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Theory of Production

In economics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. This function is an assumed technological relationship, based on the current state of engineering knowledge; it does not represent the result of economic choices, but rather is an externally given entity that influences economic decision-making. Almost all economic theories presuppose a production function, either on the firm level or the aggregate level. Factors of production: Inputs (Sometimes called factors of production) or ingredients mixed together by a firm through its technology to produce outputs. Production function: A relation between inputs and outputs that identifies the maximum output that can be produced per time period by each specific combination of inputs. Q = f (L,K) Here, Q = Output L = Labour K = Capital This function indicates what is Technologically Efficient ----- A condition in which the firm produces the maximum output from any given combination of labour and capital inputs.

Production when only one input is variable:


Average product: The total output or product divided by the amount of the input used to produce that output. Marginal Product: The change in total output that results from a one unit change in the amount of an input, holding the quantities of other inputs constant.
Amount of Capital 3 3 3 3 3 3 3 3 3 3 Average product of Labor 5 9 10 10 9 8 7 6.125 5

Amount of Labor 0 1 2 3 4 5 6 7 8 9

Total product 0 5 18 30 40 45 48 49 49 45

Marginal product of labor 5 13 12 10 5 3 1 0 -4

Production function as a graph

Quadratic Production Function

Stages of production
To simplify the interpretation of a production function, it is common to divide its range into 3 stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing output per unit, the latter reaching a maximum at point B (since the average physical product is at its maximum at that point). Because the output per unit of the variable input is improving throughout stage 1, a price-taking firm will always operate beyond this stage. In Stage 2, output increases at a decreasing rate, and the average and marginal physical product are declining. However, the average product of fixed inputs (not shown) is still rising, because output is rising while fixed input usage is constant. In this stage, the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. The optimum input/output combination for the price-taking firm will be in stage 2, although a firm facing a downward-sloped demand curve might find it most profitable to operate in Stage 1. In

Stage 3, too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. The output per unit of both the fixed and the variable input declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible output is being obtained from the fixed input.

The Law of Diminishing Marginal Returns: In economics, diminishing returns (also called diminishing marginal returns) is decrease in the marginal (per-unit) output of a production process as the amount of a single factor of production is increased, while the amounts of all other factors of production stay constant. The law of diminishing returns (also law of diminishing marginal returns or law of increasing relative cost) states that in all productive processes, adding more of one factor of production, while holding all others constant, will at some point yield lower perunit returns. The law of diminishing returns does not imply that adding more of a factor will decrease the total production, a condition known as negative returns, though in fact this is common. For example, the use of fertilizer improves crop production on farms and in gardens; but at some point, adding more and more fertilizer improves the yield less and less, and excessive quantities can even reduce the yield. A common sort of example is adding more workers to a job, such as assembling a car on a factory floor. At some point, adding more workers causes problems such as getting in each other's way, or workers frequently find themselves waiting for access to a part. In all of these processes, producing one more unit of output per unit of time will eventually cost increasingly more, due to inputs being used less and less effectively. The law of diminishing returns is one of the most famous laws in all of economics.[1] It plays a central role in production theory.

Production when all inputs are variable: Short Run A period of time in which changing the employment levels of some inputs is impractical Long run A period of time in which a firm can vary all its inputs. Variable inputs All inputs in the long run

Production Isoquant A curve that shows all the combinations of inputs that, when used in a Technologically efficient way, will produce a certain level of output.

An isoquant map where Q3 > Q2 > Q1. A typical choice of inputs would be labor for input X and capital for input Y. More of input X, input Y, or both is required to move from isoquant Q1 to Q2, or from Q2 to Q3.

Marginal rate of technical substitution In economics, the Marginal Rate of Technical Substitution (MRTS) - or Technical Rate of Substitution (TRS) - is the amount by which the quantity of one input has to be reduced ( x2) when one extra unit of another input is used (x1 = 1), so that output remains constant ( ).

where MP1 and MP2 are the marginal products of input 1 and input 2, respectively, and MRTS(x1,x2) is Marginal Rate of Technical Substitution of the input x1 for x2. Along an isoquant, the MRTS shows the rate at which one input (e.g. capital or labor) may be substituted for another, while maintaining the same level of output. The MRTS can also be seen as the slope of an isoquant at the point in question.

Returns to scale The term returns to scale arises in the context of a firm's production function. It refers to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor). If output increases by that same proportional change then there are constant returns to scale (CRS). If output increases by less than that proportional change, there are decreasing returns to scale (DRS). If output increases by more than that proportional change, there are increasing returns to scale (IRS). Thus the returns to scale faced by a firm are purely technologically imposed and are not influenced by economic decisions or by market conditions. A firm's production function could exhibit different types of returns to scale in different ranges of output. Typically, there could be increasing returns at relatively low output levels, decreasing returns at relatively high output levels, and constant returns at one output level between those ranges.

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