Production Analysis and Compensation Policy: Questions & Answers Q8.1

Chapter 8
PRODUCTION ANALYSIS AND COMPENSATION POLICY
QUESTIONS & ANSWERS

Q8.1
Q8.1
Is use of least-cost input combinations a necessary condition for profit maximization?

Is it a sufficient condition? Explain.
ANSWER
Employment of least-cost input combinations is a necessary but not sufficient
condition for profit maximization. It is necessary because a failure to operate with a
least-cost input combination means that costs could be lowered and profits increased
at any given output level. It is not a sufficient condition because the cost-minimizing
level does not incorporate any information concerning demand relations, and
therefore provides no information about the optimal level at which to operate: that is,
information concerning demand relations must be added to the analysis to determine
how much to produce for profit maximization (an optimal level of output).
In short, employment of a least-cost input combination will result in an optimal
production of a target level of output. Conversely, employment of inputs such that
MRPi = Pi for each input will result in an optimal production of an optimal level of
output.
Q8.2
AOutput per worker is expected to increase by 10% during the next year. Therefore,
wages can also increase by 10% with no harmful effects on employment, output
prices, or employer profits.@ Discuss this statement.
Q8.2
ANSWER
This statement is correct so long as the projected increase in output per worker is
solely due to an improvement in labor productivity and provided that the demand for
output is also expected to rise. Gains in labor productivity are sometimes derived
from an improvement in worker skill due to education or experience, elimination of
obsolete work rules, labor-saving technical change, and so on. When increases in
output per worker can be directly attributed to such gains in labor productivity, a
commensurate increase in wages can be justified with no resulting increase in output
prices or decrease in employer profits. So long as output demand is growing as fast
as the gain in labor productivity, no reduction in employment opportunities will
result. However, should output demand be stagnant, an increase in labor
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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productivity could reduce employment opportunities by reducing the number of

workers required to produce a given level of output.
It is important to recognize that increases in output per worker are sometimes
made possible by increased capital investment per worker, improvements in supplier
efficiency, and so on. In such instances, increases in output per worker are not
directly attributable to gains in labor productivity, and do not imply that a higher
wage rate could be justified.
Q8.3
Commission-based and piece-rate-based compensation plans are commonly

employed by businesses. Use the concepts developed in the chapter to explain these
phenomena.
Q8.3
ANSWER
Commission-based and piece rate-based compensation plans ensure that the relevant
labor cost per unit of output is the same for all units produced (or sold). More
productive employees earn greater total compensation, although less productive
employees earn the same compensation per unit of output. Using output-oriented
labor compensation schemes, employers ensure that the MPL/PL ratio is equal for all
employees and that optimal labor input proportions are employed.
Q8.4
AHourly wage rates are an anachronism. Efficiency requires incentive-based pay

tied to performance.@ Discuss this statement.
Q8.4
ANSWER
Given that many successful firms use hourly wage rates, it seems rash to dismiss
them as an inefficient method for employee compensation. When hourly wages are
paid, employees are expected to provide a standard level of effort per hour. Because
reprimand or dismissal for substandard performance, or Agoldbricking,@ is always
possible, even hourly employees have strong incentives to provide a satisfactory
level of performance. In addition, Abeing there@ is often an important component of
an employee's service to customers. Thus, hourly input is often synonymous with the
hourly output of service.
Q8.5
Explain why the MP/P relation is deficient as the sole mechanism for determining
the optimal level of resource employment.
Q8.5
ANSWER
The equality of the MP/P ratio across input factors in a production system is
necessary to insure a least-cost input combination for production of any level of
output. Satisfying this requirement does not, however, insure that the optimal
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Production Analysis and Compensation Policy

activity level has been selected because it does not reflect the demand for output. An
equality of MP/P ratios can be found at activity levels both above and below that
activity (output) level at which profits are maximized.
Q8.6
Develop the appropriate relations for determining the optimal quantities of all inputs
to employ in a production system, and explain the underlying rationale.
Q8.6
ANSWER
The necessary and sufficient condition for optimal resource employment is that each
input must be used at a level such that its price equals its marginal revenue product
(PX = MRPX). This relation is derived from the simple notion that marginal costs and
marginal revenues for each input must be equal for profit maximization.
Symbolically:
Marginal cost of
Marginal revenue of
last input unit

last input unit
TC TR
=
X
X
TR Q
x
PX =
Q X
= MR Q x MP X
Q8.7
= MRP X
Suppose that labor, capital, and energy inputs must be combined in fixed proportions.
Does this mean that returns to scale will be constant?
Q8.7
ANSWER
No, the fact that labor, capital, and energy inputs must be combined in fixed
proportions does not imply that returns to scale will be constant. In such a situation,
returns to scale could just as easily be increasing or diminishing. To judge the nature
of returns to scale, we must consider the relation between the increase in output
caused by a proportionate increase in all inputs. If output increases faster (slower)
than all inputs, returns to scale are increasing (decreasing). Returns to scale are
constant when a given increase in all inputs leads to a proportionate increase in
output.
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Chapter 8
Q8.8
What is meant by the Apace@ of economic productivity growth, and why is it

important to economic welfare?
Q8.8
ANSWER
The pace of productivity growth is the rate of increase in output per unit of input.
For example, if the amount of output produced in the economy were to grow by 5%
following only a 2% increase in the quantity of inputs employed, then the overall
rate of productivity growth would be roughly 3%. When productivity growth is
robust in the overall economy, economic welfare per capita rises quickly. When
productivity growth is sluggish, economic welfare improves slowly. If productivity
growth is robust for individual companies, or within specific industry groups,
superior efficiency is suggested and exceptional profitability often ensues. Thus, the
rate of productivity growth is important both for managers and investors in
individual companies, and for decision makers in the public sector.
Q8.9
Cite some potential ways for increasing productivity growth in the United States.
Q8.9
ANSWER
During the late-1990s, annual rises in productivity in nonfarm businesses have

averaged 3.1%, a big jump from the 1.4% annual rate common during the early1990s. This burst in productivity growth is similar in timing and magnitude in many
advanced industrial economies. As a result, it cannot be explained by purely
domestic factors.
Many economists point to a business cycle effect as partial explanation for the
recent burst in productivity growth. During economic booms, such as that
experienced during the late-1990s, productivity jumps. However, economists argue
such business cycle effects contribute only 0.04 percent to the recent boost in
productivity.
Faster growth of inputs, both physical and human capital, is a major cause of
faster productivity growth. In the U.S., the capital-labor ratio has grown faster since
the early-1990s, but not enough to account for all of the increase in productivity
growth. The percentage point contribution from greater capital services (capital
deepening) may be as much as 0.38 percent. The rate of increase of human capital,
as measured by the average education level and experience of workers, has
accelerated since the 1950s and 1960s. Human capital growth is now responsible for
roughly one-quarter of total productivity growth during the past 30 years, but
relatively flat over the past decade. Thus, although policies to increase investment,
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education, and training, are important, they do not explain the underlying causes of
the recent boost in productivity.
From an accounting perspective, a significant share of the recent boost in
productivity growth is attributable to the more effective use of worker skills made
possible through recent improvements in communications technology. Increasingly,
companies have been eager to buy powerful computers and computer software at
relatively low prices. Rapid advances in computer hardware and software
technology, combined with the widespread adoption of the Internet, have led to an
unprecedented boom in communications technology. Benefits from the recent boom
in communications technology are evident in every home and workplace, and are
broadly reflected in the late-1990s burst in productivity growth.
Q8.10
Explain why company productivity is important to managers, employees, and

investors. Is superior worker productivity a necessary and sufficient condition for
above-average compensation?
Q8.10
ANSWER
For managers and other employees, profits and revenues per employee give helpful
insight concerning the income potential from employment. When profits and
revenues per employee are high, the potential for high wages and growing incomes
for exceptional employees can be significant. On the other hand, companies in
industries that seldom generate an attractive rate of return rarely have the
wherewithal to pay attractive and growing salaries. For example, Microsoft is well
known for generous compensation policies that have allowed many Microsoft
employees to earn stock-based rewards in excess of one million dollars each. At the
same time, total compensation tends to be low for employees of regulated utilities
and in other low-profit industries. Similarly, for investors, profits and revenues per
employee give valuable insight on the investment potential of various companies and
industries. For example, financial services like stock brokerage and specialized
insurance are marvelous businesses that hold out the potential for exceptional rates of
return for investors. Conversely, garbage collection (environmental and waste) is a
tough business where it is extraordinarily difficult to make above-average rates of
return.
Finally, it is worth remembering that superior worker productivity is only a
necessary and not sufficient condition for above-average compensation. When
profits and revenues per employee are high, the potential for high wages and growing
incomes for exceptional employees can be significant. However, wages and
employee compensation reflect the relative productivity of the marginal employee.
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Chapter 8
Only superior employees with hard-to-duplicate contributions can expect to earn

above-average compensation.
SELF-TEST PROBLEMS & SOLUTIONS
ST8.1
Optimal Input Usage. Medical Testing Labs, Inc., provides routine testing services
for blood banks in the Los Angeles area. Tests are supervised by skilled technicians
using equipment produced by two leading competitors in the medical equipment
industry. Records for the current year show an average of 27 tests per hour being
performed on the Testlogic-1 and 48 tests per hour on a new machine, the Accutest-3.
The Testlogic-1 is leased for $18,000 per month, and the Accutest-3 is leased at
$32,000 per month. On average, each machine is operated 25 eight-hour days per
month.
A.
Describe the logic of the rule used to determine an optimal mix of input usage.
B.
Does Medical Testing Lab usage reflect an optimal mix of testing equipment?
C.
Describe the logic of the rule used to determine an optimal level of input usage.
D.
If tests are conducted at a price of $6 each while labor and all other costs are
fixed, should the company lease more machines?
ST8.1
SOLUTION
A.
The rule for an optimal combination of Testlogic-1 (T) and Accutest-3 (A)
equipment is
MP T = MP A
PT
PA
This rule means that an identical amount of additional output would be produced
with an additional dollar expenditure on each input. Alternatively, an equal marginal
cost of output is incurred irrespective of which input is used to expand output. Of
course, marginal products and equipment prices must both reflect the same relevant
time frame, either hours or months.
B.
On a per hour basis, the relevant question is
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27
$18, 000 /(25 x 8)
=?
0.3 = _
48
$32, 000 /(25 x 8)
0.3
On a per month basis, the relevant question is

27 x (25 x 8)
$18, 000
=?
48 x (25 x 8)
$32, 000
0.3
=_
0.3
In both instances, the last dollar spent on each machine increased output by the same
0.3 units, indicating an optimal mix of testing machines.
C.
The rule for optimal input employment is

MRP = MP MRQ = Input Price
This means that the level of input employment is optimal when the marginal
sales revenue derived from added input usage is equal to input price, or the
marginal cost of employment.
D.
For each machine hour, the relevant question is

Testlogic-1
MRPT = MPT MRQ
=?
PT
27 $6
=?
$18,000/(25 8)
$162 > $90.

Accutest-3
MRPA = MPA MRQ
=?
PA
48 $6
=?
$32,000/(25 8)
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Chapter 8
$288 > $160.

Or, in per month terms:
Testlogic-1
MRPT = MPT MRQ
=?
PT
27 (25 8) $6
=?
$18,000
$32,400 > $18,000.

Accutest-3
MRPA = MPA MRQ
=?
PA
48 (25 8) $6
=?
$32,000
$57,600 > $32,000.

In both cases, each machine returns more than its marginal cost (price) of
employment, and expansion would be profitable.
ST8.2
Production Function Estimation. Washington-Pacific, Inc., manufactures and sells

lumber, plywood, veneer, particle board, medium-density fiberboard, and laminated
beams. The company has estimated the following multiplicative production function
for basic lumber products in the Pacific Northwest market using monthly production
data over the past two and one-half years (30 observations):
Q = b 0 L b1K b 2 E b3
where
Q = output
L = labor input in worker hours
K = capital input in machine hours
E = energy input in BTUs
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Each of the parameters of this model was estimated by regression analysis using
monthly data over a recent three-year period. Coefficient estimation results were as
follows:
b0 = 0.9; b1 = 0.4; b 2 = 0.4; and b 3 = 0.2
The standard error estimates for each coefficient are:

b0 = 0.6; b1 = 0.1; b 2 = 0.2; b3 = 0.1
A.
Estimate the effect on output of a 1% decline in worker hours (holding K and E

constant).
B.
Estimate the effect on output of a 5% reduction in machine hours availability

accompanied by a 5% decline in energy input (holding L constant).
C.
Estimate the returns to scale for this production system.
ST8.2
SOLUTION
A.
For Cobb-Douglas production functions, calculations of the elasticity of output with

respect to individual inputs can be made by simply referring to the exponents of the
production relation. Here a 1% decline in L, holding all else equal, will lead to a
0.4% decline in output. Notice that:
Q/Q Q L
=
x
L/L L Q
=
(b 0b1L b1 - 1K b 2 E b3) x L
Q
-1 +1
b 0 b1L b1 K b 2 E b3
b 0 L b1K b 2 E b3
= b1
And because (Q/Q)/(L/L) is the percent change in Q due to a 1% change in L,
=
Q/Q
L/L
= b1
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Chapter 8
Q/Q = b1 L/L
= 0.4(-0.01)
= -0.004 or -0.4%
B.
From part A it is obvious that:

Q/Q
= b2(K/K) + b3(E/E)
= 0.4(-0.05) + 0.2(-0.05)
= -0.03 or -3%
C.
In the case of Cobb-Douglas production functions, returns to scale are determined by

simply summing exponents because:
Q = b 0 L b1K b 2 E b3
hQ = b 0(kL ) b1(kK ) b 2(kE ) b3

= k b1 + b 2 + b3b 0 L b1K b 2 E b3
= k b1 + b 2 + b3 Q
Here b1 + b2 + b3 = 0.4 + 0.4 + 0.2 = 1 indicating constant returns to scale. This
means that a 1% increase in all inputs will lead to a 1% increase in output, and
average costs will remain constant as output increases.
PROBLEMS & SOLUTIONS
P8.1
Marginal Rate of Technical Substitution. The following production table provides

estimates of the maximum amounts of output possible with different combinations of
two input factors, X and Y. (Assume that these are just illustrative points on a
spectrum of continuous input combinations.)
Units of
Y Used
Estimated Output per Day
210
305
360
421
470
188
272
324
376
421
162
234
282
324
360
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2
130
188
234
272
305
94
130
162
188
210
Units of X used
A.
Do the two inputs exhibit the characteristics of constant, increasing, or

decreasing marginal rates of technical substitution? How do you know?
B.
Assuming that output sells for $3 per unit, complete the following tables:
X Fixed at 2 Units
Units of
Y Used
Total
Product
of Y
Marginal
Product
of Y
Average
Product
of Y
Marginal
Revenue
Product
of Y
1
2
3
4
5
Y Fixed at 3 Units
Units of
X Used
Total
Product
of X
Marginal
Product
of X
Average
Product
of X
Marginal
Revenue
Product
of X
1
2
3
4
5
C.
Assume that the quantity of X is fixed at 2 units. If output sells for $3 and the
cost of Y is $120 per day, how many units of Y will be employed?
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Chapter 8
D.
Assume that the company is currently producing 162 units of output per day
using 1 unit of X and 3 units of Y. The daily cost per unit of X is $120 and that
of Y is also $120. Would you recommend a change in the present input
combination? Why or why not?
E.
What is the nature of the returns to scale for this production system if the
optimal input combination requires that X = Y?
P8.1
SOLUTION
A.
The inputs exhibit the characteristic of a decreasing marginal rate of technical

substitution throughout. For decreasing MRTS, the slope of the production isoquants
diminishes as one input is increasingly substituted for another. We can also see this
point algebraically by holding X or Y constant in the input-output matrix and noting
the decline in the relative marginal product of the other input as its usage level grows.
B.
X Fixed at 2 Units
Units of
Y Employed
TPY
(1)
MPY
(2)
APY
(3)
MRPY
(4) = $3 (2)
130
130
130
$390
188
58
94
174
234
46
78
138
272
38
68
114
305
33
61
99
Y Fixed at 3 Units
Units of
X Employed
TPX
(1)
MPX
(2)
APX
(3)
MRPX
(4) = $3 (2)
162
162
162
$486
234
72
117
216
282
48
94
144
324
42
81
126
360
36
72
108
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C.
Y = 3 will be employed. The marginal value of the first three units of Y is greater
than their marginal cost. The marginal value of the fourth unit is only $114 or $6
less than its cost, and hence, the firm would employ no more than 3 units of Y.
D.
A change would be in order because the firm could produce 188 units at the same
cost using 2 units of each output: that is, the marginal product to price ratios of the
two inputs are not equal at the current input proportions. Relatively less Y, and more
X, is needed to provide an optimal combination.
E.
The system exhibits constant returns to scale. This is true because a given increase
in both inputs causes an increase in output of the same proportion.
P8.2
Output
94 1 = 94
94 2 = 188
94 3 = 282
94 4 = 376
94 5 = 470
Production Function Concepts. Indicate whether each of the following statements is

true or false. Explain your answers.
A.
Decreasing returns to scale and increasing average costs are indicated when
Q < 1.
B.
If the marginal product of capital falls as capital usage grows, the returns to
capital are decreasing.
C.
L-shaped isoquants describe production systems in which inputs are perfect

substitutes.
D.
Marginal revenue product measures the profit earned through expanding input
usage.
E.
The marginal rate of technical substitution will be affected by a given

percentage increase in the marginal productivity of all inputs.
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Chapter 8
P8.2
SOLUTION
A.
True. When Q < 1, the percentage change in output is less than a given percentage
change in all inputs. Thus, decreasing returns to scale and increasing average costs
are indicated.
B.
True. Returns to the capital input factor are decreasing when the marginal product of
capital falls as capital usage grows.
C.
False. L-shaped production isoquants reflect a perfect complementary relation

among inputs.
D.
False. Marginal revenue product is the revenue generated by expanding input usage
and represents the maximum that could be paid to expand usage. Because MRP is
calculated before input costs (wages in the case of labor, for example), it does not
measure the increase in profit earned through expansion.
E.
False. The marginal rate of technical substitution is measured by the relative

marginal productivity of input factors.
This relation is unaffected by a
commensurate increase in the marginal productivity of all inputs.
P8.3
Compensation Policy. APay for performance@ means that employee compensation

closely reflects the amount of value derived from each employee=s effort. In
economic terms, the value derived from employee effort is measured by net marginal
revenue product. It is the amount of profit generated by the employee, before
accounting for employment costs. Holding all else equal, indicate whether each of
the following factors would be responsible for increasing or decreasing the amount
of money available for employee merit-based pay.
A.
Government mandates for employer-provided health insurance
B.
Rising productivity due to better worker training
C.
Rising employer sales due to falling imports
D.
Falling prices for industry output
E.
Rising prevalence of uniform employee stock options.
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P8.3
SOLUTION
A.
Decreasing. Government mandates for employer-provided health insurance increase

the costs of employment with no offsetting benefit in terms of increasing worker
productivity and thereby decrease the funds available for merit-based pay.
B.
Increasing. Rising productivity due to better worker training increases the profits
gained through expanding employment and increases the pool of funds available for
merit-based pay.
C.
Increasing. As imports fall, domestic output and employer sales revenue rise,
holding all else equal. Thus, output demand and MRQ would rise and increase the
pool of available funds for merit-based pay.
D.
Decreasing. As output prices fall, so too does MRQ and the MRP of workers. This
reduces the pool of funds available for merit-based pay.
E.
Decreasing. A rising prevalence of uniform employee stock options increases the

costs of employment with no offsetting gain in worker productivity. This reduces the
pool of funds available for merit-based pay.
P8.4
Returns to Scale. Determine whether the following production functions exhibit

constant, increasing, or decreasing returns to scale.
A.
Q = 0.5X + 2Y + 40Z
B.
Q = 3L + 10K + 500
C.
Q = 4A + 6B + 8AB
D.
Q = 7L2 + 5LK + 2K2
E.
Q = 10L0.5K0.3
P8.4
SOLUTION
A.
Initially, let X = Y = Z = 100, so output is:

Q = 0.5(100) + 2(100) + 40(100) = 4,250
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Chapter 8
Increasing all inputs by an arbitrary percentage, say 2%, leads to:

Q = 0.5(102) + 2(102) + 40(102) = 4,335
Because a 2% increase in all inputs results in a 2% increase in output (Q2/Q1 =
4,335/4,250 = 1.02), the output elasticity is 1 and the production system exhibits
constant returns to scale.
B.
Initially, let L = K = 100, so output is:

Q = 3(100) + 10(100) + 500 = 1,800
Increasing both inputs by an arbitrary percentage, say 3%, leads to:
Q = 3(103) + 10(103) + 500 = 1,839
Because a 3% increase in both inputs results in a 2.2% increase in output (Q2/Q1 =
1,839/1,800 = 1.022), the output elasticity is less than 1 and the production system
exhibits diminishing returns to scale.
C.
Initially, let A = B = 100, so output is:

Q = 4(100) + 6(100) + 8(100)(100) = 81,000
Increasing both inputs by an arbitrary percentage, say, 1%, leads to:
Q = 4(101) + 6(101) + 8(101)(101) = 82,618
Because a 1% increase in both inputs results in a 2% increase in output (Q2/Q1 =
82,618/81,000 = 1.02), the output elasticity is greater than 1 and the production
system exhibits increasing returns to scale.
D.

Q = 7(1002) + 5(100)(100) + 2(1002) = 140,000
Q = 7(1022) + 5(102)(102) + 2(1022) = 145,656
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Because a 2% increase in both inputs results in a 4% increase in output (Q2/Q1 =

145,656/140,000 = 1.04), the output elasticity is greater than 1 and the production
system exhibits increasing returns to scale.
E.

Q = 10(1000.5)(1000.3) = 398
Q = 10(1040.5)(1040.3) = 411
Because a 4% increase in both inputs results in a 3.3% increase in output (Q2/Q1 =
411/398 = 1.033), the output elasticity is less than 1 and the production system
exhibits decreasing returns to scale.
P8.5
Optimal Compensation Policy. Caf-Nervosa.com, based in Seattle, Washington, is

a rapidly growing family business that offers a line of distinctive coffee products to
local and regional coffee shops. Founder and president Frasier Crane is reviewing
the company's sales force compensation plan. Currently, the company pays its three
experienced sales staff members a salary based on years of service, past
contributions to the company, and so on. Niles Crane, a new sales trainee and
brother of Fraiser Crane, is paid a more modest salary. Monthly sales and salary
data for each employee are as follows:
Sales Staff
Average Monthly
Sales
Monthly
Salary
Roz Doyle
$160,000
$6,000
Daphne Moon
100,000
4,500
Martin Crane
90,000
3,600
Niles Crane
75,000
2,500
Niles Crane has shown great promise during the past year, and Fraiser Crane
believes that a substantial raise is clearly justified. At the same time, some
adjustment to the compensation paid to other sales personnel also seems appropriate.
Fraiser Crane is considering changing from the current compensation plan to one
based on a 5% commission. He sees such a plan as being fairer to the parties
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Chapter 8
involved and believes it would also provide strong incentives for needed market
expansion.
P8.5
A.
Calculate Caf-Nervosa.com's salary expense for each employee expressed as

a percentage of the monthly sales generated by that individual.
B.
Calculate monthly income for each employee under a 5% of monthly sales

commission-based system.
C.
Will a commission-based plan result in efficient relative salaries, efficient

salary levels, or both?
SOLUTION
A.
Average
Monthly Sales
(2)
Monthly
Salary
(3)
Commission
(4) = (3)/(2)
Roz Doyle
$160,000
$6,000
3.75%
Daphne Moon
100,000
4,500
4.50%
Martin Crane
90,000
3,600
4.00%
Niles Crane
75,000
2,500
3.33%
Sales Staff
(1)
B.
Average
Sales Staff
(1)
Monthly
Sales
(2)
Commission
(3) = (2) 0.05
Roz Doyle
$160,000
$8,000
Daphne Moon
100,000
5,000
Martin Crane
90,000
4,500
Niles Crane
75,000
3,750
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C.
The commission-based compensation plan will result in more efficient relative

salaries for sales personnel. Under this plan, Caf-Nervosa.com sales compensation
costs average 5%, irrespective of which member of the sales staff generates a given
dollar of sales. Each employee is treated equally under this plan in the sense that all
are paid the same rate for generating business.
Although a commission-based plan will result in an efficient relative salary
structure, a 5% commission may or may not result in an optimal level of
compensation being paid to each employee. If 5% of sales represents the net
marginal revenue (marginal revenue minus all costs except sales expenses) generated
by the sales staff, then optimal levels of compensation would be generated under
such a commission-based plan. However, if net marginal revenues are different than
this rate, some adjustment to the commission rate would be appropriate.
P8.6
Optimal Input Mix. The First National Bank received 3,000 inquiries following the
latest advertisement describing its 30-month IRA accounts in the Boston World, a
local newspaper. The most recent ad in a similar advertising campaign in
Massachusetts Business, a regional business magazine, generated 1,000 inquiries.
Each newspaper ad costs $500, whereas each magazine ad costs $125.
A.
Assuming that additional ads would generate similar response rates, is the
bank running an optimal mix of newspaper and magazine ads? Why or why
not?
B.
Holding all else equal, how many inquiries must a newspaper ad attract for the
current advertising mix to be optimal?
P8.6
SOLUTION
A.
No. The rule for an optimal combination of newspaper (N) and magazine (M) ads is:
MP N = MP M
PN
PM
Here, the question is

3, 000
$500
=?
1, 000
$125
- 213 -
Chapter 8
In other words, the last dollar spent on newspaper ads attracted six inquiries, while
the last dollar spent on magazine ads attracted eight inquiries. Therefore, the current
ad combination is not optimal. More magazine ads and/or fewer newspaper ads
should be run.
B.
Currently, magazine ads return 33% (eight versus six) more inquiries per advertising
dollar than do newspaper ads. Therefore, in order for the current ad mix to be
optimal, inquiries generated by newspaper ads would have to increase by 33% from
3,000 to 4,000. To check:
MP N = MP M
PN
PM
4, 000
$500
=?
8 =_
P8.7
1, 000
$125
8
Optimal Input Level. The Route 66 Truck Stop, Inc., sells gasoline to both selfservice and full-service customers. Those who pump their own gas benefit from the
lower self-service price of $1.80 per gallon. Full-service customers enjoy the service
of an attendant, but they pay a higher price of $1.90 per gallon. The company has
observed the following relation between the number of attendants employed per day
and full-service output:
Route 66 Truck Stop, Inc.
A.
Number of
Attendants per day
Full-Service Output
(gallons)
2,000
3,800
5,400
6,800
8,000
Construct a table showing the net marginal revenue product derived from
attendant employment.
- 214 -
B.
How many attendants would Route 66 employ at a daily wage rate of $160
(including wages and benefits)?
C.
What is the highest daily wage rate Route 66 would pay to hire four attendants
per day?
P8.7
SOLUTION
A.
Because Route 66 operates in a perfectly competitive industry, the 104 price

premium for full-service versus self-service gasoline is stable. Thus, the net
marginal revenue product of attendant labor (sometimes referred to as the value of
marginal product) is:
Route 66 Truck Stop, Inc.

Number of
Attendants
per Day
(1)
Full Service
Output
(gallons)
(2)
Marginal
Product
of Labor
(3)
Net Marginal
Revenue
Product of Labor
(4) = (3) 104
--
--
2,000
2,000
$200
3,800
1,800
180
5,400
1,600
160
6,800
1,400
140
8,000
1,200
120
B.
From the table above, it becomes clear that employment of three attendants could be
justified at a daily wage cost of $160 because MRPA=3 = $160. Employment of a
fourth attendant could not be justified because MRPA=4 = $140 < $160.
C.
From the table above, the marginal revenue product of a fourth attendant MRPA=4 =
$140. Thus, $140 is the highest daily wage cost Route 66 would be willing to pay to
hire a staff of four attendants.
P8.8
Optimal Input Level. Ticket Services, Inc., offers ticket promotion and handling
services for concerts and sporting events. The Sherman Oaks, California, branch
office makes heavy use of spot radio advertising on WHAM-AM, with each 30-second
- 215 -
Chapter 8
ad costing $100. During the past year, the following relation between advertising
and ticket sales per event has been observed:
Sales (units) = 5,000 + 100A - 0.5A2
Sales (units)/Advertising = 100 - A
Here, A represents a 30-second radio spot ad, and sales are measured in numbers of
tickets.
Rachel Green, manager for the Sherman Oaks office, has been asked to
recommend an appropriate level of advertising. In thinking about this problem,
Green noted its resemblance to the optimal resource employment problem studied in
a managerial economics course. The advertising/sales relation could be thought of
as a production function, with advertising as an input and sales as the output. The
problem is to determine the profit-maximizing level of employment for the input,
advertising, in this Aproduction@ system. Green recognized that a measure of output
value was needed to solve the problem. After reflection, Green determined that the
value of output is $2 per ticket, the net marginal revenue earned by Ticket Services
(price minus all marginal costs except advertising).
A.
Continuing with Green's production analogy, what is the marginal product of

advertising?
B.
What is the rule for determining the optimal amount of a resource to employ in
a production system? Explain the logic underlying this rule.
C.
Using the rule for optimal resource employment, determine the profitmaximizing number of radio ads.
P8.8
SOLUTION
A.
The marginal product of advertising is given by the expression:

MPA = S/A
= $100 - A
B.
The rule for determining the optimal amount of a resource to employ is:
MRPA = PA
- 216 -
The logic of this rule can be best understood by simply dissecting the above relations:
MRPA = PA
MPA MRQ = PA
Q TR
x
A Q
TC
A
TR
A
TC
A
TR = TC
Inflow = Outflow
C.
The optimal advertising level is found where:

MRPA = PA
MPA MRQ = PA
(100 - A) $2 = $100
200 - 2A = 100
-2A = -100
A = 50
P8.9
Net Marginal Revenue. Will Truman & Associates, LLC is a successful Manhattanbased law firm. Worker productivity at the firm is measured in billable hours, which
vary between partners and associates.
Partner time is billed to clients at a rate of $250 per hour, whereas associate
time is billed at a rate of $125 per hour. On average, each partner generates 25
billable hours per 40-hour workweek, with 15 hours spent on promotion,
administrative, and supervisory responsibilities. Associates generate an average of
35 billable hours per 40-hour workweek and spend 5 hours per week in
administrative and training meetings. Variable overhead costs average 50% of
- 217 -
Chapter 8
revenues generated by partners and, given supervisory requirements, 60% of
revenues generated by associates.
A.
Calculate the annual (50 workweek) net marginal revenue product of partners
and associates.
B.
If partners earn $175,000 and associates earn $70,000 per year, does the
company have an optimal combination of partners and associates? If not, why
not? Make your answer explicit and support any recommendations for change.
P8.9
SOLUTION
A.
The annual marginal revenue product calculation for partners (P) and associates (A)
identifies the amount of net revenue generated per employee.
MRPP = MPP MRQ
= (Billable hours per year) (Net marginal revenue per hour)
= (25 50) ($250 0.5)
= $156,250
MRPA = MPA MRQ
= (Billable hours per year) (Net marginal revenue per hour)
= (35 50) ($125 0.4)
= $87,500
Here it is important to note that each marginal hour of effort by partners brings to the
firm $250 in revenue plus $125 of variable costs, for a net marginal revenue (value)
for partner output of $125 per hour. Similarly, the net marginal revenue of associate
output is $50 per hour. Both net marginal revenue figures reflect the marginal value
of each service output.
B.
A comparison of marginal revenue product figures with salary data suggests:

MRPP = $156,250 < $175,000 = PP
- 218 -
MRPA = $87,500 > $70,000 = PA

Therefore, partners bring in $18,750 per year less in net marginal revenues than their
salary, whereas associates bring in a surplus of $17,500. At the margin, therefore, a
$175,000 salary for each partner represents a marginal loss of $18,750 to the firm,
whereas a $70,000 salary for associates represents a marginal profit of $17,500.
Holding all else equal, the firm would seek to marginally reduce the number of
partners. Alternatively, some small increase in the number of associates would be
warranted. Either move would help shift the firm to a position where MRPL = PL,
and profits would be maximized.
As a first step, the firm might expand the number of associates until such a
point as MRPA = $70,000 = PA. Then, a reevaluation of MRPP should be made to see
if it has increased, as seems likely. If the new MRPP = $175,000 = P, no further
change in staffing would be necessary. On the other hand, some adjustment
(reduction) in the number of partners may be required.
P8.10
Production Function Estimation. Consider the following Cobb-Douglas production

function for bus service in a typical metropolitan area:
Q = b 0 L b1k b 2 F b3,
where
Q = output in millions of passenger miles,
L = labor input in worker hours,
K = capital input in bus transit hours, and
F = fuel input in gallons.
Each of the parameters of this model was estimated by regression analysis using
monthly data over a recent three-year period. Results obtained were as follows:
b0 = 1.2; b1 = 0.28; b 2 = 0.63; and b 3 = 0.12

The standard error estimates for each coefficient are:
b0 = 0.4; b1 = 0.15; b 2 = 0.12; b3 = 0.07

- 219 -
Chapter 8
A.
Estimate the effect on output of a 4% decline in worker hours (holding K and F

constant).
B.
Estimate the effect on output of a 3% reduction in fuel availability

accompanied by a 4% decline in bus transit hours (holding L constant).
C.
Estimate the returns to scale for this production system.
P8.10
SOLUTION
A.
For Cobb-Douglas production functions, calculations of the elasticity of output with

respect to individual inputs can be made by simply referring to the exponents of the
production relation. Here a 4% decline in L, holding all else equal, will lead to a
1.12% decline in output because:
Q/Q Q L
=
x
L/L L Q
(b 0 b1L b1 - 1k b 2 Fb3) x L
Q
-1 +1
b 0 b1L b1 k b 2 Fb3
b 0 L b1K b 2 Fb3
= b1
Because (Q/Q)/(L/L) is the percent change in Q due to a 1% change in L,
=
Q/Q
L/L
= b1
Q/Q = b1 L/L
= 0.28(-0.04)
= -0.0112 or -1.12%
B.
From part A it is obvious that:

Q/Q = b2(K/K) + b3(F/F)
- 220 -

= 0.63(-0.04) + 0.12(-0.03)
= -0.0288 or -2.88%
C.
In the case of Cobb-Douglas production functions, returns to scale are determined by

simply summing exponents because:
Q = b 0 L b1K b 2 Fb3
hQ = b 0(kL ) b1(kK ) b 2(kF ) b3
= k b1 + b 2 + b3b 0 L b1K b 2 Fb3
= k b1 + b 2 + b3 Q
Here b1 + b2 + b3 = 0.28 + 0.63 + 0.12 = 1.03 > 1.0 indicating slight increasing
returns to scale. This means that a 1% increase in all inputs will lead to a 1.03%
increase in output, and average costs will fall slightly as output increases.
APPENDIX 8A: A CONSTRAINED OPTIMIZATION
APPROACH TO DEVELOPING THE OPTIMAL INPUT
COMBINATION RELATIONSHIPS
PROBLEM & SOLUTION

8A.1
Assume that a firm produces its product in a system described in the following
production function and price data:
Q = 3X + 5Y + XY
PX = $3
PY = $6
Here, X and Y are two variable input factors employed in the production of Q.
A.
What are the optimal input proportions for X and Y in this production system?
Is this combination rate constant regardless of the output level?
B.
It is possible to express the cost function associated with the use of X and Y in
the production of Q as Cost = PXX + PYY or Cost = $3X + $6Y. Use the
Lagrangian technique to determine the maximum output that the firm can
produce operating under a $1,000 budget constraint for X and Y. Show that
- 221 -
Chapter 8
the inputs used to produce that level of output meet the optimality conditions
derived in Part A.
C.
D.
What is the additional output that could be obtained from a marginal increase
in the budget?
Assume that the firm is interested in minimizing the cost of producing 14,777
units of output. Use the Lagrangian method to determine what optimal
quantities of X and Y to employ. What will be the cost of producing that output
level? How would you interpret , the Lagrangian multiplier, in this problem?
8A.1
SOLUTION
A.
Optimal input proportions are found by solving the following relation:

MPX
PX
MPY
PY
3+ Y
3
5+X
6
18 + 6Y = 15 + 3X
X = 2Y + 1 or Y = (X - 1)/2
Because Q appears in neither of the above expressions, these optimal unit
proportions are invariant with respect to the output level.
B.
The optimization problem faced by the firm can be written

Maximize Q = 3X + 5Y + XY,
Subject to $3X + $6Y = $1,000,
which suggests the following Lagrangian expression:
LQ = 3X + 5Y + XY + ($1,000 - $3X - $6Y).
(1)
LQ/X = 3 + Y - 3
= 0
- 222 -

(2)
LQ/Y = 5 + X - 6
= 0
(3)
LQ/ = 1,000 - 3X - 6Y
= 0
To solve, take 2 times (1) minus (2):

2 (1)
minus (2)
6 + 2Y - 6 = 0
- (5 + X - 6 = 0)
1 + 2Y - X = 0.
Then, multiplying this result by 3 and adding (3) yields the following:
3 (above)
plus (3)
3 + 6Y - 3X = 0
1,000 - 6Y - 3X = 0
1,003 - 6X = 0
X
= 167.
Then, from (3):

(3)
1,000 - 3(167) - 6Y
6Y
= 0
= 499
Y = 83.
And, solving for using (1):
(1)
3 + 83 - 3 = 0
3 = 86
= 28.7.
Part A above showed that X and Y should be combined in the ratio

X
= ? 2Y + 1
and
- 223 -
Chapter 8
167
=_
2(83) + 1.
Thus, X and Y are combined in optimal proportions.

C.
The incremental output obtainable from an additional $1 expenditure on X and Y is

28.7 units as determined by the value of in Part B. This implies that the marginal
cost of one output unit is
MC =
D.
TC 1
= = $0.035 (or 3.5 cents per unit).
Q
The alternative optimization problem for the firm can be written as

Minimize TC = $3X + $6Y
Subject to 14,777 = 3X + 5Y + XY,
which suggests the following Lagrangian expression:
LTC = $3X + $6Y + (14,777 - 3X - 5Y - XY).
(1)
(2)
(3)
LTC/X = 3 - 3 - Y
LTC/Y = 6 - 5 - X
LTC/ = 14,777 - 3X - 5Y - XY
= 0
= 0
= 0
To solve, take 2 times (1) minus (2):

2 (1)
minus (2)
6 - 6 - 2Y = 0
-(6 - 5 - X = 0)
- + X - 2Y = 0
(- 1 + X - 2Y) = 0
In order for (-1 + X - 2Y) = 0, either or (-1 + X - 2Y) must equal zero. Because
costs are an increasing function of output, 0, and therefore (-1 + X - 2Y) = 0.
This implies
X = 2Y + 1 or Y = (X - 1)/2
- 224 -

Substituting 2Y + 1 for X in (3) yields:
(3)
14,777 - 3(2Y + 1) - 5Y - (2Y + 1)Y
= 0
14,777 - 6Y - 3 - 5Y - 2Y2 - Y
= 0
14,774 - 12Y - 2Y2
= 0
or
-2Y2 - 12Y + 14,774
= 0,
which is a quadratic equation of the form

aY2 + bY + c = 0,
where a = -2, b = -12, and c = 14,774. Its two roots can be obtained from the
quadratic formula
Y
- b b 2 - 4 ac
2a
12 144 - 4(-2)(14, 774)

-4
12 344
-4
= 83 or -89
Although both 83 and -89 are mathematically feasible, negative output is not
economically feasible. Therefore, Y = 83 is the correct answer, and
X = 2Y + 1
= 2(83) + 1
= 167
- 225 -
Chapter 8
TC = $3(167) + $6(83)
= $501 + $498
. $1,000.
This answer is identical with part A because,

Q = 3X + 5Y + XY
= 3(167) + 5(83) + (167)(83)
= 14,777
Maximizing output subject to a given budget constraint is equivalent to minimizing
cost subject to a given output constraint.
The Lagrangian multiplier, , in this problem measures the marginal cost of
producing one additional unit of output.
3 - 3 - Y = 0
3 - 3 - (83)
= 0
86
= 3
= 0.035
The marginal cost of an additional unit of output at the 14,777 unit production level
is 3.5 cents. This is identical to our finding in part C. (Note: The increase in output
per dollar expended is Q = 1/ = 28.7 units, which was measured by in part B.)
CASE STUDY FOR CHAPTER 8
Employee Productivity Among the Largest S&P 500 Firms
Traditional measures of firm productivity tend to focus on profit margins, the rate of return on
stockholder=s equity, or related measures like total asset turnover, inventory turnover, or
receivables turnover. Profit margin is net income divided by sales and is a useful measure of a
company=s ability to manufacture and distribute distinctive products. When profit margins are
high, it=s a good sign that customer purchase decisions are being driven by unique product
characteristics or product quality rather than by low prices. When profit margins are high,
- 226 -

companies are also able to withstand periods of fluctuating costs or weak product demand
without devastating consequences for net income. While high profit margins have the potential
to attract new competitors, they also act as credible evidence that a firm offers a hard-to-imitate
combination of attractive goods and services.
Return on equity (ROE), defined as net income divided by the accounting book value of
stockholder=s equity, is an attractive measure of firm performance because it reflects the effects
of both operating and financial leverage. When ROE is high, the company is able to generate an
attractive rate of return on the amount of money entrusted to the firm by shareholders in the
form of common stock purchases and retained earnings. High profit margins give rise to high
ROE, as do rapid turnover in inventory, receivables and total assets. Rapid inventory turnover
reduces the risk of profit-sapping product closeouts where slow-moving goods are marked down
for quick sale. Rapid receivables turnover eases any concern that investors might have in terms
of the firm=s ability to collect money owed by customers. High total asset turnover, defied as
sales divided by total assets, documents the firm=s ability to generate a significant amount of
business from its fixed plant and equipment.
Despite these obvious advantages, each of these traditional firm performance measures
suffers certain shortcomings. Profit margins are strongly influenced by industry-related factors
that might obscure superior firm productivity when firms from different industries are compared.
For example, the automobile industry is huge and net profit margins for mediocre performers
are commonly in the 2.5-3% range. Even standout performers, like Toyota, struggle to earn 6%
on sales. Meanwhile, even mediocre banks commonly report profit margins in the 15-20% range.
Similarly, and despite obvious advantages, ROE suffers as a performance measure because
steep losses can greatly diminish retained earnings, decimate the book value of stockholder=s
equity, and cause ROE to soar. When companies buy back their shares in the open market at
prices that greatly exceed accounting book values, the book value of shareholder=s equity also
falls, and can unfairly inflate the ROE measure. For these reasons, some analysts look to the
accounting rate of return as a more simple and less easily distorted measure of accounting profit
performance.
However, the biggest problem with corporate performance measures based upon profit
rates tied to sales, stockholder=s equity or assets has nothing to do with measurement problems
tied to irregular profit and loss patterns or corporate restructuring. The biggest problem with
traditional corporate profit measures is that they fail to reflect the firm=s efficient use of its most
precious resources: human resources. In the services-based economy of the new millennium, the
most telling indicator of a company=s ability to compete is its ability to attract, train, and
motivate a capable workforce. In economics, the term human capital is used to describe the
investment made in workers and top management that make them more efficient and more
profitable employees. Employee training and education are two of the most reliable tools that
companies can use to keep an edge on the competition. However, determining an efficient
amount of worker training and education is more tricky than it might seem at first.
- 227 -
Chapter 8
In a competitive labor market, employees can expect to command a wage rate equal to
the amount they could compel in their next-best employment opportunity. At least in part, this
opportunity cost reflects employee productivity created by better worker training and education.
Because dissatisfied workers can be quick to jump ship, employers must be careful to maintain a
productive work environment that makes happy employees want to stay and contribute to the
firm that paid for their education and training. Employers need capable and well-trained
employees, but no employer wants to be guilty of training workers that end up working for the
competition! All successful firms are efficient in terms of constantly improving employee
productivity, and then motivating satisfied and capable employees to perform. In light of the
importance placed upon capable and well-motivated employees, an attractive alternative means
for measuring corporate productivity is in terms of profits and revenues per employee.
Table 8.6 here
Table 8.6 gives interesting perspective on employee productivity by showing revenue per
employee and profits per employee for the largest 30 companies in the S&P 500 Index, when
these corporate giants are ranked by the market capitalization of common stock.
A.
B.
What firm-specific and industry-specific factors might be used to explain differences

among giant corporations in the amount of revenue per employee and profit per
employee?
A multiple regression analysis based upon the data contained in Table 8.6 reveals
the following (t statistics in parentheses):
Profit/Emp.= $17,267.679 + 0.052 Ind. Profit/Emp. + 0.083 Rev./Emp. + 0.006 Ass./Emp.
(1.26) (0.16)
(5.19)
(3.86)
R2 = 98.0%, F statistic = 417.12
Interpret these results. Is profit per employee more sensitive to industry-specific or
firm-specific factors for this sample of giant corporations?
CASE STUDY SOLUTION

A.
Firm-to-firm variation in the amount of profits per employee is sure to depend upon
both firm-specific and industry-specific factors. For example, at the industry level of
aggregation, the amount of capital employed per worker tends to be very high in
financial services like banking and credit services. As a result, even the most
mediocre banks in terms of relative efficiency report high profits and revenues per
employee. However, the most efficient financial service companies will have better
trained workers and motivate them most efficiently. Thus, it is important to control
for industry effects when considering firm productivity as measured by profits and
- 228 -

revenues generated on a per employee basis. Differences in employee productivity
will be affected by differences in total assets per employee, worker education and
training, the effectiveness of incentive compensation plans, the amount of employee
stock ownership, and so on.
B.
Based upon this sample of giant corporations taken from the S&P 500, profit per
employee appears to be more sensitive to firm-specific factors than to industryspecific factors.
On an overall basis, the simple model estimated here explains a very large
proportion (98.0%) of the variation in profits per employee for the 30 largest firms
found within the S&P 500, when ranked according to market capitalization. This is a
statistically significant explanation (F = 417.12) of a meaningful share of the total
amount of variation in profits per employee.
Clearly, the firm-by-firm variation in profits per employee cannot be simply
explained as a byproduct of industry effects. What is surprising in this simple model
is that industry effects offer no marginal explanation of profits per employee when
revenue per employee (t = 5.19) and total assets per employee (t = 3.86) are
constrained. In other words, the marginal effects of revenues per employee and total
assets per employee overwhelm the marginal effects of industry-specific factors. It is
also interesting that both revenues per employee and total assets per employee have
marginal influences on the amount of total profits generated on a per employee basis.
Of course, the strong influence of revenues per employee on profits per employee
stems from the fact that both are commonly employed measures of employee
productivity. However, at a minimum, results reported here suggest that profits per
employee reflect the amount of revenue generated per employee and the amount of
total assets each employee has at their disposal.
- 229 -

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Chapter 8

PRODUCTION ANALYSIS AND COMPENSATION POLICY

QUESTIONS & ANSWERS

Is use of least-cost input combinations a necessary condition for profit maximization?

productivity could reduce employment opportunities by reducing the number of

Commission-based and piece-rate-based compensation plans are commonly

AHourly wage rates are an anachronism. Efficiency requires incentive-based pay

Production Analysis and Compensation Policy

last input unit

What is meant by the Apace@ of economic productivity growth, and why is it

During the late-1990s, annual rises in productivity in nonfarm businesses have

Production Analysis and Compensation Policy

Explain why company productivity is important to managers, employees, and

Only superior employees with hard-to-duplicate contributions can expect to earn

On a per hour basis, the relevant question is

Production Analysis and Compensation Policy

On a per month basis, the relevant question is

The rule for optimal input employment is

For each machine hour, the relevant question is

$162 > $90.

$288 > $160.

$32,400 > $18,000.

$57,600 > $32,000.

Production Function Estimation. Washington-Pacific, Inc., manufactures and sells

Production Analysis and Compensation Policy

The standard error estimates for each coefficient are:

Estimate the effect on output of a 1% decline in worker hours (holding K and E

Estimate the effect on output of a 5% reduction in machine hours availability

Estimate the returns to scale for this production system.

For Cobb-Douglas production functions, calculations of the elasticity of output with

From part A it is obvious that:

In the case of Cobb-Douglas production functions, returns to scale are determined by

hQ = b 0(kL ) b1(kK ) b 2(kE ) b3

Marginal Rate of Technical Substitution. The following production table provides

Estimated Output per Day

Production Analysis and Compensation Policy

Do the two inputs exhibit the characteristics of constant, increasing, or

The inputs exhibit the characteristic of a decreasing marginal rate of technical

Production Analysis and Compensation Policy

Production Function Concepts. Indicate whether each of the following statements is

L-shaped isoquants describe production systems in which inputs are perfect

The marginal rate of technical substitution will be affected by a given

False. L-shaped production isoquants reflect a perfect complementary relation

False. The marginal rate of technical substitution is measured by the relative

Compensation Policy. APay for performance@ means that employee compensation

Government mandates for employer-provided health insurance

Rising productivity due to better worker training

Rising employer sales due to falling imports

Falling prices for industry output

Rising prevalence of uniform employee stock options.

Production Analysis and Compensation Policy

Decreasing. Government mandates for employer-provided health insurance increase

Decreasing. A rising prevalence of uniform employee stock options increases the

Returns to Scale. Determine whether the following production functions exhibit

Q = 7L2 + 5LK + 2K2

Initially, let X = Y = Z = 100, so output is:

Increasing all inputs by an arbitrary percentage, say 2%, leads to:

Initially, let L = K = 100, so output is:

Initially, let A = B = 100, so output is:

Initially, let L = K = 100, so output is:

Production Analysis and Compensation Policy

Because a 2% increase in both inputs results in a 4% increase in output (Q2/Q1 =

Initially, let L = K = 100, so output is: