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Theory of Production

Theory of Production. Theory of Production.

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Theory of Production

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  1. Theory of Production

  2. Theory of Production • In economics, production means creation of new utility rather than creation of new goods or services i.e. changing the shape of the matters to satisfy human wants like the law of indestructibility of physics(human beings neither create nor destroy matters). Transforming the matters to create new utility by rendering services.

  3. Theory of Production • Unused wood lying at the courtyard • Transforming into a chair • Bringing the wax from the forest to the market & increasing utility

  4. Theory of Production • 4 factors of production required to produce, where the factors need remuneration to be in the operation • Land - Rent • Labor - Wage • Capital - Interest • Organization - Profit

  5. Theory of Production • Objective is to maximize profit or to minimize cost • Industry(made up of firms) • Firm, farm(composed up of plants)

  6. Production Function • It is a technical relationship between the inputs/factors of production & output of the firm; the relationship is such that the level of output depends on the levels of inputs used, not vise versa. • Q = F(K,L)

  7. Production Function • Q = F(K,L) • Q = the amount of output • F = the symbol of relation determined by the production engineers • K = the level of capital • L = the level of labor

  8. Production Function • Short Run(at least 1 factor fixed) • Long Run(all factors are varying) • Doesn’t depend on specific time period rather on the nature of commodity • Raw materials, intermediate goods, capital machinery all are inputs but not the same thing • Final goods(consumer goods) • Secondary goods(outputs used as inputs)

  9. Short Run Production Function • Q = F(K,L) here K is fixed • Table • Graph • Total Product–shows how output varies in the short run as more of any one input is used together with fixed amounts of other inputs under current technology

  10. Short Run Production Function • Total Product of a variable input–the amount of output produced over any given period when that input is used along with other fixes inputs. • Marginal Product-the increase in output from one more unit of an input when the quantity of all other inputs are fixed

  11. Short Run Production Function • Average Product-on average what is the amount of output produced by each unit of labor • AP = TP / Q

  12. Short Run Production Function • Initially TP increases at a increasing rate as MP & AP is increasing • Then TP increases at a decreasing rate as MP starts to fall(MP is max at inflection point) • When MP cuts AP, AP is maximum • Fall in MP also pulls down AP & TP • MP can also be negative

  13. Law of Variable Proportions • Increased amount of labor applied to a fixed amount of other inputs results in decreased amount of MP • Increasing Returns • Decreasing Returns • Negative Returns(disguised unemployment) • Returns

  14. Law of Variable Proportions • Hiring decision upon the input prices, as long as MP is positive L & K are hired • If K is free but L is not free(AP = MP) • If L is free but K is not free(MP = 0) • If both are not free, then decision according to productivity • If MP negative by withdrawing L,TP can be raised • The ratio between K & L is changing

  15. Long Run Production Function • Q = F(K,L) here K & L both are variable • Proportionate variation in factors(input ratio constant) • Disproportionate variation in factors

  16. Long Run Production Function • TP may rise in different ways • Increasing Returns To Scale • Decreasing Returns To Scale • Constant Returns To Scale

  17. Equal product Curves/Iso Quants • An indifference curve consists of different combinations of inputs(K,L) to produce same amount of output(Q) • Same level of production

  18. Characteristics of Iso Quants • Downward sloping • Convex to origin • 2 Iso quants cannot intersect each other • Higher Iso quants denotes higher level of output

  19. Budget Lines/Iso Costs • In production analysis it shows the different combinations of 2 inputs a firm can buy with a given amount of budget given the input prices. • K.R + L.W = M

  20. Least combination of Factors • TR(max) = TC(min) = Profit(max) • Necessary condition is the tangency between Iso cost & Iso quant Rent/Wage = MPof L/MP of K • Sufficient condition is that at the least cost combination the Iso quant curve must be equal to the origin

  21. Iso Quants & returns to Scale • IRS – changes in inputs less than changes in output • CRS – changes in inputs & output are identical • DRS - changes in inputs more than changes in output • Expansion Path shows how the minimum costs of producing any given output changes as a firm expands output

  22. Theory of Distribution

  23. Theory of Distribution • Income refers to the total receipts or cash earned by a person or household during a given time period.The aggregate of all income is the NY • Rent • Wage • Interest • Profit

  24. Theory of Distribution • Biggest share of NY goes to labor as wages, salaries,fringe benefits • Property income(rent,net interest,corporate profits,proprietor’s income) • Public Sector Vs Private Sector • Factor Incomes Vs Personal Incomes

  25. Theory of Distribution • Tangible Assets(houses,real estate, vehichele,business investment,others) • Financial Assets(accounts,stocks,bonds, money market instruments,insurances) • Input pricing based on the marginal productivity of the factor • Wage in USA is higher than Mexico

  26. Theory of Distribution • Wage of male is higher than female • Demand & Supply of factor determines its market price • Demand of a factor is Derived Demand • High rent but profitable business so requires more office spaces • Higher demand for output raises input demand

  27. Theory of Distribution • Demands of factors are interdependent requiring all the factors • Labor – father • Land – mother

  28. Theory of Production • TP,MP of labor • MRP – Marginal Revenue Product of Labor • MRP=Output Price×MP of labor • Firm wanting to maximize profits in terms of monetary unit so transforming MP into MRP • As competitive market so per unit output price fixed • Imperfect competition price falls with output rise

  29. Theory of Distribution • Hire labor up to the point where • MRP = Wage • MRP exceeds factor price,hire more factor • Factor price exceeds MRP,fire factor • Same for all the other factors • Use of factor rises,MP of the factor declines

  30. Theory of Distribution • Least-Cost Rule – Costs are minimized if marginal products per taka of inputs are the same for both perfect & imperfect competitions • MP of L/wage = MPof K/rent = 1/MR(output price) • MP of L/MP of K = wage/rent • MRP = Demand for Factor

  31. Theory of Distribution • Substitution Rule states that if price of one input rises while the other factor prices remain fixed then the firm will make profit from substituting with the cheaper input • Supply of Factor depends on availability of factors,elasticity of supply etc.

  32. Theory of Distribution • Determination of factor prices by demand & supply • Fast-food worker, physician • All factor receive the price(wage) equaling the MP of the last unit of factor(labor) • Per unit factor price×Factor employed = Share of factor in NY

  33. Theory of Distribution • If productivity of a factor is high,factor price will be high,share in NY will be big • Horizontally summing up individual firm’s factor demand we get the market demand • If factor supply is fixed then factor price is called as rent/pure economic rent(land,oil) • Market equilibrium

  34. Theory of Distribution • Surplus decreases price • Deficit increases price • Factor Price = (Factor demand & supply, Derived demand) • Tax burden borne by the factor owner if supply is fixed due to supply inelasticity

  35. Theory of Distribution • Capital – produced factor,consists of those durable produced goods that are in turn used as productive inputs for further production lasting for more than 1 year or long • Structures(buildings) • Equipments(machine,computer) • Inventories

  36. Theory of Distribution • Rentals-payments for temporary use of capital goods(not for fixed factors rather for durable factors) • Rate of return on capital- periodical interest • Long term Vs Short term Interest Rates • Real Vs Nominal Interest Rates • Time Value of Money Concepts-PV,FV

  37. Theory of Distribution • Accounting & Economic Profits(all the implicit costs as well as opportunity costs) • Profit – reward for risk bearing • Profit –Reward for innovations • Capital investment ensures future prosperity • Diminishing returns & demand for capital • Interest determined by demand & supply

  38. Theory of Distribution • Supply inelastic in the short-run • USA wage exceeds BD wage • Capital earnings rising rapidly over last 2 decades where wages are stagnated

  39. Labor Market

  40. Labor Market • Real wage = Purchasing capacity = • Nominal wage/Price level • Human capital formation • Overtime real wage has increased due to rise in labor productivity triggered by education,training,technological development resulting in high living standards

  41. Labor Market • High wage rate in USA • Low wage rate in Bangladesh • Determinant of labor demand is MRP • Backward bending supply curve where income effect(due to higher wages preferring leisure) outweighs substitution effect(overtime for raising earnings)

  42. Labor Market • Labor force participation(adult males & females,teenagers, child labor,elders) • Influx of female workers • Unemployment patterns(seasonal,causal, frictional,technological,structural,disguised) • Wage differentials(skill,gender,profession, market imperfections – professional & regional segmented markets)

  43. Labor Market • Compensating differentials(fringe benefits) • Rent of unique individuals - Da Vinci • Time required for transformation from unskilled to skilled labor • Rigidity regarding shifting occupation • Role of trade unions in raising wages & creating unemployment(bilateral monopoly)

  44. Labor Market • Fallacy of lump of labor(due to specialized nature of tasks workload cannot be shared to raise employment during recessions) • Rise in labor supply could be sustained through more employment but deteriorates real wage • Labor market adjusts to shift in demand & supply through changes in real wage & migration of labor & capital

  45. Labor Market • Decrease in demand due to technological shifts reduces relative wages & migration of labor & capital providing new jobs to the displaced workers

  46. Fiscal Policy & Monetary Policy

  47. Fiscal Policy • A government's program with respect to • Purchase of goods & services (G) • Spending on transfer payments (R) • The amount & type of taxes (T) • Basically entailing all the sources of govt. earnings as well as heads of expenses

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