PRODUCTION

Introduction
In the supply process, people first offer their factors of production to the market. Then the factors are transformed by firms into goods that consumers want.
Production is the name given to that transformation of factors into goods.

The Role of the Firm

The firm is an economic institution that transforms factors of production into consumer goods it:
Organizes factors of production. Produces goods and services. Sells produced goods and services.

The Firm and the Market

Firms are the production organizations that translate factors of production into consumer goods.

The Role of the Firm

In the supply process, people offer their factors of production, such as land, labor, and capital, to the market

Firms transform the factors into goods for consumers

Production is the transformation of factors into goods Ultimately, all supply comes from individuals because control the factors of production
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The Role of the Firm

A firm is an economic institution that transforms factors of production into goods and services

Firms

1. Organize factors of production and/or 2. Produce goods and services and/or 3. Sell produced goods and services

A virtual firm organizes production and subcontracts out all work Many of the organizational structures of business are being separated from the production process
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Firms Maximize Profit

The goal of a firm is to maximize profits Profit = total revenue total cost

For economists, total cost is explicit payments to the factors of production plus the opportunity cost of the factors provided by the owners of the firm For economists, total revenue is the amount a firm receives for selling its product or service plus any increase in the value of the assets owned by the firm
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Firms Maximize Profit

Economists and accountants measure profit differently

Accountants focus on explicit costs and revenues

Accounting profit = explicit revenue explicit cost Economists focus on both explicit and implicit costs and revenue Implicit costs are the opportunity costs of production that do not require monetary payment. Economic profit = (explicit and implicit revenue) (explicit and implicit cost)
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The Production Process

The production process can be divided into the long run and the short run Long run Short run A firm is constrained in A firm chooses from all regard to what production possible production decisions it can make techniques Some inputs are fixed All inputs are variable Fixed Inputs Inputs such as buildings and equipments that do not change with output. The terms long run and short run do not necessarily refer to specific periods of time, but to the flexibility the firm has in changing the level of output
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The Firms Inputs

Inputs - are resources that contribute in the production of a commodity.
Most resources are lumped into three categories: Land, Labor, Capital.

Fixed Vs. Variable Inputs

Fixed inputs -resources used at a constant amount in the production of a commodity. Variable inputs - resources that can change in quantity depending on the level of output being produced. The longer planning the period, the distinction between fixed and variable inputs disappears, i.e., all inputs are variable in the long run.

Total and Marginal Product

Total product (Q) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc)
The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant.

Production Tables and Production Functions

Firms combine factors of production to produce goods and services

A production table is a table showing the output resulting from various combinations of factors of production or inputs
Real-world production tables are complicated This analysis will concentrate on short run production when in which one of the factors is fixed
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The Production Function

The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time, ceteris paribus. The production function is dependent on different time frames. Firms can produce for a brief or lengthy period of time.

Production Tables and Production Functions

A production table shows the output resulting from various combinations of factors of production or inputs.

Production Tables and Production Functions

Marginal product is the additional output that will be forthcoming from an additional worker, other inputs remaining constant.

Production Tables and Production Functions

Average product is calculated by dividing total output by the quantity of the output.

Production Tables and Production Functions

Production function a curve that describes the relationship between the inputs (factors of production) and outputs.

Production Tables and Production Functions

The production function tells the maximum amount of output that can be derived from a given number of inputs.

A Production Table
Number of workers 0 1 2 3 4 5 6 7 8 9 10 Total output 0 4 10 17 23 28 31 32 32 30 25 Marginal product 4 6 7 6 5 3 1 0 2 5 Average product 4 5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5

A Production Function
32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 7 6 TP Output per worker 5 4 3 2 1 1 2 3 4 5 6 7 Number of workers 8 9 10 3 4 5 6 7 Number of workers (b) Marginal and average product 0 1 2 8 9 MP 10 AP

Output

(a) Total product

A Production Table
# of workers Total Output Marginal Product Average Product

0 1

0 4

4
6 7

--4

2 3 4 5 6 7 8 9 10

10 17 23 28 31 32 32 30 25

6
5 3

1
0 -2 -5

5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5

Average product is the output per worker

Marginal product is the additional output that will be forthcoming from an additional worker, other inputs constant

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The Law of Diminishing Marginal Productivity

Both marginal and average productivities initially increase, but eventually they both decrease.

The Law of Diminishing Marginal Productivity

This means that initially the production function exhibits increasing marginal productivity. Then it exhibits diminishing marginal productivity. Finally, it exhibits negative marginal productivity.

The Law of Diminishing Marginal Productivity

The most relevant part of the production function is that part exhibiting diminishing marginal productivity.

The Law of Diminishing Marginal Productivity

Law of diminishing marginal productivity as more and more of a variable input is added to an existing fixed input, after some point the Fixed input output one gets from the additional additional input will fall.

The Law of Diminishing Marginal Productivity

Number of workers 0 1 2 3 4 5 6 7 8 9 10 Total output 0 4 10 17 23 28 31 32 32 30 25

Marginal product
4 6 7 6 5 3 1 0 2 5

Average product 4 5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5 Increasing marginal returns

Diminishing marginal returns Diminishing absolute returns

The Law of Diminishing Marginal Productivity

32 30 28 26 24 22 20 Increasing 18 16 marginal returns 14 12 10 8 6 4 2 0 1 2 3 4 5 6 7 Number of workers (a) Total product Diminishing marginal returns Diminishing absolute returns 7 6 TP Output per worker 5 4 3 2 1 8 9 10 3 4 5 6 7 Number of workers (b) Marginal and average product 0 1 2 8 9 MP 10 AP

Diminishing marginal returns

Diminishing absolute returns

Output

Graphing a Production Function

Q
32 26 20 14 8 2 1 2 Increasing marginal productivity 3 4 5 6 7 Diminishing marginal productivity 8 9 10 Diminishing Absolute productivity Number of workers

TP

A production function is the relationship between then inputs and the outputs

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Graphing Marginal and Average Productivity

Marginal marginal Eventually marginal Then productivity productivity isdeclines productivity negative first increases

6
4 2

AP
1 2 3 4 5 6 7 8 9 10 Number of workers

0
-2 -4

-6 Increasing marginal productivity

MP
Diminishing marginal productivity Diminishing Absolute productivity
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Law of Diminishing Marginal Productivity

# of worker s Total Output Marginal Product Average Product Law of diminishing marginal productivity states as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall Increasing marginal productivity Diminishing marginal productivity Diminishing Absolute productivity

0 1 2 3 4 5 6

0 4 10 17 23 28 31

--4 5 5.7 5.8 5.6 5.2

6
7 6 5 3 1 0 -2 -5

7 8 9 10

32 32 30 25

4.6 4.0 3.3 2.5

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The Law of Diminishing Marginal Productivity

This law is also called the flower pot law. If it did not hold true, the worlds entire food supply could be grown in a single flower pot. Counter-intuitive proof: if the law of diminishing returns does not hold, the worlds supply of food can be produced in a hectare of land.

The Isocost/Isoquant Graph

The analyst creates a graph showing various combinations of factors of production that can produce a certain amount of output.

The Isocost/Isoquant Graph

More than 3 units of machinery and more than 4 units of labor Less than 3 units of machinery and less than 4 units of labor

The Isoquant Curve

Isoquant curve a curve that represents combinations of factors of production that results in equal amounts of output. A point on the isoquant curve is technically efficient.

The Isoquant Curve

Labor A B C D E F 3 4 6 10 15 20 Machines Pairs of Earrings 20 15 10 6 4 3 60 60 60 60 60 60

The Isoquant Curve

The Isoquant Curve

The isoquant curve is bowed inward because of the law of diminishing marginal productivity.

Properties of Isoquant
Isoquants are negatively inclined. No Isoquants can intersect each other. No Isoquants can touch either axis. Each Isoquant is convex to the origin. An Isoquant lying above and to the right of one more stands indicates the maximum productivity.

The Isoquant Curve

Marginal rate of substitution the rate at which one factor must be added to compensate for the loss of another factor, to keep output constant.
n

It is the slope of the isoquant curve.

The Isoquant Curve

The absolute value of the slope at a point on the isoquant curve equals the ratio of the marginal productivity of labor to the marginal productivity of machines.
MPlabor Slope MPmachine Marginal rate of substitution

An Isoquant
Capital, K (machines rented)
12 10 8 i 6 4 2 j 0 1 2 3 4 5 6 7

Each point on a given isoquant represents different recipes for producing the same level of output.

Quantity of Soybeans = 1 (kg./hour)

8 9 10 Labor, L (worker-hours employed)

43

An Isoquant Map
Capital, K (machines rented) 9 10 m

Different isoquants represents different levels of output.

Quantity of Soybeans = 2 (kg./hour)

k j

Quantity of Soybeans = 1 (kg./hour)

0 0 1

9 10

Labor, L (worker-hours employed)

44

The Isoquant Curve

Isoquant map a set of isoquant curves that show technically efficient combinations of inputs that can produce different levels of output.

An Isoquant Map

The Isocost Line

Isocost line a line that represents alternative combinations of factors of production that have the same costs.

Changes in One Resource Price

Capital, K (machines rented)
10 8 6 4 2 $10 0 1 2 3 h 4 5 6 A Change in W a

Cost = $30; R = $3/machine The money wage, W = ...

$6
f 7 8 9 10 Labor, L (worker-hours employed)
48

Changes in Cost
Capital, K (machines rented)
10 8 6 4 2 h 0 1 2 3 4 5 6 7 8 9 10 Labor, L (worker-hours employed)
50

A Change in Cost; every point between g and h costs $18.

W = $6; R = $3;C = $30

Slope of an Isocost
Wage-rental ratio
With K on the y axis and L on the x axis, the slope of any isocost line equals W/R, the wage-rental ratio. It is also the relative price of labor

The Isocost Line

Choosing the Economically Efficient Point of Production

The least cost combination of inputs for a given output occurs where the isocost curve is tangent to the isoquant curve for that output.

Choosing the Economically Efficient Point of Production

The slopes of the two curves are equal at that point of tangency.
MPlabor Plabor MPlabor MPmachines so that MPmachines Pmachines Plabor Pmachines

Choosing the Economically Efficient Point of Production

The firm is operating efficiently when an additional output per dollar spent on labor equals the additional output per dollar spent on machines.

Combining Isoquant and Isocost Curves

Cost Minimization
Capital, K (machines rented) 12 10 8 a

Choose the combination where the desired isoquant is tangent to the lowest isocost.

C = $36

6 4 2
C = $18 W = $6; R = $3;C = $30

equ.

8 9 10 Labor, L (worker-hours employed)

58

ISOQUANT & ISOCOSTCURVES

100 80 60 ISOCOST shows exchange/ subs between items keeping budget constant (ECONOMY). ISOQUANT shows exchange/ subs between items keeping output
A

constant (EFFECTIVENESS).
50 TARGETS 40 TARGETS 30 TARGETS 20 TARGETS 10 TARGETS

BOMBERS
40 20 0

E1

20

40

BOMBS

60

80

100

Conclusion: Buy resources such that the last dollar spent on K adds the same amount to output as the last dollar spent on L.
The |slope| of the isocost line = W/R. The |slope| of the isoquant = MPL/MPK

60

LAW OF RETURN TO SCALE

DEALS WITH EFFECT ON OUTPUT, WHEN ALL INPUTS CHANGE SIMULTANEOUSLY IN SAME RATIO - DOUBLE, TREBLE ETC LARGER THE SCALE OF ACTIVITIES LOWER GENERALLY THE COST OF ACHIEVING OUTPUT. ECONOMIES OF SCALE ARISE FROM LARGE SCALE ACTIVITIES.

LAW OF RETURN TO SCALE

ECONOMIES OF SCALE TRUE ONLY UP TO A POINT.

THEN DIS-ECONOMIES SETS IN.

THREE STAGES INCREASING RETURNS MARGINAL RETURN RISES CONSTANT RETURNS MARGINAL RETURN CONSTANT DIMINISHING RETURNS MARGINAL RETURN DIMNISHES

RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)

FACTORS OF PRODN EMP

1 WORKER+3 hrs

TOTAL PRODUCTS/R ETURNS

MARGINAL PRODUCT/ RETURNS

STAGE OF RETURN TO SCALE

RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)

FACTORS OF PRODN EMP

1 WORKER+3 hrs
2 WORKERS + 6 hrs

TOTAL PRODUCTS/R ETURNS

MARGINAL PRODUCT/ RETURNS

STAGE OF RETURN TO SCALE

RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)

FACTORS OF PRODN EMP

1 WORKER+3 hrs
2 WORKERS + 6 hrs 3 WORKERS + 9hrs

TOTAL PRODUCTS/R ETURNS

MARGINAL PRODUCT/ RETURNS

STAGE OF RETURN TO SCALE

4 WORKERS+ 12 hrs
5 WORKERS +15 hrs 6 WORKERS + 18 hrs. 7 WORKERS + 21 hrs 8 WORKERS + 24 hrs 9 WORKERS + 27 hrs

RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)

FACTORS OF PRODN EMP

1 WORKER+3 hrs
2 WORKERS + 6 hrs 3 WORKERS + 9hrs

TOTAL PRODUCTS/R ETURNS

MARGINAL PRODUCT/ RETURNS

STAGE OF RETURN TO SCALE

200
500 900

4 WORKERS+ 12 hrs
5 WORKERS +15 hrs 6 WORKERS + 18 hrs. 7 WORKERS + 21 hrs 8 WORKERS + 24 hrs 9 WORKERS + 27 hrs

1400
1900 2400 2800 3100 3200

RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)

FACTORS OF PRODN EMP

1 WORKER+3 hrs
2 WORKERS + 6 hrs 3 WORKERS + 9hrs

TOTAL PRODUCTS/R ETURNS

MARGINAL PRODUCT/ RETURNS

STAGE OF RETURN TO SCALE

200
500 900

200
300 400

STAGE OF INCREASING RETURNS

4 WORKERS+ 12 hrs
5 WORKERS +15 hrs 6 WORKERS + 18 hrs.

1400
1900 2400

500
500 500 STAGE OF CONSTANT RETURNS

7 WORKERS + 21 hrs
8 WORKERS + 24 hrs 9 WORKERS + 27 hrs

2800
3100 3200

400
300 100

STAGE OF DECREASING RETURNS

LONG-RUN COST
Plant Size and Cost
When a firm changes its plant size, its cost of producing a given output changes. Will the average total cost of producing a gallon of smoothie fall, rise, or remain the same? Each of these three outcomes arise because when a firm changes the size of its plant, it might experience:
Economies of scale Diseconomies of scale Constant returns to scale

LONG-RUN COST
Economies of Scale Economies of scale exist if when a firm increases its plant size and labor employed by the same percentage, its output increases by a larger percentage and average total cost decreases. The main source of economies of scale is greater specialization of both labor and capital.

LONG-RUN COST
Diseconomies of Scale Diseconomies of scale exist if when a firm increases its plant size and labor employed by the same percentage, its output increases by a smaller percentage and average total cost increases. Diseconomies of scale arise from the difficulty of coordinating and controlling a large enterprise. Eventually, management complexity brings rising average total cost.

LONG-RUN COST
Constant Returns to Scale Constant returns to scale exist if when a firm increases its plant size and labor employed by the same percentage, its output increases by the same percentage and average total cost remains constant. Constant returns to scale occur when a firm is able to replicate its existing production facility including its management system.

Economies of Scope
If a single firm can jointly produce goods X and Y more cheaply that any combination of firms could produce them separately, then the production of X and Y is characterized by economies of scope

It refers to reduction in unit cost realized when firm produces two or more products jointly rather than separately.

Economies of scope can be measured by as follows:

C (Q1 ) C (Q2 ) C (Q1 , Q2 ) SC C (Q1 ) C (Q2 )

Where C(Q1,Q2) is the cost of jointly producing goods 1 and 2 in the respective quantities; C(Q1) is is the cost of producing good 1 alone, and similarly for C(Q2). Example: Let C(Q1) = $12 million; C(Q2) = $8 million; and C(Q1,Q2) = $17 million. Thus:

$12 $8 $17 $3 SC .15 $12 $8 $20

Thus joint production of goods 1 and 2 would result in a 15 percent reduction in total costs

Economies of scope arise from complementarities in the production or distribution of distinct goods or services