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Chapter 6 Production Introduction Our study of consumer behavior was broken down into 3 steps Describing consumer preferences Consumers face budget constraints Consumers choose to maximize utility Production decisions of a firm are similar to consumer decisions

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Chapter 6 l.jpg

Chapter 6

Production


Introduction l.jpg
Introduction

  • Our study of consumer behavior was broken down into 3 steps

    • Describing consumer preferences

    • Consumers face budget constraints

    • Consumers choose to maximize utility

  • Production decisions of a firm are similar to consumer decisions

    • Can also be broken down into three steps

Chapter 6


Production decisions of a firm l.jpg
Production Decisions of a Firm

  • Production Technology

    • Describe how inputs can be transformed into outputs

      • Inputs: land, labor, capital & raw materials

      • Outputs: cars, desks, books, etc.

    • Firms can produce different amounts of outputs using different combinations of inputs

Chapter 6


Production decisions of a firm4 l.jpg
Production Decisions of a Firm

  • Cost Constraints

    • Firms must consider prices of labor, capital and other inputs

    • As consumers must consider budget constraints, firms must be concerned about costs of production

Chapter 6


Production decisions of a firm5 l.jpg
Production Decisions of a Firm

  • Input Choices

    • Given input prices and production technology, the firm must choose how much of each input to use in producing output

    • Given prices of different inputs, the firm may choose different combinations of inputs to minimize costs

Chapter 6


Slide6 l.jpg

Q: Decision Making of Owner-Manager

  • Suppose you are running a small business.

    • What is your objective?

    • What are you supposed to decide?

    • What is profit?

    • How can you make your profit max?

Chapter 6

Chapter 8

6


The technology of production l.jpg
The Technology of Production

  • Production Function:

    • Indicates the highest output (q) that a firm can produce for every specified combination of inputs.

    • For simplicity, we will consider only labor (L) and capital (K)

Chapter 6


The technology of production8 l.jpg
The Technology of Production

  • The production function for two inputs:

    q = F(K,L)

    • Output (q) is a function of capital (K) and Labor (L)

    • If technology increases, more output can be produced for a given level of inputs

    • Q: Why is raw material not included?

Chapter 6


The technology of production9 l.jpg
The Technology of Production

  • Short-Run versus Long-Run

    • It takes time for a firm to adjust production from one set of inputs to another

    • Firms must consider not only what inputs can be varied but over what period of time that can occur

    • We must distinguish between long run and short run

Chapter 6


The technology of production10 l.jpg
The Technology of Production

  • Short-Run

    • Period of time in which quantities of one or more production factors cannot be changed.

    • These inputs are called fixed inputs.

  • Long-run

    • Amount of time needed to make all production inputs variable.

  • Short-run and long-run are not time specific

Chapter 6


Production one variable input l.jpg
Production: One Variable Input

  • We assume capital is fixed and labor is variable

    • Output can only be increased by increasing labor

    • How does output change as the amount of labor is changed?

Chapter 6



Production one variable input13 l.jpg
Production: One Variable Input

  • Observations:

    • When labor is zero, output is zero as well

    • With additional workers, output (q) increases up to 8 units of labor.

    • Beyond this point, output declines

      • Increasing labor can make better use of existing capital initially

      • After a point, more labor is not useful and can be counterproductive

Chapter 6


Production one variable input14 l.jpg
Production: One Variable Input

  • Average product of Labor - Output per unit of labor

  • Measures the productivity of a firm’s labor in terms of how much, on average, each worker can produce

Chapter 6


Production one variable input15 l.jpg
Production: One Variable Input

  • Marginal Product of Labor – additional output produced when labor increases by one unit

  • Change in output divided by the change in labor

Chapter 6



Production one variable input17 l.jpg

D

112

Total Product

C

60

B

A

Production: One Variable Input

Output

per

Month

At point D, output is maximized.

Labor per Month

0

1

2

3

4

5

6

7

8

9

10

Chapter 6


Production one variable input18 l.jpg

Marginal Product

E

Average Product

Labor per Month

0

1

2

3

4

5

6

7

8

9

10

Production: One Variable Input

Output

per

Worker

  • Left of E: MP > AP & AP is increasing

  • Right of E: MP < AP & AP is decreasing

  • At E: MP = AP & AP is at its maximum

  • At 8 units, MP is zero and output is at max

30

20

10

Chapter 6


Marginal average product l.jpg
Marginal & Average Product

  • When marginal product is greater than the average product, the average product is increasing

  • When marginal product is less than the average product, the average product is decreasing

  • When marginal product is zero, total product (output) is at its maximum

  • Marginal product crosses average product at its maximum

Chapter 6


Product curves l.jpg

C

20

60

B

1

10

9

0

2

3

4

5

6

7

8

0

1

2

3

4

5

6

7

8

9

10

Labor

Labor

Product Curves

AP is slope of line from origin to point on TP curve

q

q/L

112

30

10

Chapter 6


Product curves21 l.jpg

q

q

D

112

30

60

30

10

A

0

1

2

3

4

5

6

7

8

9

10

Labor

Product Curves

MP is slope of line tangent to corresponding point on TP curve

15

10

9

0

2

3

4

5

6

7

8

1

Labor

Chapter 6


Law of diminishing marginal returns l.jpg
Law of Diminishing (Marginal) Returns

  • When the labor input is small and capital is fixed, output increases considerably since workers can begin to specialize and MP of labor increases

  • When the labor input is large, some workers become less efficient and MP of labor decreases

Chapter 6


Production two variable inputs l.jpg
Production: Two Variable Inputs

  • In the long run, capital and labor are both variable.

  • We can look at the output that can be achieved with different combinations of capital and labor.

Chapter 6



Production two variable inputs25 l.jpg
Production: Two Variable Inputs

  • The information can be represented graphically using isoquants

    • Curves showing all possible combinations of inputs that yield the same output

  • Curves are smooth to allow for use of fractional inputs

    • Curve 1 shows all possible combinations of labor and capital that will produce 55 units of output

Chapter 6


Isoquant map l.jpg

E

5

Capital

per year

4

3

A

B

C

2

q3 = 90

D

q2 = 75

1

q1 = 55

1

2

3

4

5

Labor per year

Isoquant Map

Ex: 55 units of output can be produced with

3K & 1L (pt. A)

OR

1K & 3L (pt. D)

Chapter 6


Production two variable inputs27 l.jpg
Production: Two Variable Inputs

  • Holding capital at 3 and increasing labor from 0 to 1 to 2 to 3.

    • Output increases at a decreasing rate (0, 55, 20, 15) illustrating diminishing marginal returns from labor in the short-run and long-run.

Chapter 6


Production two variable inputs28 l.jpg
Production: Two Variable Inputs

  • Holding labor constant at 3 increasing capital from 0 to 1 to 2 to 3.

    • Output increases at a decreasing rate (0, 55, 20, 15) due to diminishing returns from capital in short-run and long-run.

Chapter 6


Diminishing returns l.jpg

E

5

Capital

per year

4

3

A

B

C

2

q3 = 90

D

q2 = 75

1

q1 = 55

1

2

3

4

5

Labor per year

Diminishing Returns

Increasing labor holding capital constant (A, B, C)

OR

Increasing capital holding labor constant (E, D, C

Chapter 6


Production two variable inputs30 l.jpg
Production: Two Variable Inputs

  • Substituting Among Inputs

    • Slope of the isoquant shows how one input can be substituted for the other and keep the level of output the same.

    • Positive slope is the marginal rate of technical substitution (MRTS)

Chapter 6


Production two variable inputs31 l.jpg
Production: Two Variable Inputs

  • The Marginal Rate of Technical Substitution equals:

Chapter 6


Marginal rate of technical substitution l.jpg

2

1

1

1

Q3 =90

2/3

1

1/3

Q2 =75

1

Q1 =55

Marginal Rate ofTechnical Substitution

Capital

per year

5

Slope measures MRTS

MRTS decreases as move down the indifference curve

4

3

2

1

Labor per month

1

2

3

4

5

Chapter 6


Mrts and marginal products l.jpg
MRTS and Marginal Products

  • If we increase labor and decrease capital to keep output constant, we can see how much the increase in output is due to the increased labor

    • Amount of labor increased times the marginal productivity of labor

Chapter 6


Mrts and marginal products34 l.jpg
MRTS and Marginal Products

  • Similarly, the decrease in output from the decrease in capital can be calculated

    • Decrease in output from reduction of capital times the marginal produce of capital

Chapter 6


Mrts and marginal products35 l.jpg
MRTS and Marginal Products

  • If we are holding output constant, the net effect of increasing labor and decreasing capital must be zero

  • Using changes in output from capital and labor we can see

Chapter 6


Mrts and marginal products36 l.jpg
MRTS and Marginal Products

  • Rearranging equation, we can see the relationship between MRTS and MPs

Chapter 6


Isoquants special cases l.jpg
Isoquants: Special Cases

  • Perfect substitutes

    • MRTS is constant at all points on isoquant

    • Same output can be produced with a lot of capital or a lot of labor or a balanced mix

Chapter 6


Perfect substitutes l.jpg

A

B

C

Q1

Q2

Q3

Perfect Substitutes

Capital

per

month

Same output can be reached with mostly capital or mostly labor (A or C) or with equal amount of both (B)

Labor

per month

Chapter 6


Isoquants special cases39 l.jpg
Isoquants: Special Cases

  • Perfect Complements

    • Fixed proportions production function

    • There is no substitution available between inputs

    • The output can be made with only a specific proportion of capital and labor

    • Cannot increase output unless increase both capital and labor in that specific proportion

Chapter 6


Fixed proportions production function l.jpg

Q3

C

Q2

B

Q1

K1

A

L1

Fixed-ProportionsProduction Function

Capital

per

month

Same output can only be produced with one set of inputs.

Labor

per month

Chapter 6


Returns to scale l.jpg
Returns to Scale

  • Rate at which output increases as inputs are increased proportionately

    • Increasing returns to scale

    • Constant returns to scale

    • Decreasing returns to scale

Chapter 6


Increasing returns to scale l.jpg

Capital

(machine

hours)

4

30

20

2

10

Labor (hours)

5

10

Increasing Returns to Scale

The isoquants move closer together

A

Chapter 6


Returns to scale43 l.jpg

Capital

(machine

hours)

A

6

30

4

20

2

10

Labor (hours)

5

10

15

Returns to Scale

Constant Returns: Isoquants are equally spaced

Chapter 6


Returns to scale44 l.jpg

A

4

15

2

12

10

5

10

Returns to Scale

Capital

(machine

hours)

Decreasing Returns:

Isoquants get further

apart

Labor (hours)

Chapter 6


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