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Chapter 4

Chapter 4 EC260.docx

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Karen Huff

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
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