Economic Theory of Production
Economic theory of the firm begins with theory of production. What is a firm? The essence of a firm is to buy inputs, convert them to outputs, and sell these outputs to consumers, firms or government. Therefore a firm is poised between two markets. It is a demander in factor markets. It buys the inputs required for production in factor markets (markets that supply inputs for firms). It is a supplier in market for goods and services. It has to adjust its production to satisfy the demand curve of its customers at profit.
It is assumed that the firm or the owner of the firm always strives to produce efficiently, or at lowest cost. He will always attempt to produce the maximum level of output for a given dose of inputs avoiding waste whenever possible.
The production function is the relationship between the maximum amount of output that can be produced and the inputs required to make that output. Put in other way, the function gives for each set of inputs, the maximum amount of output of a product that can be produced. It is defined for a given state of technical knowledge (If technical knowledge changes, the amount of output will change.)
Importance of the Concept of Production Function
In an economy there will be thousands and millions of production functions because each firm will have one for each of the products that it is making. From the production function, the cost curves of a firm for each of its products can be determined. Contribution of each factor of production i.e., land, land, capital is also determined from production functions. The price that a factor of production will command in the market will be determined by the production functions from the demand side. Total, Average and Marginal Products
Total product or output is the total output produced in physical units by using a set of inputs. It is given by the product function directly. Marginal product of an input is the extra product or output produced when 1 extra unit of that input is added while other inputs are held constant at any given set of inputs. Average output is total output divided by total units of input. It can be calculated for each input separately also. Law of diminishing marginal returns
It holds that the marginal product of each unit of input will decline as the amount of that input increases, holding all other inputs constant. Returns to scale
Returns to scale reflect the responsiveness of total product when all the inputs are increased proportionately.
The scale effect can be constant returns, decreasing returns, and increasing returns. Constant returns to scale means, if inputs are doubled output also will double. Decreasing returns to scale means if inputs are doubled output is not doubling. Increasing returns to scale means if inputs are doubled, output is getting more than double.
Time Horizon of Analysis
Three different time periods are used to develop theories of production and production costs Momentary run: The period of time is so short that no change in production can take place. Short run: The period of time in which labor and material can be changed, but all inputs cannot be changed simultaneously. Especially, equipment and machinery cannot be fully modified or increased. Long run: All fixed and variable factors employed by the firm can be changed. Technology change
Technology change is said to occur when more output can be produced from the same inputs. Example: Wide-body jets increased the number of passenger-miles per unit of input by almost 40 percent. The meaning of productivity
When economists and government ministers talk about productivity they are referring to how productive labor is. But productivity is also about other inputs. So, for example, a company could increase productivity by investing in new machinery which embodies the latest technological progress, and which reduces the number of workers required to produce the same...
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