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FOUNDATION IN BUSINESS

ECONOMICS 1

PRODUCTION

Production refers to theprocess of transforming inputs into output. Inputs are

categorised into 2 - fixed inputand variable input.

Definition

Fixed input as input that does not change in the short run. For example, the

number of classrooms available in IPG is fixed, if we were toconsider a time period of 3 months. That qualifies the classrooms

as fixed input.

Variable input input that changes in the short run. When a factory needs toproduce more, electricity is easily available. So, electricity is

suitable to be considered as variable input.

Short run (SR) a time period where there is at least one fixed input.

Long run (LR) a time period where all inputs are variable inputs.

There is no clear measurement of time period to separate a short run from a long run.

Short Run Production

Total Product (TP) refers to the maximum output level produced at each level of variableinput, given that fixed input and technology are constant, in a given time period. A

production schedule shows the quantity produced (TP) at each variable input level, in a

given time period.

Assumptions:

1. There are only 2 inputs - L, as the variable input, and K, as the fixed input.

2. The inputs are homogenous.

3. The inputs have perfect mobility and divisibility.

4. The technology is static.

5. The production is in short run.6. The producer is rational.

TP = f(K, L, Tech)

As K and technology are assumed to be constant, only the changing L has impact on the

level of TP.

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L TP APL MPL1 10 10 10

2 22 11 12

3 36 12 14

4 48 12 12

5 58 11.6 10

6 66 11 8

7 72 10.3 6

8 76 9.5 4

9 78 8.7 2

10 78 7.8 0

11 76 6.9 -2

12 72 6 -4

Marginal Product (MP) refers to the additional output due to the last unit of input hired.Average Product (AP) refers to the output per unit input.

L TP AP MP

10 1000 100 -

12 13001300/12 =

108.33300/2 = 150

14 17001700/14 =

121.43400/2 = 200

Total Product increases initially, at an increasing rate. After a certain quantity of labouradded to the fixed capital, eventually total product increases at a decreasing rate. This

happens after L = 3. Total Product continues to increase until it reaches the maximum

when L = 10. Additional L after L = 10 causes the Total Product to decrease.

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Marginal Product (MP) refers to the additional total product due to the last unit of labour

hired. MPL=dL

dTP. MPLincreases initially until to the maximum, and thereafter

decreases. Where TP is maximum, MPLis zero. When TP decreases, MPLis negative.

Average Product (AP) refers to total product per unit labour. APL= TP/L.

Total Product shapes like this because it reflects the law of diminishing returns. The

law of diminishing returns says that as variable input increases, eventually total productincreases at a decreasing rate, given that fixed input and technology are constant, in a

given time period.

From zero labour until L = 4, this is Stage I. Stage II ends at L = 10. Beyond L = 10, it is

Stage III. In stage I, MP is higher than AP. In stage II and III, AP is higher than MP.

Stage II begins where AP is maximum.

A rational producer would not hire L more than Stage II, as the TP is decreasing. This

means that there is a relatively more L to K. Neither would the producer hire L as low as

in Stage I only, as there is relatively less L to K. A rational producer hires the amount of

L in Stage II. The exact amount of L to be hired depends on the additional revenue andthe additional cost of hiring the last unit of labour.