Principles of Microeconomics

Theory of Production

PRODUCTION FUNCTION

Inputs

Land, labor, capital, and so forth

Outputs

(cars, vaccines, gadgets,

TV broadcasts, and so forth)

A firm can expand output by employing more ______________ only.

Short run and Long run

A period when there are both ___________ and _____________.

fixed inputs variable inputs

variable inputs

Short run Long run

A period when all factors are ________. variable

A firm can expand output by increasing the use of __________. all inputs

The Production Function

Its employment ________ as output increases.

Its employment _______________ when output increases.

Fixed and Variable Input

Fixed Input

factory buildings, land, capital tools and entrepreneurial skills

increases

raw materials, labour, fuel and electricity

remains constant

Examples

Variable Input

Definition

Assume there are two factors only: capital (fixed) and labor (variable). Technology is constant.

Input-output relationship in the short run

4

10

20

28

34

38

40

40

39

37

1

2

3

4

5

6

7

8

9

10

Total product

(units) Labor

4

10

20

28

34

38

40

40

39

37

Why do diminishing marginal returns occur ?

Law of Diminishing Marginal Returns

As more and more variable factors are added to a given quantity of fixed factors, holding technology constant, marginal product eventually drops

Output

Variable factor

MP

Lessons of Diminishing Returns

1.The size of a resource, given the rest as fixed, should not go beyond its product maximizing point.

2.Plant capacity can only increase with more of all resources unless technology changes.

3.Resources are basically complementary.

Input-output relationship in the short run

4

10

20

28

34

38

40

40

39

37

1

2

3

4

5

6

7

8

9

10

Total product

(units) Labour

Average product (AP) = TP/n

Average product

(units)

4.00

5.00

6.60

7.00

6.80

6.34

5.72

5.00

4.34

3.70

4.00

5.00

6.60

7.00

6.80

6.34

5.72

5.00

4.34

3.70

Input-output relationship in the short run

4

10

20

28

34

38

40

40

39

37

1

2

3

4

5

6

7

8

9

10

Total product

(units) Labour

Marginal product (MP) = ∆ 𝑖𝑛 𝑇𝑃 a result of a change in input

Marginal product

(units)

4

6

10

8

6

4

2

0

-1

-2

4

6

10

8

6

4

2

0

-1

-2

Production Costs in the Long Run

ISOQUANT

AN ISOQUANT OR ISO PRODUCT CURVE OR EQUAL PRODUCT CURVE OR A PRODUCTION INDIFFERENCE CURVE SHOW THE VARIOUS COMBINATIONS OF TWO VARIABLE INPUTS RESULTING IN THE SAME LEVEL OF OUTPUT.

IT IS DEFINED AS A CURVE PASSING THROUGH THE PLOTTED POINTS REPRESENTING ALL THE COMBINATIONS OF THE TWO FACTORS OF PRODUCTION WHICH WILL PRODUCE A GIVEN OUTPUT.

Labour

(Units)

Capital

(Units)

Output

(Units)

1 5 10

2 3 10

3 2 10

4 1 10

5 0 10

SLOPE OF ISOQUANT

THE SLOPE OF AN ISOQUANT HAS A TECHNICAL NAME CALLED THE MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS) OR THE MARGINAL RATE OF SUBSTITUTION IN PRODUCTION. THUS IN TERMS OF CAPITAL SERVICES K AND LABOUR L

MRTS = Dk/DL

TYPES OF ISOQUANTS

1. LINEAR ISOQUANT

2. RIGHT-ANGLE ISOQUANT

3. CONVEX ISOQUANT

LINEAR ISOQUANT

IN LINEAR ISOQUANTS THERE IS PERFECT SUBSTITUTABILTY OF INPUTS.

RIGHT-ANGLE ISOQUANT

IN RIGHT-ANGLE ISOQUANTS THERE IS COMPLETE NON- SUBSTITUTABILTY BETWEEN INPUTS.

CONVEX ISOQUANT IN CONVEX ISOQUANTS THERE IS SUBSTIUTABILTY

BETWEEN INPUTS BUT IT IS NOT PERFECT.

PROPERTIES OF ISOQUANTS

1. AN ISOQUANT IS DOWNWARD SLOPING TO THE RIGHT.

2. A HIGHER ISOQUANT REPRESENTS LARGER OUTPUT.

3. NO TWO ISOQUANTS INTERSECT OR TOUCH EACH OTHER.

4. ISOQUANT IS CONVEX TO THE ORIGIN.

RETURNS TO SCALE

• DIMINISHING RETURNS REFER TO RESPONSE OF OUTPUT TO AN

INCREASE OF A SINGLE INPUT WHILE OTHER INPUTS ARE HELD

CONSTANT.

• WE HAVE TO SEE THE EFFECT BY INCREASING ALL INPUTS.

• WHAT WOULD HAPPEN IF THE PRODUCTION OF WHEAT IF LAND,

LABOUR, FERTILISERS, WATER ETC,. ARE ALL DOUBLED. THIS

REFERS TO THE RETURNS TO SCALE OR EFFECT OF SCALE

INCREASES OF INPURTS ON THE QUANTITY PRODUCED.

CONSTANT RETURNS TO SCALE

• THIS DENOTES A CASE WHERE A CHANGE IN ALL

INPUTS LEADS TO A PROPORTIONAL CHANGE IN

OUTPUT.

INCREASING RETURNS TO SCALE

• THIS IS ALSO CALLED ECONOMIES OF SCALE. THIS ARISES WHEN

AN INCREASE IN ALL INPUTS LEADS TO A MORE-THAN-

PROPORTIONAL INCREASE IN THE LEVEL OF OUTPUT.

DECREASING RETURNS TO SCALE

• THIS OCCURS WHEN A BALANCED INCREASE OF ALL INPUTS

LEADS TO A LESS THAN PORPORTIONAL INCREASE IN TOTAL

OUTPUT.

IMPORTANCE OF RETURNS TO SCALE CONCEPT

• IF AN INDUSTRY IS CHARACTERIZED BY INCREASING RETURNS TO

SCALE, THERE WILL BE A TENDENCY FOR EXPANDING THE SIZE

OF THE FIRM AND THUS THE INDUSTRY WILL BE DOMINATED BY

LARGE FIRMS.

• THE OPPOSITE WILL BE TRUE IN INDUSTRIES WHERE

DECREASING RETURNS TO SCALE PREVAIL.

• IN CASE OF INDUSTRIES WITH CONSTANT RETURNS TO SCALE,

FIRMS OF ALL SIZES WOULD SURVIVE EQUALLY WELL.

RUDOLPH D. VELASCO, MM

R214b, QMS Office, Main Building, MQC Main Monday to Tuesday 5:00- 8:00 pm 09083016693 rudolph_tornado@yahoo.com.ph http://istudyguide.weebly.com

Photo Sources

• http://abhinavpmp.com/wp-content/uploads/market-competition-advantages.jpg

• http://www.clker.com/cliparts/9/6/f/7/1206558524578237244johnny_automatic_frame_goes_on_the_assembly_line.svg.hi.png

• http://www.usagold.com/publications/images/diminishingreturns.jpeg

• Graphs and Quick Activity Source: http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&uact=8&sqi=2&ved=0CB0QFjAA&url=http%3A%2F%2Fwww.ylmass.edu.hk%2F~econ%2FCE%2520Law%2520of%2520DMP.ppt&ei=ULi9VObsJYWxmwXei4HYAg&usg=AFQjCNHOLNl6utHLa72lVAQ03l5gUYBG3g&bvm=bv.83829542,d.dGY