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CHAPTER 4

lEARN1NG OBJECTIVeS

The Production Function with

One Vanahle

The Law 01 Dlfmnishlng

Returns

I~argifla!

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 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.:

PRODliCTION [HEORY

level of the second mput, the

fUBction is

Q

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

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

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

~"' '~~

otparts

'

1,~OO

-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

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

Amount

of

{Number of

Machines!

. holding X2 conslanl

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

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

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

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

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

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~

THEORY

FIGURE 4.2

l} .il

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::

Oilipul

dx

0'

( clx

dx

IS

C';('d~"~1

lcro.

And hence

flAP

dx

AP

I. I

3 4

I

B

I I I

10 11 12 13 14 1:)

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.

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

John Tholl1as' world. With a longer time horizon, the

fIXed inDut of five CNC machines becomes vanable. Table 4.3 shows the

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

ISOQUANTS

TABLE 4,3

Production

Two Variable

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

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

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)

AQ/AX,; the marginal product of the

Tolal I

oulpul'

is AQ/6.X"

B,

B,

B

Amellol 01 labor

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

Sible iejfieientimpul bundle'

capable nf producing a 9'Vl'O

Qulput level.

to an output of G' G. All we need to do is cut the sur

the result beiM EGF, and

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'\

ISOQUANl S

G'G

Slates, although it did not focus on steel production until

Ihe 't960s.ln 2U08,15 first qUilrler sale';.were approach

plants] to jOin the constuction team. Using these meth

past

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

arc furnaces to make stcel producls from scrap metal.

In 2007 Nucorwas the nation's

recyder, repro

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

section).

.4~

FIGURE 4.4

of

';'

'\.

keep employees focused on efficient production?

Nucor uses the following multiprongedapproilch:

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

It maintains a

\.

"

K1~--""

..,.

slre.amlined

Most divisions use only three

of man

agement Each diviSion is treated as a

'\

K,

cenler and

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

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

per unit oj lime

105

stitution iMRTSi MRT:, shoVis Ihe

rale at which one mpui IS sub

sliluled lor Jnolhel IWlih

remaining constant]

angles,

the output

MRTSis

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

MRTS ~

300

ilX1

200

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

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

aXJ ) dX1

+ ( aX2 1dX2

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)

marginal products 01 inpu\s df::

negative,

THE OPTIMAL COMBINATION OF INPUTS

FIGUHE 4.6

'""pit81

out'.lde the

OUafld OV

the combinations of

aiM.

Amounl01

capilalused

100

P.

Labor

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.

follows that

M

K = PI(

PI(

MIP,

(pel unit 01 time)

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

chased at a specified cost

RETURNS TO SCALE

FIGURE 4.8

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

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.

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

flETurlNSTO SCALE

FIGURE 4.10

---------

ouiput mcreases by exactty the

-----

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

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

that can be produced IS

1/ only labor were used, the IIrm could produce only

cheapest way 10 produce 0: unll"

Amount

olr.apltal

M'I!'K

!!.Q

!!.T

MP,

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

03

lEI and technicians used IT]

Q = 20

f2 + 12T 0.5P

(4.7)

equatton (481 and noting that PE =

12 -'. T

2,000

20 - 2E

4,000

per month for the combined

2,000(20 -2E)

4,000

0,

12

10

he rhust choose a bundle of engl-

12

E 12 ~ T

T E-l 2

MlP,

M'IP,

Amount of tabor

Pc

(4.8)

P7

have

4,000E + 2,ooOT

Suppose we consider a

managers increase the level

to

portion than Inputs.

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

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

to Eand T, we find thai

MPE =

!!.Q

!!.E = 20

2E

(4.9a)

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

28,000

output from the $28,000 outlay on wages, the presi

dent should hire 4 engineers and 6 technicians.

MPL ~. ~C!

ilL

5( KL

MPK ~ ilK

._\ 1<

~.

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

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

5K

80L

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

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:

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,

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

01 change 10 OUtput resulting

a 1 percent increase In all inp":.

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)

CWAiH OPTION,

Incre'ased, as shown here;

Year

=c

baLbWIL = b(OIL)

!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

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

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

. the orice 01 apound

1.35

sign IratherHian fhe minos siglll befoie Ib7

thislormuta; but this olher value is not relevant here.

110

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

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

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

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"

PRODUCTION THEORY'

tOMI3INAIIUN~

is fixed at 6,500 _

wheD each amount is used.

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:

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

-"-"-"-~-

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'

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

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:

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=

used of the second input. The firm's total

E' Therefore,

+ X.Po

.~

OJ)

both inullts is

E-'

1')1

CHAPTER

I,;

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

f'

(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'

iJX1

problem is to minimize

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?

to zero, we obtain

iJX2

oX -P

,

MP ,

)..P1

=0

? -

iJX; -

iiA

MP2

'hP2

A ill(X 1,X2)

= Q'

(4,24)

=0

(4,25)

aX 1

12<1

(4.21)

iJX2

l\Xl' X2)

14.26}

"/h

for

and

for

CHAPTER 5

~-

P,

P2

LEi'.RNING 08Jf:ClIVES

Opper [unity Costs

P, = 'AMP,

P2

side

(1127) by

we find that

Economies

P2

r(onomies

or

Analysis

EANALYSIS OF COSTS

P,

P"

Analysis and Operating Lever~::,

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-_;

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