Chapter 4 Production

Chapter 4 The Theory of Production

Production Process of transforming inputs into outputs Inputs are factor of production (such as land, labor, capital & entrepreneur) whereas output are goods and services produced. Production function refers to r/ship between inputs & outputs # as input increases, output also increases

Elements in the Process of Production Firm Productive unit or business (small unit) which convert inputs into outputs for sale in market Industry Group of firms which produce the same type of products  produce more good than firms Factors of production Fixed factors ( fixed inputs) Do not change as output increases or decreases (eg: land & capital Variable factors (variable inputs) Change as output increases or decreases. (eg: labor & entrepreneur)

Time range Short run At least one fixed input with one or more variable inputs  to increase output, producer needs to change his variable inputs but not fixed inputs) Eg: producer cannot change land & factory size but can change the quantity of labor or raw materials Long run No fixed inputs only variable inputs Land, labor, capital & entrepreneur are all variable inputs Firms able to build new factories or purchase new machineries

Short Run Production Function Q=f (variable inputs, fixed inputs) The production is subjected to the law of diminishing marginal returns  the additional output from each additional unit of variable input will diminish

Important Concepts Total product of labor (TP L ) Total number of goods produced with a given amount of factors of production TP L = AP L x Q L (Quantity of labors) Eg: Q L = 4 labor , AP L = 4 units TP L = AP L x Q L = 4 units x 4 labors = 16 units

Average Product of Labor (AP L ) Total product (TP L ) per unit of labor AP L = TP L /Q L Eg: Q L = 3 labors, TP L = 11.70 AP L = TP L /Q L = 11.70 units / 3 labors = 3.90 units Marginal Product of Labor (MP L ) Additional output produced as a result of employing one additional unit of labor MP L = ∆TP L /∆Q L = TPn – TPn-1 (where n = period 1,2,3,4,5,…) Q L n – Q L n-1

Total Product, Marginal Product and Average Product of Labor TP labour MP (∆TP/ ∆L) AP(TP/L) 0 0 - 0 8 1 8 8 20 2 12 10 33 3 13 11 44 4 11 11 50 5 6 10 54 6 4 9 56 7 2 8 56 8 0 7 54 9 -2 6 50 10 -4 5

Relationship between TP L , AP L and MP L Land Labor TP L AP L MP L Law of Marg. Returns Stages of Production 1 1 3 3 - Increasing Marg. Returns Stage 1 1 2 7 3.5 4 1 3 33 11 26 1 4 50 12.5 17 Diminishing Marg. Returns Stage 2 1 5 65 13 15 1 6 75 12.5 10 1 7 80 11.43 5 1 8 80 10 0 1 9 78 8.67 -2 Negative Marg. Returns Stage 3 1 10 72 7.2 -6

Production Labor TP L maximum TP L AP L MP L MP L = 0 AP L maximum MP L maximum 0 Stage 1 Stage 2 Stage 3 3 Stages of Production Curve in Short Run

Stages of Production Stage 1 Begins from point 0 to the intersection point of MP and AP curves. At this stage, there is sharp increase of total product (TP) as we increase the units of labor employed  each additional increase in labor units will result in a greater increase of the TP.  A rational producer will continue to produce goods at this stage as TP increase by increasing more labor

Stage 2 Begins from the intersection point of MP and AP curves ( end of stage 1) until MP curve touches the x-axis. At this stage, the values of AP and MP are decreasing.  AP curve is always higher than the MP curve, and when the MP curve touches the x-axis, the TP reaches its maximum point  most efficient stage of production because the combinations of variables and fixed inputs are used efficiently.  rational producer will want to produce at this stage of production as the TP has already achieved its maximum point (if he continues to produces beyond this stage, TP will start to decline)

Stage 3 Begins when MP equals to zero and continues to decline thereafter.  rational producer should not be producing at this stage of production because an increase in labor leads to a decline in the total product.

Law of Diminishing Marginal Returns States that as labor (variable input) is added to land, eventually MP will fall. Law of diminishing returns starts when MP is at its maximum point (point a) until MP equal to zero (point b)

Production Labor TP L maximum TP L AP L MP L MP L = 0 AP L maximum (APL = MPL) MP L maximum 0 Stage 1 Stage 2 Stage 3 Law of Diminishing Marginal Returns (a) (b) R/ship between TP & MP When MP is increasing, TP is increasing at an increasing rate When MP is declining, TP is increasing at a decreasing rate When MP is zero, TP is maximum When MP is negative, TP is falling

Production Labor TP L maximum TP L AP L MP L MP L = 0 AP L maximum (APL = MPL) MP L maximum 0 Stage 1 Stage 2 Stage 3 Law of Diminishing Marginal Returns (a) (b) R/ship between AP & MP When MP is increasing, AP is also increasing MP cuts AP when AP is maximum When MP above AP, the AP is rising When MP below AP, the AP is falling

Long Run Production Function period where all inputs used are variable inputs (no fixed inputs) Firms use this period to plan their production by changing all their inputs Law of returns to scale applicable in long run when all inputs are variable Thus, in long run Q=f(variable inputs: land,labor,capital,entrepreneur)

Economies of Scale Show the r/ship between output & long run cost Refer to the advantages & benefits of firm enjoys as it becomes larger (expand its production) since the long run average cost (LRAC) falls. 2 types: Internal economies of scale External economies of scale

Internal economies of scale Benefits enjoyed by the firm itself Occurs as a result of a firms internal decision to increase the scale of its operation Division of labor specialization Leads to an increase in efficiency  brings higher output thus results in increasing returns to scale Financial economies Large firms obtain loans more easily (interest charged also lower) Can also sells shares to obtain more capital to expand firms results in lower LRAC as output expand Managerial economies Administrative economies such as the employment of professionals like economists or accountants

External economies of scale Benefits enjoyed by the entire industry Caused by the factors external to the firms itself, relating to the scale of the industry or market as a whole Economies of concentration Grouping of firms together within 1 industrial zone can reduce cost since it is cheaper + easier for government to supply necessary facilities Infrastructure Facilities available to the industry to ensure smooth operation of the whole industry Eg: road, ports, railways, water supply, telecommunication, etc  enable firms to save cost & production be more efficient Economies of information Exposed to new information  important to improve quality of the existing product

Diseconomies of Scale Disadvantages/ problems a firm will face it becomes too large because increases in output causes a firm’s LRAC curve to rise and reduces efficiency 2 types: Internal diseconomies of scale External diseconomies of scale

Internal diseconomies of scale Disadvantages faced by the firm when it become too big Bureaucratic organization Lead to slow process of decision making  costly to firms Low productivity Division of labor may lead to alienated & demoralize of workers when the organization gets bigger Higher wages of professionals Increase the cost of production

External diseconomies of scale Disadvantages that result from the expansion of the entire industry Social cost Taxes will be imposed by the govt because the problem of pollution or traffic congestion Wage differential in the industry Eg: AB company pays RM20 per day while CD company pay RM25 per day to their labors  prevent worker from leaving the firms + attract new labors, AB company has to pay RM26 or more per day  production cost for both firms will increase Increase in cost of production & fall in returns With stiff competition, whole industry will suffer because their competition in terms of buying & selling  increase in cost of production

Producers’ objective and responsibility Conventional view Producer’s objective is to attain maximum profit  make economics decisions Islamic view Strive hard in order to get the blessings from Allah SWT + harmony society Maximize profit without sacrificing the blessings from Allah SWT according to Al Quran & Sunnah

Chapter 4 Production

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Chapter 4 Production