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Production refers to the transformation of inputs or resources into outputs of goods and services
Creation of utility
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Created by human labor and capital
Satisfy human wants directly or indirectly
Are comparatively scarce and have
economic value
Have a definite monetary price/cost
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EnterpriseCapitalLaborLand
•Immobile•Passive•Heterogeneous
•Active•Mobile•Variable•productivity
•Structures•Equipment•Cap.goods•Money
•Innovative function •Risk•Decision making
Factors of Production
INPUTS
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INPUTS
CAPITAL
EntrepreneurWorkersLand &
Structures
LABOR
Machineryplant &equipment
Natural Resources
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InputsFixed InputsVariable Inputs
Short Run- At least one input is fixed
Long Run - All inputs are variable The length of long run depends on industry.
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Level of production can be altered changing the proportion of variable inputs
Output = Fixed inputs + Variable inputs
• Scale of production can be altered by changing the supply of all the inputs only in the long run
Output = Total inputs(variable inputs)
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Total Product - total volume of goods produced during a specific period of time
Average Product - the per unit product of a variable factor
Marginal Product - the rate at which total product increases / addition to total product resulting from a unit increase in the quantity of the variable factor
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Production Function With Two Inputs
Input & output are measured in physical unitsAssumption- Technology is constant the during analysis period- All units of L & K are homogenous
K Q6 10 24 31 36 40 395 12 28 36 40 42 404 12 28 36 40 40 363 10 23 33 36 36 332 7 18 28 30 30 281 3 8 12 14 14 12
1 2 3 4 5 6 L
Q = f(L, K)
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Discrete Production Surface
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Total Product TP = Q = f(L)
Marginal Product MPL =TP L
Average Product APL =TP L
Production orOutput Elasticity
Q/Q L/L
Q/ L Q/L
== =ELMPL
APL
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L Q MPL APL EL
0 0 - - -1 3 3 3 12 8 5 4 1.253 12 4 4 14 14 2 3.5 0.575 14 0 2.8 06 12 -2 2 -1
Total, Marginal, and Average Product of Labor, and Output Elasticity
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L Q MPL APL EL
0 0 - - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1
Total, Marginal, and Average Product of Labor, and Output Elasticity
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-3
-2
-1
0
1
2
3
4
5
0 1 2 3 4 5 6 7
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7
6
A
B
C
D E
F
A’
B’ C’ D’E’
F’
TotalProduct
Marginal& AverageProduct
Labor
Labor
Production Function with One Variable Input
TP
MP
AP
Law of Diminishing Returns states that when increasing amounts of Variable inputs are combined with a fixed level of another input, a point will be reached where MP will decline.
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-3
-2
-1
0
1
2
3
4
5
0 1 2 3 4 5 6 7
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7
6
A
B
C
D E
F
B’ C’
A’D’
E’F’
I
TotalProduct
Marginal& AverageProduct
Labor
Labor
The Law of Diminishing Returns & Stages of Production
Stage I of Labor Stage II of Labor Stage III of Labor
TP
MP
AP
GInflection pt.
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-3
-2
-1
0
1
2
3
4
5
0 1 2 3 4 5 6 7
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7
6
A
B
C
D E
F
B’ C’
A’D’
E’F’
I
TotalProduct
Marginal& AverageProduct
Labor
Labor
The Law of Diminishing Returns & Stages of Production
Stage I of Labor Stage II of Labor Stage III of Labor
TP
MP
AP
G
MPL is increasingMPK is negative MPL is negativeMPL & MPK Positive
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Marginal RevenueProduct of Labor
MRPL = (MPL)(MR)
Marginal ResourceCost of Labor
MRCL =TC L
Optimal Use of Labor MRPL = MRCL
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L MPL MR = P
2.50 4 $103.00 3 103.50 2 104.00 1 104.50 0 10
Optimal Use of the Variable Input
Assumption : Firm hires additional units of labor at constant wage rate = $20
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L MPL MR = P MRPL MRCL
2.50 4 $10 $40 $203.00 3 10 30 203.50 2 10 20 204.00 1 10 10 204.50 0 10 0 20
Use of Labor is Optimal When L = 3.50
Optimal Use of the Variable Input
Assumption : Firm hires additional units of labor at constant wage rate
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2.5 3.0 3.5 4.0 4.5
40
30
20
10
0
MRCL = w = $20
dL = MRPL
Units of Labor Used
$
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The marginal product of labor equation for a firm is given by: MPL = 10(K/L)0.5
Currently the firm is using 49 units of capital and 100 units of labor. Capital usage is fixed, but labor can be varied. If the price of labor is $20 per unit and the firms' output sells for $4, is the firm producing efficiently in the short run? If not, explain and determine the optimal rate of labor input.
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MRPL = MRCL = w
28 ≠ 20 Not efficient
L = 196
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Isoquants show combinations of two inputs that can produce the same level of output.
K
Q
6 10 24 31 36 40 395 12 28 36 40 42 404 12 28 36 40 40 363 10 23 33 36 36 332 7 18 28 30 30 281 3 8 12 14 14 12
1 2 3 4 5 6 L
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Isoquants
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Economic Region of ProductionFirms will only use combinations of two inputs that are in the economic region of production.
WRidge line
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Marginal Rate of Technical Substitution
Q/ L = MPL and Q/ K = MPK
(L) MPL = -(K) MPK
Q = f(L,K)
dQ=Q/ L *dL + Q/ K *dK= 0
dK= (-) Q/ LdL Q/ K
dK - MPL = MRTS
dL MPK
=
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MRTS = -(-2.5/1) = 2.5
Marginal Rate of Technical Substitution
Absolute value of the slope of isoquant is called the MRTS
K
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Perfect Substitutes Perfect Complements
6
4
2
2 4 6 8 10 12
6
4
2
2 4 6
Capital Capital
Labor Labor0 0
-1K
2L
2K1L
C
A
B
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Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost.
C wL rK
C wK L
r r
C Total Cost
( )w WageRateof Labor L
( )r Cost of Capital K
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10
8
6
4
2 2 4 6 8 10
Capital
Labor
1K
1L
AB C = $100, w = r = $10A
B
slope = -w/r = -1
vertical intercept = 10
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4 8 10 12 14 16 20
14
10 8
4
A
A’
A”
BB” B’ B*0 Labor
Capital
Isocost Lines
Isocost Lines
AB C = $100, w = r = $10
A’B’ C = $140, w = r = $10
A’’B’’ C = $80, w = r = $10
AB* C = $100, w = $5, r = $10
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MRTS = w/r
Isocost Lines
AB C = $100, w = r = $10
A’B’ C = $140, w = r = $10
A’’B’’ C = $80, w = r = $10
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Optimal input combinations:Slope of isoquant = Slope of isocost line
(absolute)Slope of isoquant = (absolute) Slope of isocost line
MRTS = w r
Since MRTS = MPL/ MPK
MPL = wMPK r
MPL = MPK
w r
If MPL = 5, MPK =4, and w = r
MPL > MPK
w r
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MRP(input) = MRC(input)with constant input pricesMRP(input) = input price
To maximize Profits:MRPL = w = (MPL)(MR)
MRPK = r = (MPK)(MR) MPL = MPK
w r
MPL = wMPK r
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Returns to scale refers to the degree by which output changes as a result of a given change in the quantity of all inputs used in production.
•Long run function
•Both L & K are changing
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Production Function Q = f(L, K)
Q = f(hL, hK)
If = h, constant returns to scale.
If > h, increasing returns to scale.
If < h, decreasing returns to scale.
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Constant Returns to
Scale
Increasing Returns to
Scale
Decreasing Returns to
Scale
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Cobb-Douglas Production Function
Q = AKaLb
For example: the inputs are doubled i.e. instead of K & L, we are using 2K & 2L, then by how much the production will increase.
New Q = A(2K)a(2L)b
= A(2)a+bKaLb
= 2a+bAKaLb
= 2a+bQ
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Now Q = 2a+bQ
If a + b = 1, constant returns to scale.
If a + b > 1, increasing returns to scale.
If a + b <1, decreasing returns to scale.
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Do the following production functions have constant, increasing or decreasing returns of scale? ( K, L, M are inputs)
a. Q = 0.5X + 2Y + 40Zb. Q = 3L + 10K + 500c. Q = K/Ld. Q = 4A + 6B + 8ABe. Q = 10L 0.5 K 0.6
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A. constant returns to scale.B. diminishing returns to scale.C. Decreasing returns to scaleD. increasing returns to scale.E. increasing returns to scale
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Technology – cost effective at high level of production
Specialization of labour
Diseconomies of scale Transportation cost Difficult to manage
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Medical Testing Labs, Inc., provides routine testing services for blood banks in the Los Angeles area. Tests are supervised by skilled technicians using equipment produced by two leading competitors in the medical equipment industry. Records for the current year show an average of 27 tests per hour being performed on the Testlogic-1 and 48 tests per hour on a new machine, the Accutest-3. The Testlogic-1 is leased for $18,000 per month, and the Accutest-3 is leased at $32,000 per month. On average, each machine is operated 25 eight-hour days per month.
a. Does Medical Testing Lab usage reflect an optimal mix of testing equipment?
b. If tests are conducted at a price of $6 each while labor and all other costs are fixed, should the company lease more machines?
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a) (27*25*8)/ 18000 = (48*25*8) / 32000 = 0.3In both instances, the last dollar spent on each
machine increased output by the same 0.3 units, indicating an optimal mix of testing machines.
b) For each machine hour, the relevant question is Testlogic-1
27 ×(25×8)× $6 > $18,000 or $32,400 > $18,000.Accutest-348 ×(25×8)× $6 > $32,000 or $57,600 > $32,000.
In both cases, each machine returns more than its marginal cost (price) of employment, and expansion would be profitable.
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The marginal product of labor for international trading is given by the equation
MPL = 10K0.5/L0.5
Currently the firm is using 100 units of capital and 121 units of labor. The capital stock is constant but the labor can be varied. If the price of labor is 10/- and price of output is Rs. 2/- per unit, is the firm operating efficiently in the short run? If not, determine the optimal rate of labor input.
Exercise
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Answer: not optimally, L = 400
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The production function is : Q = 20K0.5L0.5
With marginal product functions
MPK = 10L0.5/K0.5 MPL = 10K0.5/L0.5
If the price of capital is Rs. 5/- and price of labor is Rs. 4/- per unit, determine the expansion path for the firm.
The firm currently is producing 200 units of output per period using input rates of L = 4 and K =25. is this an efficient input combination? Why or why not? If not, determine the efficient input combination for producing an output rate of 200.
If the price of labor increases from Rs 4 to Rs 8 per unit, determine the efficient input combination for an output rate of 200. What is the capital –labor ratio now?
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Answer: K= 0.8L, L= 11.18 and K= 8.94, L = 7.905 and K = 12.65
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Suppose the price of one unit of labor is $10 and price of one unit of capital is $2.50.
Use this information to determine the isocost equations corresponding to a total cost of $200 and $500.
Plot these two isocost lines on a graph If the price of labor falls from $10 per unit to $8 per
unit, determine the new $500 isocost line and plot it on the same diagram used in part (b)
Answer: K = 80- 4L and K = 200 – 4L, K = 200 – 3.2L
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4. Given the production function Q = 30K0.7L0.5
and input prices r = 20 and w = 30. Determine an equation for the
expansion path What is the efficient input combination
for an output rate of Q = 200? For 500?
Answer: K = 2.1L, for 200: L = 3.15 and K = 6.62, for 500: L = 6.765 and K = 14.207
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The revenue dept. of a state govt. employs certified public accountants (CPAs) to audit corporate tax returns and book keepers to audit individual returns. CPAs are paid $31200 per yr, while the annual salary of a bookkeeper is $18200. Given the current staff of CPAs and bookkeepers, a study made by the dept’s economist shows that adding one year of a CPA’s time to audit corporate returns results in an additional tax collection of $52000. In contrast, an additional bookkeeper adds $41600 per year in additional tax revenue.
If the dept’s objective is to maximize tax revenue collected, is the present mix of CPAs and bookkeepers optimal? Explain
If the present mix of CPAs and bookkeepers is not optimal, explain what re-allocation should be made. That is, should the department hire more CPAs and fewer bookkeepers or vice versa.
Answer: CPAs – 1.67 and bookkeepers – 2.29