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THr PRODUCTION FUNCTION WITH ONE VARIABtr INPUl

CHAPTER 4
lEARN1NG OBJECTIVeS
The Production Function with
One Vanahle
The Law 01 Dlfmnishlng
Returns

I~argifla!

The PlOuuction Function with


Two Variable
lsoquants
The Marginal Rate of Technical
Substitution
The Optimal Combination 01
Inpuls

PRODUCTION THEOR

Corner Solutions
Relurns 10 Scale
The Output Elasticity
Eslimattons 01 Produclion
Funclions
Appendix. Lagrangian
Moltipliers and Oplimallnput
Combinations

Once managers determine the demand for the firm's product or service, their'
is far from over. Now they must choose the optimal method to
need to be as efficient
hallmark of good managers. Efficiency
tion process. Simply staled, a production process explains
or service (output). The production
precisely specifies the relationship between inputs and outputs.
Production issues are not confined to the physical transformation of'
into outputs. In business,
goods and services, such as employment
distribution.
managers are concerned with rtflnenttv
intellectual resources.
into
demand, is required
for managers to optimize
process.
cannot understand their firm's cost structure unless they understand
the production process.

THE PRODUCTION FUNCTION WITH ONE VARIABLE INPUT


The production function is a table, a grapn, or an
product output achieved from any specified set of inputs. The function summa
rizes the characteristics of existing tedlilology at a
time; it shows the techconstraints managers face. Any manager should want to use the most
efficient process known. So we assume managers presuppose technical efficiency.
Unfflrtnnotptv ll1any managers view processes as static. Production is dynamic:

CHAPitR

I.:

THE PilODUCTION FUNCTION WITH ONE VARIABLE

PRODliCTION [HEORY

a process uses two


level of the second mput, the

is the level of the first


fUBction is
Q

where Qis the firm's output rate.


Cognitivel)', the simplest case has one input whos\:'
whose qnantity is variable. Excd inputs cannot be
lb be sure, economists assume the time needed to
ning of what is called the long term. Fixed invuts often
machinery,
Variable inputs can be
example. In
run, all inputs are variable.
John Thomas is an entrepreneur who
He woils as a contractor in the airplane

Olltput if he were to hire various numbers of machinists. (Please note


the following output l1tllllhers are
in hundreds.) Tbomas estimates
one machinist produces 49 piirts per year. Thomas Lall produce more parts
Jllore workers, as we see in Table 4.1. This table represents a
ThollYas Machine
when five machine tools are used. More
the curve ill Figur~ 4.1 presents exactly the same results. In fact, the

between Total Output and Amount of Labor Used


Machine Tools, Thomas Machine Company
oulput increases as labor increases at an increasing rate lup 106.67 ulliis
labor! and Hlcreascs at a decreasing rate luntil slightly more than 11, units of
lahorl. Thereafter, output decreases as.more units of labor are deployed. Managers
. 'Will never williully deploy labor in the latter circumstance. The production function
shows the relationship between o\lt~ullin this case nUl1\ber 01 parts oroducedl and
input [in lhis case unils 01 labor!'

TABlE4.1

Output of Metal Parts When Various Amounts of labor Are Applied to

~"' '~~

otparts

'

1,~OO

FIve MachIne Tools. Thomas Machine

-Tolatoutpul

1.400 .

Amount 01

Amount of
Cdpital [Number of

Labor

Machines]

Output 01 Parts
10. hundreds ~er year]

o
?
3

1.300
1.200

1,9

1,1DO

132

1,000

243

376

5
6
6.67
7

52'J

684

792.'39

gOO
800

700

847

600

1,008

500

1.161

10

1,300

11

1.419

12
13

5
5

1,512
1.573
1,596
1,:175

14

15

II~PUj

400 "
300"
200"

:l!IIf,;rL

CHAPrEll!' PRODUCTION 1HFORY

Average product iAPI Common


measunng device lor estlmat!nQ
the uOlls 01 output, on average

numbers in Table 4.1 (and Table 4.2) are derived from the
to Q 30L + 20U P. Lis
We can think of the production lunctlOn as
technology use. Thomas is clearly interested in
the number of machinists varies. One common measure used by m,lIlY manager~iII
is 01ltput Jl9T wOIker. This measure is Wh~li tconOinim call aVefdge product
Because we are varvin~ machinists, this is output per worker or

per mpul

-X~

AP

Metric lor
eSllmallog the efficiellcy 01 each
rnpullo which the "'pufs MP is
(qual 10 Ihe Incremental change
rn output created by a small
change in the input

THE PRODUCTION [,UNCI ION WITH OI~E VARIAI3LE INPUT

Average and Marginal Products of Labor, Thomas Machine Company


Amount
of
{Number of
Machines!

. holding X2 conslanl

tells Thomas how many units of output, on average, each


ist is respollsible for. If he wants a better metric to estimate the
worker, he should use what economists call the marginal product IMP],
MP is eaual to the incremental change ill output created by a small

3
4

5
6

6.67
MP

IlQ

f,X I '

x? constanl

Por machinists, the marginal product represents the impact on output of a


in machinists. If Thomas adds a machinist, the
more units did we produce because I hired this last machinist?" If he mllst let
go, it is, "How many fewer units did we produce because I let this machinist
The marginal

10
11
12
13

Output of
Parts !Q,
Hundreds
of Parts!

tA..verage

Marginal
Product

~A" ... n; .... -.I


1'1011j"IOl

Product

!D/L1

IllOIM I'

Ida/dUo

Product

5,

5
5

49

49

49

1:l2

83

21,3

66
81

111

5
5
5
5
5
5
5
5
5
5
5

376

9t,

133

142

525

105

149

1~5

67
98
123

684

114

159

162

792 59
847

118.89

162.89

16133

121

163

163

1,008

126

161

158

1,161

129

153

1&7

1,300

1:jQ

139

119

130
107
78
43
2
-45

1,419

129

1,512

126

93

'1,573

121

61

23
-19

14

1,596

114

15

IS/5

105

ligures In Ihe I'lO/M column pertain to the ,nterval belween Ihe indicated amounl 01 tabor and
one Ilnitlesslhan Ihe mdicaled amount 01 tabor The ligures inlhe dO/dt column <lre the conlinuous
marginat product-Ihalls, dO/dL = MPL 30+ 'Ot - 3L 2

average
parts per machinist between the fllst and second hires. Results for
hires are shown in Table 1.2.

QUANT OPTION
More precisely. the

product 01 an Input

reaches a maximum (at L ~ 6.67 and


the derivative of output

to the quantity 01 the Input ThaI IS, rf Q is the output and x Ihe
quantily ollhe input, the marginal product 01 the input equals dO/dx If the
With

quanlities of all other lopuls ale fixed

The average and marginal products of machinists are shown in


numbers are derived from Table 4.1. The curve is rpnrp<pnh
tion processes. The average product of machinists
maximum (at L 10 and Q/L '" 130), then falls. The

processes. Figure 4.2 shows that the marginal product


the average
when the latter reaches a maximum; thal is, MP AP ~ 130 when L 10.
in Table U. The lirst

CHAPTER

I, pr'ODUcrIOI~

THE PRODUCTiON rUNCTION WITH IWG VARIABLE INPUTS

THEORY

FIGURE 4.2
l} .il

Average and Marginal Product Curves for Labor


Mal [Jlnal praGue: eHcelb average product when the lallel is incrEaSing dnd is less
:hdfi JVeragf product when the iatler 15
IOutput ~er unil ollabar is mea
sur(ld if I hundrp.d::

Enough chat; lels get SIIOlJ'. !i x

Input With 2S. the output, Ihen AP

is O/X and MP IS dOldx

Oilipul

dx

0'

( clx

When the average product

dx

IS

at a maximum. dlOfxVdx equals

C';('d~"~1

lcro.

And hence
flAP

dx

AP

LAW OF DIMINISHING MARGINAL RETURNS

I. I
3 4

I
B

I I I
10 11 12 13 14 1:)

returns is a well known constrmnt in managenal econom


one for managers to understand.lt teilches managers to remain in
For most vroduction processes, jf managers add
(MP) to out

It is not hard

Amounlo1
rullor

The second (dQI elL) assumes that Thomas can employ labor continuously, as
J.25 workers or J,33 workers. This could be achieved by
or workers who work more or Jess time than in a standard day's work.
MP equals AP when AP is maximized. A
llltuitive frame may help. Assume your IJrofessOT is
average of test scores by

II.

score is
must decrease. This is a natural law of mathern<ltics. So as
than Ap, AP mllst be increasl11g. \lJhcn MP is less than AP, AP must be
MPinlersects wilh ilPwhen AP is nt a maximum.

jml"l('\rt~l'\t

prod
five machines. As more machin
will have to ration machines, or new hires will be assigned to
tasks.

Choosing the optimal input bundle is not an easy managenal


cannot hold all inputs but one constant; and they cannot expect that adding more
units will always result 1Il
ll1creases in output. It is not as simple as
as we

THE PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS


John Tholl1as' world. With a longer time horizon, the
fIXed inDut of five CNC machines becomes vanable. Table 4.3 shows the

law of diminishing returns


Awellknown occurrence when
when managers and equal inert
menls 01 an input while holding
other IIlpullcvels conslanl. Ihe
incremenlal gains 10 oulpul eve
luaUy gel smailer

CHAPTER /, PllODUCTION THeORY

ISOQUANTS

TABLE 4,3

Production

Two Variable

Thomas Machine Company


surface, OAQB, shows Ihe amollnl o! lold! output thai (on be

Quantity 01 Machine Tools


IHundreds of Parts Produced per Year!

Amount of Labor

!Unitsl

11

18

11.

30

22
30
35

60

50
80

Bl
84

1/,0

2
3
I.

115

exira input combinations to consider. Though Thomas will have to consider m


choices, the process is similar to that of the onevariable input case.
To illustrate, suppose Thomas is considering whether to
tional eNC machines. Engineers
machines and derive Table 4.3, The average product of either machirie tools
machinists is computed by dividing the total output by the amount of cit
machine tools or machinists used, The marginal product of each input is obla'
by holding the other input constant. For example, the marginal product 0
additional machine tool when using four machinists and three machine t,
5,1 00 parts per machine tool; the marginal product of an additional macrun
when using three machinists and four CNC machines is 2,100 parts per unit.
XI is the amount of the first input and X2 is the amount of the second
function is

f(X~,

X2)

where Q is the firm's output rate. The


AQ/AX,; the marginal product of the

Tolal I
oulpul'

of the first input


is AQ/6.X"

B,

B,

B
Amellol 01 labor

function by a surface, as shown in


We measure output for any
down from a point
bundle. For exam
machinists and
machine tools. Conversely, we can take any amounts of machine tools
say OAl machine tools and OBl machinists, and find thcir output
the height of the production surface at D', the point where
'machinists is OEl and machine tool input is OAr According to Figure 4.3, the
equals D'D, Input bundles that produce identical output have the same

QUANT OPIION
the iaslldio1l5, we have

MP, ~ ~X,

10?

MP

iJO
ilX2

bundles capable of

Isoquanl Curve showing all i::'


Sible iejfieientimpul bundle'
capable nf producing a 9'Vl'O
Qulput level.

surface of Figure 4.3. Suppose we want to find


to an output of G' G. All we need to do is cut the sur
the result beiM EGF, and

L This surfacf is no! meilnt to


resent the numerical values in 1; I.
4.3 but i~ a general reprcsen!at>:;;
how aproduction surface of lh:.J .
is likely to appear.

HI'\

CHAPTER 4. PRODlJC110N lHEORY

ISOQUANl S

this results in a curve that includes

G'G

Nucor is one of tile largest steel firms In the United


Slates, although it did not focus on steel production until
Ihe 't960s.ln 2U08,15 first qUilrler sale';.were approach

work habits of individUals .Those with good work habits

ing $5 billion; the t,rm achieveurecord first quarter net

are recruited to work in the plant when it opens. II also

earnings tor the fifth consecutive year. Managers hali!?

brings workers from other plants [who have already built


plants] to jOin the constuction team. Using these meth

past

implemented to achieve this

to J different output rate, are shown ill


figure 4.4. The two axes Jlleasure the qll<lJltities of inputs. In contrast to the
.ous diagralJ)~, we assume labor and Glpii<rI~-Jlot Jlla(hini~ts and machine
particular form of labor and capital)-'are the relevant inpu(s, The curves show
the various input bundles that produce J00, 200, and 300 units of output. For
,'~xample, consider the isogllallt for 100 lInits of output. This isoqllant shows it is
to Llroduce 100 units if to units of labor and Ko units of capital are used
this output rate can be attained with LI units of
I., units of labor and Kl llJ1its.
nrrmp.-!;p< of iSO(]U3IltS. The farther the
we Ciln draw iln

One difference is thai Nucor is a"minimI!!, " hot an

ees monitor each olher. Bonuses are based on the

integratedsteel firm. MinimiUs have adifferent prOduc

ca.pabiliti~sol the ~quipment ahqav!;'rage 80percent

tion function than do integrated mills. They use electric


arc furnaces to make stcel producls from scrap metal.
In 2007 Nucorwas the nation's

recyder, repro

represents an infinite number of possible input combinations.


'arealways downward-sloping and convex to the origjn (we will see why in the next
section).

output atepm produces. the higher are its bonuses..


.4~

Nucor treats all employees equally.


FIGURE 4.4

varrous combinatIOns of capital and labor that can


of

';'

'\.

How db Nucor managers


keep employees focused on efficient production?
Nucor uses the following multiprongedapproilch:

leadel.lt was the first firm to produce thin-slab casilng


ments.ih sted pmdu~tioh. This.emphasis.on innovation

It maintains a

\.

"

K1~--""

..,.

is reinforced by the firm's flat

slre.amlined

tlonal structure th~t encourages decentralized decision


Most divisions use only three
of man
agement Each diviSion is treated as a

'\

at aiT1iniil)ill~!ld5earches worldwide for new develop

Decisions can be made and


K,

cenler and

IS exoecled to earn a 25 percent return on total assets.


2. The company ;lcts as the general contractor
rural areas where
land is cheap land unions are weak!, Also, each planl is
located near water ond is served by at leasllwo railroad

'ISO 9000 is a set of quality standards. To receive ISO 9000


certification, !nanagers musl luUill various quatily assurance
requireinen!s anti be audrted by an external registrar. If a
firlll's qualily assurance syslem IS approved by Ihls regislrar,
Ihe lirrrl is awarded an ISO 9000 cerliircalion and is allowed to
adverlise Ihis lacl to all cuslomers.

300

200
Ko'-

100

L2

L,

1.0

Amounl allobar used


per unit oj lime

105

I HE MARGINAL RAr[ Of' TECHNICAL SUBS1ITU110N

CHIIPT[R 4: PRODUCtiON 1HEORY

THE MARGINAL RATE OF TECHNICAL SUBSTITUTION

oquants in the Case of Fixed Proportions

Marginal rale of technical 5ub


stitution iMRTSi MRT:, shoVis Ihe
rale at which one mpui IS sub
sliluled lor Jnolhel IWlih
remaining constant]

angles,

inputs musl be used In ilxed proportions, the isoauilnts are

input is sllbstituted for another

the output

o ' f(X" X2)


MRTSis
~-,-"=,,,,v,,""'C,

MRTS ~

300

ilX1
200

oftechnical substitution is 1times the


of the isoquant. This makes sense because 6.X/6.X1 measures the slope, which
downward or negative (so X, is on the yaxis and Xl is on the x
It is useful for managers to think of MRTS as the ratio of
for inputs I and 2, Managers need to
shows the incremental effect on output of the ,last unit
managers want to increase the use of inputs with relatively
ucts, though they must also consider the costs of inputs,
The rate of substitutabilitv
processes, one type of labor is
ized
sible; to produce a unit of output, a fixed amount of each
inputs must be used in fixed proportions. Figure 4.5 shows the firm's isoquants
such a case; as you can see, they are right angles, Few production processes
no substitution among inputs, but in some,

QUANlOPllON

100

Labor

are

Jines connecting the

segments or bend back


4.6, Above au and below av, the
that increases in both capital and labor are required
output rate, If this is the case, the marginal plOduct of one
Above au, the marginal product of capital is nega
output increases if less capital is used while the Jevel of labor is held
Below OV, the

dO

tines IhJI
profil' maxlmillng fir ms

Ridge lines The

lime for some fun!

aXJ ) dX1

+ ( aX2 1dX2

manager will operate at a point outside the ridge lines


the same output with less of both inputs, This choice is
Consider point H in Figure 4,6, This point is located on a posisegment of the isoquant (and so outside the
lines), It will always
of both labor and caoital than

Therefore,

MP2

(4,3)

wilh,n, because oulside olltlcl,


marginal products 01 inpu\s df::

negative,

CHAPlER 4: PRO[JUCTION THEORY


THE OPTIMAL COMBINATION OF INPUTS

FIGUHE 4.6

No prolit-maxtmlzlnq firm operales at a point


'""pit81

out'.lde the

OUafld OV

isocost curve shows

the combinations of

can be ohtained Jor a

aiM.

Amounl01
capilalused

100
P.

Labor

THE OPTIMAL COMBINATION OF INPUTS


analysis did not include the costs
costs because the inputs are scarce. A manager who wants to maximize profit
try to minimize the (Ost of producing a given output or maximize the
level of cost. l Suppose a manager takes
capital and labor, that vary in the relevant
and labor should the manager choose to maximize the
bination
derived from the
level of cost?
First we dctermme the various input combinations that can be obtained
cost. If capital and labor are !he inputs and the
of labor is PI per
and the price of capital is PKper unit, theinpl1t combinations that are obtained
of Mare slIch that
2. The conditions (or minimizing
the cost 01 producing, given output
are the same ab those (or maximizing
the OU1put (rom agiven (OSlo Thj~ is
~hown in the present section. There
fore, we (an vlfwlhe firm)s problem
in either way.

where L is the level of labor and K is the level of


follows that
M

K = PI(

PI(

MIP,

Amounl 01 labor uSP-O


(pel unit 01 time)

and labor that can be purchased,


are represented by the straight line shown in Figure 4.7. (Capital is plotted on
vertical axis, and labor is plotted on the horizontal axis.) This line, which has
on the vertical axis equal to MIPK am] aslope of PP\, is called all
curve. It shows all the input bundles that can be purchased at a specified
sUF,cnmposethe relevant isocost curve on the isoquant map, we see the
bundle !hat maximizes output for a
cost. An efficient manager should
ptht;)nl'\~t"\tA

combination
to choose an mput bundle where the margi.nal prod
per dollar spent of Jabor and capital are identical. If they are ]]ot, the manager
increase the use of the immt with the higher marginal per dollar value.
the manager maximizes output by distrib
so the maminal oroduct of a dollar's worth

150c05t curve Curve showIng

rnput bundles thai can be P'


chased at a specified cost

CHAPTER k PRODUCTION THEORY

RETURNS TO SCALE

FIGURE 4.8

---- --- - - - - - -

Maximization of Output for a Given Cost


maXIn)lze the output for a given cost. the firm should ci1oo;,e the Input com

C"""'Mn~;nfl

tlOn at pOint R
Amount j

to Ihis 150

An10tJni I

of capital.

of ("pitat

fsoquent
WMlS

Arnollnt of labor

of one
used. In

of a dollar's worth
bundle such that
MPa
p.

where

!:'!PIJ
Pb

l1n

Amount of labO!

CORNER SOLUTIONS

P"

products
a, b, .. , 11.
bundle that minimizes production costs, we
along the isoquant of the stipulated
that lies on the lowest isocost curve-for example, S
Input bundles on isocost curves like Co that iie below S are cheaper
the desired output.
like Cz that lie above S
is obvious that the optimal bundle S is a point where the isocost curve is tafi!\cnJijl,
to the isoquant. Therefore, to minimize the cost of producing a
to maximize the output from a given cost outlay, the finn must equa te
and P/Pi> this means that
needed, the manager must

MP'F'"

an isocost curve. In the two- input case, this means that just one input is used
in the least expensive way
to produce the most output
4.6 will now be an inequality reading MPKIPK >
cases where just capilal is used and MPKIPK MP,lPL for cases where
labor is used. The former case is shown in Figure 4.1 O.

We have seen how managers can represent technology as a production fUIlction


and average product to operate more
want to continue this theme and examine some long-term considerations manag
,crs face. These fOCllS all scale. Basically, what is the incremental change to output
as managers increase their use of capital and labor?

111

CHAPTER 4 PRODUCTION THEORY

flETurlNSTO SCALE

may double oulput. This is the case of constant

FIGURE 4.10

---------

Constant returns to scale Whe,


ouiput mcreases by exactty the

-----

salnp proportion a5 Inputs

At first glance, some managers may believe thai production functions neces
exhibit constant returns to scale. After all, if a manager can build two fa(
size and Iypes of workers, can't she achieve the same
twice the size' Blit things arc not this simple. jf man

may employ tecimiqucs that are econbmi


infeasible at t?C smaller scale. Some inputs are not available in small units;

we cannot install half a robot. Because of indivisibilities of this sort,

ACorner Solution Where


that can be produced IS
1/ only labor were used, the IIrm could produce only
cheapest way 10 produce 0: unll"

Wllh outlay 01 M, the most

could be prodUCed With aft iJuHoy oi M' > rvi

thai would be lne/fiCient.

Amount

olr.apltal
M'I!'K

!!.Q
!!.T

MP,
~~;'O!Iffi;.lU>~I:.~

03

related in the followihg way to the number of


lEI and technicians used IT]
Q = 20

f2 + 12T 0.5P

(4.7)

Ihese expressions lor


equatton (481 and noting that PE =

2,OUO, il follows that

ty wage of an engineer is $.\,000, and the

12 -'. T
2,000

20 - 2E
4,000

of a technician is $2,000. If the presl


per month for the combined

2,000(20 -2E)
4,000

0,

12

10

is to maximize output I/or his


he rhust choose a bundle of engl-

12

E 12 ~ T
T E-l 2

Because Belswanger allocates $28,000 per month


MlP,

M'IP,

for the total wages 01 engineers and technicians, we

Amount of tabor

Pc

(4.8)

P7

have
4,000E + 2,ooOT

Increasing return to scale When

Suppose we consider a
managers increase the level
to

output increases hy a larger pro


portion than Inputs.

Decreasing returns to scale


When ou!put incre()se C, by a

smaller proportion than inputs

double output. This is the case of increasing returns to scale. Or output


increase by a smaller proportion than inputs; for example, doubling all
to less than a doubling of outout. This is the case of decreasing
the same proportion as
to scale.
output may increase by

112

28,000

IE + 21 lor Tgives us
, and PI is the wage of a lech

the change in equation (UI with


to Eand T, we find thai
MPE =

!!.Q
!!.E = 20

2E

(4.9a)

4,000E + 2,000( + 2)

28,000

ThiS means that E "land T = 61. So to rnaximize


output from the $28,000 outlay on wages, the presi
dent should hire 4 engineers and 6 technicians.

Hit OUTPUT EL,\STICITY

CHAP1TR 4 PRODUCTION mEORY

MPL ~. ~C!
ilL

5( KL

MPK ~ ilK

._\ 1<

~.

x I X J box is SIX sqnare fect, so the former


on)y fonr times ;)$ nH1(1 \~100d 3$ the L:Hler
is not
returns to scaJ~. The 1110st (ommon Ctllpnt IS tne (jlallcnge ot (oor(lmatmg a
It can be difficult even in a small fum for managers to obtain
finn such prob

are obvious, scale can generate inefficiencies. For example, III


kinds of research and development, large teams lend to be Jess effective

5K

80L
which means that K .cc 4L. Because 0 ~ 800,

Whether scale returns are constant, increasing, or decreasing is an


that must be settled case by case. There is 110
In some industries the evidence suggests that returns increase over a cer
but the answer is likely to depend on the output considered.
increasinp returns to scale at small output levels and constant or
levels. In addition, managers need to know
are 110t all increased or decreased in the same

OUTPUT ELASTICITY
increasing, decreasing, or constant returns to
The output elasticity is dcfilled as the percent
in omput resulting from a 1 percent increase in all inDuts. If the
increasing returns to
if it
are constant returns to scale; and if it is Jess than 1, there are decreasing returns
a maker of aircraft parts,
function:

o " O.8L o3KOB


areas, and airlines dedicate computers to
reservations.
size may <llso generate
because the aggregate behavior of a
may not h<lve to increase in
to be more stable, a linn's
its sales,

per yeaqmeasured in millions


the number of workers hired, and Kis the amollnt of capital used. This is the
",~_1 ..... ~~ 1".. 1.1.. T'\~... ~L .........1.. -,: ... function (named after Charles Cobb

Output elasticity The perceni' c,


01 change 10 OUtput resulting
a 1 percent increase In all inp":.

ES IIMATIONS.OF PRODUCTION FUNCTIONS

CHAPTER 4 PRODUCTlOI" THEORY

,TlMATIONS OF PRODUCTION FUNCTIONS


functions,
of the first steps in cstimat
fllnction is to choose its mathematical form. Mallagers com
~obb-DOllPlaS form. With only two inouts, this form is

nrArll1rti()IJ

aLbKc

(4.10)

QIS the number otp<uts nr()nl1rcd

CWAiH OPTION,

the 19705, ihe size of oil tankers


Incre'ased, as shown here;

Year

iJO/iJL '" baLbW =

=c

baLbWIL = b(OIL)

Average Oil Tanker Size


!Thousandso! dwtl

to trayel at 15 knots.
requires 42.500 horseoower to do the same. So 2.7
times the

of labor

be
S()4tCS;

baL'J-iKC =

blAPd

011 the values of both Land


are taken of both sides of equation

www,oceanatiils.orglunattas/uses/transportalion;

logO

ioga+blogL+clogK

(4,11)

Note that if managers use the Cobb-Douglas form, they can easily estimate
returns
to scale. If the Sllm of the exponents (that is, b + c) exceeds 1, increas
To calculate the output elasticity at the Lone Star
returns
to scale are indicated; if the sum of the exponents equals l, constant
to Qif we multiply ooth inputs (Land K) oy 1.01.
to
scale
prevail; and jf the sum of the exponents is less than 1, decreasing
Q(that is,
to scale are indicated. This is true because if the Cobb-Douglas produc
0' =
the output elasticity equals the sum of the exponents, For
section the output elasticity of the Lone Star Company
the sum of the exponents (OJ and 0.8).
There is no cut-and-dried way to determine which mathematical form is best
= 1.0 11 0054840
:;.-..v"aUse the answer depends on the particular situation. Frequently a good proce
dure is to try more than one mathematical form and see which fits the data best
Therefore, If a manager illcreases the use of both
The
important thing is that the chosen form provide a faithful representation of
more than Ll percent; this means the output
thc actual situation. '1'0 dctermine whether this is the case, it often is useful to see
nnwwim,tpiv 1.J. It is exactly U for all infinitesimal
is larQcr than infinitesimal, the inrrp1,P~1 how weJl a oarticular estimated oroduction function can forecast the Quantity of
output
med.
in output is

FSTIMATIONS OF PRODUCTION JUNCTIONS

CHAPTEH 4: PHODUCTION THEORY

a One-Pound Weight Gain for a Broiler and Isocost Curve If Corn Price Is %
Oilmeal Price
input combination i5 1.35 pounds of corn and 0.61 pounds of soybean OIlrnea!.
lor hOI,omle Cooperalion and Devclopment.lnterdisciplin;;ry Reseqrch

PouIK1s 01
pmilrtiler

0.61

combination if the price 01 a pound 01 corn is


. the orice 01 apound

1.35

Pounds of com pel brbilei .

01 5, which corresponds to Ihe


sign IratherHian fhe minos siglll befoie Ib7
thislormuta; but this olher value is not relevant here.

110

CHAPTER 4. PRODUCTION THEO~Y

PROBLEMS

SUMMARY
1. The production function. defines the relationship among variolls .
and the maximum quantity of a good that can be procluced.l\1anagers study
duction hmctions to gain insights into the firm's cost structure.
2. An isoquant is a curve showing all possible (effJCient) com' .
inpuls capable .of producing a panicuiar quantity of oUlpl1L Th~
.of technical substitution shows the rate at which one input Gill be
for allother

to
isocost curve.
4. lf a manager increases all
increases by more
than this
retUrllS to scale,
of inputs, various geometrical relations, or
returns to scale can also occur; the most frequently cited reaSO]1 is the
CUllY of managing a huge enterprise. Whether there are constant, i
or decreasing returns to scale is an empirical question that mnst be settled
by case.
5. Managers have estimated production functions in many firms
industries. Many studies show that a Cobb-Douglas function is the best fit
the data.
wwnorton.com/studyspace ~

PROBLEMS
t In the

the

of hours of skilled labor

between output
and unskilled labor ( U) is

Q 3m') + tOOU

0.25 2

0.3U2

and
is $5. The firm can hire as much labor as it wants at these wage rates.
a.
chief
recommends that the firm hire 400 hours
of skilled labor and 100 hours of unskilled labor. Evaluate this
recommendation.
b. If the Elwyn Company decides to spend a total of $5,000 on skilled and
unskilled labor, how many hOllrs of each type of labor should it hire?
c. If the price of a unit of output is $10 (and does not vary with output
level), how many hours of un;;killed labor ,hould the company hire?
120

A consl1lting firm specializiJ1g in agriculture determines that the follow


combinations of hay and grain consumption per lamb will result in 8
,25-pound gain for a lamb:

Pounds of Grain

130.9
125.1
120.1
15.7
1.8
108.3
102.3
97.4
93.8

a. The firm's president wants to estimate the marginal product of a pound


of grain in producing lamb. Can he do so on the basis of these data?
b. The firm's president is convinced that constant returns to scale prevail
in lamb production. If this is true and hay and grain consumption per
lamb are the only inputs, how much gain accrues if the hay consumption
per lamb is 100 pounds and the grain consumption per lamb is 250.2
pounds?
c. What is the marginal rate of technical substitution of hay for grain when
between 40 and 50 pounds of hay (and between 130.9 and 125.1
of grain) arc consumed per lamb?
A major advance in technology occurs that allows farmers to
25-pound gain per lamb with less hay and
than the
indicates. If the marginal rate of technical substitution
is the same after the
correspondmg to a
which produces stationery, hires a consultant to
function. The consu!tallt concludes that

esti~

Q = 0.9P + 0.06L

where Qis the llumber of pounds of stationery produced by Ascot per year,
l. is the number of hours of labor per year, and Pis the number of pounds of
paper used per year.
a. Does this production function seem to include all the relevant in puts).
Explain.
1'}1

CIlAPTEI~ I"

APPENDIX LAGRANGIAN MULTIPLIERS AND OPIIMAL INPlJ'l

PRODUCTION THEORY'

tOMI3INAIIUN~

is fixed at 6,500 _
wheD each amount is used.

b, Does this production fUDction seem reasonable if it is

returns?
4. A Cobb-Douglas production function was estimated for six types of
There were five inpnts in the production function: (lJ land, (2) labor,
livestock and feed, and (5) other resolllc(' services. The
was as follows:

are fed, and when


returns?

Exponent
Livestock
Farm Type

Land

Labor

Equipment

and Feed

Crop farms
farms
farms
General farms'
Large farms
Small farms

0,24

0.07
0,02
0.01

0.08
0.10
0.06
0.16
0.11
0.08

DC"
.J..)

0.02

0.74

0.03

0.63

0.02

0,46

0.03
003
0.03

0.07
0.10

0.17
0.28
0.21

0,12
0,01

0.05

0.53
0.43

-"-"-"-~-

a. Do there appear to be increasing returns to scale in any of these six


of farms?
b. In what type of farm does a 1 percent illcrease in labor have the
percentage effect on
c. Based on these results, would you expect output to increasC' if many of
the farms included in this
5, According to the
is the output rate, L is the rate of labor
increasing returns to scale.
a. Is the owner correct?
b, Jf ~ were 0.2 rather than OJ, would she be CO[fCctl
c. Does output perunit of labor depend
6. According to data obtained by the U.S, nO~""nH>n'

a, What advice would you give him'

the price of labor increases to $2 per uniL What effect will this
have on output per unit of labor?
c. Is this plant subject to decreasing returns to scale? ','lhy or why not?
Volvo A,B., the Swedish auto firm, operated a car
in 1988, The idea was to have a small team of highly skilled workers build an
entire car. According to the proponents, this would reduce the tedium associated
with the conventional assembly Iim~ and cut absenteeism and turnover among
workcIs.ln J99 J there were reports that it took 50 hours of labor to assemble a
car at Uddevalla, in contrast to 25 hours at Volvo's conventional
at Ghent, Belgium. If you were Volvo's chief executive officer, what
take?
would you ask Uddevalla's managers, and what

LAGRANGIAN MULTIPLIERS AND OPTIMAL

must be satisfied if a firm is to maxi


or if it is to minimize the cost of produc
In this appendix we show how the decision rule
the method of Lal!raJll!ian multiuliers, To

is as follows:

Output from aSpecified Expenditure Level


Amount of Grain
IPoundsl

Amount of Milk
(Pounds)

1,200
1,800
2,400

5,917
'1,250
8,379

3,000

9,371

0=

Q is output, Xl is the amount used of the first


used of the second input. The firm's total
E' Therefore,

+ X.Po

.~

OJ)

and Xl is the amount


both inullts is

E-'
1')1

CHAPTER

I,;

APPENDIX: LAGRANGIAN MULTIPLIERS AND OPTIMAL \I~PUI COlvlBINATIONS

PI(O[)UCTION TH[ORY

by the rf)l"rp<:ntinnil1o

where PI is the
manager seeks IU)''':t,u'"11C
wants to maximize Q, where

viP,
Q~

MP2

P2

P1

P2

to the constraint that

f'

We first construct the Lagrangian function, which is the


(4.14)

L,

+ )..(f> . Xl,

f\X"

X,P2)

respect to

decision rule in
managers want to equate the
of Lagrangian
constraint.

aX

'AP,

X,P1

f'
iJ'A

Q'

[(X"
)..P?

X2P2

ilX2

iJX2

Thus

of output, Q'

a manager is committed to produce a


iJX1

problem is to minimize

These are the conditions for output maximization


constraint.
MP, is the marginal product of input one and MP2 is that for input two.
definition, we know the following is true:

(4.22)

0'

(4.23)

we first construct

DQ ~ MP 1

ax,

iJX,

al\X" X2 ) =
iJX2

ilQ ~ MP?

the partial derivatives of Ll with


to zero, we obtain

iJX2

Equations (4.16) and (4.17) can be restated as


oX -P
,
MP ,

)..P1

=0

? -

iJX; -

iiA

MP2

'hP2

A ill(X 1,X2)

= Q'

(4,24)

=0

(4,25)

aX 1

which implies that

12<1

(4.21)

iJX2

l\Xl' X2)

are the conditions for cost minimization

14.26}

to the output constraint.


"/h

CHAPTEIl!;; PRODUCTION THEORY

for

and

for

CHAPTER 5
~-

P,

P2

LEi'.RNING 08Jf:ClIVES

which imvlies that


Opper [unity Costs

P, = 'AMP,

Shorl-Run Cost Functions

P2

side

Average and Marginal Costs

(1127) by

long-Run Cost Functions

we find that

Managerial Use 01 Scale


Economies

P2

Managerial Use of Scope

r(onomies
or

Managerial Use of Break-Eve,


Analysis

EANALYSIS OF COSTS
P,

Profl! Contribution Analysis

P"

Appendix A; Break-f ven


Analysis and Operating Lever~::,

which is our decision rule ill

between inputs and out-

all business
comparisons of costs and benefits. A manager wants to under
an action if the additional (marRinall revenue attributable to that action
wishes to produce at an output level where the
cost. Obviously this calculation is not
many four-lettered words) jnvokes multiple interpretations. Man
find that what seems like a simple concept often provokes controversy over
accounting in virtually every MBA program),
of cost is necessary for a variety of basic
cost control, and
for future
consideration of costs must include both short-run and
consequences for an
Inntr_
managerial decisions
170

tJ.t'Tn

vision.

127

Appendix 8: Measurement of
Short-Run Cosl Functions; H,c_
Choice of a Mathematical Fon-_;