Chapter 5Chapter 5

Theory of Production

Chapter 5Chapter 5Prof. DrProf. Dr..

Mohamed I. MigdadMohamed I. MigdadProfessor of EconomicsProfessor of Economics

20152015

Main QuestionsMain QuestionsProduction decisions

concentrate on the following questions:

1.What goods to produce;2.How to produce them; that

include the technology.3.For whom to produce, that

determine the quality and price.

4.The costs of production;

AssumptionsAssumptions We assume all firms to try to

produce efficiently at the lowest cost.

Or they try to produce the maximum level of output for a given level of inputs.

We also assume firms to try to maximize economic profits.

DefinitionDefinition A firm is an organization that

comes into reality when a person or a group of people decide to produce a good or a service in order to meet a perceived demand.

Most firms exist to make a profit but production is not limited to firms; many important differences exist between firms.

Production ProcessProduction Process Production is simply the conversion of

inputs to outputs. It is an economic process that uses

resources to create commodities that are suitable for exchange.

Some economists define production broadly as "the act of making things, creating things, producing things, and, in particular, the act of making products that will be traded or sold commercially".

ContinueContinue For those economists, this can

include manufacturing, storing, shipping, and packaging.

They see every commercial activity, other than the final purchase, as some form of production.

Production technology Production technology (PT)(PT)

(P.T) refers to the quantitative relationship between inputs and outputs. The production technology could be a labor-intensive technology or a capital intensive one.

A labor-intensive technology relies heavily on human labor instead of capital, while

A capital-intensive technology relies heavily on capital instead of human labor.

Production function (PF)Production function (PF) (P.F) explain that Production

quantity is a function of factors-of-production. In the short run, it is a function of the variable FoP while in the long run, it is a function of the total (FoP).

Q = F (L, C, M, E, R ….. N)

Technological Change Technological Change (TC)(TC)

Economic history records that total output in the US has grown more than tenfold over the last century.

Part of that gain has come from increased inputs such as labor and machinery.

Much of the increase of the output has come from the technological changes which improve productivity and raises living standards.

Technological changeTechnological change

Q Production

L

TP1

0 3 8

MPL

APL

2

Production Curve

TP2

Productive activitiesProductive activities

A farm takes fertilizer, seed, land, water & labor and tern them into wheat or corn.

Factories takes energy, raw materials, machinery & labor and tern them into tractors or TVs.

An airline takes airplanes, fuel, labor & computerized reservation system and provide passengers with the ability to travel quickly.

continuecontinue

An accounting firms takes pencils, papers, computers, office space & labor and produce audits reports or tax returns for clients.

We assume that all firms try to produce efficiently, that is, at lowest cost. Or they try to produce the maximum level of output for a given does of inputs.

We assume that firms try to maximize economic profits.

The Production ProcessThe Production ProcessProduction technology refers

to the quantitative relationship between inputs and outputs.

A labor-intensive technology relies heavily on human labor instead of capital.

A capital-intensive technology relies heavily on capital instead of human labor.

Technological changeTechnological changeEconomic history record that total output

in the US has grown more than tenfold over the last century.

Part of that gain has come from increased inputs such as labor and machinery.

Much of the increase of the output has come from the technological change which improve productivity and raises living standards.

ExamplesExamples

Fiber optics that have lowered cost and improved reliability in telecommunications.

Improvement in computer technologies that have increased computational power by more than 1000 times in three decades.

When the firm adjust the production process to reduce waste and increase outputs.

Profits and Economic Profits and Economic CostsCosts

Profit (economic profit) is the difference between total revenue and total economic cost.

cost economic total revenue totalprofit economic

Total revenueTotal revenue

Total revenue is the amount received from the sale of the product:

)(. Q x PrevenueT

Profits and Economic Profits and Economic CostsCosts Total cost (total

economic cost) is the total of1. Out of pocket costs,2. Normal rate of return on

capital, and3. Opportunity cost of each

factor of production.

Profits and Economic Profits and Economic CostsCostsThe rate of return, often

referred to as the yield of the investment, is the annual flow of net income generated by an investment expressed as a percentage of the total investment.

Short-Run Versus Long-Run Short-Run Versus Long-Run DecisionsDecisions

The short run is a period of time for which two conditions hold:1. The firm is operating under a fixed

scale (or fixed factor) of production, and

2. Firms can neither enter nor exit the industry.

Short-Run Versus Long-Run Short-Run Versus Long-Run DecisionsDecisions

The long run is a period of time for which there are no fixed factors of production. Firms can increase or decrease scale of operation, and new firms can enter and existing, firms can exit the industry.

The Production FunctionThe Production FunctionThe production

function or total product function is a numerical or mathematical expression of a relationship between inputs and outputs. It shows units of total product as a function of units of inputs.

Marginal ProductMarginal Product

Marginal product is the additional output that can be produced by adding one more unit of a specific input, ceteris paribus.

MPLMPL

m arg in a l p ro du ct o f lab o r = chang e in to ta l p rod uc t

ch an ge in un its o f lab o r u sed

The Law ofThe Law ofDiminishing Marginal ReturnsDiminishing Marginal ReturnsThe law of diminishing marginal returns states that:

When additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines.

Average ProductAverage Product

Average product is the average amount produced by each unit of a variable factor of production.

APLAPL

averag e p ro du c t o f lab o r = to ta l p ro d u ct

to ta l un its o f lab o r

Production ScheduleProduction Schedule7

(1)LABOR UNITS (EMPLOYEES)

(2) TPTOTAL PRODUCT

(SANDWICHES PER HOUR)

(3) MPLMARGINAL

PRODUCT OF LABOR

(4) APLAVERAGE

PRODUCT OF LABOR

0 0

1 50 50 502 120 70 603 180 60 604 220 40 555 250 30 506

7

8

9

10

270

280

280

270

250

20

10

0

-10

-20

45

40

35

30

25

Q Production

L

TP

0 3 82

Production Curve

The relation between TP, MP The relation between TP, MP & AP& AP

Q Production

L

TP

0 3 8

MPL

APL2

Production Curve

Total, Average, and Marginal Total, Average, and Marginal ProductProduct

Marginal product is the slope of the total product function.

• At point C, total product is maximum, the slope of the total product function is zero, and marginal product intersects the horizontal axis.

• At point A, the slope of the total product function is highest; thus, marginal product is highest.

Total, Average, and Marginal Total, Average, and Marginal ProductProduct

Total, Average, and Marginal Total, Average, and Marginal ProductProduct

When average product is maximum, average product and marginal product are equal.

• Then, average product falls to the left and right of point B.

Total, Average, and Marginal Total, Average, and Marginal ProductProduct

Remember that:As long as marginal

product rises, average product rises.

When average product is maximum, marginal product equals average product.

When average product falls, marginal product is less than average product.

Appendix: Isoquants and Appendix: Isoquants and IsocostsIsocosts

An isoquant is a graph that shows all the combinations of capital and labor that can be used to produce a given amount of output.

Appendix: Isoquants and Appendix: Isoquants and IsocostsIsocosts

Alternative Combinations of Capital (K) and Labor (L) Required to Produce 50, 100, and 150 Units of Output

qx = 50 qx = 100 qx= 150

K L K L K LA 1 8 2 10 3 10B 2 5 3 6 4 7C 3 3 4 4 5 5D 5 2 6 3 7 4E 8 1 10 2 10 3

Appendix: Isoquants and Appendix: Isoquants and IsocostsIsocosts

The slope of an isoquant is called the marginal rate of technical substitution.

L

K

MPKL MP

• Along an isoquant:

LK MPLMPK

Appendix: Isoquants and Appendix: Isoquants and IsocostsIsocosts

An isocost line is a graph that shows all the combinations of capital and labor that are available for a given total cost.

• The equation of the isocost line is:

LPKP LK

Appendix: Isoquants and Appendix: Isoquants and IsocostsIsocosts

Slope of the isocost line:

//

K L

L K

TC P PKL TC P P

Appendix: Isoquants and Appendix: Isoquants and IsocostsIsocosts

By setting the slopes of the isoquant and isocost curves equal to each other,

L L

K K

MP PMP P

L K

L K

MP MPP P

we derive the firm’s cost-minimizing equilibrium condition is found

Appendix: Isoquants and Appendix: Isoquants and IsocostsIsocosts

Plotting a series of cost-minimizing combinations of inputs (at points A, B, and C), yields a cost curve.