SHORT-RUN THEORY OF PRODUCTION

1
SHORT-RUN THEORY OF PRODUCTION

• Profits and the aims of the firm
• Long-run and short-run production
• fixed and variable factors
• The law of diminishing returns
• The short-run production function
• total physical product (TPP)
• average physical product (APP)
• marginal physical product (MPP)
• the graphical relationship between TPP, APP and
  MPP

2
Wheat production per year from a particular farm
(tonnes)
3
Wheat production per year from a particular farm
Number of workers 0 1 2 3 4 5 6 7 8
TPP 0 3 10 24 36 40 42 42 40
Tonnes of wheat produced per year
Number of farm workers
4
Wheat production per year from a particular farm
TPP
Tonnes of wheat produced per year
Number of farm workers
5
Wheat production per year from a particular farm
TPP
Diminishing returns set in here
Tonnes of wheat produced per year
b
a
Number of farm workers
6
Wheat production per year from a particular farm
d
TPP
Maximum output
Tonnes of wheat produced per year
b
a
Number of farm workers
7
Wheat production per year from a particular farm
TPP
Tonnes of wheat per year
DTPP 7
Number of farm workers (L)
DL 1
MPP DTPP / DL 7
Tonnes of wheat per year
Number of farm workers (L)
8
Wheat production per year from a particular farm
TPP
Tonnes of wheat per year
Number of farm workers (L)
Tonnes of wheat per year
Number of farm workers (L)
MPP
9
Wheat production per year from a particular farm
TPP
Tonnes of wheat per year
Number of farm workers (L)
APP TPP / L
Tonnes of wheat per year
APP
Number of farm workers (L)
MPP
10
Wheat production per year from a particular farm
TPP
Tonnes of wheat per year
b
Diminishing returns set in here
Number of farm workers (L)
b
Tonnes of wheat per year
APP
Number of farm workers (L)
MPP
11
Wheat production per year from a particular farm
d
TPP
Maximum output
Tonnes of wheat per year
b
Number of farm workers (L)
b
Tonnes of wheat per year
APP
d
Number of farm workers (L)
MPP
12
Wheat production per year from a particular farm
d
c
Slope TPP / L APP
TPP
Tonnes of wheat per year
b
Number of farm workers (L)
b
c
Tonnes of wheat per year
APP
d
Number of farm workers (L)
MPP
13
LONG-RUN THEORY OF PRODUCTION

• All factors variable in long run
• The scale of production
• constant returns to scale
• increasing returns to scale
• decreasing returns to scale

14
LONG-RUN THEORY OF PRODUCTION

• Economies of scale
• 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

15
LONG-RUN THEORY OF PRODUCTION

• Diseconomies of scale
• External economies and diseconomies of scale
• Optimum combination of factorsMPPa/Pa MPPb/Pb
  ... MPPn/Pn

16
ISOQUANT- ISOCOST ANALYSIS

• Isoquants
• their shape
• diminishing marginal rate of substitution
• isoquants and returns to scale
• isoquants and marginal returns
• Isocosts
• slope and position of the isocost
• shifts in the isocost

17
An isoquant
a
Units of K 40 20 10 6 4
Units of L 5 12 20 30 50
Point on diagram a b c d e
Units of capital (K)
Units of labour (L)
18
An isoquant
a
Units of K 40 20 10 6 4
Units of L 5 12 20 30 50
Point on diagram a b c d e
Units of capital (K)
b
Units of labour (L)
19
An isoquant
a
Units of K 40 20 10 6 4
Units of L 5 12 20 30 50
Point on diagram a b c d e
Units of capital (K)
b
c
d
e
Units of labour (L)
20
Diminishing marginal rate of factor substitution
g
MRS 2
MRS DK / DL
DK 2
h
DL 1
Units of capital (K)
isoquant
Units of labour (L)
21
Diminishing marginal rate of factor substitution
g
MRS 2
MRS DK / DL
DK 2
h
DL 1
Units of capital (K)
j
MRS 1
DK 1
k
DL 1
isoquant
Units of labour (L)
22
An isoquant map
Units of capital (K)
I1
Units of labour (L)
23
An isoquant map
Units of capital (K)
I2
I1
Units of labour (L)
24
An isoquant map
Units of capital (K)
I3
I2
I1
Units of labour (L)
25
An isoquant map
Units of capital (K)
I4
I3
I2
I1
Units of labour (L)
26
An isoquant map
Units of capital (K)
I5
I4
I3
I2
I1
Units of labour (L)
27
An isocost
Assumptions PK 20 000 W 10 000 TC 300
000
a
Units of capital (K)
TC 300 000
Units of labour (L)
28
An isocost
Assumptions PK 20 000 W 10 000 TC 300
000
a
Units of capital (K)
b
TC 300 000
Units of labour (L)
29
An isocost
Assumptions PK 20 000 W 10 000 TC 300
000
a
Units of capital (K)
b
c
TC 300 000
Units of labour (L)
30
An isocost
Assumptions PK 20 000 W 10 000 TC 300
000
a
Units of capital (K)
b
c
TC 300 000
d
Units of labour (L)
31
ISOQUANT- ISOCOST ANALYSIS

• Least-cost combination of factors for a given
  output
• point of tangency
• comparison with marginal productivity approach
• Highest output for a given cost of production

32
Finding the least-cost method of production
Assumptions
PK 20 000 W 10 000
TC 200 000
Units of capital (K)
TC 300 000
TC 400 000
TC 500 000
Units of labour (L)
33
Finding the least-cost method of production
Units of capital (K)
TPP1
Units of labour (L)
34
Finding the least-cost method of production
Units of capital (K)
TC 400 000
r
TPP1
Units of labour (L)
35
Finding the least-cost method of production
s
TC 500 000
Units of capital (K)
TC 400 000
r
t
TPP1
Units of labour (L)
36
Finding the maximum output for a given total cost
Units of capital (K)
TPP5
TPP4
TPP3
TPP2
TPP1
O
Units of labour (L)
37
Finding the maximum output for a given total cost
Units of capital (K)
Isocost
TPP5
TPP4
TPP3
TPP2
TPP1
O
Units of labour (L)
38
Finding the maximum output for a given total cost
r
Units of capital (K)
TPP5
TPP4
v
TPP3
TPP2
TPP1
O
Units of labour (L)
39
Finding the maximum output for a given total cost
r
s
Units of capital (K)
u
TPP5
TPP4
v
TPP3
TPP2
TPP1
O
Units of labour (L)
40
Finding the maximum output for a given total cost
r
s
Units of capital (K)
t
TPP5
u
TPP4
v
TPP3
TPP2
TPP1
O
Units of labour (L)
41
Finding the maximum output for a given total cost
r
s
Units of capital (K)
t
K1
TPP5
u
TPP4
v
TPP3
TPP2
TPP1
O
L1
Units of labour (L)