Theory of Production Theory of Production

Theory of Production

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.

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

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

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

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)

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

Production Function • Short Run(at least 1 factor fixed) • Long Run(all factors are varying) • Doesn’t 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)

Short Run Production Function • • Q = F(K, L) here K is fixed Table Graph Total Product–shows 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

Short Run Production Function • Total Product of a variable input –the 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

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

Labor 0 1 2 3 4 5 6 7 8 9 10 11 TP 0 7 18 33 46 55 60 63 65 66 66 64 MP 0 7 11 15 13 9 5 3 2 1 0 -2 AP 0 7 9 11 11. 5 11 10 9 8. 13 7. 33 6. 6 5. 82

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

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

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

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

Long Run Production Function • TP may rise in different ways • Increasing Returns To Scale • Decreasing Returns To Scale • Constant Returns To Scale

step K L 1 10 20 K-L Total Ratio Output. 5 100 2 20 40 . 5 300 3 30 80 . 5 600 4 40 160 . 5 1000

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

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

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

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 combination the Iso quant curve must be equal to the origin

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

Theory of Distribution

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

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

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

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

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

Theory of Production • • TP, MP of labor MRP – Marginal Revenue Product of Labor MRP=Output Price×MP 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

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

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

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

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.

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 price×Factor employed = Share of factor in NY

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 firm’s 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

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

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

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

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

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

Labor Market

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

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)

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)

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)

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

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

Fiscal Policy & Monetary Policy

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

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

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

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

Types • Expansionary • Contractionary

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)

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

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

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

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

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

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

Monetary Policy • The objectives of the central bank in exercising its control over money, interest rates & credit conditions • Money supply(broad money/ M 2) growth • Interest Rate (I) • Credit conditions

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

Credit Policy • • Credit conditions Credit market Authority Laws, Rules & Regulations(FE guidelines, circulasr regarding FERA’ 47)

Monetary Policy • Money supply • Interest rate

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)

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

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

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

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

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

Differences between MP & FP • • • Definitional Instruments Authority Activeness(lags) Although targets are almost identical

Welfare Economics

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

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