PRODUCTION: CH 6
OUTLINE
The Technology of Production
Production with One Variable Input (Labor)
Production with Two Variable Inputs
Returns to Scale
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PRODUCTION DECISION OF A FIRM
The theory of the firm describes how a firm makes
cost minimizing production decisions and how the
firm’s resulting cost varies with its output.
Production decision of a firm
The production decisions of firms are analogous to the
purchasing decisions of consumers, and can likewise be
understood in three steps:
1. Production Technology
2. Cost constraints ( Similar like budget constraint)
3. Input choices
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Production Function
● factors of production Inputs into the production process (e.g., labor,
capital, and materials).
The Production Function q F ( K , L) (6.1)
Inputs Process Output
Land
Product or
Labor service
generated
Capital
– value added
PRODUCTION FUNCTION
“Function showing the highest output that a firm can produce for
every specified combination of inputs”.
q = F (K, L)
Production functions describe what is technically feasible when
the firm operates efficiently.
Long-run and short run:
short run Period of time in which quantities of one or
more production factors cannot be changed.
●fixed input: Production factor that cannot be varied.
●long run: Amount of time needed to make all
production inputs variable. 5
Periods of Production, Inputs, and Costs
DIFFERENT TYPES OF PRODUCTION
CURVE
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THREE STAGES OF PRODUCTION
Three stages of Production:
Stage 1: From origin to the point where AP of labor is
highest.[ MP of Capital is Negative for capital intensive
production function]
Stage 2: From Highest point of AP of labor to the point
where MP of labor is Zero.[AP of labor and MP of labor,
both are positive, this stage is the optimal/efficient stage
of production]
Stage 3: The point where MP of labor starts to be
negative. [MP of labor is negative]
At Labor 4, AP of labor is highest [see. previous figure]
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APL AND MPL RELATIONSHIP
Relationship Between AP and MP. [ Page 209]
As long as MPL is increasing, APL is also increasing
Managerial Economics, BUS-525
(MPL is above of APL).
When APL = MPL; APL is optimum
When MPL is decreasing, APL also starts decreasing
[ APL is above of MPL]
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AVERAGE & MARGINAL PRODUCTS
Average product of labor
AP = Q/L
Marginal product of labor
MP = Q/L
When AP is rising, MP is greater than AP
When AP is falling, MP is less than AP
When AP reaches it maximum, AP = MP
Law of diminishing marginal product
As usage of a variable input increases, a point is reached beyond which
its marginal product decreases
EXERCISE 3. PAGE 227.
Labor Output MPL(dq/dL) APL [ Q/L]
0 0 - -
1 225 225 225
2 600 375 30
3* 900 300 300
4 1140 240 285
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Short-Run Technology Constraint
To increase output in the short run, a firm must increase
the amount of labor employed.[ capital is fixed]
Three concepts describe the relationship between output
and the quantity of labor employed:
1. Total product
2. Marginal product
3. Average product
© 2012 Pearson Addison-Wesley
Short-Run Technology Constraint
Product Schedules
Total product is the total output produced in a given
period.
The marginal product of labor is the change in total
product that results from a one-unit increase in the
quantity of labor employed, with all other inputs remaining
the same.
The of labor is equal to total product divided average
product by the quantity of labor employed.
© 2012 Pearson Addison-Wesley
USE OF THE CURVES SHOWN EARLIER
[AS LONG AS MP LABOR > AP LABOR, WE SHOULD HIRE
WHEN MP LABOR < AP LABOR, WE SHOULD NOT HIRE]
When to stop hiring new employees? Ans: If marginal productivity
declines, it doesn’t mean that we have to stop hiring new people.
Hiring may continue as long as marginal productivity is greater than
average productivity even though MP has started declining.
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Production with one variable input
(contd.)
Marginal Product of Capital
MPk = ΔQ/ ΔK
Using Cobb-Douglas: [CHARLES C. COBB AND ; PAUL H.
DOUGLAS; 1920-1930]
Q =AKαLβ [ ALPHA+ BETA = 1; Constant Returns to Scale]
RTS: CRS; IRS; DRS
A = TECHNOLOGY PARAMETER; Total factor productivity;
MPL =Marginal product of labor = dQ/dL = βAKαLβ-1
MPk = Marginal product of Capital = dQ/dK= αAKα-1Lβ
Average Product of Labor
APL =TPL/L
Average Product of capital
APK =TPK/K
Production with one variable input
(contd.)
Marginal Product of Capital
MPk = ΔQ/ ΔK
Using Cobb-Douglas: [CHARLES C. COBB AND ; PAUL H.
DOUGLAS; 1920-1930]
Q K L LNQ LNK LNL
Q =AKαLβ [ NON-LINEAR FUNCTION]
LNQ = LNA+ALPHAlNk + BetaLnL
= 2.32+0.19LNK + 0.88LNL [[ ALPHA + Beta = 0.19 + 0.88 = 1.07; IRS ; If we increase capital
and labor by 1%, output increases by more than 1% (1.07%)
Q =AKαLβ [ PRESS SHIFT LNX; 2.32 IT BECOMES 10.28]
= 10.28K019*L.88
Returns to scale
Input increases output increase RTS
1% 1% CRS
1% >1% IRS
1% <1% DRS
THE COSTS OF PRODUCTION 17
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
The Law of Diminishing
Marginal Returns [DMR]:
Principle that as the use of an
input increases with other inputs
fixed, the resulting additions to
output will eventually decrease.
Labor productivity (output per
unit of labor) can increase if
there are improvements in
technology, even though any
given production process exhibits
diminishing returns to labor. As
we move from point A on curve
O1 to B on curve O2 to C on
curve O3 over time, labor 18
productivity increases.
Why MPL Diminishes
. In general, MPL diminishes as L rises
whether the fixed input is land or capital (equipment,
machines, etc.).
Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal).
The law of diminishing returns states that: As a firm
uses more of a variable input [LABOR] with a given
quantity of fixed inputs [CAPITAL], the marginal
product of the variable input eventually diminishes.
THE COSTS OF PRODUCTION 19
Three important relationships can be found
1. Substitutability between Factors: There are a variety of
ways to produce a particular rate of output (example: to produce
a fixed units, any combination can be used). Therefore, the
question of labor or capital-intensive production arises. Q = 100;
2K, 10L; OR 4K, 8L ( WE SUBSITUTUTED LABOR FOR CAPITAL]
2. Returns to Scale: If input rates are doubled, the output rate
also doubles. [example: 200 = 1K + 4L, if 2K + 8L the Q would be
= 400]. The relationship between output change and proportionate
changes in both inputs is referred to Return to Scale. In this case
we have CRS. [ IF 450 = IRS; IF less than 400 = DRS]
3. Returns to Factor: When output changes because one
input changes while the other remains constant, the changes in
the output rates are referred to as Return to Factor. [example: 200 =
1K + 4L → 1K + 8L = 250; CHANE OF LABOR = 4; CHANGE OF OUTPUT =
PRODUCTION WITH TWO VARIABLE INPUTS
AND ISO-QUANT CURVE
Iso-quant Curve
showing all
possible
combinations of
inputs that yield
the same output.
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CHARACTERISTICS OF ISO-QUANT
Properties of Iso-quant: [ SAME LIKE INDIFFERENCE CURVE]
1. Iso-quant is downward sloping.
2. Iso-quant is convex to the origin
3. Two Iso-quants can not cross (intersect)
4. Higher Iso-quant is better than lower Iso-quant.
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ISO-QUANT MAP AND DMR
A set of isoquants that
describe firm’s production
function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D), to
isoquant q2 (75 units per year
at points such as B) and to
isoquant q3 (90 units per year
at points such as C and E).
DMR: Holding the amount of
capital fixed at a particular
level—say 3, we can see that
each additional unit of labor
generates less and less 23
additional output.
CONCEPT OF MRTS: [MRTS IS THE NEGATIVE SLOPE OF
ISO-QUANT]
Marginal rate of technical
substitution (MRTS):
Amount by which the
quantity of one input can
be reduced when one extra
unit of another input is
used, so that output
remains constant.
(MPL ) / (MPK ) = (change
in K /change in L ) =
MRTS
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Marginal rate of Technical
Substitution (MRTS)
The MRTS is the slope (-) of an isoquant.
The rate at which the two inputs can be
substituted for one another while
maintaining a constant level of output.
K
MRTS
L
The minus sign is added to make MRTS a positive
number since K L , the slope of the isoquant, is
negative
Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
PRODUCTION FUNCTIONS: TWO SPECIAL
CASES
1. When factors are perfect
substitutes: MRTS will be equal
(constant) at each point of the iso-
quant.[two inputs are perfect
substitute]
2. The Leontief production
function or fixed proportions
production function is a
production function that implies the
factors of production will be used in
fixed (technologically pre-
determined) proportions, as there is
no substitutability between factors. .
[two inputs are perfect complements]
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ANY RELATIONSHIP BETWEEN THESE FIGURES
Managerial Economics, BUS-525
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RETURNS TO SCALE
Returns to scale: Rate at which output increases as inputs
are increased proportionately.
Increasing returns to scale: Situation in which output more
than doubles when all inputs are doubled.
Constant returns to scale: Situation in which output
doubles when all inputs are doubled.
Decreasing returns to scale: Situation in which output less
than doubles when all inputs are doubled.
EXERCISE: 2, 3, 7, 8, 9, 10.
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RETURNS TO SCALE
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EXAMPLES
8. Do the following functions exhibit increasing, constant, or
decreasing returns to scale? What happens to the marginal
product of each individual factor as that factor is increased
and the other factor held constant?
1. q = 3L + 2K
2. q = (2L + 2K)1/2
3. q = 3LK2
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Do the following functions exhibit increasing, constant, or
decreasing returns to scale? What happens to the
marginal product of each individual factor as that factor
is increased and the other factor held constant?
1. q = 3L + 2K
Managerial Economics, BUS-525
LET L =K = 2; Q = 3L + 2K = 10
LET L =K = 4; Q = 3L + 2K = 20
CRS: INPUTS ARE DOUBLED, AND
OUTPUT IS ALSO DOUBLED.
……………………………………
dq/dL = 3 = MPL [ CAPITAL IS FIXED]
dq/dK = 2 = MPK [ LABOR IS FIXED]
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RTS; MPL; MPK
Q = (2L + 2K)1/2
LET L = K = 2
Q = (2*2+ 2*2)^1/2 = 2.83
LET L = K = 4
Managerial Economics, BUS-525
Q = (2*4+ 2*4)^1/2 = 4 ;
DRS: DECREASING RETURNS TO SCALE AS OUTPUT
INCERASED BUT DID NOT DOUBLE.
………………………………………………………………..
MPL = dQ/dL = ½((2L + 2K)1/2 -1 dQ/dL (2L)
= ½(2L + 2K)^-1/2 *2
= (2L + 2K)^-1/2
= 1/(2L +2K)^1/2 ; AS LABOR IS INCERASED MPL IS DECREASED
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RTS ; MPL; MPK
Q = 3LK2
LET L = K= 2; Q = 24 ;
LET L = K= 4 ; Q = 192 ; IRS
dQ/dL = 3k^2 = MPL
Managerial Economics, BUS-525
dQ/dK = 3L*2*K^2 -1 = 6LK
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MATHEMATICAL EXAMPLES
10. Wheat is produced according to the production function
q = 100(K0.8L0.2), where K is capital and L is labor.
a. Derive the marginal product of labor and the marginal
product of capital.
MPL = dQ/dL = 100K^.8*.2L^.2 -1 = 20K^0.8L^-0.8
b. Show that the marginal product of labor and the
marginal product of capital are both decreasing (hint:
beginning with K = 4, and L = 49).
c. Does this production function exhibit increasing,
decreasing, or constant returns to scale? [ ALPHA +
BETA = 0.8 +.2 =1 = CRS]
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Managerial Economics, BUS-525
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L = 49; K =4 ; Q = 100(K0.8L0.2 = 660.21
Managerial Economics, BUS-525
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Managerial Economics, BUS-525
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EXERCISE 10.
PRACTICE EXAMPLES: EX 9. PAGE.227
The production function for the personal computers of
Company A, Inc., is given by q = 10K0.5L0.5, where q is
the number of computers produced per day, K is hours of
machine time, and L is hours of labor input. A’s
competitor, Company B, Inc., is using the production
function q = 10K0.6L0.4.
If both companies use the same amounts of capital and
labor, which will generate more output?
Assume that capital is limited to 9 machine hours, but
labor is unlimited in supply. In which company is the
marginal product of labor greater? Explain.
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Managerial Economics, BUS-525
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ANSWER
a)
Q1(FIRM 1) = 10K^0.5*L^0.5 = 10*9^0.5*L^0.5 =30L^0.5
Q2 (FIRM 2) = 37.372L^0.4
Managerial Economics, BUS-525
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Expansion Path
Expansion path gives the efficient (least-
cost) input combinations for every level
of output
Derived for a specific set of input prices
Along expansion path, input-price ratio is
constant & equal to the marginal rate of
technical substitution
Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
Expansion Path
Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
Economies of Scale, Diseconomies of Scale, and Constant
Returns to Scale
• Economies of Scale exist when inputs are increased by some
percentage and output increases by a greater percentage,
causing unit costs to fall.
• Constant Returns to Scale exist when inputs are increased by
some percentage and output increases by an equal
percentage, causing unit costs to remain constant.
• Diseconomies of Scale exist when inputs are increased by
some percentage and output increases by a smaller
percentage, causing unit costs to rise.
• Minimum Efficient Scale is the lowest output level at which
average total costs are minimized. Efficient scale:
The quantity that minimizes ATC.
