Production is the process of changing inputs into output.
Continued….
The production function indicates the maximum level of
output the firm can produce for any combination of inputs.
• The technological relationship that describes the
process whereby factors of production are efficiently
transformed into goods and services is called the
production function.
• Mathematically, a production function utilizing capital,
labour, and land inputs may be written as:
Q= f( K, L, M)
• The production function can be expressed equivalently
as an equation, a table or a graph
Production In the short run
The short run in production refers to that period of
time during which at least one factor of production is
held constant.
– The law of diminishing MP/returns (the law of
Variable proportion) is a short-run phenomenon.
The long run in production occurs when all factors of
production are variable.
In the short run production function may be written
as:
Q= f( K, L) where K is constant and labour is variable.
TOTAL PRODUCT OF LABOR(TPL)
If we assume that the level of capital usage is fixed.
Is the maximum amount of output attainable from any
given level of labour usage given some fixed level of
capital usage.
AVERAGE PRODUCT OF LABOR(APL)
is simply the total product per unit of labour usage and
is determined by dividing the total product of labour
by the total amount of labour usage.
MARGINAL PRODUCT OF LABOR ( MPL)
is defined as the incremental change in output
associated with an incremental change in the amount
of labour usage.
Mathematically, since the amount of capital is
constant, this is equivalent to the first partial
derivative of the production function with respect to
labour.
It is the slope of the TPL
Continued….
Similarly, the marginal product of capital is defined
as :
Optimal use of an input, in the short run
The law of diminishing returns means that the firm faces
a basic trade-off in determining its level of production.
By using more of a variable input, the firm obtains a
direct benefit--- increased output; in return for
incurring an additional input cost.
The law of diminishing marginal return starts to
operate after the point where the MPL reaches
maximum .
What usage of the variable input is optimal?
Marginal revenue product of labor (MRPL )= Price (MCL)
This MRPL means the revenue obtained from one
additional labor.
Example:
• Unit selling price per unit of output = 100 birr
• Marginal product of labor = 5 units
• Hence, MRPL = 100 *5 = 500 birr
• Profit is maximized at , MRPL = MCL
So, adding one more labor is profitable up to
MCL or the price of one labor is 500 birr.
The firm should continue to increase its labor force so long as
the amount of additional profit is positive (MRPL > or = MCL)
If selling price of one unit is 45 birr and the unit cost of labor is
130.
– Determine the optimal level of labor utilization.
• optimal use of labor reaches maximum at 50 workers
Number of workers Output MPL MRPL Price per Labor
10 100 - 130
20 140 4 45*4 = 180 130
30 190 5 45*5 = 225 130
40 250 6 45*6 = 270 130
50 280 3 45*3 = 135 130
60 300 2 45*2 = 90 130
70 300 0 45*0 =0 130
80 280 -2 45*-2 = -90 130
Production Function in the Long Run (all inputs are
variable)
• The firm can produce a certain output by using more and
more of these variable inputs (labor and capital).
• The long run production is studied with the help of
isoquant and isocost.
• An isoquant is a curve (or locus of points) showing all
possible combinations of the inputs physically capable of
producing a given (fixed) level of output.
• Each point on an isoquant is technically efficient.
• The concept of an isoquant implies that it is possible to
substitute some amount of one input for some of the other,
say, labor for capital, while keeping output constant.
Example:
Production function of Q= 40L – L2 +54K-1.5K2
Given price of labor is 10 and capital is 15
Total cost = 120
How many combinations of labor and capital used
to produce maximum output given 120 as total
cost?
TC = wL +rK
10L + 15K = 120
10 (K +2) + 15K = 120
10K + 20 + 15K = 120
25K + 20 = 120
25K = 100
K=4
L = K+2 = 6
22
• What is the optimum level of output?
Q= 40L – L2 +54K-1.5K2
Q= 40(6) – 62 +54(4)-1.5(42)
Q= 240 – 36 + 216 – 24
Q= 396
The Law of Returns to Scale
The law of returns to scale shows how output is changing when
inputs such as labour and capital are proportionately and
simultaneously changed in the long run.
This law is called the long run production function.
There are three possible ways in which output may be increase
when all inputs are proportionally increased.
Increasing returns to scale (IRS): increase in output (30%)
is more than proportionate to increase in inputs (20%).
Decreasing returns to scale (DRS): increase in output (30%) is
less than proportionate to increase in inputs (40%).
Constant returns to scale (CRS): increase in output (30%) is
equal to the proportional change in inputs (30%).
Consider the Cobb-Douglas production function
Where: Q is output; A refers to the technology applied; α
and β are the output elasticity of L and K respectively.
1. If α+ β > 1, it is IRS
2. If α+ β < 1, it is DRS
3. If α+ β = 1, it is CRS