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Returns to Scale 4. Technological Progress 5. Some Special Functional Forms

When deciding about factory design, e.g. the right combination of machines and workers, need to know the trade-offs • to which degree can one be replaced by the other? • the optimal combination has to take relative costs into account (next chapter)

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Inputs (also known as “factors of production”) are resources, such as labor and capital equipment, that a firm uses to produce goods and services. Outputs are the goods and services produced by a firm. Production transforms a set of inputs into a set of outputs. Technology determines the quantity of output that is feasible to attain for a given set of inputs. Production function states the maximum amount of output that can be produced for any given amount of inputs. Example: Q = f(L,K,M) where L: labor, K: capital, M: materials Q = f(L,F,A) where L: labor, F: fertilizer, A: land area

• The production set is the set of technically feasible combinations of inputs and outputs • A firm is technically efficient if it produces the maximum possible output given the inputs, i.e. operates at the boundary of the production set The analysis of production functions follows that of utility functions. • Think of a utility function as a production function for “happiness” • Difference: since production function measures real output, production function is cardinal.

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The Production Function and Technical Efficiency for one input

• The variables in the production function are flows (the amount of the input used per unit of time), not stocks (the absolute quantity of the input). ðExample: stock of capital is the total factory installation; flow of capital is the machine hours used per unit of time in production (including depreciation). • Capital refers to physical capital (goods that are themselves produced goods) and not financial capital (the money required to start or maintain production).

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production function Q = f(L) area of technically not achievable production

C

•

• •B

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technically efficient production is on the production function

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area of technically inefficient production

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Total, Average, and Marginal Products Q Average product of an input resource is the average amount of output produced per unit of the input. average product of labor APL = Q/L average product of capital APK = Q/K Marginal product of an input resource is the rate at which total output changes as the amount of the input is changed. marginal product of labor MPL = dQ/dL marginal product of capital MPK = dQ/dK Law of diminishing marginal returns The marginal product of an input eventually decreases as its usage is increased, while holding all other inputs constant.

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Q(L)

MPL maximized

L

APL maximized

APL MPL

TPL maximized where MPL is zero. TPL falls where MPL is negative. TPL rises where MPL is positive. APL = Q(L)/L

L

MPL = dQ(L)/dL

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Note: • When the marginal product is positive, the total product is increasing • When the marginal product is larger than the average product, the average product is increasing (why? Because the added unit adds more to the total then the previous units on average, so it drives the average up) • When the marginal product is smaller than the average product, the average product is decreasing • The average product is maximal where it is equal to the marginal product • The same holds for total, average and marginal for all 9 magnitudes, such as cost, utility, revenue, etc

An isoquant traces all combinations of inputs that allow a firm to produce the same quantity of output. e.g. Q = K1/2L1/2, then isoquant for Q = 20 is given by K1/2L1/2 = 20, hence KL = 400, and K = 400/L • Marginal rate of technical substitution MRTSL,K is the rate at which the capital input K must be decreased (increased) to keep output level constant after the labor input L is increased (decreased) by one unit. MRTSL,K = –∆K/∆L (negative slope of the isoquant) = MPL/MPK (ratio of the marginal products) along an isoquant we have MPL(∆L) + MPK(∆K) = 0, 10 thus MPL/MPK = -∆K/∆L = MRTSL,K

K Example: Isoquants • If both marginal products are positive, the slope of the isoquant is negative • If we have diminishing marginal returns, we also have a diminishing marginal rate of technical substitution (but not the other way around) For many production functions, marginal products eventually become negative. We can ignore the upward-sloping part of the isoquants in a graph because these regions are uneconomic. L

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All combinations of (L,K) along the isoquant produce 20 units of output.

Q = 20 Slope=∆K/∆L 0 Q = 10

K

Example: The Economic and the Uneconomic Regions of Production Isoquants MPK < 0 uneconomic regions Firms’ Choice output from inputs derived from technologies MPL < 0 Q = 20 economic region cardinal marginal product of X (MPX) isoquant Q = 10 L

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Consumer’s Choice utility from consumption derived from preferences ordinal marginal utility of X (MUX) indifference curve marginal rate of substitution MRS

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marginal rate of technical substitution MRTS

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Example: The Elasticity of Substitution

The Elasticity of substitution σ measures the percent change in the capital-labor ratio K/L for each one percent change in MRTSL,K. It hence measures the degree of substitutability between different inputs σ = = = ∆(K/L)/(K/L) ∆MRTSL,K/MRTSL,K (∆(K/L)/∆MRTSL,K)(MRTSL,K/(K/L)) MRTSL,K ∆(K/L) ∆MRTSL,K (K/L)

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**The shape of the isoquant indicates the degree of substitutability of the inputs σ=0 σ=1 σ=5 σ=∞ 0 L
**

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Calculating the returns to scale Production function Q1 = AL1αKβ1 Returns to scale RTS measure the relative increase in output, when ALL input quantities increase by a given amount RTS = %∆Q / %∆(all inputs) • increasing returns to scale a 1% increase in all inputs results in a more than 1% increase in output • constant returns to scale a 1% increase in all inputs results in an equally 1% increase in output • decreasing returns to scale a 1% increase in all inputs results in a less 1% increase in output Increase all inputs by the scale factor λ: Q2 = A(λL1)α(λK1)β = λα+β AL1αKβ1 = λα+βQ1 so the scale will depend on the value of α+β. • constant returns to scale: α+β = 1 • decreasing returns to scale: α+β < 1 • increasing returns to scale: α+β > 1 Note: The marginal product of a single factor may diminish while the returns to scale do not • Can there really be decreasing returns to scale? They reflect that we do not increase all inputs or not in the same quality

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K Example: Returns to Scale constant RS: Q1 = 2Q0 increasing RS: Q1 > 2Q0 decreasing RS: Q1 < 2Q0 Technological progress • more output from any given combination of inputs • any given output from fewer inputs • isoquants of all output levels shift inwards • neutral technological progress MRTSL,K remains unchanged along any ray from the origin • labor saving technological progress MRTSL,K decreases => less K is needed per unit L L

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2K Q = Q1 Q = Q0 0

K

L

2L

• capital saving technological progress MRTSL,K increases => more K is needed per unit L

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K

Example: neutral technological progress K Q = 100 ante

Example: Labor Saving Technological Progress

Q = 100 ante Q = 100 post MRTS remains same Q = 100 post MRTS gets smaller

K/L L K/L

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L

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Example: capital saving technological progress K

Example: Initially a firm’s production function takes the form: Q = 500[L+3K]

Q = 100 ante Q = 100 post MRTS gets larger

after an innovation, its production function becomes: Q = 1000[.5L + 10K] MPL1= 500 MPL2 = 500 MPK1= 1500 MPK2 = 10,000 So MRTSL,K has decreased (labor saving technological progress)

K/L L

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Linear Production Function Q = aL + bK • linear isoquants • MRTS constant • elasticity of substitution σ = ∞ • constant returns to scale

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Fixed Proportion (Leontief) Production Function Q = min(aL, bK) • L-shaped isoquants • MRTS varies (0, infinity, undefined) • elasticity of substitution σ = 0 • constant returns to scale

2K

K

Q = Q1 Q = Q0

2 1 L

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Q=2 Q=1 2 4 H

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0

L

2L

0

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Cobb-Douglas Production Function Q = aLαKβ • smooth convex isoquants • MRTS varies along isoquants • elasticity of substitution σ = 1 • returns to scale • increasing if α + β > 1 • constant if α + β = 1 • decreasing if α + β < 1

Q = Q1 Q = Q0

Constant Elasticity of Substitution (CES) Production Function Q = [aLφ+bKφ]1/φ where φ = (σ-1)/σ •σ=0 •σ=∞ •σ=1 => Leontief case => linear case => Cobb-Douglas case

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L

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1. Production function is analogous to utility function and is analyzed with many of the same tools 2. The production function is cardinal, not ordinal. It is easier to measure than a utility function, using engineering and econometric methods. 3. Returns to Scale refers to the percentage change in output when all inputs are increased a given percentage. 4. Technological progress shifts the production function. It allows the firm to produce more output from a given combination of inputs 29

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