MIEC 5: Theory of production

Theory of production

Production Study of organisations responsible for producing and supplying goods and services in the market. Market Aggregate demand and aggregate supplyDemand curve Underlying consumer behaviourSupply curve Underlying producer behaviour

Firm Is an organisation combine resources to produce goods and services.  Economic unit formed by profit seeking entrepreneurs IndustryGroup of firms that produce similar products or sell output in the same market.Plant Physical capital at a particular location E.g. Toyota car factory in Thailand

Legal forms of firm Sole proprietorship Partnership Corporation

Objectives of firm Primary - Maximise profits Sales maximisation, social objectives, personal objectives

Production

Is the process of combining and transforming resources and making them into output.

InputLand (Gifts of nature)Labour (Human effort)Capital (Buildings, tools)Entrepreneur

OutputGoods & Services

Resources Fixed and variable resourcesFixed Resource Quantity cannot be changed in the period under consideration E.g. Size of building E.g. Technology Variable Resource Quantity can be changed to increase or decrease the level of output E.g. Labour E.g. Raw materials

Period of productionShort Run (SR)Long Run (LR)

Period of production Short Run (SR) Long Run (LR) Short Run At least 1 resource is fixed. The rest are variable resources.Long RunAll resources are to be varied. No fixed

Law of diminishing returns At least one resource is fixed, the rest are variable As more and more units of a variable resource (Labour) is added to a fixed resource (Capital) Marginal product of the additional variable input would ultimately decline.

Total Product (TP) Total output of goods and services produced by firmMarginal Product (MP) Change in TP that occurs when the usage of a particular resource changes by 1 unit, all others constant. MPP = Change in TP/ Change in Variable inputAverage product (AP) TP produced per unit of variable inputAP = TP / Units of the variable input Marginal product increases because additional workers can specialise and make more efficient use of the fixed resources' Gains from division of labour and specialisation Diminishing Returns Hiring more workers increases total product by smaller and smaller amounts Overcrowding and congestion of fixed resources by too many variable In SR, firm cannot simply continue increasing amount of variable input to increase output In LR, need to increase fixed input

Marginal Revenue Product

Marginal revenue product (MRP) How much variable input should a firm employ? MRP change in Total Revenue that results from employing one more unit of labour. MRP = MP x Price Hire until MRP = Wage Rate

Assumptions (SR analysis) At least one fixed input and one variable input Variable input are homogeneous. (All the workers are of the same efficiency)  Technology is constant

Relationship between TP & MP MP is the slope of TP When MP is increasing, TP is increasing at increasing rate When MP is decreasing and positive, TP is increasing at decreasing rate. When MP = 0, TP is at max When MP is negative, TP is decreasing

Short run costsOpportunity cost / Implicit costBenefit from best alternative forgone for chosen alternativeExplicit costActual cash payments for resources (Expense) E.g. Wages, rent, interest

Accounting profit = TR - Explicit costEconomic profit = TR - (Implicit cost + Explicit cost)

Normal Profit (Break even) Profit earned when all resources used by the firm are earning their opportunity cost Accounting profit = implicit cost Economic profit = 0 Minimum profit the entrepreneur must earn to remain in business

Theory of production

Production

Short Run Production

Marginal Revenue Product