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Economic Analysis for Managers (ECO 501) Fall:2 012 Semester

Economic Analysis for Managers (ECO 501) Fall:2 012 Semester. Khurrum S. Mughal. Theme of the Lecture. Production Theory Introduction The Production Function Production with One Variable Input Production with Two Variable Input Returns to Scale. Production.

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Economic Analysis for Managers (ECO 501) Fall:2 012 Semester

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  1. Economic Analysis for Managers (ECO 501)Fall:2012Semester Khurrum S. Mughal

  2. Theme of the Lecture • Production Theory Introduction • The Production Function • Production with One Variable Input • Production with Two Variable Input • Returns to Scale

  3. Production Production refers to the transformation of inputs or resources into outputs of goods and services

  4. Production INPUTS CAPITAL LABOR Land & Structures Natural Resources Entrepreneur Workers Machinery plant & equipment

  5. Factors of Production • Short Run- At least one input is fixed • Long Run - All inputs are variable • The length of long run depends on industry.

  6. Level and Scale of Production Level of production can be altered changing the proportion of variable inputs Output = Fixed inputs + Variable inputs • Scale of production can be altered by changing the supply of all the inputs (only in the long run) Output = Total inputs(variable inputs)

  7. Production Function • General equation for Production Function: Q = f (K,L), where L = Labour K = Capital • Maximum rate of output per unit of time obtainable from given rate of Capital and Labour • An engineering concept: Relates out puts and inputs

  8. Production Function with Two Inputs Q = f(L, K) 6 10 24 31 36 40 39 5 12 28 36 40 42 40 4 12 28 36 40 40 36 3 10 23 33 36 36 33 2 7 18 28 30 30 28 1 3 8 12 14 14 12 1 2 3 4 5 6 • Devoid of economics Capital (K) Labor (L) • Substitutability between factors of production • Returns to Scale vs Returns to Factor

  9. Theme of the Lecture • Production Theory Introduction • The Production Function • Production with One Variable Input • Production with Two Variable Input • Returns to Scale

  10. Production With One Variable Input Total Product TP = Q = f(L) Marginal Product TPL MPL = Average Product TP L Production orOutput Elasticity MPL APL APL = Q/Q L/L Q/ L Q/L EL = = = • Q = f (K,L), where K is fixed

  11. Production With One Variable Input Total, Marginal, and Average Product of Labor, and Output Elasticity

  12. Production With One Variable Input MP AP E L Q L L L 0 0 - - - 1 3 3 3 1 2 8 5 4 1.25 3 12 4 4 1 4 14 2 3.5 0.57 5 14 0 2.8 0 6 12 -2 2 -1 Total, Marginal, and Average Product of Labor, and Output Elasticity

  13. Law of Diminishing Returns and Stages of Production Stage I of Labor Stage II of Labor Stage III of Labor D’ A’ E’ F’ Total Product 16 D E 14 C F TP 12 I 10 B 8 G 6 A 4 2 Marginal & Average Product 0 0 1 2 3 4 5 6 7 Labor 6 B’ C’ 5 4 3 AP 2 1 0 0 1 2 3 4 5 6 7 -1 MP Labor -2 -3

  14. Relationship Among Production Functions • 1: • Marginal product reaches a maximum at L1 (Point of Inflection G). The total product function changes from increasing at a increasing rate to increasing at a decreasing rate. • 2: • MP intersects AP at its maximum at L2. • 3: • MP becomes negative at labor rate L3 and TP reaches its maximum.

  15. Optimal use of the Variable Input Marginal RevenueProduct of Labor MRPL = (MPL)(MR) Optimal Use of Labor MRPL = w

  16. Optimal use of the Variable Input MP L MR = P L 2.50 4 $10 3.00 3 10 3.50 2 10 4.00 1 10 4.50 0 10 Assumption : Firm hires additional units of labor at constant wage rate = $20

  17. Optimal use of the Variable Input MP MRP w L MR = P L L 2.50 4 $10 $40 $20 3.00 3 10 30 20 3.50 2 10 20 20 4.00 1 10 10 20 4.50 0 10 0 20 Assumption : Firm hires additional units of labor at constant wage rate Use of Labor is Optimal When L = 3.50

  18. Optimal use of the Variable Input $ 40 30 20 10 w = $20 dL = MRPL 0 2.5 3.0 3.5 4.0 4.5 Units of Labor Used

  19. Optimal use of the Variable Input • Production function of global electronics: • Q=2k0.5L0.5 • Compute Optimal use of labor when • K is fixed at 9, • Price is Rs. 6 per unit • and wage rate is Rs. 2 per unit

  20. Theme of the Lecture • Production Theory Introduction • The Production Function • Production with One Variable Input • Production with Two Variable Input • Returns to Scale

  21. Production with Two Variable Input Isoquants show combinations of two inputs that can produce the same level of output. K 6 10 24 31 36 40 39 5 12 28 36 40 42 40 Q 4 12 28 36 40 40 36 3 10 23 33 36 36 33 18 2 7 28 30 30 28 1 3 8 12 14 14 12 1 2 3 4 5 6 L

  22. Marginal Rate of Technical Substitution K

  23. Marginal Rate of Technical Substitution • A movement down an Isoquant the • gain in out put from using more labor equals loss in output from using less capital • MRTS: Slope of the Isoquant • _ (MPL) = MRTS • (MPK)

  24. ISOCOST Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost.

  25. Isocost Line Capital AB C = $100, w = r = $10 A 10 8 6 4 2 slope = -w/r = -1 vertical intercept = 10 1K 1L B Labor 2 4 6 8 10

  26. Isocost Line Capital A’ 14 10 8 4 Isocost Lines AB C = $100, w = r = $10 A’B’ C = $140, w = r = $10 AB* C = $100, w = $5, r = $10 A B B’ B* 0 Labor 4 8 10 12 14 16 20

  27. Optimal Combination of Inputs Isocost Lines AB C = $100, w = r = $10 A’B’ C = $140, w = r = $10 A’’B’’ C = $80, w = r = $10 MRTS = w/r

  28. Optimal Employment of Two Inputs MPL = w MPL = MPK w r MPK r • Optimal combination is where slope of Iso Cost and that of Isoquant are equal:

  29. Profit Maximization MPL = w MPL = MPK w r MPK r • To maximize Profits, each input must be hired at the efficient input rate • MRPL = w = (MPL)(MR) • MRPK = r = (MPK)(MR) • Profit Maximizing follows that the firm must be operating efficiently

  30. Expansion Path

  31. Theme of the Lecture • Production Theory Introduction • The Production Function • Production with One Variable Input • Production with Two Variable Input • Returns to Scale

  32. Economies of Scale - Returns to Scale Production Function Q = f(L, K) Q = f(hL, hK) If  = h, constant returns to scale. If  > h, increasing returns to scale. If  < h, decreasing returns to scale.

  33. Returns to Scale Constant Returns to Scale Increasing Returns to Scale Decreasing Returns to Scale

  34. Returns to Scale in An Empirical Production Function Cobb-Douglas Production Function Q = AKaLb If a + b = 1, constant returns to scale. If a + b > 1, increasing returns to scale. If a + b <1, decreasing returns to scale.

  35. Sources of Increasing Returns to Scale • Technologies that are effective at larger scale of production generally have higher unit costs at lower level of production • Labor Specialization • Labor may specialize in their specific tasks and perform it efficiently • Inventory economies • Larger firms have lesser need for machine inventory backup

  36. Sources of Decreasing Returns to Scale • Managerial Issues due to large size of the firm • Increased Transportation costs • Larger labor costs due to requirement of increased wages to attract labor from farther areas

  37. Economies of Scope • Using facility for producing additional products • E.g. Daewoo Bus Service for passenger and cargo movement • Using unique skills or comparative advantage • Proctor & Gamble using its existing sales staff and production capabilities for marketing various products as substitutes and complements

  38. Measuring Productivity • Total Factor Productivity

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