Scale
Constant returns to scale: output doubles
when all inputs are doubled
Size does not affect productivity
May have a large number of producers
Isoquants are equidistant apart

Slide 39
 Constant Returns to Scale
Capital
(machine
A
hours)
6
30

4 Output doubles
20
when all inputs
are doubled
2

10
Labor (hours)
5 10 15

Slide 40