Theory%20of%20Production

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Theory of Production
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Theory of Production

• In economics, production means creation of new
  utility rather than creation of new goods or
  services i.e. changing the shape of the matters
  to satisfy human wants like the law of
  indestructibility of physics(human beings neither
  create nor destroy matters). Transforming the
  matters to create new utility by rendering
  services.

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Theory of Production

• Unused wood lying at the courtyard
• Transforming into a chair
• Bringing the wax from the forest to the market
  increasing utility

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Theory of Production

• 4 factors of production required to produce,
  where the factors need remuneration to be in the
  operation
• Land - Rent
• Labor - Wage
• Capital - Interest
• Organization - Profit

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Theory of Production

• Objective is to maximize profit or to minimize
  cost
• Industry(made up of firms)
• Firm, farm(composed up of plants)

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Production Function

• It is a technical relationship between the
  inputs/factors of production output of the
  firm the relationship is such that the level of
  output depends on the levels of inputs used, not
  vise versa.
• Q F(K,L)

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Production Function

• Q F(K,L)
• Q the amount of output
• F the symbol of relation determined by the
  production engineers
• K the level of capital
• L the level of labor

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Production Function

• Short Run(at least 1 factor fixed)
• Long Run(all factors are varying)
• Doesnt depend on specific time period rather on
  the nature of commodity
• Raw materials, intermediate goods, capital
  machinery all are inputs but not the same thing
• Final goods(consumer goods)
• Secondary goods(outputs used as inputs)

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Short Run Production Function

• Q F(K,L) here K is fixed
• Table
• Graph
• Total Productshows how output varies in the
  short run as more of any one input is used
  together with fixed amounts of other inputs under
  current technology

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Short Run Production Function

• Total Product of a variable inputthe amount of
  output produced over any given period when that
  input is used along with other fixes inputs.
• Marginal Product-the increase in output from one
  more unit of an input when the quantity of all
  other inputs are fixed

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Short Run Production Function

• Average Product-on average what is the amount of
  output produced by each unit of labor
• AP TP / Q

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Labor TP MP AP
0 0 0 0
1 7 7 7
2 18 11 9
3 33 15 11
4 46 13 11.5
5 55 9 11
6 60 5 10
7 63 3 9
8 65 2 8.13
9 66 1 7.33
10 66 0 6.6
11 64 -2 5.82
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Short Run Production Function

• Initially TP increases at a increasing rate as MP
  AP is increasing
• Then TP increases at a decreasing rate as MP
  starts to fall(MP is max at inflection point)
• When MP cuts AP, AP is maximum
• Fall in MP also pulls down AP TP
• MP can also be negative

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Law of Variable Proportions

• Increased amount of labor applied to a fixed
  amount of other inputs results in decreased
  amount of MP
• Increasing Returns
• Decreasing Returns
• Negative Returns(disguised unemployment)
• Returns

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Law of Variable Proportions

• Hiring decision upon the input prices, as long as
  MP is positive L K are hired
• If K is free but L is not free(AP MP)
• If L is free but K is not free(MP 0)
• If both are not free, then decision according to
  productivity
• If MP negative by withdrawing L,TP can be raised
• The ratio between K L is changing

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Long Run Production Function

• Q F(K,L) here K L both are variable
• Proportionate variation in factors(input ratio
  constant)
• Disproportionate variation in factors

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Long Run Production Function

• TP may rise in different ways
• Increasing Returns To Scale
• Decreasing Returns To Scale
• Constant Returns To Scale

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step K L K-L Ratio Total Output
1 10 20 .5 100
2 20 40 .5 300
3 30 80 .5 600
4 40 160 .5 1000
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Equal product Curves/Iso Quants

• An indifference curve consists of different
  combinations of inputs(K,L) to produce same
  amount of output(Q)
• Same level of production

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Characteristics of Iso Quants

• Downward sloping
• Convex to origin
• 2 Iso quants cannot intersect each other
• Higher Iso quants denotes higher level of output

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Budget Lines/Iso Costs

• In production analysis it shows the different
  combinations of 2 inputs a firm can buy with a
  given amount of budget given the input prices.
• K.R L.W M

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Least combination of Factors

• TR(max) TC(min) Profit(max)
• Necessary condition is the tangency between Iso
  cost Iso quant
• Rent/Wage MPof L/MP of K
• Sufficient condition is that at the least cost
  combination the Iso quant curve must be equal to
  the origin

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Iso Quants returns to Scale

• IRS changes in inputs less than changes in
  output
• CRS changes in inputs output are identical
• DRS - changes in inputs more than changes in
  output
• Expansion Path shows how the minimum costs of
  producing any given output changes as a firm
  expands output

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Theory of Distribution
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Theory of Distribution

• Income refers to the total receipts or cash
  earned by a person or household during a given
  time period.The aggregate of all income is the NY
• Rent
• Wage
• Interest
• Profit

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Theory of Distribution

• Biggest share of NY goes to labor as wages,
  salaries,fringe benefits
• Property income(rent,net interest,corporate
  profits,proprietors income)
• Public Sector Vs Private Sector
• Factor Incomes Vs Personal Incomes

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Theory of Distribution

• Tangible Assets(houses,real estate,
  vehichele,business investment,others)
• Financial Assets(accounts,stocks,bonds, money
  market instruments,insurances)
• Input pricing based on the marginal productivity
  of the factor
• Wage in USA is higher than Mexico

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Theory of Distribution

• Wage of male is higher than female
• Demand Supply of factor determines its market
  price
• Demand of a factor is Derived Demand
• High rent but profitable business so requires
  more office spaces
• Higher demand for output raises input demand

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Theory of Distribution

• Demands of factors are interdependent requiring
  all the factors
• Labor father
• Land mother

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Theory of Production

• TP,MP of labor
• MRP Marginal Revenue Product of Labor
• MRPOutput PriceMP of labor
• Firm wanting to maximize profits in terms of
  monetary unit so transforming MP into MRP
• As competitive market so per unit output price
  fixed
• Imperfect competition price falls with output
  rise

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Units of L TP MP Output rice MRP
0 0 0 3 0
1 20 20 3 60
2 30 10 3 30
3 35 5 3 15
4 38 3 3 9
5 39 1 3 3
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Theory of Distribution

• Hire labor up to the point where
• MRP Wage
• MRP exceeds factor price,hire more factor
• Factor price exceeds MRP,fire factor
• Same for all the other factors
• Use of factor rises,MP of the factor declines

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Theory of Distribution

• Least-Cost Rule Costs are minimized if marginal
  products per taka of inputs are the same for both
  perfect imperfect competitions
• MP of L/wage MPof K/rent 1/MR(output price)
• MP of L/MP of K wage/rent
• MRP Demand for Factor

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Theory of Distribution

• Substitution Rule states that if price of one
  input rises while the other factor prices remain
  fixed then the firm will make profit from
  substituting with the cheaper input
• Supply of Factor depends on availability of
  factors,elasticity of supply etc.

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Theory of Distribution

• Determination of factor prices by demand supply
• Fast-food worker, physician
• All factor receive the price(wage) equaling the
  MP of the last unit of factor(labor)
• Per unit factor priceFactor employed Share of
  factor in NY

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Theory of Distribution

• If productivity of a factor is high,factor price
  will be high,share in NY will be big
• Horizontally summing up individual firms factor
  demand we get the market demand
• If factor supply is fixed then factor price is
  called as rent/pure economic rent(land,oil)
• Market equilibrium

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Theory of Distribution

• Surplus decreases price
• Deficit increases price
• Factor Price (Factor demand supply,
• Derived demand)
• Tax burden borne by the factor owner if supply is
  fixed due to supply inelasticity
  
  

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Theory of Distribution

• Capital produced factor,consists of those
  durable produced goods that are in turn used as
  productive inputs for further production lasting
  for more than 1 year or long
• Structures(buildings)
• Equipments(machine,computer)
• Inventories

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Theory of Distribution

• Rentals-payments for temporary use of capital
  goods(not for fixed factors rather for durable
  factors)
• Rate of return on capital- periodical interest
• Long term Vs Short term Interest Rates
• Real Vs Nominal Interest Rates
• Time Value of Money Concepts-PV,FV

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Theory of Distribution

• Accounting Economic Profits(all the implicit
  costs as well as opportunity costs)
• Profit reward for risk bearing
• Profit Reward for innovations
• Capital investment ensures future prosperity
• Diminishing returns demand for capital
• Interest determined by demand supply

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Theory of Distribution

• Supply inelastic in the short-run
• USA wage exceeds BD wage
• Capital earnings rising rapidly over last 2
  decades where wages are stagnated

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Labor Market
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Labor Market

• Real wage Purchasing capacity
• Nominal wage/Price level
• Human capital formation
• Overtime real wage has increased due to rise in
  labor productivity triggered by
  education,training,technological development
  resulting in high living standards

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Labor Market

• High wage rate in USA
• Low wage rate in Bangladesh
• Determinant of labor demand is MRP
• Backward bending supply curve where income
  effect(due to higher wages preferring leisure)
  outweighs substitution effect(overtime for
  raising earnings)

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Labor Market

• Labor force participation(adult males
  females,teenagers, child labor,elders)
• Influx of female workers
• Unemployment patterns(seasonal,causal,
  frictional,technological,structural,disguised)
• Wage differentials(skill,gender,profession,
  market imperfections professional regional
  segmented markets)

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Labor Market

• Compensating differentials(fringe benefits)
• Rent of unique individuals - Da Vinci
• Time required for transformation from unskilled
  to skilled labor
• Rigidity regarding shifting occupation
• Role of trade unions in raising wages creating
  unemployment(bilateral monopoly)

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Labor Market

• Fallacy of lump of labor(due to specialized
  nature of tasks workload cannot be shared to
  raise employment during recessions)
• Rise in labor supply could be sustained through
  more employment but deteriorates real wage
• Labor market adjusts to shift in demand supply
  through changes in real wage migration of labor
  capital

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Labor Market

• Decrease in demand due to technological shifts
  reduces relative wages migration of labor
  capital providing new jobs to the displaced
  workers

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Fiscal Policy Monetary Policy
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Fiscal Policy

• A government's program with respect to
• Purchase of goods services (G)
• Spending on transfer payments (R)
• The amount type of taxes (T)
• Basically entailing all the sources of govt.
  earnings as well as heads of expenses

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Targets

• Macroeconomic stability(both internal external)
• Countercyclical measures
• Price stability
• Egalitarian income wealth distribution
  (progressive taxation)
• Optimum utilization of resources (productive
  sectors)
• Optimum level of tariff taxes
• Economic development

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Variables

• GDP National Income Output Level
• Full Employment Level
• Unemployment Rate
• Inflation Rate
• Foreign Exchange Rate

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Instruments

• Demand Management Policy
• G, T, t, R all hitting AD
• Safety net programmes
• Subsidy
• Forced savings(providend fund)
• Borrowing
• Lending

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Types

• Expansionary
• Contractionary

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Role

• Enhancing savings investment
• Entrepreneurial development
• Current Vs future consumption
• Resource transfer to productive sectors (ADP
  Revenue Budget NBR Police dept)
• Raising output employment(subsidy liquidity
  trap)
• Manageable not prolonged budget deficit(LDC)

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Role in Unemployment

• Budget deficit (borrowing ,circulating notes
  public investment to raise consumption, labor
  demand,emploment,output income
• Unchanged govt. spending but reduced tax rate to
  raise MPC
• Balanced budget i.e. raising G, T, R
  simultaneously

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Role in Inflation

• Reducing G to lower AD for pushing down
  unemployment(unproductive sector)
• Raising tax revenue
• Borrowing (bank, non-bank external)
• Forced savings
• Exchange rate manipulation to restrict import

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Bangladesh Perspective

• Tax incentives for investment(tax holiday,tax
  waiver,capital machinery)
• High taxes on conspicuous consumptions
• Retained earnings
• Optimum resource utilization
• Developing social economic infrastructure
• Incentives for FDI

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Bangladesh Perspective

• Countercyclical measures
• Price stability
• Egalitarian income wealth distribution
  (progressive taxation)

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Problems

• According to classical economists no need for FP
  as full employment level attained
• Addressing income inequality
• Addressing unemployment problem
• Political complexity
• Administrative weakness
• Under developed financial sector

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Problems

• Controlling inflation
• Tax collection
• Budget deficit(huge subsidy, loss of SoEs)
• Deficit financing
• Debt servicing
• Crowding out
• Addressing inequality
• Laffer phenomena

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Monetary Policy

• The objectives of the central bank in exercising
  its control over money, interest rates credit
  conditions
• Money supply(broad money/ M2) growth
• Interest Rate (I)
• Credit conditions

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Instruments

• Circulation of notes coins
• Discount/Bank Rate
• Reserverequirements(CRR,SLR)
• OMO(OMS,OMP)
• Required Credit Margin (like stock market)
• Limits(lending cap,credit limit)
• psublicity

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Credit Policy

• Credit conditions
• Credit market
• Authority
• Laws,Rules Regulations(FE guidelines,circulasr
  regarding FERA47)

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Monetary Policy

• Money supply
• Interest rate

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Types

• Contractionary/Restrictive
• Expansionary(raising MS not adjusting I through
  OMP or reducing SLR or bank rate to match up
  enhanced demand for money to raise
  employment,output )
• Neutral(classical view for macro stability
  unchanged macro variables)

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Objectives

• Price stability(internal balance)
• FX market stability(external balance)
• Fixed exchange rate regime-FP affective
• Flexible exchange rate regime-MP affective
• Counter cyclical policy
• Attainment of full employment
• Raising investment
• Economic development

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Bangladesh Perspective

• Utilizing unutilized resources(SME sector)
• Inflation
• Savings
• BOP considerations
• Public financing

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Limitations

• Unable to prevent to business cycle
• Reduced interest may raise conspicuous
  consumptions though it was targeting capital
  accumulation
• Liquidity trap(very low interest rate)
• High interest sensitivity of money demand
• Low interest sensitivity of investment demand

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Limitations

• Information gap(demand pull or cost push
  inflation)
• Contradiction Phillips curve)
• Underdeveloped unorganized financial sector
• Transmitting from financial to real sector
• Financial inclusion

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Limitations

• Bureaucracy
• Lack of coordination between MP FP (autonomy of
  BB)

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Differences between MP FP

• Definitional
• Instruments
• Authority
• Activeness(lags)
• Although targets are almost identical

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Welfare Economics
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Welfare Economics

• Vilfredo Pareto introduced welfare criterion free
  of interpersonal comparison of utility
• Pareto optimality- The position of maximum
  welfare for the economy is attained when a policy
  through reallocation of resources cannot improve
  the position of some persons without degrading
  the position of at least 1 person

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Welfare Economics

• Pareto improvement
• Pareto efficiency in consumption
• Pareto efficiency in production
• Utility Possibility Curve
• Production Possibility Curve
• Pareto efficiency in product mix
• Grand utility Possibility Curve Bliss point
• Perfect competition ensuress efficiency not equity