PB102 PB102 MICROECONOMICSMICROECONOMICS

CHAPTER 5CHAPTER 5

THEORY OF PRODUCTIONTHEORY OF PRODUCTION

Chapter ObjectivesChapter Objectives

• Firm’s behavior in production processFirm’s behavior in production process

• How producer determined the level of How producer determined the level of output which give maximize outputoutput which give maximize output

• Firm’s equilibrium – determination of price Firm’s equilibrium – determination of price and output level and output level

• Which combination of factors of production Which combination of factors of production give higher level of output?give higher level of output?

• Which combination of factors of production Which combination of factors of production that minimize the cost?that minimize the cost?

SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION

• Profits and the aims of the firm

• Long-run and short-run production: – fixed and variable factors

• The law of diminishing returns

• The short-run production function:– total product (TP)

– average product (AP)

– marginal product (MP)

– the graphical relationship between TP, AP and MP

• Profits and the aims of the firm

• Long-run and short-run production: – fixed and variable factors

• The law of diminishing returns

• The short-run production function:– total product (TP)

– average product (AP)

– marginal product (MP)

– the graphical relationship between TP, AP and MP

Total Product (TP)Total Product (TP)

• Total Product (TP) is the amount of output Total Product (TP) is the amount of output produced when a given amount of that input produced when a given amount of that input is used along with fixed inputis used along with fixed input

Average ProductAverage Product

• The average product will measure the The average product will measure the productivity of labor by calculating the total productivity of labor by calculating the total output produced by a labor in a dayoutput produced by a labor in a day

• Can be obtain as: Can be obtain as:

AP = AP = Total Product Total Product

Total LaborTotal Labor

Marginal ProductMarginal Product

• The relationship between changes in total The relationship between changes in total output corresponding changes in additional output corresponding changes in additional unit of labor, assuming other inputs is fixedunit of labor, assuming other inputs is fixed

• Can be obtained as:Can be obtained as:Marginal Product (MP) = Marginal Product (MP) = Change in Total ProductChange in Total Product

Change in LaborChange in Labor

The Law of Diminishing ReturnsThe Law of Diminishing Returns

• Determines the shape of Marginal Product Determines the shape of Marginal Product CurveCurve

• States that beyond some point the marginal States that beyond some point the marginal

product product decreasesdecreases as additional units as additional units of a variable factor (labor) are added to fixed of a variable factor (labor) are added to fixed factor (land)factor (land)

Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)

Diminishing returns

0

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Wheat production per year from a particular farmWheat production per year from a particular farm

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Number of workers

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TP 0 310243640424240

Wheat production per year from a particular farmWheat production per year from a particular farm

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Wheat production per year from a particular farmWheat production per year from a particular farm

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Diminishing returnsset in here

Wheat production per year from a particular farmWheat production per year from a particular farm

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Maximum output

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Wheat production per year from a particular farmWheat production per year from a particular farm

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TP = 7

L = 1

MP = TP / L = 7

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Wheat production per year from a particular farmWheat production per year from a particular farm

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MPP

Number offarm workers (L)

Number offarm workers (L)

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Wheat production per year from a particular farmWheat production per year from a particular farm

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nes

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TP

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AP

MP

AP = TP / L

Number offarm workers (L)

Number offarm workers (L)

0

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Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

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heat

per

yea

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TP

-2

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AP

MPP

b

Diminishing returnsset in here

Number offarm workers (L)

Number offarm workers (L)

b

0

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0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

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TP

-2

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Number offarm workers (L)

Number offarm workers (L)

Maximumoutputb

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Wheat production per year from a particular farmWheat production per year from a particular farm

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nes

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-2

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MP

b

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d

Number offarm workers (L)

Number offarm workers (L)

Slope = TP / L= AP

c

c

LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION

• All factors variable in long run

• The scale of production:

– constant returns to scale

– increasing returns to scale

– decreasing returns to scale

• All factors variable in long run

• The scale of production:

– constant returns to scale

– increasing returns to scale

– decreasing returns to scale

LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION

• Economies of scale– specialisation & division of labour

– indivisibilities

– container principle

– greater efficiency of large machines

– by-products

– multi-stage production

– organisational & administrative economies

– financial economies

– economies of scope

• Economies of scale– specialisation & division of labour

– indivisibilities

– container principle

– greater efficiency of large machines

– by-products

– multi-stage production

– organisational & administrative economies

– financial economies

– economies of scope

LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION

• Diseconomies of scale

• External economies and diseconomies of scale

• Optimum combination of factorsMPPa/Pa = MPPb/Pb ... = MPPn/Pn

• Diseconomies of scale

• External economies and diseconomies of scale

• Optimum combination of factorsMPPa/Pa = MPPb/Pb ... = MPPn/Pn