Pr oduction

T heor y
Production Theory
 The production theory basically addresses
itself to the question: If you have fixed
amount of inputs, how much output can
you get ? The state of technology and
engineering knowledge is assumed to
remain constant.
 The production function specifies the
maximum output that can be produced
with a given quantity of inputs. It is
defined for a given state of engineering
and technical knowledge.
Total, Average and Marginal
Product
 Total product is the total amount of
output produced in physical units like
bushels of wheat or quintals of rice.
 Average product equals the total output
divided by total units of input.
 Marginal (or extra) product of an input is
the extra output produced by one
additional unit of that input while other
inputs are held constant.
Total, Average and Marginal Product

 The following diagram shows the

total product curve rising as
additional inputs of labor are added,
holding other things constant.
However, total product rises by
smaller and smaller increments as
additional units of labor are added.
 Total Product
TP
4,000

3,000
Total Product

2,000

1,000

0 1 2 3 4 5
Labor
 Marginal Product
MP

3,000
Marginal Product (per unit of labor)

2,000

1,000

0 1 2 3 4 5
Labor
Marginal Product
 The preceding diagram shows the
declining steps of marginal product.
It must be understood that each
dark rectangle is equal to the
equivalent dark rectangle in the
total product curve.
Total, Average and Marginal Product
(1) (2) (3) (4)
Units of Total Marginal Average
Labor input Product Product Product
0 0
2000
1 2000 2000
1000
2 3000 1500
500
3 3500 1167
300
4 3800 950
100
5 3900 780
The Law of Diminishing Returns
 The Law of Diminishing Returns holds that we will
get less and less extra output when we add
additional doses of an input while holding other
inputs fixed. In other words, the marginal product
of each unit of input will decline as the amount of
that input increases.
 The Law of Diminishing Returns expresses a very
basic relationship. As more of an output such as
labor is added to a fixed amount of land,
machinery and other inputs, the labor will have
less and less of the other factors to work with.
The land gets more crowded, the machinery is
overworked, and the marginal product of labor
declines.
The Law of Diminishing Returns
 You might find that the first hour of
studying economics on a given day is
productive – you learn new laws and
facts, insights and history. The second
hour might find your attention wandering
a bit, with less learned. The third hour
might show that diminishing returns have
set in with a vengeance, and by the next
day the third hour is a blank in your
memory. Hence, hours devoted to
studying should be spread out rather than
crammed into the day before exams.
Returns to Scale
 While marginal products refer to infusion of a
single input, we are sometimes interested in the
effect of increasing all inputs. Returns to scale is
the study of the effect on production if all inputs
or the scale of inputs is altered. Returns to scale
are of three types:
 Constant Returns to scale denote a case where
a change in all inputs leads to a proportional
change in output. For example, if labor, land,
capital and other inputs are doubled, then under
constant returns to scale output would also
double.
Returns to Scale
 Increasing returns to scale (also
referred to as economies of scale) arise
when an increase in all inputs leads to a
more-than-proportionate increase in the
level of output. For example, an engineer
planning a small-scale chemical plant will
generally find that increasing the inputs of
labor, capital and materials by 10% will
increase the total output by more than
10%. Engineering studies have
determined that many manufacturing
processes enjoy modestly increasing
returns to scale.
Returns to Scale
 Diminishing returns to scale
occurs when a balanced increase of
all inputs leads to a less-than-
proportionate increase in total
output. Many productive activities
involving natural resources like
agriculture, mining, vineyards etc
show decreasing returns to scale.
Returns to Scale
Short Run and Long Run
 To account for the role of time in production
and costs, we distinguish between two
different time periods.
We define the short run as a period in which
firms can adjust production by changing
variable factors such as materials and labor
but cannot change fixed factors such as land
and capital.
 The long run is a period sufficiently long that
all factors including fixed factors can be
adjusted.
Production Function
 Assume that all factors or inputs of
production can be grouped into two broad
categories: labor (L) and capital (K). The
general equation for the production function
is
Q = f(K,L)
The above function defines the maximum
quantity of output that could be obtained
from a given rate of labor and capital
inputs. Output may be in physical terms or
intangible terms like in case of services.
Production Function
 Production function is a purely
engineering concept which is devoid
of economic content. However, if the
production function were to be more
meaningful it has to be integrated to
economic theory. Such integration
will give answers to many managerial
issues like least-cost capital-labor
combination or the most profitable
output rate.
Production Function
 Production implies the maximum
output rate which is related to
efficient management of resources.
Firms that do not manage resources
efficiently (as defined by the
production function) will be rendered
uncompetitive and unprofitable.
Hence, they go out of business.
Production Function
 Economists use a variety of functional forms to
describe production. The multiplicative form,
generally referred to as Cobb-Douglas
production is widely used in economics because
it has properties representative of many
production processes. It is represented by the
equation:
Q = AKα Lβ
Consider a production function with parameters
A=100, α =0.5 and β =0.5. That is
Q = AK0.5L0.5
Production Function and Returns to
Scale
 From the preceding Cobb-Douglas
production function, we may conclude on
the returns to scale with the following
chart:

Sum of exponents ( Returns to Scale

α +β )
Less than one Decreasing
Equal to one Constant
More than one Increasing
Production Function
 A production table shows the
maximum output associated with
each of a number of input
combinations. The following table
shows production rates for various
input combinations applied to the
production function.
 Production Table
8 283 400 490 565 632 693 748 800
7 265 374 458 529 592 648 700 748
6 245 346 424 490 548 600 648 693
K
5 224 316 387 447 500 548 592 632
4 200 283 346 400 447 490 529 565
3 173 245 300 346 387 424 458 490
2 141 200 245 283 316 346 374 400
1 100 141 173 200 224 245 265 283
1 2 3 4 5 6 7 8
L
Production Function
 Two important relationships emerge
from the preceding production
tables. Firstly, the table indicates
that there are a variety of ways to
produce a particular rate of output.
For example, 245 units of output
can be produced with any of the
following input combinations :
Production Function
Combination K L

a 6 1

b 3 2

c 2 3

d 1 6
Production Function
 This implies that there is
substitutability between the factors
of production. The firm can use a
capital intensive production process
characterized by combination a, a
labor intensive process such as d, or
a process that uses a resource
combination somewhere between
these extremes, such as b or c.
Production Function
 The concept of substitution is important
to us because it means that managers
can change the mix of capital and labor in
response to changes in the relative prices
of these inputs.
 Secondly, the preceding table also
suggests a relationship between the input
deployment and output generation.
Production Function
 For example, maximum production with 1
unit of capital and 4 units of labor is 200.
Doubling the input rates to K=2, L=8
results in the rate of output doubling to
Q-400.
 The relationship between output change
and proportionate changes in both inputs
is referred to as returns to scale which in
this case is constant returns to scale.
Production Function
 Although the production table provides
considerable information on production
possibilities, it does not allow for the
determination of the profit-maximizing
rate of output or even the best way to
produce some specified rate of output.
Hence, the production function needs to
be integrated with economic theory to
determine optimum allocation of
resources.
Production Function
 For a two-input production process,
the total product of labor (TPL) is
defined as the maximum rate of
output forthcoming from combining
various rates of labor input with a
fixed capital output. Denoting the
fixed capital input as K, the total
product of labor function is:
TPL = f(K,L)
Production Function
 Similarly, the total product of capital
function is:
TPK = f(K,L)
 Two other product relations may be
examined. Firstly, marginal product
(MP) is defined as the change in output
per one-unit change in the variable
input. Thereby, MP of labor is:
MPL = ∆ Q/ ∆ L
Production Function
 The MP of capital is:
MPK = ∆ Q/ ∆ K
For infinitesimal changes in the variable
output, the MP function is the first
derivative of the production function
with respect to the variable input.
Production Function
 For the general Cobb-Douglas function
Q = AKα Lβ

 The marginal products are

MPK = dQ/dK = α AKα -1
Lβ
and
MPL = dQ/dL = β AKα Lβ -1
Production Function
 Average product (AP) is total product
per unit of the variable input and is
found by dividing the rate of output by
the rate of the variable input. The
average product of labor function is
APL = TPL/L
and the average product of capital is
APK = TPK/K
Production Function
Consider a hypothetical production
function. If capital is fixed at two units,
the rates of output generated by
combining various levels of labor with two
units of capital (ie. The total product of
labor) are shown in the following table.
The average and marginal products of
labor are also shown.
The total product function can be thought
of as a cross section or vertical slice of a
three-dimension production surface as
shown in the next figure.
 Production Function
Rate of labour TPL APL MPL
input (L)
0 0 - -
1 20 20 20
2 50 25 30
3 90 30 40
4 120 30 30
5 140 28 20
6 150 25 10
7 155 22 5
8 150 19 -5
Production Function
Production Function
Diminishing Marginal Returns
 This law states that when increasing
amounts of the variable input are
combined with a fixed level of another
input, a point will be reached where the
marginal product of the variable input will
decline. This is called the law of
diminishing marginal returns. This law is
not a theoretical argument but is based
on actual observation of many production
processes.
Production Function
 Suppose the capital stock is fixed at
K1. The total product of labor function
f(K1,L) is shown as the line starting at
K1 and extending through point A.
Similarly, if the labor input is fixed at
L2, the total product of capital function
is shown as the line beginning at L2
and going through points A and C.
Relationships among the Product
Functions
 A set of typical total, average and marginal
product functions for labor is shown in the
following figure. Total product begins at the
origin, increases at a increasing rate over the
range O to G and then increases at a
decreasing rate. Beyond I, total product
actually declines.
 Explanation – Initially, the input proportions
are inefficient – there is too much of the fixed
factor, capital. As the labor input is increased
from 0 to G, output rises more than in
proportion to the increase in the labor input.
Production Function
With One Variable Input
Relationships among the Product
Functions
 That is, marginal product per unit of labor
increases as a better balance of labor and
capital inputs is achieved. As the labor input
is increased beyond G, diminishing marginal
returns set in and marginal product
declines.
 The following relationships between total,
average and marginal products are worth
noting:
1. Marginal product reaches a maximum at G’
which corresponds to an inflection point
Relationships among the Product
Functions
G on the total product function. At the
inflection point, total product changes
from increasing at an increasing rate to
increasing at a decreasing rate.
2. Marginal product intersects average
product at the maximum point on the
average product curve. This occurs at
labor input rate H’. Note that whenever
the MR curve is rising it is above the AR
curve and whenever the MR curve is
faling it is below the AR curve.
Relationships among the Product
Functions

This implies that the intersection

must happen only at the highest
value of AR.
3. Marginal product becomes
negative at the point I’ which
corresponds to the point where the
total product curve is at the
maximum.
Optimal Employment of a Factor of
Production
 The General Motors Corporation has a
worldwide physical capital stock valued at
about $70 billion. Consider this to be the fixed
input for the firm. About 760,000 workers are
employed to use this capital stock. What
principles guide the decisions about the level
of employment? In general, to maximize
profit, the firm should hire labor as long as the
additional revenue associated with hiring of
another unit of labor exceeds the cost of
employing that unit. For example, suppose
that the marginal product of an additional
worker
Optimal Employment of a Factor of
Production
 is two units of output (ie. Automobiles)
and each unit of output is worth $20,000.
Thus the additional revenue to the firm
will be $40,000 if the worker is hired. If
the additional cost of a worker (wage
rate) is $30,000, that worker will be hired
because $10,000, the difference between
additional revenue and additional cost,
will be added to profit. However, if the
wage rate is $45,000, the worker should
not be hired because profit would be
reduced by $5,000.
Optimal Use of the
Variable Input
 How much labor should the firm use to
maximize profits? The answer is that the
firm should employ an additional unit of
labor as long as the extra revenue
generated from the sale of the output
produced exceeds the extra cost of hiring
the unit of labor.
 In the following graph, it pays the firm to
hire more labor as long as the marginal
revenue product (MRPL) exceeds the
marginal resource cost of hiring labor
(MRCL) and until MRPL=MRCL. At MRCL =
$20 the firm maximizes total profit.
Optimal Use of the
Variable Input
Optimal Use of the
Variable Input
• Isoquants show combinations of two inputs that
can produce the same level of output
Properties:
1. Isoquants are downward sloping because, as
one factor is removed (and we move down one
axis), more of another factor must be added to
maintain the old level of output (moving up the
other axis).
2. They are convex to the origin, because
increasing amounts of a second factor are
required to compensate for unit decreases in
the first (MRTS)
Optimal Use of the
Variable Input

Isoquants
Optimal Use of the
Variable Input
 Firms will only use combinations of two
inputs that are in the economic region of
production, which is defined by the
portion of each isoquant that is negatively
sloped.
 Ridge lines separate the relevant
(negatively sloped) from the irrelevant
(positively sloped) portions of the
isoquants. In the following figure, ridge
lines join points on the various isoquants
where the isoquants have zero slope.
Production With Two
Variable Inputs

Economic
Region of
Production
Production With Two
Variable Inputs
 Marginal Rate of Technical
Substitution is the absolute value of
the slope of the isoquant.
 MRTS = -∆ K/∆ L = MPL/MPK

Between points N and R on the

isoquant 12Q, MRTS = 2.5.
Production With Two
Variable Inputs

MRTS = -(-2.5/1) = 2.5

Perfect Substitutes and
Complementary inputs
 The shape of an isoquant reflects the
degree to which one input can be
substituted for another in production. The
smaller the curvature of an isoquant, the
greater is the degree of substitutability of
inputs in production. On the other hand,
the greater the curvature of an isoquant,
the smaller is the degree of
substitutability.
Perfect Substitutes and
Complementary inputs
 In the following figure, when an isoquant is
a straight line (so that its absolute slope or
MRTS is constant), inputs are perfect
substitutes. In the left panel, 2L can be
substituted for 1K regardless of the point of
production on the isoquant. With the right
angled isoquants in the right panel,
efficient production can take place only
with 2K/1L. Thus, labor and capital are
perfect complements. Using only more
labor or only more capital does not
increase output (ie. MPL=MPK=0)
 Production With Two
Variable Inputs

Perfect Substitutes Perfect Complements

Optimal Combination of Inputs
The isoquant is a physical relationship that
denotes different ways to produce a given rate
of output. The next step toward determining the
optimal combination of capital and labor is to
add information on the cost of those inputs. This
cost information is introduced by a function
called a production isocost.
Isocost lines represent all combinations of two
inputs that a firm can purchase with the same
total cost.
Optimal Combination of Inputs
 Given the per unit prices of capital
(r) and labor (w), the total
expenditure (c) on capital and
labor input is
C = wL + rK

w = Wage Rate of Labor (L )

r = Cost of Capital (K )
Optimal Combination of Inputs
 For Eg., if r=3 and w = 2, the
combination of 10 units of capital and 5
units of labour will cost $40 i.e. 40 =
3(10) + 2(5). For any given cost C, the
isocost line defines all combinations of
capital and labour that can be purchased
for C.
 Solving for K as a function of L,
C w
K= − L
r r
Optimal Combination of Inputs
 Changes in the budget amount cause the
isocost line to shift in a parallel manner.
 Changes in either the price of capital or
labour cause both the slope and one
intercept of the isocost function to
change.
 Optimal Combination of Inputs

AB C = $100, w = r = $10 A’B’ C = $140, w = r = $10

A’’B’’ C = $80, w = r = $10 AB* C = $100, w = $5, r = $10
Optimal Combination of Inputs
 When both capital and labor are
variable, determining the optimal
input rates of capital and labor
requires that the technical
information from the production
function (i.e., the isoquants) be
combined with the market data on
input prices (i.e., the isocost
functions).
Optimal Combination of Inputs
 At the tangency of the isoquant and
isocost, the slopes of the two functions
are equal. Thus, the marginal rate of
technical substitution (i.e., the slope of
the isoquants) equals the price of labour
divided by the price of capital. That is,
MRTS = w/r
The above identity is a necessary
condition for efficient production.
Optimal Combination of Inputs
MRTS = w/r
Optimal Combination of Inputs
 These principles can be used to test for
efficient resource allocation in production.
The slope of the isocost is the negative of
the ratio of the wage rate and price of
capital (i.e., -w/r) and that the slope of
the isoquant is the negative of the ratio of
the marginal product of labour to that of
capital (i.e., -MPL/MPK). Further, at the
point of tangency, the slopes of both
isocost and isoquant are equal.
Optimal Combination of Inputs
 Thus,
-MPL / MPK = -w/r
MPL / MPK = w/r
Or
MPL/w = MPK/r
Optimal Combination of Inputs

Effect of a Change in Input Prices

Sources of Economies of Scale
 There are several reasons why increasing returns
to scale occur. Firstly, technologies that are cost
effective at high levels of production generally
have higher unit costs at lower levels of output.
 Secondly, increasing returns accrue due to
specialization of labor. As a firm becomes larger,
the demand for employee expertise in specific
areas grows. Instead of being generalists,
workers can concentrate on learning all the
aspects of particular segments of the production
process.
 Thirdly, increasing returns are also the result of
inventory economies. Large firms may not need
to increase inventories or replacement parts
proportionately with size.
Economies of Scope
 Firms often find that per unit costs are lower
when two or more products are produced.
Sometimes, the firm will have excess capacity
that can be used to produce other products with
little or no increase in its capital costs. For e.g.
airlines can rearrange their seating system to
convert a passenger plane into a cargo plane.
 Certain firms have taken advantage of their
unique skills or comparative advantage in
marketing to develop products that are
complementary with the firms existing products.
For e.g. Proctor and Gamble sells all kinds of
cleaning products
Discussion Questions
 1) Explain the concept of a
production function. Why is having
only qualitative information about
the production function inadequate
for making decisions about efficient
input combinations and the profit-
maximizing rate of output?
Discussion Questions
 Ans: A production function is a
relationship that shows the maximum rate
of output forthcoming from any specified
rate of input for capital and labor. The
production function provides information
only about the maximum rate of output
associated with given input rates. It says
nothing about the costs of those input
combinations or which is preferred.
Discussion Questions
 2) Explain the law of diminishing
marginal returns and provide an
example of this phenomenon.
Discussion Questions
 Ans: The law of diminishing marginal returns
states that when one input is held constant
while the other is increased, a point will be
reached where the marginal product of the
variable input will diminish. Examples of
diminishing marginal returns in higher
education might include: a) additional hours of
study each day may result in progressively
smaller increases in average grades attained;
b) increasing the number of hours of computer
time in a research project may result in
progressively smaller increases in research
output.
Discussion Questions
 3) What is the difference between
short run and the long run? What
are examples of a firm where the
short run would be quite short (eg.
A few days weeks) and where would
it be quite long (eg. Several months
or years). Explain.
Discussion Questions
 Ans: The short run is that period of time during
which the input rate of at least one factor of
production is fixed. In the long run, all factors of
production can be varied. An example of firms
where the short run would be quite “short” would
be a lawn-care business. Such a business could
very quickly increase or decrease its stock of
trucks, lawnmowers and labor. In contrast,
electrical generating plants typically require
several years to change the stock of generators.
An airline may require a number of months to
increase the stock of airplanes.
Discussion Questions
 4) What is meant by the statement
that “firms operate in the short run
and plan in the long run”. Relate
this statement to the operation of
the college or university that you
are attending.
Discussion Questions
 Ans: This statement means that at any
point in time, virtually all firms have one
input that is fixed in amount. That is, they
must make operating decisions based on
that fixed input. Hence, it is said that they
operate in the short run. However, most
firms are planning or at least considering
changes in the scale of their operations.
Because this takes some time, it is said
the firm is planning in the long run.
Discussion Questions
 5) Legislation in the USA requires
that most firms pay workers at least
a specified minimum wage per hour.
Use principles of marginal
productivity to explain how such
laws might affect the quantity of
labor employed.
Discussion Questions
 Ans: It has been shown that the profit-
maximizing firm will hire labor until the
marginal revenue product of that labor is
equal to the wage rate. In general, to the
extent that a legislated minimum wage
would increase the wage rate above the
wage rate that would have prevailed in
the absence of such legislation, less labor
will be employed.
Discussion Questions
 6) What would the isoquants look
like if all inputs were nearly perfect
substitutes in a production process?
What if there was near zero
substitutability between inputs?
Discussion Questions
 Ans: If two inputs are perfect
substitutes the isoquant is a straight
line uniform slope or MRTS.
Discussion Questions
 7) Explain why the isocost function
will shift in a parallel fashion if the
cost level changes, but the isocost
will pivot about one of the
intercepts if the price of either input
changes.
Discussion Questions
 Ans: The slope of the isocost is
determined by the ratio of the input
prices. If the cost level changes but the
input prices are constant, then the slope
does not change – the function shifts
parallel to the original function. However,
if either input price changes, the ratio of
the input prices change implying that the
slope of the isocost function will change,.
Discussion Questions
 8) Suppose wage rates at a firm are
raised 10%. Use theoretical
principles of production to show
how the relative substitution of one
input for another occurs as a result
of the increased price of labor.
Provide an example of how input
substitution has been made in
higher education.
Discussion Questions
 Ans: If wage rates increase by 10%, the slope of the
isocost function will change. The original equilibrium
point must occur at a tangency of the isoquant and
isocost functions. When the slope of the isocost
changes, the equilibrium point occurs where the
capital-labor is higher. In general, the input rate for a
factor that has increased in relative cost would fall
relative to the input rate for the other input.
 Examples of input substitution in higher education
include: a) substituting larger classrooms for
additional professors and b) the substitution of
movies and video tape lectures fotr personal
lectures.
Discussion Questions
 9) When estimating production
functions, what would be some of
the problems of measuring output
and inputs for each of the following?
 A) A multiproduct firm
 B) A construction company
 C) An entire economy
Discussion Questions
 Ans: A) For any firm, there may be a problem
providing adequate measures of the capital
and labor inputs. For example, both inputs
come in varying kinds and qualities, and it is
difficult to reduce these to a common unit.
Labor comes in the form of different kinds of
skills (ie. Carpenters, bricklayers, etc) and
within those skills, the productivity of labor
may vary significantly from person to person.
The same problem applies to capital inputs.
How does one adequately compare one hour
of time on a drill press to an hour of time on a
lathe?
Discussion Questions
 B) Coming up with an aggregate measure of output
also is difficult in some firms. For example, a
multiproduct firm often produces a variety of
disparate products. It may be difficult to reduce
these outputs to a common unit. The same
problems apply in a construction company where a
variety of different labor skills and capital equipment
are used to build houses and other structures.

 C) For the economy as a whole, the basic problem is

one of having to combine very disparate types of
capital, labor and output into aggregate measures of
these three variables.
Discussion Questions
 10) The following table shows the relation
ship between hours of study and final
examination grades in each of three
classes for a particular student, who has a
total of 15 hours to prepare for these
tests. If the objective is to maximize the
average grade in the three classes, how
many hours should this student allocate
to preparation for each of these classes?
Explain your approach to this problem
 Discussion Questions
Manage History Chemist
rial ry
Econom
ics
Hours Grade Hours Grade Hours Grade
 Discussion Questions

Managerial History Chemistry

Economics
Hours Grade Hours Grade Hours Grade
0 40 0. 50 0. 30
1. 50 1. 60 1. 50
2. 59 2. 69 2. 60
3. 67 3. 77 3. 66
4. 74 4. 84 4. 71
5. 79 5. 90 5. 74
6. 83 6. 95 6. 76
7. 86 7. 96 7. 77
8. 88 8. 97 8. 77
9. 89 9. 97 9. 77
10. 89 10. 97 10. 77