Mic 6

CHAPTER

6
Theory of Production

Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
6– 1

DEFINITION OF PRODUCTION
Production is the process of
transforming inputs into outputs.
INPUTS
OUTPUTS
Input refers to
Refers to what we
the factors of
Processing get at the end of
production
the production
that a firm uses in
process, that is,
the production
finished products.
process

6– 2

CLASSIFICATION OF FACTORS
OF PRODUCTION
LAND LABOUR
All natural resources Physical or mental
or gifts of nature activities of human beings

CLASSIFICATION
OF FACTORS ENTREPRENEUR
OF PRODUCTION A person who combines
CAPITAL the different factors of
Part of man-made production, and initiates
wealth used for further the process of
production production and also
bears the risk

6– 3

THE PRODUCTION FUNCTION
The production function is a statement of the
functional relationship between inputs and
outputs, where the maximum output that can be
produced is shown with given inputs.
Q = (K, L)
Where Q = Output
K = Capital
L = Labour

6– 4

SHORT RUN
PRODUCTION FUNCTION
In the short run, we assume that at least one
inputs is fixed, that is, capital.
In the short run, the production function can
written as:
Q = ( K , L)
Where Q = Output
L = Labour
K = Capital (fixed)
6– 5

SHORT RUN
PRODUCTION FUNCTION (CON’T)
TOTAL PRODUCT (TP)
The amount of output produced when a given amount
of that input is used along with fixed inputs.

AVERAGE PRODUCT (AP)
Divide the total product by the amount of that
input used in the production.
Average Product (AP) = Total Product
Total Labour
AP = TP/ L

6– 6

SHORT RUN

MARGINAL PRODUCT (MP)
Change in the total product of that input corresponding to
an additional unit change in its labour assuming
other factors, that is, capital fixed.

Marginal Product (MP) = Change in Total Product
Change in Total Labour

MP =  TP/  L

6– 7

SHORT RUN
LAW OF DIMINISHING MARGINAL RETURNS
It states that if the quantities of certain factors
are increased while the quantities of one or
more factors are held constant, beyond a
certain level of production, the rate of increase
in output will decrease.

6– 8

SHORT RUN
Stage I Stage II
• Proportion of fixed factors are greater •Called law of diminishing returns.
than variable factors. •The most efficient stage of production
• Under utilization of fixed factors. •because the combinations of inputs are fully
• Operation involves a waste of resources utilized.

STAGES OF PRODUCTION
Stage III
• Proportion of fixed factors is lower than
• variable factors.
• Increase in variable factors decline TP because overcrowding.
• A producer would not like to operate at this stage.

6– 9

SHORT RUN
60 TPMAX
STAGE I STAGE II STAGE III
50

40

30 TP

MP
20
APMAX; AP
AP=MP
10
MP= 0
0
0 1 2 3 4 5 6 7 8 9 10
-10

6– 10

LONG-RUN
PRODUCTION FUNCTION
In the long-run a firm can
produce its output in various
ways by adjusting the amount
of labour and capital.

6– 11

LONG-RUN
Isoquant
• Isoquant represents all possible combinations
of variable inputs that are used to generate
the same level of output (total product).
• Isoquant analysis illustrates that there are
various ways to generate a given quantity of
output in one time period.
6– 12

LONG-RUN
Isoquant Table
LABOUR
CAPITAL
1 2 3 4 5

1 250 450 550 700 800
2 450 650 800 900 950
3 600 800 950 1050 1100
4 700 900 1050 1150 1200
5 800 950 1100 1200 1250

6– 13

LONG-RUN
 There are various combinations of capital
and labour. Different combination of inputs
can yield diffrerent outputs.
 For example, using 2 units of capital and 2
units of labur, total output would be 650
units.

6– 14

LONG-RUN
Isoquant Curve
Output
6
5
4
Capital

3
2 Output
1
0
1 2 3 5
Labour

6– 15

ISOQUANT MAP

Isoquant Map
• A number of isoquants that are combined in a
single graph can be used to estimate the
maximum attainable output from different
combinations of inputs.
• A higher isoquant curve represents a higher level
of output.

6– 16

ISOQUANT MAP(CON’T)
Is oquant map
6
5
4
C apital

3
2 Q =800
1
0 Q =600

1 2 3 4 5

MICROECONOMICS 17
6– 17

MARGINAL RATE OF TECHNICAL
SUBSTITUTION ( MRTS)
Marginal Rate of Technical Substitution (MRTS)

The technique to estimate the amount of capital input to be
replaced by labour input without increasing or
decreasing output.

MRTS = Change in Capital
Change in Labour
MRTS = –  K/  L

6– 18

SCALES OF PRODUCTION
DECREASING RETURNS TO SCALE
All the factors of production are increased in a given proportion, and output
would increase by a smaller proportion.

CONSTANT RETURNS TO SCALE
would increase by the same proportion.

INCREASING RETURNS TO SCALE
would increase by a greater proportion.

6– 19

SCALES OF PRODUCTION (CON’T)
In Cobb Douglas function, the return to scale is
determined by the coefficient of labour and capital.
Production Function: Q = AKaLb
If,
a + b > 1, Increasing Returns to Scale
a + b < 1, Decreasing Returns to Scale
a + b = 1, Constant Returns to Scale

6– 20

SCALES OF PRODUCTION (CON’T)
In linear production function, the returns to scale is determined
by substituting the labour and capital values.
Production Function: Q = 2L + 2KL + 4K
Let us assume L = 1 and K = 1, then substitute these values into
the equation.
Q = 2(1) + 2(1)(1) + 4(1) = 8
Let us assume L and K are increased by two times
Q = 2(2) + 2(2)(2) + 4(2) = 20
The new output (20 units) is more than double of the old
output (8 units), so it is increasing returns to scale.

6– 21

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