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Production

Function

Tanu Kathuria 1
Tanu Kathuria 2
Production Function

Tanu Kathuria 3
Production Function
 States the relationship between inputs and outputs
 Inputs – the factors of production classified as:
 Land – all natural resources of the earth – not just
‘terra firma’!
 Price paid to acquire land = Rent

 Labour – all physical and mental human effort


involved in production
 Price paid to labour = Wages

 Capital – buildings, machinery and equipment


not used for its own sake but for the contribution
it makes to production
 Price paid for capital = Interest

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Production Function

Inputs Process Output

Land
Product or
Labour service
generated
– value added
Capital

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Production Function
 Mathematical representation
of the relationship:
 Q = f (K, L, La)
 Output (Q) is dependent upon the amount
of capital (K), Land (L) and Labour (La)
used

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Analysis of Production Function:
Short Run
 In the short run at least one factor fixed in supply but all other
factors capable of being changed
 Reflects ways in which firms respond to changes
in output (demand)
 Can increase or decrease output using more or less of some
factors but some likely to be easier
to change than others
 Increase in total capacity only possible
in the long run

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Analysis of Production Function:
Short Run
In times of rising
sales (demand)
firms can increase
labour and capital
but only up to a
certain level –
they will be limited
by the amount of
space. In this
example, land is
the fixed factor
which cannot be
altered in the
short run.

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Analysis of Production Function:
Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example it reduces
its labour and
capital but again,
land is the factor
which stays fixed.

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Analysis of Production Function:
Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example, it
reduces its labour
and capital but
again, land is the
factor which stays
fixed.

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Short-Run Changes in Production
Factor Productivity
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q


change, when the quantity of L is
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increased? Tanu Kathuria
The Marginal Product of Labour
 The marginal product of labour is the
increase in output obtained by adding 1 unit
of labor but holding constant the inputs of all
other factors

Marginal Product of L:
MPL= ∆Q/∆L (holding K constant)
= δQ/δL

Average Product of L:
APL= Q/L (holding K constant)
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Relationship Between Total,
Average, and Marginal Product:
Short-Run Analysis
 Total Product (TP) = total quantity of
output

 Average Product (AP) = total product per


total input

 Marginal Product (MP) = change in


quantity when one additional unit of input
used Tanu Kathuria 13
Short-Run Analysis of Total,
Average, and Marginal Product
 If MP > AP then
AP is rising
 If MP < AP then
AP is falling
 MP = AP when
AP is
maximized
 TP maximized
when MP = 0 14
Tanu Kathuria
Three Stages of Production in Short
Run
AP,MP
Stage I Stage II Stage III

APX

MPX X
Fixed input grossly Specialization and
underutilized; teamwork continue to
specialization and result in greater output Fixed input capacity
teamwork cause AP to when additional X is is reached;
increase when additional used; fixed input being additional X causes
X is used properly utilized output to fall

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Law of Diminishing Returns
(Diminishing Marginal Product)
Holding all factors constant except one, the
law of diminishing returns says that:
 As additional units of a variable input are
combined with a fixed input, at some point
the additional output (i.e., marginal product)
starts to diminish
 e.g. trying to increase labor input without also
increasing capital will bring diminishing returns
 Nothing says when diminishing returns will start
to take effect, only that it will happen at some
point
 All inputs added to the production process are
exactly the same in individual productivity
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Analysing the Production
Function: Long Run
 The long run is defined as the period of time taken to vary all factors of
production
 By doing this, the firm is able to increase its total capacity – not
just short term capacity
 Associated with a change in the scale of production
 The period of time varies according to the firm
and the industry
 In electricity supply, the time taken to build new capacity could be
many years; for a market stall holder, the ‘long run’ could be as little
as a few weeks or months!

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Analysis of Production Function:
Long Run

In the long run, the firm can change all its factors of production thus
increasing its total capacity. In this example it has doubled its capacity.

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Long-Run Changes in Production
Returns to Scale
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q change,


when the quantity of both L and K is
increased? Tanu Kathuria 19
Optimal Combination of Inputs
 Now we are ready to answer the question
stated earlier, namely, how to determine the
optimal combination of inputs
 As was said this optimal combination
depends on the relative prices of inputs and
on the degree to which they can be
substituted for one another
 This relationship can be stated as follows:
MPL/MPK = PL/PK
(or MPL/PL= MPK/PK)
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An Isoquant
Graph of Isoquant

Y
7

0
1 2 3 4 5 6 7 X

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Law of Diminishing Marginal Rate
of Technical Substitution:
Table 7.8 Input Combinations
for Isoquant Q = 52
Combination L K ∆L ∆K MRTS
A 6 2
-2 1 2
B 4 3
C 3 4 -1 1 1
D 2 6 -1 2 1/2
E 2 8 0 2

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Law of Diminishing Marginal Rate of
Technical Substitution continued
Y 7
A
6

5
∆Y =- 2
B
4
∆X = 1 C
3 ∆Y = -1
D
∆X = 1 E
2
∆Y = -1
∆X = 2
1

0
2 3 4 6 8 X

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Isocost Curves

Assume PL =$100
Input Combinations and PK =$200
Rs.1000 Budge
Combination L K
A 0 5
B 2 4
C 4 3
D 6 2
E 8 1
G 10 0

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Isocost Curve and Optimal
Combination of L and K
K

100L + 200K = 1000


5

“Q52”

10 L

Isocost andTanu
isoquant
Kathuria
curve for inputs L and
25
Expansion Path: the locus of points which presents
the optimal input combinations for different isocost
curves
The long-run situation:
both factors variable
Expansion path
Units of capital (K)

300
TC =
£60 000
TC =
TC = £40 000 200
£20 000
100
O Tanu Kathuria 26
Units of labor (L)
Returns to Scale

 Let us now consider the effect of


proportional increase in all inputs on the
level of output produced

 To explain how much the output will


increase we will use the concept of returns
to scale

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Returns to Scale continued
 If all inputs into the production process
are doubled, three things can happen:
 output can more than double
 increasing returns to scale (IRTS)
 output can exactly double
 constant returns to scale (CRTS)
 output can less than double
 decreasing returns to scale (DRTS)

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Graphically, the returns to scale concept can be
illustrated using the following graphs

IRTS CRTS DRTS


Q Q Q

X,Y X,Y X,Y

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