“ In its broadest formulation this theory is a crucial element of the economic theory of social organization ,for it underlies every question of market organization and the role of governmental control over economic life” - George J.Stigler
The Production Function
A production function defines the relationship between inputs and the maximum amount that can be produced within a given time period with a given technology.
A production function indicates the output Q that a firm produces for every specified combination of inputs. For simplicity, we will assume that there are two inputs, labor L and capital K. We can then write the production function as
Q= F (K, L)
A bakery takes inputs like flour, water, yeast, labor, and heat and makes loaves of bread.
An earth-moving company takes capital equipment, ranging from shovels to bulldozers, and labor and digs holes.
A computer manufacturer buys parts, generally “off-the-shelf” like disk-drives and memory, along with cases and keyboards and other parts that may be manufactured specially for the computer manufacturer, and uses labor to produce computers.
Starbucks takes coffee beans, water, some capital equipment, and labor and produces brewed coffee.
Production in Retailing
Sales- Quantity of Goods Sold
Accessibility of Location
Assurance of Product Delivery
Delivery at desired time and desired form
Prices, availability and other characteristics
Short run function vs Long Run function
The short run refers to a period of time in which one or more factors of production cannot be changed. Factors that cannot be varied over this period are called fixed inputs.
A firm's capital, for example, usually requires time to change-a new factory must be planned and built, machinery and other equipment must be ordered and delivered, all of which can take a year or more.
Total Productivity: Total output
Average productivity: Average output of the firm
Marginal Productivity: Increase in productivity following one unit increase of labor or any other factor of production
The figures illustrate TP, MP, and AP graphically.
Stage I – TP & AP are Increasing and MP is first increasing and then decreasing.
Stage II – TP is increasing, AP is decreasing and MP is also decreasing.
Stage III -- TP is diminishing, AP is decreasing & MP is negative
Production in the Long Run
In the long run, all inputs are variable.
The long run production process is described by the concept of returns to scale .
Returns to scale describes what happens to total output as all of the inputs are changed by the same proportion.
If all inputs into the production process are doubled, three things can happen:
output increases more than proportionately with an increase in the inputs
increasing returns to scale (IRTS)
output increases in the same proportion as the inputs
constant returns to scale (CRTS)
output increases less than proportionately with an increase in the inputs
decreasing returns to scale (DRTS)
Production in the Long Run
Graphically, the returns to scale concept can be illustrated using the following graphs.
Q X,Y IRTS Q X,Y CRTS Q X,Y DRTS
Law of Diminishing Returns
As the use of an input increases (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease. When the labor input is small (and capital is fixed), small increments in labor input add substantially to output as workers are allowed to develop specialized tasks. Eventually, however, the law of diminishing returns applies. When there are too many workers, some workers become ineffective, and the marginal product of labor falls.
The law of diminishing marginal product
If one factor of production is substituted for other factor of production ,the marginal product of one factor declines as the marginal product of other increases.
Condition: Isoquants must be convex at every point in order to satisfy the principle of diminishing rate of marginal product
ISOQUANT An Isoquant is a curve representing the various combinations of two inputs that produce the same amount of output. Q = f( L ,K) Example- diff combinations of L n k ,required to produce 45 units of goods X, join the points by a curve……
P roperties of isoquants
Downward - sloping to the right
higher isoquants represents larger output
No two isoquants intersects or touch each other
Isoquants are convex to the origin
slope of isoquant = d k /d L = M R TS(l,k)
An isoquant map Units of capital ( K ) Units of labour (L) I 1 I 2 I 3 I 4 I 5