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ch06Handouts

# ch06Handouts

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09/17/2010

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1
1. Motivation
2. The Production Function
•Marginal and Average Products
Isoquants
The Marginal Rate of Technical Substitution
3. Returns to Scale
4. Technological Progress
5. Some Special Functional Forms
2

When deciding about factory design, e.g. the right
combination of machines and workers, need to

• to which degree can one be replaced by the
other?
• the optimal combination has to take relative costs
into account (next chapter)

3
Inputs(also known as “factors of production”) are
resources, such as labor and capital equipment, that a firm
uses to produce goods and services.

Outputsare the goods and services produced by a firm.
Productiontransforms a set of inputs into a set of outputs.
Technologydetermines the quantity of output that is

feasible to attain for a given set of inputs.
Production functionstates the maximum amount of
output that can be produced for any given amount of inputs.

Example:
Q = f(L,K,M) where L: labor, K: capital, M: materials
Q = f(L,F,A) where L: labor, F: fertilizer, A: land area

4
• The production set is the set of technically feasible
combinations of inputs and outputs
A firm istechnically efficient if it produces the
maximum possible output given the inputs, i.e. operates
at the boundary of the production set
The analysis of production functions follows that of
utility functions.
Think of a utility function as a production
function for “happiness”
Difference: since production function measures
real output, production function is cardinal.
5
The Production Function and Technical Efficiency
for one input
production function
Q = f(L)
L
Q
C
D
A
B
area of technically inefficient production
area of technically not
achievable production
technically efficient production
is on the production function
6
The variables in the production function areflows (the
amount of the input used per unit of time), notstocks (the
absolute quantity of the input).
ðExample: stock of capital is the total factory installation;
flow of capital is the machine hours used per unit of time in
production (including depreciation).
Capital refers tophysical capital
(goods that are themselves produced goods) and not
financial capital(the money required to start or maintain
production).
7
Average productof an input resource is the average
amount of output produced per unit of the input.
average product of labor
APL = Q/L
average product of capital
APK = Q/K
Marginal productof an input resource is the rate at which
total output changes as the amount of the input is changed.
marginal product of labor
MPL = dQ/dL
marginal product of capital
MPK = dQ/dK
Law of diminishing marginal returns
The marginal product of an input eventually decreases as its
usage is increased, while holding all other inputs constant.
8
Total, Average, and Marginal Products
L
APL
MPL
Q
L
MPL maximized
APL maximized
TPL maximized
where MPL is zero.
TPL falls where MPL
is negative.
TPL rises where MPL
is positive.
Q(L)
MPL = dQ(L)/dL
APL = Q(L)/L
9
Note:
When the marginal product is positive, the total product
is increasing
When the marginal product is larger than the average

product, the average product is increasing (why? Because
units on average, so it drives the average up)

When the marginal product is smaller than the average
product, the average product is decreasing
The average product is maximal where it is equal to the
marginal product
The same holds for total, average and marginal for all
magnitudes, such as cost, utility, revenue, etc
10
Anisoquant traces all combinations of inputs that allow

a firm to produce thesame quantity of output.
e.g. Q = K1/2L1/2, then isoquant for Q = 20 is given by
K1/2L1/2 = 20, hence KL = 400, and K = 400/L

Marginal rate of technical substitution MRTSL,K

is the rate at which the capital input K must be decreased
(increased) to keep output level constant after the labor
input L is increased (decreased) by one unit.

MRTSL,K
= –K/L
(negative slope of the isoquant)
= MPL/MPK

(ratio of the marginal products)
along an isoquant we have MPL(L) + MPK(K) = 0,
thus MPL/MPK = -K/L = MRTSL,K

11
L
K
Q = 10
Q = 20
All combinations of (L,K) along the
isoquant produce 20 units of output.
0
Slope=K/L
Example: Isoquants
12
If both marginal products are positive, the slope of
the isoquant is negative
If we have diminishing marginal returns, we also
have adiminishing marginal rate of technical
substitution(but not the other way around)

For many production functions,
marginal products eventually
become negative. We can ignore
the upward-sloping part of the
isoquants in a graph because
these regions are uneconomic.

13
Example: The Economic and the
Uneconomic Regions of Production
L
K
Q = 10
Q = 20
0
MPK < 0
MPL < 0
Isoquants
economic region
uneconomic regions
14
Consumer’s Choice
Firms’ Choice
marginal rate of substitution
MRS
marginal rate of technical
substitution MRTS
indifference curve
isoquant
marginal utility of X (MUX)
marginal product of X (MPX)
ordinal
cardinal
derived from preferences
derived from technologies
utility from consumption
output from inputs
15

TheElasticity of substitutionσ measures the percent
change in the capital-labor ratio K/L for each one
percent change inMRTSL,K. It hence measures the degree
of substitutability between different inputs

σ=
(K/L)/(K/L)
MRTSL,K/MRTSL,K
=
((K/L)/MRTSL,K)(MRTSL,K/(K/L))
=
(K/L)
MRTS
L,K
MRTSL,K (K/L)
16

The shape of the isoquant
indicates the degree of
substitutability of the
inputs

Example: The Elasticity of
Substitution
L
K0
σ=0
σ=1
σ=5
σ=
17
Returns to scale RTS
measure the relative increase in output, when ALL
input quantities increase by a given amount
RTS = %Q / %(all inputs)

increasing returns to scale
a 1% increase in all inputs results in a more than 1%
increase in output

constant returns to scale
a 1% increase in all inputs results in an equally 1%
increase in output

decreasing returns to scale
a 1% increase in all inputs results in a less 1%
increase in output

18
Calculating the returns to scale
Production function Q1 = AL1αKβ1
Increase all inputs by the scale factorλ:
Q2 = A(λL1)α(λK1)β
=λα+β AL1αKβ1 =λα+βQ1
so the scale will depend on the value ofα+β.
• constant returns to scale:
α+β=1
• decreasing returns to scale:
α+β<1
• increasing returns to scale:
α+β>1
Note:The marginal product of a single factor may

diminish while the returns to scale do not
• Can there really be decreasing returns to scale?
They reflect that we do not increase all inputs or not in

the same quality