Unit - 3 THEORY OF PRODUCTION
Unit - 3 THEORY OF PRODUCTION
Unit - 3 THEORY OF PRODUCTION
THEORY OF PRODUCTION
TP, AP, MP
2 30 15 20 70
3 60 20 30 60
4 80 20 20 50
.
ax
m
5 90 18 10
is
40
P,
M
=M
a,
6 90 15 0 30
AP
b,
P
7 80 11.4 -10 20 MP>A
10 AP
c
0
1 2 3 4 5 6 7
-2 Units of Labour
MP
In table & diagram ,as units of labour increase up to 3 unit AP & MP
rd
K L TP AP MP stage d
90
TP , AP ,MP
80 TP
10 0 -- -- --
10 1 10 10 10 70
60 2nd stage 3rd stage
10 2 30 15 20 1st 1st stage
50 increasing decreasing negative
10 3 60 20 30 return return return
40
10 4 80 20 20
a
10 5 90 18 10 2 nd 30
b
20
10 6 90 15 0
10 AP
10 7 80 11.4 -10 3rd
c
0
1 2 3 4 5 6 7
-10
Unit of labour MP
The table is an isoquant schedule which In the diagram, the Iq is derived by joining
shows all the combinations of K & L where all the combinations (A,B,C,D,E) of K& L.
all the combinations are equally efficient All these combinations produce the same
to Produce the same level of output. level of output.
In order to maintain the same level of Amount of a factor is decreased to increase
output some units of K must decrease the amount of other factor so that out put
to increase a unit of L remains unchanged
MRTSLK decrease as we move down along
an Isoquant, so ,Isoquant is convex to origin
Isoquant Map
An isoquant map shows a bundle of different isoquant
curves where each upper isoquant represents the
higher level of output because as the producer moves
to upper isoquant from lower one, more quantity of
both the factors-labour & capital is employed . So upper
isoquant represents higher level of out put.
Unit of K
00
I Q3 = 3
k2 b
0
a IQ2=20
k1 0
IQ1 =10
O
L1 L2 Unit of L
Properties of Isoquant Curve
A
K1 b
e
m c
B d
K2 n
Iq = 100 Iq = Q
O
L1 L2 L O L
Con.
3. Isoquant curves never intersect 4. Upper isoquent represents
each other: Higher level of production:
upper isoquant gives higher level of As we move from lower Iq to
production but when two isoquants upper Iq the quantity of both
intersect at a point , the point of factors-L & K Increase, so,
intersection shows the equal level higher Iq represents higher
of out put which is against the level of production.
assumption of isoquant curve .
Hence, isoquants never intersect
each other.
By assumption IC2 > IC1 K
K
But at point a IC1 = 1C2
Which is not possible
a Iq=300
K1
IC1 = 100 Iq=200
IC2 = 200 Iq=100
O O
L1 L L
Marginal Rate of Technical Substitution (MRTS)
• Marginal rate of technical substitution (MRTS) is a rate
at which two factors of production are exchanged or an
input is substituted for other without changing level of
output .
• Marginal Rate of Technical Substitution of labour for
capital (MRTSLK ) is a ratio of change in capital to the
change in labour keeping output unchanged.
• Hence, MRTSLK is the slop of Isoquant curve which is
negative because the amount of a factor must decrease
in order to increase the amount of other factor so that
the level of out put remains same.
K
Com. L K MRTSLK ΔK A
12
= ΔL
ΔK
A 1 12 … 8 B
F ΔL
B 2 8 4 C
5 G
C 3 5 3 D
3 H E
D 4 3 2 2 J
Iq = 100
E 5 2 1 O 1 2 3 4 5 L
At point A , If L= 0 , K = C/r
At point B , If K= 0 , L = C/w
Shift in Isocost Line
• Isocost line shifts due to the change in total outlay or
cost other things remaining the same.
• Given the factor price increase in total cost shifts isocost
line to the right and decrease in total cost shifts isocost
line to the left
K
A’’ • AB is initial Isocost line
• When total cost increases AB shifts
A to right as A’’B’’ which shows more
of the quantity of both the
factors-L&K can be purchased
A’
and vice versa.
B’ B B’’
O L
Swing in Isocost line
• Isocost line swings due to the change in the price of any
factor of production
Keeping all other things unchanged Keeping all other things unchanged
if the price of a factor say labour if the price of a factor say labour
decreases Isocost line swings to increases Isocost line swings to
the right. the left.
K A
K A
B B’ O B’ B
O L L
• Con.
Keeping all other things unchanged Keeping all other things unchanged
if the price of a factor say capital (K) if the price of a factor say capital (K)
decreases Isocost line swings to decreases Isocost line swings to
the right. the left.
K K
A’ A
A
A’
B B
O O
L L
Producer’s Equilibrium
• Producer’s equilibrium is such a point where the
producer is able to choose the optimum combination of
factors of production whereby a given level of output
can be produced minimizing the cost or a maximum
quantity of output can be produced given the cost so
that the profit can be maximized.
• A producer to be in equilibrium following two conditions
should be fulfilled
1. First order condition/NC : The Isoquant curve should be tangent
to Isocost line or the slop of isoquant should be equal the slop of
Isocost line .i.e. MRTSLk = w/r
2. Second order condition/SC : At the point of tangency the
Isoquant should be convex to the origin
• Based on the above mentioned two conditions the producer’s
equilibrium can be explained in two ways
1. Maximizing output given the cost : • In the diagram AB is given cost
Under this method the producer line. & Q, Q2 & Q3 are different
Attempts To produce a possibly Isoquant curves.
maximum amount of out put at • At e both the conditions are
a given level of cost. fulfilled so, it equilibrium where
the producer can produce
K Possibly maximum amount
(Q=200) of output purchasing
A the e combination of L and K.
j • The combinations j & k can also
be purchased by the same cost
but these can Only produce
K1 e less (Q=100) amount of Output.
Q=300 • Hence producer attempts
k Q=200
to Choose only the point or
Q=100
B combination e. So, e is the
O equilibrium point not j & k .
L1 L
.
2. Minimizing cost given the out put/ • In the diagram Q is Isoquant curve
Least cost combination : and AB ,A’B’ & A’’B’’ are different
Under this method , the producer, Isocost lines.
• At point e both the conditions are
in order to produce a desired or
fulfilled , So , it is equilibrium where
given level of out put, attempts to
the producer Can produce a desired
choose such a combination of L & K or given level (Q=200) of out put
at which the cost is minimum. purchasing the e Combination
of L& K with possible minimum
K cost AB.
A’’
• The j & k combinations of L &K
A j also can Produce the same level of
output but Require higher cost A’’B’’ .
A’ • Hence , producer does not remain
at J & K and attempts to be only at
K1 e point e purchasing Ok1 of K
k and OL1 of L
Q= 200
B’ B B’’
O L1
L
Law of Returns to scale
Q=400
A
Q=200 OA > AB > BC
O Q=100
L
2. Constant returns to scale : If the proportionate change
in output is equal to the proportionate change in inputs
is known as increasing returns to scale.
K
P
OA = AB = BC
C
4K B
Q
2K A
Q
1K
Q
O
1L 2L 4L L
3. Decreasing returns to scale: If the proportionate
change in output is less than the proportionate change
in inputs is known as increasing returns to scale.
Causes of increasing return:
K P •Managerial diseconomies
C •Exhaustation of natural resources
•Labour diseconomies.
B Q=400
Q=100
O
L
OA < AB < BC
Cobb-Douglas Production Function
Cobb-Douglas production was developed by two
economists Cobb &Doulas which is popular by their
name Cobb-Douglas production . it is a most widely
used and empirically tasted production function .it can
be expressed as,
Q = A KαLβ ………i
Q : output
A : a constant or efficiency parameter
K : capital
L : labour
α & β: are elasticity parameters
Features of C-D production function
1. C-D production function shows the returns to scale:
if α + β = 1 : Shows constant returns to scale
If α + β > 1 : Shows increasing returns to scale
If α + β < 1 : Shows decreasing returns to scale
MPL = ꝺQ/ꝺL
d(K/L)
(K/L) (β/α) d(K/L) (K/L)
= = = 1
(β/α) d(K/L) (β/α) (K/L) d(K/L)
(β /α) (K/L)
AP = TP/L = 48/3 = 16
MRTS = dK/dL
4) Suppose a producer has Rs 1000 to spend on two inputs-L & K . If
the price of labour is Rs 50 and price of capital is Rs 100. sketch
the Isocost line. ( See the concept of budget line)
5) Suppose the production function of firm is Q = 30 K3 L2 , and if it
employs 5 units of labour and 6 units of capital , find the total
output .
6) Determine the degree the returns to scale. If the production
function is ,
a) Q = A K0.60 L0.40 , given α =0.60 , β = 0.40 , if α + β = ?
b) Q = A K0.80 L0.30
c) Q = A K0.30 L0.40
Also determine the factor intensity if K/L = ?
Suppose the price of per unit labour and per unit capital are Rs 200 & 100
respectively.
compute total cost for each combination in each schedule and identify the
least cost combination which minimize cost for given level of output .
• A firm can uses different three production technologies with
labour and capital requirement to each level of output as follows:
Technology 1 Technology 2 Technology 3
Daily output K L K L K L
400 6 14 8 10 10 8
500 6 20 8 14 10 10
600 8 22 10 16 12 12
700 10 26 12 20 14 16
For each level of output which technology is the cheaper, when a firm
is operating in a high wage country , with capital per day cost is
Rs 200 and labour cost Rs 160 per day.
For each level of out put which technology is the cheaper with capital
cost Rs 200 and labour cost Rs 80.
Technology 1 Daily out put K L C = wL+rK
400 6 14
500 6 20
600 8 22
700 10 26