Theory of Production Flashcards
What is the Theory of Production?
• Firms convert inputs into outputs
What is the short-run production function?
- no specific time period
- at least one fixed factor of production
– total physical product (TPPL)
– average physical product (APPL)
– marginal physical product of labour (MPPL)
Differentiate TPPL- you get MPPL
What is the total physical product?
TPPL
total output from the firm
What is the average physical product?
APPL
§ Output by e.g. each worker
APP = TPP/L
(L- labour)
what is the marginal physical product of labour
MPPL How a small change affects production MPP = ∆TPP/∆L (= dTPP/dL) i.e. Differentiate TPPL
Define short-run
one fixed factor or production
define long-run
all factors of production are variable
define Marginal Product of labour
If I get x number or workers, how many more products will they produce
-is constant- why line is linear
MPL= Q/L = g
what will happen to the marginal labour product, as the marginal requirement for labour increases?
assume marginal physical product of labour remains constant- each worker produces the same amount
what is the law of diminishing returns production?
- as labour increases, total output increases, but gets smaller
○ As I take on more workers, each new worker become more unproductive
○ Marginal productivity i.e. efficiency, goes down
○ Marginal product requirement increases
What is constant returns to labour?
CRL
- Average product of labour in constant at all levels of outputs to labour
- marginal product of labour in constant at all levels of output
- MRL- e.g. half and extra worker required
What is diminishing returns to labour?
DRL
APL is decreasing
MPL is decreasing
As output goes up, marginal labour requirement (MRL) also goes up
What is increasing returns to labour?
APL is increasing
MPL is increasing
MRL is decreasing
Define the law of diminishing returns?
- When increasing amounts of a variable factor with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.
- Short-run concept as there is a fixed factor of production
What types of return will Labour affect?
• A firm’s decision-making process
○ E.g. how many workers to employ; how much to increase output, when to invest/ expand
• Its opportunity cost
○ Combination of input the firm uses e.g. capital vs. labour intensive
• Its costs
- therefore their profit
Define the production possibility frontier
- The maximum combination of two goods that can be produced with given resources and technology
- With a given stock of inputs of labour and physical capital, firms have to decide on a product mix which uses the inputs most effectively
define allocative efficient
are they producing the right combination of goods
define opportunity cost
(using e.g.)
o to increase production of X, cut no. of workers who produce Y
E.g. With constant returns to labour, increasing the output of 1 good does not lead to falling or increasing efficiency in the production of that good
Define linear
constant opportunity cost, ever worker is productive
Variable costs
from variable inputs
Fixed costs
from fixed or quasi-fixed inputs
What does quasi-fixed result from?
○ a) institutional constraints on layoffs,
e.g. labour laws, trade unions
○ b) skills and knowledge of the labour force in which firms have invested and which they want to amortise . Replacement is also costly
define quasi-fixed
some characteristics of being fixed, and some of being variable
Total cost formula
Total cost = fixed cost + variable cost
independent of Q) + (dependent on Q
Average cost formula
AC = TC / Q
Define marginal
increase in total cost if you produce one extra uni
Marginal cost formula
MC = change in TC/ change in Q
or
MC = derivative TC/ derivative Q
What happens to the average total, average fixed and average variable costs as Q increases for constant returns?
ATC - decreases: as output produced increases,
(As AFC (b/Q) is decreasing)
AFC- decreases
What is the marginal cost for constant returns?
MC = differentiate change in TC/ change in Q = w
will be the same and constant and output changes
What are the diminishing returns production costs
○ TC = b + wQ + wQ2 § TFC = b § TVC = wQ + wQ2 § AFC = b/Q § AVC = wQ+wQ2/Q = w+ wQ § ATC = b/Q + w + wQ MC = w + 2wQ
What are the constant returns production costs?
constant returns function:
TC = b + wQ
□ TFC = b- fixed cost (doesn’t depend on output)
□ TVC = wQ (depends on output)
□ ATC= (b+ wQ)/ Q = b/Q + w
□ AFC= b/Q
□ AVC= wQ/Q = w
□ MC = differentiate change in TC/ change in Q = w
n.b. last two: same and constant as output changes
What will the average total cost curve look like (diminishing)
As Q increases,
1) b/Q- will decrease i.e. ATC decreases
2) W- doesn’t change
3) +wQ- increases i.e. ATC increases
Therefore ATC will increase
What are the increasing returns production costs?
○ TC = b + wQ - wQ2 § TFC = b § TVC = wQ - wQ2 § AFC = b/Q § AVC = wQ + wQ2/Q = w - wQ § ATC = b/Q + w - wQ MC = w - 2wQ
What will the average total cost curve look like (increasing)
○ As Q increases,
- b/Q- will decrease i.e. ATC decreases
- W- doesn’t change
- -wQ- decreases i.e. ATC decreases
Therefore ATC will decrease
What is the Mixed Case
• Increasing returns dominate at low levels of output
– This leads to falling marginal costs
• Decreasing returns then dominate at high levels of output
– This then leads to rising marginal costs
Economies of scale: what are the benefits of falling average costs as output expands?
–specialisation & division of labour – indivisibilities – container principle – greater efficiency of large machines – by-products – multi-stage production – organisational & administrative economies – financial economies – Economies of scope
What is diseconomies of scale?
• Costs begin to rise when output expands beyond the minimum efficient scale (MES)
○ Managerial complexity
○ Alienation
○ Industrial relations problems
○ Disruption if part of complex production chains fail
What causes profit to fall?
a) SRATC increases, Profit decreases
b) Q decreases, profit decreases
Which ways can firms be vulnerable?
i) a steep SRATC curve -( big cost penalty)
(ii) rises in external bought in costs - susceptible to profit changing significantly
effect is volatile profit
the problem of an economic downturn
Q↓ so SRATC ↑
The cost penalty depends on the shape of SRATC
What makes the SRATC curve steep?
High fixed costs of physical capital and ‘quasi-fixed’ personnel costs
Low variable costs when Q < Q* so fixed/variable ratio is raised
Learning which causes input productivity to rise as output increases and to fall if output falls
external costs- problem of an economic boom
Oil, energy and raw material prices rise
This pushes up the SRATC curve and raises the cost of producing Q* to C3
What makes a firm vulnerable to rising external costs?
high input cost intensity, e.g. executive salaries for banks, energy and iron ore for steel manufacturers and universities anxious about their RAE scores!
How can the vulnerability of a firm be reduced?
Type 1 vulnerability (a steep SRATC curve)
- reduce fixed costs and convert them to variable costs (‘variabilisation’) e.g. outsourcing
- will flatten the SRATC curve
- may increase Type 2
vulnerability
Type 2 vulnerability (to external costs)
- reducing dependence on the input
- negotiate a long term contract with suppliers at an agreed price
- vertical integration ( buy out main suppliers)
