7.production MBA

Production
Factors of production
 Land
 Labor
 Capital
 Entrepreneurship
Remuneration to factors of production
 Land ----rent
 Labor……wages
 Capital….interest
 Entrepreneurship…..profits/loss
Production
 Transformation of inputs to outputs

 Creation of value to the existing matter by giving a
shape or a form
 Raw materials to finished goodsd
Production function
 Production function…. Output = f (inputs)

- Short run Production function (Law of variable
Proportions / law of diminishing marginal returns)
- Long run production function (Returns to scale).
Production in the Short Run
 In the short run, three production measurements

used to help optimize the process.
• Total Product (TP)
 Total output in the SR
• Marginal Product (MP)
 Change TP due to a unit change in the input

• Average Product (AP)
 TP per input
Calculation of Marginal Product
Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0
Q 8
1 8  8
2 18 X 1
3 29
4 39
5 47
6 52
7 56
8 52
Calculation of A.P
Variable Total Average
Input Product Product
(X) (Q or TP) (AP)
0 0 ---
Q 88
11 88  8
X 11
2 18
3 29
4 39
5 47
6 52
7 56
8 52
Q(total
X(labor input) Product)output AP (Q/X) MP (∆Q/∆X)
0 0
1 8 8 8
2 18 9 10
1st stage3 29 9.666667 11
4 39 9.75 10
5 47 9.4 8
6 52 8.666667 5
2nd stage 7 56 8 4
3rd stage 8 52 6.5 -4
 Graph TP, MP, and AP to

illustrate their
relationships (and
create at optimization
map!)
 If MP is positive then Max

TP is increasing.
 If MP is negative then
TP is decreasing.
 TP reaches a
maximum when
MP=0 (Maximization
Condition!)
The Law of Diminishing Returns
 Why does MP eventually decline?

 Due to the law of diminishing return
or 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.
Diminishing Returns
Increasing Returns
Teamwork and Specialization
MP
Diminishing Returns Begins
Fewer opportunities for teamwork
and specialization
MP
 MP & AP
 If MP > AP then AP
is rising.
 If MP < AP then AP
is falling.
 MP=AP when AP is
maximized.
The Three Stages of Production
 MP & AP Optimization Map

 Stage I
 From zero units of the variable input to where AP is maximized
 Stage II
 From the maximum AP to where MP=0
 Stage III
 From where MP=0 on where MP < 0
 In the short run, rational firms should only be

operating in Stage II.
 Why Stage II?
• Why not Stage III?

• Use more variable inputs to produce less output
• Why not Stage I?

• Underutilizing fixed capacity.
Optimal Use of Variable Input Usage
Labor Total Average Marginal

Unit Product Product Product
(X) (Q or TP) (AP) (MP)
0 0
1 10,000 10,000 10,000
2 25,000 12,500 15,000
3 45,000 15,000 20,000
4 60,000 15,000 15,000
5 70,000 14,000 10,000
Stage II 6 75,000 12,500 5,000
7 78,000 11,143 3,000
8 80,000 10,000 2,000
Output Decision Variables:

Total Revenue Product (TRP) = Q•P
Marginal Revenue Product (MRP) =
TRP (Q  P) P  Q
   P  MP
X X X
Total Labor Cost (TLC) = w•X
Marginal Labor Cost (MLC) =
TLC
w
X
 Operating in perfectly competitive markets, firms

optimize the use of variable input when their
MRP=MLC
Total product 15 (a) Total product
Total
(tons/day)
product
10
0 5 10 Workers per day
Increasing Diminishing but

5 (b) Marginal product
Marginal product
marginal positive
4 marginal returns Negative
returns
3
(tons/day)
marginal
2 Marginal returns
1 product
0
5 10 Workers per day

Isoquants
 Isoquant shows all the technologically efficient

combinations of two resources, such as labor and
capital, that produce a certain rate of output
Isoquants
23
Units of capital per month

10
a
h
f
b g
5
e
Q3
c Q2
d
Q1
0 5 10
Units of labor per month
Marginal Rate of Technical Substitution
24
 Anywhere along the isoquant, the

marginal rate of technical substitution
of labor for capital equals the marginal
product of labor divided by the
marginal product of capital, which also
equals the absolute value of the slope of
the isoquant
 MRTS = MPL / MPC

Isocost Lines
25
Isocost line identifies all
m o nt h
combinations of capital and
labor the firm can hire for a
given total cost
10
Total cost = 15, 000, 19000
U ni t s of c a pi t al p e r
and 22,500
Price of capital = 2500
Price of labor= 1500
5
0 5 10 15
Optimal Combinations of Inputs
The profit maximizing firm 26
will operate at point e, where

the isoquant is just tangent to 10
the isocost line.
At point e, the isoquant and
isocost line have the same
slope  the marginal rate of
technical substitution equals
the ratio of input prices 5
e
0 5 10
Units of labor
per month
A Firm’s Optimal Combination
of Inputs
TC = $19,000
10 e: isoquant Q2 is tangent
to the isocost line
a f
5 e Q3 (475)
Q2 (415)
Q1 (290)
0 5 10
A Firm’s Expansion Path
Expansion path
- Slopes up to the right
- More of both
resources is needed
to increase output
Expansion path
d
c Q4
b h
C a Q3
Q2
Q1
0 L L’
Production in the Long Run
 In the long run, all inputs are variable.

 The process is described by the concept of returns to scale.
 Measures what happens to TP as all of the inputs are changed by
the same proportion
 EQ= Percentage change in Q

Percentage change in all inputs
If E>1 then IRTS

If E=1 then CRTS
If E<1 then DRTS
The returns to scale concept can be illustrated using

the following graphs.
IRTS CRTS DRTS

Q Q
Q
X,Y X,Y X,Y

 May exhibit at first

increasing returns,
then constant returns,
and finally decreasing
returns to scale.
Returns to scale
Case 1 Case 2 Case 3

Input Output Input Output Input Output
2000 4000 2000 4000 2000 4000
4000 10000 4000 8000 4000 6000
increasing Constant Diminishing
Output
Constant
increasing
Diminishing
Input

7.production MBA

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Production

 Transformation of inputs to outputs

 Production function…. Output = f (inputs)

 In the short run, three production measurements

 Change TP due to a unit change in the input

 Graph TP, MP, and AP to

 If MP is positive then Max

 Why does MP eventually decline?

 MP & AP Optimization Map

 In the short run, rational firms should only be

• Why not Stage III?

• Why not Stage I?

Labor Total Average Marginal

Output Decision Variables:

 Operating in perfectly competitive markets, firms

0 5 10 Workers per day

Increasing Diminishing but

5 10 Workers per day

 Isoquant shows all the technologically efficient

Units of capital per month

 Anywhere along the isoquant, the

 MRTS = MPL / MPC

Units of capital per month

 In the long run, all inputs are variable.

 EQ= Percentage change in Q

If E>1 then IRTS

The returns to scale concept can be illustrated using

IRTS CRTS DRTS

X,Y X,Y X,Y

 May exhibit at first

Case 1 Case 2 Case 3

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