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Production Theory

Production - Process of transforming resources


(inputs) into products (outputs).
• Inputs: are the resources used in the
production of goods and services.
– It is broadly classified into labour (L), capital (K),
land, natural resources and entrepreneurial
talent.

• Output (Q): is the outcome of production,


usually in the form of products: goods and
services.
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The Production Function

• It is a relation that defines the maximum


output that can be produced with a given
set of inputs.
• It can be an equation, table, or graph such
as Q = f (L,K) where output is a function of
labor (L) and capital (K).
• Note that both inputs and outputs are
measured in physical rather than in
monetary units. Here technology is assumed
to remain constant during the period of the
analysis.
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Production Function With Two Inputs

Q = f(L, K)
K Q  The table shows
6 10 24 31 36 40 39 that by using 1
5 12 28 36 40 42 40 unit of labour
4 12 28 36 40 40 36 (L=1) and 1 unit
3 10 23 33 36 36 33 of capital (K=1),
2 7 18 28 30 30 28
the firm would
1 3 8 12 14 14 12
1 2 3 4 5 6 L
produce 3 units of
output (Q=3).
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The Two Main Types of Inputs

• Fixed Input: are resources that cannot


be readily changed during a time period.
– Examples: a firm’s plant and specialized
equipment.
– The amount of output may change but the
amount of inputs used remain the same.

 Most capital resources are fixed inputs in the


S-R
 In L-R, the entrepreneur may increase his
capital resources; thereby fixed inputs
become variable inputs.
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The Two Main Types of Inputs

 Variables Inputs: are resources that can be


varied easily and on very short notice such
as raw materials and unskilled labour.
 The amount of output produced depends on
the amount of inputs used.
 More (Less) inputs used will produce more (less)
output. Ex. natural and human resources

 Short-run is the time period during which


at least one input is fixed; whereas
 Long-run is when all inputs are variable.
• Key Assumptions
– Technology is regarded as a given.
– Whatever input or input combinations
are included in a particular function,
the output resulting from their
utilization is at the maximum level.
Short Run Vs. Long Run Decisions

• In the short run some factors of production are


fixed and this limits the choice in making input
decisions.
e.g. Car manufacturing company: Capital is fixed
but labor and steel can be adjusted making
them variable inputs
• The short run production function is essentially
a function of only labor. Q = f (L, Ῡ)
• In the long run the manager can adjust all
factors of production  in the long run all
inputs are variable.

• Example: If it takes a company 3 years to


acquire additional capital machines, then
the long run for that company is 3 years
and the short run is less than 3 years
In Summary:
• The short-run production function shows
the maximum quantity of good or service
that can be produced by a set of inputs,
assuming the amount of at least one of the
inputs used remains unchanged.
• The long-run production function shows
the maximum quantity of good or service
that can be produced by a set of inputs,
assuming the firm is free to vary the
amount of all the inputs being used.
Short Run Functions
• Assume Q = F(K, L) = K.5 L.5
– K is fixed at 16 units.
– Short run production function:
Q = (16).5 L.5 = 4 L.5
– What is the total output when 100
units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units
Measure of Productivity in S-R

• Managers must determine the


productivity of inputs used in the
production process
• This is useful for evaluating the
effectiveness of the production process
and making input decisions that
maximize profit
Measure of Productivity in S-R
 Productivity - the maximum amount of output that
can be attained given the amount of inputs used.
 Labor productivity: Q = Total amount of output
L Total number of input

Example: 10,000 Haona bread in one week


5 workers
= 2,000 pcs. of Haona bread is produced on
average per worker

 If output is < 2,000 = worker is less productive


 If output is > 2,000 = worker is more productive
Measure of Productivity in S-R
 Productivity - the maximum amount of output that
can be attained given the amount of inputs used.
 Labor productivity: Q = Total amount of output__
L Total number of labor hours

Example: 10,000 Haona bread in one week


48 labor hours in a week
= An average of 208.3 pcs. of Haona bread is
produced per one hour of labor

 If output is < 208 = the worker is less productive


 If output is > 208 = worker is more productive
Measure of Productivity in S-R
• 3 most important measures of productivity
are Total Product (TP), Average Product (AP)
and Marginal Product (MP)

 Productivity - the maximum amount of output that


can be attained given the amount of inputs used.
 Labor productivity: Q = Total amount of output
L Total number of labor

 Where AP = Q/ L
TP = Q
Therefore AP = TP/ L
Average Product in S-R:
• Manager may wish to know, on average,
how much each worker contributes to the
total output of the firm.
• Average Product of Labor is APL = Q/L.
– Measures the output of an “average” worker.
– Example: Q = F(K,L) = K.5 L.5
• Suppose the inputs are K = 16 and L = 9,
then the average product of labor is
APL = [(16)0.5(9)0.5]/9 = 1.33
Marginal Product in S-R:
• Is the change in total output
attributed to the last unit of input.
• MP for an input is the
• Change in total product divided by
change in quantity use of input.
Average Product (AP) in S-R:
Q
APL 
L

Marginal Product (MP) in S-R:


Q
MPL 
L
• A bakery produces loaf bread. Loaf Bread Production in SR
• Suppose it uses only two inputs: the Total
variable input labor (L) and the fixed Product
input capital (K). 80
• Below is a table showing the amount of
loaf bread produced (TP or Q) as the 70
amount of labor (variable input) is
increased. 60
Units of Total
Variable Product Marginal Average 50
Resource (Output) Product Product
0 0 40
1 8 Assignment (whole paper)
2 20 1. Plot the TP on a
graph. 30
3 34
4 46 2. Define and compute
5 56 for MP and AP. Then 20
6 64 plot this on another
7 70 graph. 10
8 74 3. Describe the Law of
9 75 Diminishing Returns. 1 2 3 4 5 6 7 8 9 10
10 73 Quantity of Labor
Copyright (c) 2000 by Harcourt Inc.
Jump to first page All rights reserved.
Assignment (Continuation)
4. Define and differentiate the three Economies
of Scale:
Increasing Returns to Scale (IRS)
Constant Returns to Scale (CRS)
Decreasing Returns to Scale (DRS)

5. Illustrate each scale in a graph.

Copyright (c) 2000 by Harcourt Inc.


Jump to first page All rights reserved.