Chapter- 04: Production Theory

Production Theory:

A) Production function : A production function represents input – output relationship.

Q = f (X, Y, Z)

Where, Q = output (or production volume) X = Labour Y = Land called input factors or factors of production Z = Capital

Q = Dependent variablesXYZ = Independent variables

B) The Law of Diminishing Returns:

The Law of Diminishing Returns states that the additional or marginal product of a variable input factor X (say labour) successively decreases as we go on increasing that input factor at a particular point of time, other input factors Y (say land) and Z (say capital) remaining fixed.

Example: Land = 1 Acre, Capital Tk. 10,000/- , Labour change as under-

Labour (X) MPx TPx APx1 15 15 152 17 32 163 18 50 16.664 15 65 16.255 12 77 15.406 7 84 147 0 84 128 -9 75 9.38

Where, MPx = Marginal product of input factor x TPx = Total product of input factor x APx = Average product of input factor x

Mathematically, MPx = Δ TPx/ ΔX TPx = ∑ MPxi (i = 1 + n)

MPx is the additional product produced by one additional unit of input factor X.

TPx is the sum of all MPx.

Figure: MPx, TPx and APx

Relationship between MPx and TPx:

TPx is the sum of all MPx, that is TPx = ∑ MPxiWhen MPx > 0 then TPx increases.When MPx < 0 then TPx decreases.When MPx = 0 then TPx is at its maximum.

Q. Why does the law of work (or function) in real time?

Ans. In every production function there exists an optimal input factor ratio to get the optimal output.

Return to scale:a. Increasing returns to scaleb. Constant returns to scalec. Decreasing returns to scale

a. Increasing returns to scale- denotes a situation whereby a proportional increase in all input factors leads to a more-than-proportional increase in output.

b. Constant returns to scale- denotes a situation whereby a proportional increase in all input factors leads to the same proportional increase in output.

c. Decreasing returns to scale- denotes a situation whereby a proportional increase in all input factors leads to a less- than-proportional increase in output.

Example:

Situation-1: Situation-2: Let us increase all input factor by 100% or two times

Input Output Input OutputLand : 1 acreLabour : 3Capital: Total Tk 10,000/-

Q= 50 mondspaddy

Land : 2 acreLabour: 6Capital: Total Tk 20,000/-

Q= 110 or 90 or 100 mondspaddy

When Q = 110; This is the case of increasing returns to scale.When Q = 90; This is the case of decreasing returns to scale.When Q = 100; This is the case of constant returns to scale.

Isoquant: (Iso- equal, quant- quantity)An isoquant represents equal amount of output that can be produced from different combinations of two input factors.

Slope of isoquant = MRTS= MPx/MPy (MRTS- Marginal Rate of Technical Substitution)

Isocost: (means equal cost)An isocost shows equal amount of cost that a firm can incur from purchase of different combinations of two input factors.

Slope of isocost = Px/Py

Figure: Isoquant Figure: Isocost

Least –cost or optimal input combination:

Two conditions need to be satisfied here:(a) Necessary condition:

slope of isoquant = slope of isocost Figure:

MPx/MPy = Px/Py

(b) Sufficient condition:

MPx/Px = MPy/ Py

Graphically in point of tangency of an isoquant to the isocost line.

Higher levels of combination show higher levels of output. Hence Q3 > Q2 > Q1Chapter- 5: Cost Concepts, Relationships & Practical Applications

A. Fixed & variable cost concepts:

Fixed costs are those costs that do not change with changes in output levels.Example: Rent, Insurance premium, Depreciation of building etc.

Variable costs are those costs that do change (vary) with changes in output levels.Example: Raw materials cost, Direct wages.

Figure: TFC Curve Figure: TVC Curve

TFC = Total Fixed CostTVC = Total Variable CostTC = TFC + TVCAC = TC/QAFC = TFC/QAVC = TVC/QAC = AFC + AVCMC = Δ TC/ ΔQ

Marginal principal is a very important principle in economics

B. Direct & indirect costs:Direct costs are those costs that can be calculated per product or per process unit.Example: Direct raw material costs, Direct wages etc.

Indirect costs are those costs that can not per calculated per product or process unitExample: Rent, Utility bills, Depreciation etc.

C. Explicit & Implicit costs:Explicit costs are cash expenses (or expenses paid on cheques)Example: Salary, Wages, Raw material costs etc.

Implicit costs are non-cash expenses.Example: Depreciation, Opportunity cost etc.

D. Sunk cost:Sunk costs are irrecoverable expenses that is, these are expenses incurred that can’t be recovered in future.Example: Lottery ticket money when the lottery is lost, non-refundable tender bid money when the tender is lost.

E. Marginal & Incremental costs:

Marginal cost is the additional cost for one additional product unit.MC = TC/ Q

Incremental cost is the additional cost associated with implementation of one additional management decision.Example: If IIUC management decides to open a new department then the additional cost associated with the opening of a new department will be called incremental cost.

F. Opportunity costs: Opportunity cost is the potential benefit foregone (lost) from the next best decision alternative.The basic principal of opportunity cost is ‘if we do one things then we have to give something else up’.Opportunity cost is the potential benefit foregone from the alternative given up. The life involves trade offs.

Example: Opportunity cost of Tk 100.00 million of Jb. K. A. Habib Investment opportunity alternative

Return on investment Ranking Remarks

Fisheries 25% iv.Flower cultivation 30% iiiFruit cultivation 35% ii Next bestMeat processing 45% i Best

A rational investment will go for the best alternatives. In our example case the meat processing investment decision is right.

G. Economic & Accounting cost concepts:

Fixed and variable cost concepts, direct and indirect cost concepts are accounting cost concept.

Explicit and implicit, marginal and incremental, and opportunity cost concepts are economic cost concepts.

Long- Run Total Cost (LRTC) Curves:In the long-run there is nothing called fixed cost. That is, all costs are variable in the long-run

A.

Figure: LRTC Curve showing increasing returns to scale

In this case Q > C. Rate of change output is greater than the rate of change input.

B.

Figure: LRTC Curve showing decreasing returns to scale

In this case Q < CHere, rate of change output is smaller than

the rate of change input.

C.

Figure: LRTC Curve showing constant returns to scale.

The rate (or percentage) increase or decrease in output is equal to the rate (or percentage) increase or decrease in cost.

D.

Figure: LRTC exhibiting variable returns to scale

This figure initially exhibits increasing returns to scale and after certain output level (Q*) level, it exhibits decreasing returns to scale.

E.

Figure: LRTC exhibiting variable returns to scale.This figure initially exhibits decreasing returns to scale and after certain output level (Q*) level, it exhibits increasing returns to scale.

Relationships between MC, AVC, AC and AFC curves:

MC curve is U-shaped. And again MC curve determines the shapes of AVC and AC curves. Hence both AVC and AC curves are also U-shaped

Figure: MC, AVC, AC and AFC curves

AC = AFC + AVC AC > AVC

MC must cut both AC and AVC curve at the bottoms (or lowest points) from below.AFC curve is hyperbola. That means, it goes on decreasing as output is increased. AFC continuously decreased. It never cut the both X and Y axis. Its value never be zero.