Production and Cost Initial Questions
- how can you tell when a combination of labor, machines, tools and other inputs are ok?
- when should we expand or stop?
- are there laws on how various combinations of inputs turn into commodities or services?
Production Function
A descriptive statement that relates to Inputs and Outputs - show the maximum output attainable with given amounts of various inputs - fixed and variable
- depends on a) accessibility and b) cost combination
Inputs of Production
- Fixed inputs - do not change within the levels of output - e.g. machines, tools, buildings, etc.
- Variable inputs - employment or usage vary with the levels of output - e.g. labor, electricity, etc.
Law of Diminishing Returns
Business decisions are made on marginal characteristic
- As the level of variable inputs increases, the output increases for a while, then starts to decrease due to over-capacity of usage of the fixed inputs
e. g. the use of fertilizer improves crop production; but at some point, adding more and more fertilizer improves the yield less per unit of fertilizer, and excessive quantities can even reduce the yield.
Returns to Scale
It explains the behavior of rate of increase in the output/production to the subsequent increase in the inputs. Depending on the level of production, level of machinery, etc., can be:
- Decreasing
- Constant
- Increasing
Returns to Factor
The return attributable to a particular common factor. Can be:
- Decreasing
- Constant
- Increasing
Substitutability
- Flexibility in production is essentially an issue of substitution of one input - how easy is it to substitute?
- Some productions are more capital-intensive, some more labor-based.
Rate of Factor Substitution
- rate you can substitute without impacting utility
- elasticity of substitution is important and also time frame for such flexibilities
Relevant Factors of Production Function
- Total Product
- Average Product - total output per unit of variable output
- Marginal Product - per unit contribution by the last level of input (the question: should I use one more unit?)
Stages of Production
Stage 1: Marginal product is above the average product - it may be rising or falling. The beginning - production is slow - it must expand to utilize the input factor effectively
Stage 2: Marginal product falls below the average product - the average product has reached its max and is falling. Production spikes so increasing but at a slower rate - decision to employ a particular level of the factor is market driven
Stage 3: Marginal product is negative or total product has reached its maximum and is declining - production should not extend to this stage
Input Combinations
- management deciding most levels of fixed and variable input to create desired level of output
- how efficient can be and how can prices can be managed given these levels
Isoquant (equal quantity) Curve
combinations of inputs, fixed and variable, capable of producing a particular level of output
I = ab + lk (Investment = labor cost + capital cost) = curve
Isocost (equal cost) Curve
combinations of inputs, fixed and variable, producing a particular level of output that cost the same
k = a - bl = linear
Operational Feasibility
Where the isoquant curve and the isocost curve cross
Factor Substitution
- for a variety of reasons (variation in cost, availability, etc.), may want to replace one factor of production with another
e. g. labor is too expensive and therefore, use automation to cut labor cost
Marginal Rate of Technical Substitution (MRTS)
the amount of one input required to replace another input without impacting the level of output
e.g. need two robots to replace one worker…MRTS = -1L/2R
Marginal Revenue Product (MRP)
the revenue generated by using an additional input
Marginal Resource Cost (MRC)
additional cost of employing one more unit of input
Optimum Use of Singe Input Factor
MRC = MRP
Input Demand Function
what determines the demand for a factor? the input factor’s MRP
Input Supply Function
supply of a factor is not easily determined - price is the best determinant
Optimum Combination of Multiple Inputs
employ factors to the point that the ratio of their MRP to their prices is the same For two factors L and K MRPl/w = MRPk/r w = price of L r = price of k
Expansion Path
production expand along a path consistent with the optimum combination rule
Elasticity of Factor Substitution
- some factors of production can be changed easily (e.g. unskilled workers) and some cannot (e.g. technical workers)
- relative sensitivity of output to variations in an input is the elasticity of output to that input
