EC260 Chapter 4 – Production Theory Week 4
-Once managers determine the demand for the firm’s product or service, they must choose the optimal
method to produce
-A production process explains how scarce resources are used to produce a good or service
-The production function specifies the relationship between inputs and outputs
-In business, production involves all activities associated with providing goods and services, such as
employment practices, acquisition of capital resources, and product distribution
-Managers cannot understand their firm’s cost structure unless they understand the production process
The Production Function with one Variable Input
-The production function is a table, a graph, or an equation showing the maximum product output
achieved rom any specified set of inputs
-The function summarizes the characteristic of existing technology at a given time; it shows the
technological constants manager face
-We assume managers presuppose technical efficiency
-Production is dynamic: Methods, designs, and factor costs change
-If a process uses two inputs, X is he first input and X is the second: the production function is:
1 2
Q = f(X1, X2) where Q is the firm’s output rate
-The simplest case has one input whose quantity is fixed, often capital and a quantity that is variable,
such as labour
-Average product (AP) – common measuring device estimating the units of output, on average per input
unit AP = Q/X 1 holding X 2onstant
-Average product tells how many units of output, on average, each machinist is responsible for
-Marginal product – metric for estimating he efficiency of each input in which the input’s MP is equal to
the incremental change in output created by a small change in the input
MP = ∆Q/∆Q , h1lding X con2tant
-The marginal product represents the impact on output of a unit change in machinists
-MP = AP when AP is maxed
-As long as MP is greater than AP, AP must be increasing
-When MP is less than AP, AP must be decreasing
-MP intersects with AP when AP is at a maximum
The Law of Diminishing Marginal Returns
-The law of diminishing returns – a well-known occurrence where when managers add equal increments
of an input while holding other input levels constant, the incremental gains to output eventually get
smaller
-If manager add equal increments of an input while holding other input levels constant, the incremental
gains (MP) to output get smaller, and if pushed to the extreme are counterproductive
-Managers cannot hold all inputs but one constant; and hey cannot expect that adding more nits will
always result in large increases in output
Isoquants
-Isoquant – curve showing all possible (efficient) input bundles capable of producing a given output level
-An isoquant is composed of all the points having the same height in the production surface
-Isoquants are always downward-sloping and convex to the origin EC260 Chapter 4 – Production Theory Week 4
The Marginal Rate of Technical Substitution
-Marginal Rate of Technical Substitution (MRTS) – shows the rate at which one input is substituted for
another (with output remaining constant)
MRTS = -∆X /∆2 1
-The MRTS is -1 times the slope of the isoquant
-It is useful for managers to think of MRTS as eh ratio of marginal products – the marginal product
metric shows the incremental effect on output o

More
Less