Chapter - Ii Producer Behavior Page of

Adigrat University Department of Economics Microeconomics 2016
2. Theory of Producer Behavior

2.1. Theory of Production
2.1.1. Basic Concepts of Production
Production is the creation of any good or services that have economic value to either
consumers or producers. Production may be defined as the act of creating those
goods/services which have exchange value for sale (not for personal consumption).Raw
materials yield less satisfaction to the consumer by themselves. In order to get utility from
raw materials, first they must be transformed into output. However, transforming raw
materials into final products require factor inputs such as land, labor, capital and
entrepreneurial ability. Thus, no production (transforming raw material into output) can
take place without the use of inputs.
i. Production Function: It is a purely technical relationship which connects factors
(inputs) to products (outputs) at any particular time period. It also shows the maximum
quantity of output that can be produced from the given amount of variable inputs for a given
technology. It describes the technical relationship between inputs and output in physical unit.
ii. Fixed Vs Variable Inputs: In economics, inputs can be classified as fixed and variable.
Fixed inputs are those inputs whose quantity can not readily be changed when market
conditions indicate that an immediate change in output is required. In fact no input is ever
absolutely fixed, but may be fixed during an immediate requirement. For example, if the
demand for Beer shoots up suddenly in a week, the brewery factories can not plant additional
machinery over night to respond to the increased demand. It takes long time to buy new
machineries, to plant them and use for production purposes. Thus, the quantity of machinery is
fixed for some times such as a weak. Buildings, machineries and managerial personnel are
examples of fixed inputs because their quantity can not be manipulated easily in short time
periods. Variable inputs, on the other hand, are those inputs whose quantity can be changed
almost instantaneously in response to desired changes in output. That is, their quantity can
easily be diminished when the market demand for the product decreases and vise versa. The
best example of variable input is unskilled labor. In our previous example, if the brewery
factory had idle machinery before the market demand increased, the factory can easily and
immediately respond to the market condition by hiring laborers.
Chapter – II Producer Behavior Page 1 of 44

iii. Short run vs. Long run: Short run, in economics, refers to a period of time in
which the quantity of at least one input is fixed. For example, if it requires a firm one year to
change the quantities of all the inputs, those time periods below one year are considered as
short run. Thus, short run is a time period which is not sufficient to change the quantities of all
inputs, so that at least one input remains fixed. One thing to be noted here is that short run
periods of different firms have different durations. Some firms can change the quantity of all
their inputs with in a month while it takes more than a year for another type of firms. For
example, the time required to change the quantities of inputs in an automobile factory is not
equal with that of flour factory. The later takes relatively shorter time. On the other hand, long
run is a time period (planning horizon) which is sufficient to change the quantities of all
inputs. Thus, there is no fixed input in the long run
2.1.2. Production in the short run: Production with one Variable Input
Short run production function is a production function which combines at least one fixed input
with variable input.
Assumptions of Short run Production Analysis
In order to simplify the analysis of short run production, the classical economists assumed the
following conditions:
1. Perfect divisibility of inputs and outputs: This assumption implies that factor inputs
and outputs are so divisible that one can hire, for example a fraction of labor, a fraction
of manager and can produce a fraction of output, such as a fraction of automobile.
2. Limited substitution between inputs: Factor inputs can be substituted each other up
to a certain point, beyond which they can not be substituted each other. In other words,
resources are not perfect substitutes for one another as they are not identical.
3. Constant technology: It is assumed that level of technology of production is constant
in the short run. Suppose a firm that uses two inputs: Capital (which is a fixed input)
and labor (which is variable input). Given the assumptions of short run production, the
firm can increase output only by increasing the amount of labor it uses. Output varies
with the variation of the variable input. Hence, its production function is:
Q = f (L) ………………………………………. 2.0
Where; K = quantity of capital (which is fixed), Q = quantity of production (Output) ,
and L= quantity of labor used.
Chapter II Theory of Producer Behavior Page 2 of 44

The production function shows different levels of output that the firm can obtain by
efficiently utilizing different units of labor and the fixed capital. In the above short run
production function, the quantity of capital is fixed. Thus output can change only when the
amount of labor used for production changes. Hence, Q is a function of L only in the short
run.
Total Product TP), Marginal Product MP and Average Product AP
TP: Total product is the total amount of output that can be produced efficiently utilizing a
specific combination of labor and capital. The total product curve, thus, represents various
levels of output that can be obtained from efficient utilization of various combinations of
the variable input, and the fixed input.
Increasing the variable input (while some other inputs are fixed) can increase the total
product only up to a certain point. Initially, as we combine more and more units of the
variable input with the fixed input output continues to increase. But eventually, increasing
the unit of the variable input may not help output increase. Even as we employ more and
more unit of the variable input beyond the carrying capacity of a fixed input, out put may
tends to decline. Thus, increasing the variable input can increase the level of output only up
to a certain point, beyond which the total product tends to fall as more and more of the
variable input is utilized. This tells us what shape a total product curve assumes. The shape
of the total variable curve is nearly S-shape (see figure 2.1 Panel A)
MP: The marginal product of a variable input is the addition to the total product
attributable to the addition of one unit of the variable input to the production process, other
inputs being constant (fixed). Before deciding whether to hire one more worker, a manager
wants to determine how much this extra worker (L =1) will increase output. The change
in total output resulting from using this additional worker (holding other inputs constant) is
the marginal product of the worker. If output changes by Q when the number of workers
(variable input) changes by ∆L, the change in out put per worker or marginal product of the
variable input MPL is found as:
Q dTP
MPL = or MPL  ……………………………. 2.1
L dL
Thus, MPL measures the slope of the total product curve at a given point. In the short run,
the MP of the variable input first increases, reaches its maximum and then tends to decrease
to the extent of being negative. That is, as we continue to combine more and more of the

variable inputs with the fixed input, the marginal product of the variable input increases
initially and then declines.
AP: The AP of an input is the ratio of total output to the number of variable inputs.
totalproduct TP
APL   ……………………. 2.2
numberofL L
The average product of labor first increases with the number of labor (i.e. TP increases
faster than the increase in labor), and eventually it declines. However, average product can
never be zero or negative as it is a ratio of two positive numbers (total output and employed
labor).
Figure 2.0: TP, AP and MP Curve
Output
TP3
TP2 TP
TP1
L1 L2 L3
Labor L (Variable input)
APL, MPL
APL
L1 L2 L3 Labor L (Variable input)

MPL

As the number of the labor hired increases (capital being fixed), the TP curve first rises,
reaches its maximum when L3 amount of labor is employed, beyond which it tends to
decline. Assuming that this short run production curve represents a certain car
manufacturing industry, it implies that L3 numbers of workers are required to efficiently run
the machineries. If the numbers of workers fall below L 3, the machine is not fully
operating, resulting in a fall in TP below TP3. On the other hand, increasing the number of
workers above L3 will affect the production process negatively because only L 3 number of
workers can efficiently run the machine. Increasing the number of workers above L 3, rather
results in lower total product because it results in over crowded and unfavorable working
environment.
Marginal product curve increases until L1 number of labor are employed and reaches its
maximum at L1, and then it tends to fall. The MPL is zero at L 3 (when the TP is maximal);
beyond which its value assumes negative value indicating that each additional worker
above L3 tends to create over crowded working condition and reduces the total product.
Thus, in the short run (where some inputs are fixed), the marginal product of successive
units of labor hired increases initially, but not continuously, resulting in the limit to the total
production. Geometrically, the MP curve measures the slope of the TP. The slope of the TP
curve increases (MP increases) up to L1, it decreases from L1 to L3 and it becomes negative
beyond L3.
The average product curve increases up to L 2, beyond which it continuously declines. The
AP curve can be measured by the slope of rays originating from the origin to a point on the
TP curve. For example, the APL at L2 is the ratio of TP2 to L2. This is identical to the slope
of ray a.
Relationship between AP and MP of Variable Input
The relationship between MPL and APL can be stated as follows:
 For all number of workers (Labor) below L2, MPL lies above APL.
 At L2, MPL and APL are equal.
 Beyond L2, MPL lies below the APL
 Total product reaches maximum when marginal product is zero.

The MPL curve passes through the maximum of the APL curve from above. This
relationship between APL and MPL can be shown algebraically. Suppose the production
function is given:
TP = f (L) …………………………….. 2.3
dTP df ( L) TP f ( L)
MPL   and APL  =
dL dL L L
To determine the relationship between APL and MPL, consider the slope of the APL
function:
f ( L) df ( L) dL
dAPL d( ) .L  . f ( L)
Slope of APL = = L = dL dL (quotient rule of
dL 2
dL L
differentiation)
df ( L)
.L f ( L) ab a b
Slope of APL = dL - 2
----------------------------- (note that   )
2 L c c c
L
df ( L) f ( L)
= dL - L
L L
MPL  APL df ( L) f ( L)
Slope of APL = , because = MPL and = APL
L dL L
When MPL > APL, Slope of APL is positive (APL rises)
 When MPL = APL, Slope of APL is zero (APL is at its maximum)
 When MPL < APL, Slope of APL is negative (APL falls)
Law of Diminishing Marginal Returns LDMRs: Short –Run Law of Production
The LDMRs states that as the use of an input increases in equal increments (with other
inputs being fixed), a point will eventually be reached at which the resulting additions to
output decreases. When the labor input is small (and capital is fixed), extra labor adds
considerably to output, often because workers get the chance to specialize in one or few
tasks. Eventually, however, the LDMRs operates: when the number of workers increases
further, some workers will inevitably become ineffective and the MP L falls (this happens
when the number of workers exceeds L1 in figure 2.1)
The Law of diminishing marginal returns is based on two very important assumptions.
These are the existence of constant technology and homogeneous labor (the variable input).

The LDMRs operates (MP of successive units of labor decreases) not because highly
qualified laborers are hired first and the least qualified last. Diminishing marginal returns
results from limitations on the use of other fixed inputs (e.g. machinery), not from decline
in worker quality. The LDMR applies to a given production technology (when the level of
technology is fixed). Over time, however, technological improvements in the production
process may allow the entire total product curve to shift upward, so that more output can be
produced with the same level of inputs.
Stages of Production in the Short-run
We are now not in a position to determine the specific number of the variable input (labor)
that the firm should employ. Because, this depends on several other factors than the
productivity of labor such as the price of labor, the structure of input and output markets,
the demand for output, etc. However, it is possible to determine ranges over which the
variable input (labor) be employed.
The production of a firm in the short run can be divided in to three stages of production.
Stage I: Ranges from the origin to the point of equality of the APL and MPL.
Stage II: Starts from the point of equality of MP L and APL and ends at a point where MP
is equal to zero.
Stage III: Covers the range of labor over which the MPL is negative.
Figure 2.1: Stages of Production in the Short run
APL
MPL
Stage I Stage II Stage III
APL
0 Units of labor (variable input)

L1 L2 L3
MPL

Since additional units of variable inputs are contributing negatively to the total product a
firm should not operate in stage III (MP of the variable input is negative).It is due to over
crowded working environment i.e., the fixed input is over utilized.
Stage I is also not an efficient region of production though the MP of variable input is
positive. The reason is that the variable input (the number of workers) is too small to
efficiently run the fixed input; so that the fixed input is underutilized (not efficiently
utilized).
The efficient region of production is stage II. At this stage additional inputs are contributing
positively to the total product and MP of successive units of variable input is declining
(indicating that the fixed input is being optimally used). Hence, the efficient region of
production is over that range of employment of variable input where the marginal product
of the variable input is declining but positive. This stage of production is called rational or
economic stage of production.
Example 2.0: The production function is given as:
Q  f ( L)
Q  7 L  10 L2  L3
Determine:
a. The amount of employment which maximizes average productivity
b. The amount of employment which maximizes total production or at which marginal
Product is zero.
c. Define the three stages of production for the above production function.
Solution:
a. Average product reaches maximum when the slope of average product curve is
zero. In other words, average product reaches maximum when marginal product
equals to average product:
dAPL TP 7 L  10 L2  L3
APL  0   7  10 L  L2
Slope of dL , and APL= L L
d (7  10 L  L2 )
APL  0
Slope of dL
 10  2 L  0  L  5
L5

When employment of labor equals to five average products reaches its maximum level.
d (TP )
MPL  0
b. dL
d (7 L  10 L2  L3 )
MPL  0
dL
MPL  7  20 L  3L2  0
 7  20 L  3L2  0 Using Quadratic solution method, a= 3, b= -20 and c= -7

b b 2  4ac

2a

20 ( 20) 2  4(3)(7)

2(3)

20 484

6

20 22

6
20  22 20  22
 or  7 or  0.33
6 6
The total product reaches maximum when employment of the variable input equals to
seven. The three stages of production are; stage one from zero labor to 5 units of labor.
Stage two from 5 labors to 7 units of labor and Stage three above 7 units of employment
c. The stages of production for the above production function is:

APL
MPL
Stage I Stage II Stage III
APL
0 L1 5 7 L
2.1.3. Production in the Long run: Production with Two Variable Inputs
In the previous section we have examined the technological relationship between inputs
assuming that the firm uses one variable input (labor) and one fixed input (capital). Let us
turn to the long run analysis of production. Remember that long run is a period of time
(planning horizon) which is sufficient for the firm to change the quantity of all inputs. For
the sake of simplicity, assume that the firm uses two inputs (labor and capital) and both are
variable.
The firm can now produce its output in a variety of ways by combining different amounts
of labor and capital. With both factors variable, a firm can usually produce a given level of
output by using a great deal of labor and very little capital or a great deal of capital and
very little labor or moderate amount of both. In this section, we will see how a firm can
choose among combinations of labor and capital that generate the same output. To do so,
we make the use of an isoquant. So it is necessary first to see what is meant by an isoquant
and its properties.
Isoquant: An isoquant is a curve which shows alternative combinations of inputs leading
to the same level of output. It shows all possible efficient combinations of inputs that can
yield equal level of output. Every point on an isoquant represents the same level of output.
If both labor and capital are variable inputs, the production function will have the following
form:
Q = f (L, K) ………………………….. 2. 4

Thus, isoquant shows the flexibility that firms have when making production decision.
They can usually obtain a particular output (Q) by substituting one input for the other.
Isoquant Map: Isoquant map is a collection of different isoquant curves each representing
a specific out put level. When a number of isoquants are combined in a single graph, we
call the graph an isoquant map. An isoquant map is another way of describing a production
function. Each isoquant represents a different level of output and the level of out put
increases as we move up and to the right. The following figure shows isoquants and
isoquant map.
Figure 2.2: Isoquant and Isoquant Map
Capital
3
q3
2
q2
1 q1
1 3 6 Labor
Isoquants show the fact that long run production process is flexible. A firm can produce q1
level of output by using either 3 units of capital and 1 unit of labor or 2 units of capital and
3 units of labor or 1 unit of capital and 6 units of labor or any other combination of labor
and capital on the curve. The set of isoquant curves q1 q2 and q3 is called isoquant map.
Properties of Isoquants
Most of the properties of an isoquant are the same as that of an indifference curve. The
major difference between them is that output is constant along an isoquant where as
indifference curves hold utility constant. Thus, isoquants are:
1. Isoquants slope down ward: Because isoquants denote efficient combination of inputs
that yield the same output, they always have negative slope and can never be horizontal,

vertical or upward sloping. For example, if isoquants are horizontal only one point on the
isoquant is efficient.
Figure 2.3: Isoquants with Zero or Positive Slope
Capital
Capital Capital 100kg
100kg
wheat
teff
100kg
A teff
4
B
A
A
5
2 5 Labor Labor
Labor
Panel a Panel b Panel c
In figure 2.4 panel (a), the firm can produce 100kg of Teff by using either 4 capitals and 2
labors, or 4 capitals and 5labors or any other combination of labor and capital along the
curve. Obviously, only the first alternative is efficient as it uses the least possible
combination of inputs. Thus, all points, except A, are inefficient and not part of isoquant.
Thus, an isoquant can never be horizontal. In figure 2.4 panel (b), a firm can produce
100kg of wheat by using any combination of labor and capital along the isoquant. But only
point A is efficient. For example, point B shows the same number of labor as point A, but
higher capital. Thus point B is in efficient because it shows higher combination of inputs.
Thus, isoquants can never be vertical line. In figure 2.4 panel (c), all points above point A
utilize higher combination of both inputs to produce the same output (100 kg coffee). Point
A shows the least combination of inputs that can yield 100 kg coffees. Thus, all other points
are inefficient and not part of the isoquants.
Thus, efficiently requires that isoquants must be negatively sloped. As employment of one
factor increases, the employment of the other factor must decrease to produce the same
quantity efficiently.
2. The further away an isoquant lays from the origin, the greater the level of output it
denotes: Higher isoquants (isoquants further from the origin) denote higher combination
of inputs. The more inputs used, more outputs should be obtained if the firm is

producing efficiently. Thus, efficiency requires that higher isoquants must denote higher
level of output.
3. Isoquants do not cross each other: This is because such intersections are inconsistent
with the definition of isoquants1:
2.4: Crossing Isoquants
Capital
q=50
Q=20
K*
L*
The above figure (figure 2.5) shows that the firm can produce at either output level (20 or 50) with the same
combination of labor and capital (L* and K*). The firm must be producing inefficiently if it produces q = 20,
because it could produce q = 50 by the same combination of labor and capital (L* and K*). Thus, efficiency
requires that isoquants do not cross each other.
4) Standard isoquants are convex to the origin: The slope of an isoquant is called marginal rate of
technical substitution. Marginal rate of technical substitution declines as we substitute an input for the other.
This makes isoquants convex to the origin.
Figure 2.5: Convex Isoquants
Capital
Labor
1
Efficiency requires that isoquants do not cross each other because the point of their
intersection implies that there is inefficiency at this point.

Special Shapes of isoquants

Isoquants can have different shapes (curvature) depending on the degree to which factor
inputs can substitute each other.
1. Linear Isoquants: Isoquants would be linear when labor and capital are perfect
substitutes for each other. In this case, the slope of an isoquant is constant. As a result,
the same output can be produced with only capital or only labor or an infinite
combination of both.
Figure 2.6: Linear Isoquant
K
10
q=100
8
12 15
L
Capital and labor can perfectly substitute each other so that the same output (q=100) can be
produced by using either 10k or 8K and12L or 15L or an infinite combinations of both
inputs.
2. Fixed Factor Proportion or L-shaped Isoquants: When a production function
assumes fixed proportion between capital and labor, the isoquant takes “L”-shape. It is
also called Leontief isoquant. This assumes strict complementarities or zero
substitutability of factors of production. In this case, it is impossible to make any
substitution among inputs. Each level of output requires a specific combination of labor
and capital: Additional output cannot be obtained unless more capital and labor are
added in specific proportions. As a result, the isoquants are L-shaped. See the following
figure. For example to derive a car we always need one driver for one car which a one
to one ratio in this case.
Figure 2.7: L-shaped isoquant when isoquants are L-shaped

q3
q2
K2
q1
K1
L
L1 L2
There is only one efficient way of producing a given level of output: Only one combination
of labor and capital can be used to produce a given level of output. To produce q1 level of
output there is only one efficient combination of labor and capital (L1 and K1). Output
cannot be increased by keeping one factor (say labor) constant and increasing the other
(capital). To increase output (say from q1 to q2) both factor inputs should be increased by
equal proportion.
3. Kinked Isoquants: This assumes limited substitutability between inputs. Inputs can
substitute each other only at some points. Substitution of inputs is possible only at the
kink points. Thus, the isoquant is kinked and there are only a few alternative
combinations of inputs to produce a given level of output. These isoquants are also
called linear programming isoquants or activity analysis isoquants.
Figure 2.8: Kinked Isoquant

K
12 A
7 B
5 C
D
3
Q=100
L
1 3 5 9
In this case labor and capital can substitute each other only at some point at the kink (A, B,
C, and D). Thus, there are only four alternative processes of producing q=100 output.
4. Smooth and Convex Isoquants: This shape of isoquant assumes continuous
substitution of capital and labor over a certain range, beyond which factors cannot
substitute each other. Basically, kinked isoquants are more realistic: There is often limited
(not infinite) method of producing a given level of output. However, traditional economic
theory mostly adopted the continuous isoquants because they are mathematically simple to
handle by the simple rule of calculus, and they are approximation of the more realistic
isoquants. From now on we use the smooth and convex isoquants to analyze the long run
production.
Figure 2.9: Smooth and Convex Isoquant

K
∆K=4
∆L=1
∆K=2 ∆K=1/2
∆L=1 Q
∆L=1
L
This type of isoquant is the limiting case of the kinked isoquant when the number of kink is
infinite. The slope of the isoquant decrease as we move from the top (left) to the right
(bottom) along the isoquant. This indicates that the amount by which the quantity of one
input (capital) can be reduced when one extra unit of another inputs (labor) is used (so that
out put remains constant) decreases as more of the latter input (labor) is used.
Marginal Rate of Technical Substitution MRTS
The slope of an isoquant (-K/L) indicates how the quantity of one input can be traded off
against the quantity of the other, while out put is held constant. The absolute value of the
slope of an isoquant is called MRTS. The MRTS shows the amount by which the quantity
of one input can be reduced when one extra unit of another input is used, so that output
remains constant. MRTS of labor for capital, denoted as MRTS L, K (Marginal rate of
technical substitution between labor and capital) shows the amount by which the input of
capital can be reduced when one extra unit of labor is used, so that output remains constant.
The MRTS L, K decreases as the firm continues to substitute labor for capital (or as more of
labor is used). In fig.3.11 to increase the amount of labor from 1 to 2, the firm reduces 4
units of capital (K=4), to increase labor from 2 to 3, the firm reduce 2 units of capital
(K=2), and so on. Hence, the firm reduces lower and lower number of capital for the
successive one unit of labor. Dear learner, why does this happen?

The reason is that when the number of capital is large and that of labor is low, the
productivity of capital is relatively lower and that of labor is higher (due to the low of
diminishing marginal returns). Thus, at this point relatively large amount of capital is
required to replace one unit of labor (or one unit of labor can replace relatively large
amount of capital). As the employment of labor increases and that of capital decreases (as
we move down ward along the isoquant), quite the reverse will happen. That is,
productivity of capital increases and that of labor decreases. Hence, the amount of capital
that needs to be reduced increase when one extra labor is used decreases. The fact that the
slope of an isoquant is decreasing makes an isoquant convex to the origin. MRTS L, K (the
slope of isoquant) can also be given by the ratio of marginal products of factors:
K MPL
MRTS L , K    ………………………….. 2. 5
L MPK
Proof: Suppose the production function is given as:
q= f (L, K) ………………………………………… 2.6
The equation of a specific isoquant, given the production function, can be obtained by
equating the production function with a given level of output q :
q = f (L, K) = q
Total differential of q measures the total change in q that happens as a result of a

simultaneous change in L and K:
q f
dq  .dL  .dk  d q
L k
d q is zero (d q =0) because q is constant:
q q
.dL  dk  0
L k
q q
(But,  MPL and  MPk )
L k
Thus, the above equation can be written as:
MPL. dL + MPK.dk = 0
MPL  dK
  = MRTSL,K
MPk dL
There fore, the slope of an isoquant can be given as the ratio of marginal products of inputs.

Elasticity of Substitution: MRTS as a measure of the degree of substitutability of factors

has a serious defect. It depends on the units of measurement of factors. A better measure of
the ease of factor substitution is provided by the elasticity of substitution, δ. Elasticity of
substitution is percentage change in capital labor ratio divided by percentage change in
marginal rate of technical substitution. The elasticity of substitution is defined as
K
K %
% L
  L = …………………… 2. 7
MPL
% MRTS %
MPK
K
( )
d L
K
=
L
 MPL  MPL
d  ( )
 MPK  MPK
The elasticity of substitution is a pure number independent of the units of measurement of
K and L, since the numerator and the denominator are measured in the same units and be
cancelled.
Factor Intensity: A process of production can be labor intensive or capital intensive or neutral process. A
process of production is called labor intensive if it uses relatively large amount of labor than capital. If it uses
many capitals and relatively few labor it is called capital intensive technology. On the other hand, if the
process uses equal proportion of both it is called neutral technology. The factor intensity of any process is
measured by the slope of the line through the origin representing the particular process. Thus, the factor
intensity is the capital-labor ratio. The higher the capital-labor ratio is the higher the capital intensity but the
lower the capital-labor ratio is the higher labor intensity of the process.
Figure 2.10: Factor Intensity
Capital
A
K1
B
K2 X
O
L2
L1 Labor
Process A uses k1 and L1 units of labor and capital to produce X amount of output. The
factor intensity of this process can be measured by the slope of OA, which equals
OK 1 K 1
AL1/OL1 =  ………………………………… 2.8
OL1 L1
K2
Similarly, factor intensity of process B is given by
L2
K1 K 2
Since  , process A is more capital intensive than process B or B is more labor
L1 L2
intensive than A. The upper part of the isoquant includes more capital intensive processes
and the lower part, labor intensive techniques.
Now let us illustrate the above concepts with the most popular and applicable form of
production function, Cobb-Douglas production function.
Example 2.1: The Cobb- Douglas production function is of the form:
X  b0 Lb1 K b 2 …………………………………… 2. 9
From this production function:

X
1. MPL =  b1b0 Lb11 K b2
L
Lb1 b 2
since X  b0 L K
b1 b2
= b0 b1 K
L
X
 b1
L
= b1APL
K
MPK =  b2 b0 Lb1 K b 2 1
L
X
since X  b0 L K
b1 b2
= b2
K
= b2 APK
2. Marginal rate of technical substitution

X
b1
MPL L  b1 . K
(MRT SLK) = 
MPK X b2 L
b2
K
3. Elasticity of substitution
K
 
d L 
K
 L
MPL
d( )
MPK
MPL
MPK
K K
   
d L  d L 
K K
 L  L
d (b1 K L) (b1 ) d ( K L)
b2 b2
b1 K b1 K
b2 L b2 L
 1
4. Factor intensity
It is measured by the ratio b1/b2. The higher the ratio, the more labor intensive the technique.
b1
The lower the ratio of , the more capital intensive the technique.
b2
Efficiency of Production
This is measured by the coefficient b0. It is clear that if two firms have the same K, L, b 1
and b2 and still produce different quantities of output, the difference could be due to the
superior organization and entrepreneurship of one of the firms, which results in different
efficiencies. The more efficient firm will have a larger b0 than the less efficient one.

Efficient Region of Production in the Long run

In principle, the marginal product of a factor may assume any value, positive, zero or
negative. However, the basic production theory concentrates only on the efficient part of
the production function, i.e. over the range of out put over which the marginal product of
factors are positive and declining. In the short run production function, efficient region of
MPL
production prevails in stage two (stage II), where MPL >O, but < 0.
L
Moreover, efficient region of production in the long run prevails when the marginal product
of all variable inputs is positive but decreasing. In a given isoquant all points are not
economically efficient. Graphically this can be represented by the negatively slopped part
of an isoquant. The locus of points of isoquants where the marginal products of factors are
zero form the ridge lines. The upper ridge line implies that the MP of capital is zero. MP K is
negative for all points above the upper ridge line and positive for points below the ridge
line. The lower ridge line implies that the MP L is zero. For all points, below the lower ridge
line the MPL is negative and positive for points above the line. Production techniques are
technically efficient inside the ridge lines. In the long run efficient production region
can be illustrated as:
MPL
MPL >0, but <0
L
MPk
MPk >0, but <0
K
Figure 2.11: Economic Region of an Isoquant
Capital
Upper ridge line
Lower ridge line
q3
q2
q1
Labor

The efficient region of production is defined by the range of isoquants over which they are
convex to the origin. The area between the two ridge lines is called economic region or
technically efficient region of production.
MPL
From our previous section we know that MRTS L , K  and along the lower ridge
MPK
0
line since MPL is zero, MRTS L , K   0 .Along the upper ridge line
MPK
MPL MPL
MRTS L , K  .since MPK is zero, MRTS L , K    .Note that MRTSK,L equals to
MPK 0
zero along the upper ridge line
Long Run Law of Production: Law of Returns to Scale
The laws of production describe the technically possible ways of increasing the level of
production. Output may increase in various ways. In the long run, output can be increased
by changing all factors of production. This long run analysis of production is called Law of
Returns to Scale.
In the short run, output may be increased by using more of the variable factor, while capital
(and possibly other factors as well) are kept constant. The expansion of output with one
factor (at least) constant is described by the law of variable proportion or the law of returns
to the variable factor.
In the long run, all inputs are variable. Expansion of output may be achieved by varying all
factors of production by the same proportion or by different proportions. The Law of
Returns to Scale measures the change in output when all inputs are altered by same or
different proportion.
The traditional theory of production concentrates on the first case, i.e. the study of output
as all inputs change by the same proportion. The term returns to scale refers to the change
in output as all factors change by the same proportion. Due to the proportionate change in
inputs, output may change in three ways; Output changes more proportionately than the
change in inputs. This is the case of increasing returns to scale IRS. Output changes less
proportionately than the change in inputs. When the percentage Change in output is less
than that of the inputs we have what is called decreasing returns to scale DRS. When

output changes by the same percentage that inputs have been changed, the Production
function is said to exhibit constant returns to scale CRS.
Suppose initially the production function is given by X0 = f (L, K). If we increase all
factors by the same proportion c, we clearly obtain a new level of output X* where X* = f
(cL, cK) ; if X* increases by the same proportion c or if X* = cX 0, we say that there is
constant returns to scale. If X* increases less than proportionally with the increase in the
factors (or if X* increases by a proportion less than c), we have decreasing returns to scale
and if X* increases more than proportionally with the increase in the factors (by a more
than c proportion), we have increasing returns to scale.
Returns to Scale and Homogeneity of Production Function
Suppose we increase both factors of the function X0=f (L, K) by the same proportion ‘c’,
and we get the new level of output X = f (cL, cK).
If c can be factored out (that is, may be taken out of the brackets as a common factor), then
the new level of output X* can be expressed as a function of c (to any power v) and the
initial level of output. Such production function is called homogeneous production
function. X* = c v f (LK) or X* =c V
X0.
If c can not be factored out, the production function is non-homogeneous. Thus, a
homogeneous function is a function such that if each of the input is multiplied by c, then c
can be completely factored out of the function. The power v of c is called degree of
homogeneity of the function and is measure of returns to scale.
If v =1, we have constant returns to scale. This production function is sometimes called
linear homogeneous. If v <1, decreasing return to scale prevails; If v >1, increasing return
to scale prevails; and for a Cobb-Douglas production function the sum of the power of L
and K measures the nature of returns to scale. Assume a Cobb-Douglas production function
given as X = b0Lb1 Kb2, v = b1 +b2 and it is a measure of returns to scale.
Proof: Let L and K increase by c. The new level of output is:
X* = b0 (cL) b1 (ck) b2
X* = b0 cb1 lb1 cb2kb2
X* = b0Lb1Kb2 cb1+b2
X* = X (c b1+b2)
Thus v = b1+b2

Example 2.1: If a production function is given by Q 0=100 L0.3K 0.4

check whether the
production function exhibits CRS, DRS or IRS?
Solution:
 Change all inputs by a certain percentage c:
Q1 =100 (cL) 0.3 (cK) 0.4
=100(c0.3) L 0.3 (c0.4) K0.4
=100 c0.3+0.4 (L 0.3 K0.4)
=c 0.7 (100 L 0.3 K0.4)
Q1 = c 0.7 (Q0) v=0.7 < 1.
Therefore, the production function exhibits decreasing returns to scale or since the above
production function is an example of Cobb-Douglas production function, v= b1 + b2.
v=0.3 +0.4 =0.7(DRS)
Example 2.3: Assume a production function given as Q0 = 10L+5K.Does the production
function have CRS, DRS or IRS?
Answer
 Change all inputs by a certain proportion (c)
Q1 =10(cL)+ 5 (cK)
= c (10L) +c (5K)
= c (10L+5K), by factoring out c
Q1 = c Q0, since v=1, the production function exhibits constant returns to scale
For a homogeneous production function the returns to scale may be represented graphically
in an easy way. Before explaining the graphical representation of the returns to scale it is
useful to introduce the concept of product line and isoclines.
2.2: Theory of Cost of Production
2.2.1: Basic Concepts
Cost is one of the most important in any business decisions making process because it
determines business profits and objectives of the businesses. There are many types of costs
that a firm may consider relevant for decision making under varying situations. The manner
in which costs are classified or defined is largely dependent on the purpose for which the
cost data are being outlined.

Explicit Cost and Implicit Cost: Costs are said to be explicit when the expense which are
incurred by a firm in buying goods and service are directly known. Monetary expenses
incurred by a producer to hire workers, purchase of raw materials, power etc are explicit
costs. Implicit costs refers to the expenses which are owned are inputted for self owned
and self-employed resources, salary of the owner of firm, rent on own building etc are
called implicit costs.
Money Cost and Real Costs: A firm usually incurs money expenses for producing a
commodity. It may spend money on wages, salary, raw materials, plant and equipment etc
which are called money expenses. Real costs are those where the members of the society
make sacrifices in their efforts to produce a commodity. These sacrifices and efforts are the
real cost of product. Workers sacrifices and efforts of the member of the society are called
real cost of production.
Private Costs Vs Social Costs: Private costs are those that achieve directly to the
individuals of firms engaged in relevant activity. It refers to those which are actually
incurred or provided for by an individual or a firm on the purchase of goods and service
from the market. Private costs are internalized in the sense that the firm must composite the
resource owner in order to acquire the right to use the resources. External costs, on the
other hand, are passed on the persons not involved in the activity directly.
Social cost implies the cost which a society bears on account of product of a commodity.
For example; pollution, noises, etc. resulting from production are not included in the cost
structure of a firm and hence are treated as external costs from firm’s point of view.
However, such costs adversely affect and make the nearby people incur higher costs in
terms of treating the water for their use, or having to travel a great deal to fetch portable
water. If those external costs were included in the production costs of the producing firm, a
true picture of real or social costs of the output would be obtained. Ignoring external costs
may lead to an inefficient and undesirable allocation of resources in the society.
Fixed and variable costs: Fixed costs are those costs which in total do not vary with
change in output. Fixed costs are associated with the very existence of a firm’s plant and
therefore must be paid even if the firm’s output is zero. Costs such as interest on borrowed
capital, rental payment, a portion of depreciation changes on equipment and buildings, and
the salaries of top management and key personnel are generally fixed costs. On the other

hand, variable costs are those costs which increase with the level of output. They include
payment for raw materials, charges on fuel and electricity, wages and salaries of temporary
staff, depreciation charges associated with wear and tear of assets, and sales commission,
etc.
This distinction is true only for the short run. The costs associated with fixed factors are
called the fixed costs and the one associated with variable factors, are the variable costs.
Thus, if capital is the fixed factor, capital rent is taken as the fixed cost and if labour is the
variable factor, wage bill is treated as the variable cost.
2.2.2: Analysis of Cost in the Short run
The short run, as you remember from earlier discussion, is normally defined as a time
period over which some factors of production (at least one factor of production) are fixed
and others are variable. Our analysis of cost shows the relationship between input used and
output produced in the production process. Thus we consider that cost as a function of
output:
C  f (Q ) ................................................. 2.9
We begin our analysis of short run costs by defining in detail the various short run costs in
relation to production. Note that the basic cost concepts used in the analysis of cost output
relation are total, average and marginal costs. Short run total cost is composed of total fixed
cost and total variable cost.
a) Fixed Cost FC is those costs which in total do not vary with change in output. They are
associated with the very existence of a firm’s plant and therefore must be paid even if its
output is zero. Examples of fixed costs are: rental payments, depreciation on equipment
and buildings, insurance premiums and the salaries of top management and the key
personnel are generally fixed costs. Fixed costs cannot be avoided in the short run.
b) Variable Cost VC is those costs, which change with the level of output. They include
payments for materials, fuel, power, transportation service, etc.
c) Total Cost TC of any level of output is the sum of the value of all inputs used over any
given period to produce goods. It is the sum of fixed and variable costs at each level of
output:
TC  FC  VC ........................................... 2.10

Table 2.0: Different Types of Short run Costs

1 2 3 4= 2+3 8=∆4/∆1
5= 7=
6=
Q TFC TVC TC AFC AVC ATC MC

0 60 0 60 - - - -
1 60 30 90 60 30 90 30
2 60 40 100 30 20 50 10
3 60 45 105 20 15 35 5
4 60 55 115 15 13.75 28.75 10
5 60 75 135 12 15 27 20
6 60 120 180 10 20 30 45
Figure 2.12: TC and TFC

COST
TC
TVC
TFC
TFC
Short Run Average Costs and Marginal Costs

i. Average Fixed Cost AFC: It is the total fixed cost divided by the number of units
output produced. It is fixed cost incurred per unit of output.

AFC  TFC / Q
............................................ 2. 11
ii. Average Variable Cost AVC: It is the total variable cost divided by the number of
units of output. Variable cost per unit of output produced.
AVC  VC / Q ................................................ 2.12
iii. Average Total Cost ATC: It is defined as total cost divided by the number of
output produced
FC  VC FC VC
ATC  TC / Q     AFC  AVC
Q Q Q
................................................. 2.13
iv. Marginal Cost MC: is the additional cost incurred to obtain one more units of
output. It is the increment in total or variable costs due to production of one more
units of output in the production process.
MC = ∆TC/∆Q=∆TVC/∆Q ....................... 2.14
Example 2.4: given the cost function of a firm by TC  Q 3  10Q 2  55Q  100 Where, TC
is the total cost and Q is the output level:
a. Find the fixed cost of the firm
b. Workout the average total cost, average variable cost and marginal cost function of
the firm
Answer
a. Fixed cost of the firm is the part of the cost that doesn’t vary with level of output or
it is the cost that the firm incur even when there is no production at all. Therefore,
the fixed cost (FC) is Birr 100
b. Average total cost ATC is total cost per unit of output or total cost divided by output
produced
3
Q  10Q 2  55Q  100 100
ATC   Q 2  10Q  55 
Q Q
3
Q  10Q 2  55Q 
AVC   Q 2  10Q  55
Q

dTC
MC   3Q 2  20Q  55
dQ
Relationship between MC, AC, AVC and AFC

We can see form the above table (table 2.0) that there is some kinds of pattern and
relationship between average and marginal costs. Let us see one by one. The total fixed
cost is, by definition, independent of output; therefore, AFC will decline so long as output
increases. As output increases, a given total fixed cost of 60 is obviously being spread over
a longer and larger output. We find in the following figure (figure 2.1) that the AFC curve
is continuously declining as the output is increasing. Average and marginal costs have
specific shapes (see figure 2.1) which can be explained in relation to output. AVC is U-
shaped. That is, it declines initially, reaches a minimum, and then increases again. The
reason for this curvature lies in the theory of short run production. Recall form our
discussion of short run production that, as more of the variable factors is employed initially
its productivity increases. As a result, variable cost per unit will decline. Thus, because of
increasing returns initially, it takes fewer and fewer additional variable resources to
produce each of the first units of output.
The productivity of the variable factor declines As increased quantities of the variable
factors are combined with the fixed factors. In other words beyond a certain point AVC
rises as diminishing returns recuperate the use of more and more variable resources to
produce each additional units of output. Hence, AVC is U- shaped.
Average total cost is also U-shaped. But since it is the summation of AFC and AVC, the
shape of ATC takes the relative weights of the two average costs stated above. Note that
since both AFC and AVC declines initially so much the ATC.
Figure 2.13: Average and Marginal Short run Cost Curves

AC
MC
AVC
AFC
Q
Q1 Q2
2.2.3: Relationship between Short run Per Unit Production and Cost Curves
Earlier in this chapter we have said that cost function is derived from production function.
The relationship is that the short runs per unit costs are the mirror reflection (against the x-
axis) of the short run production curves. That is the short run AVC is the mirror reflection
of the short run AP of the variable input. When AP variable input increases, AVC decreases;
when AP variable input reaches its maximum, the AVC reaches its maximum point, and
finally when AP variable input starts to fall, the AVC curve starts to rise. The same
relationship exists between the short run MP of variable input curve and the MC curve.
This can be shown algebraically by using a linear short run cost function. Suppose the firm
uses two inputs, labour L (which is variable) and capital K (which is fixed input). Suppose
again that the prices of both factors are given and equal to w, and r respectively:
TC = rK + w.L ......................................... 2.15
The first term (i.e. rk) is the fixed cost because both r & k are constant. And the second
term WL is variable cost. Thus, TVC = WL.
1
TVC WL Q
AVC = Q = Q = W. L

Q 1
However, L represents APL. Therefore, AVC = W. APL . Hence, AVC and APL are
inversely related. Similarly, for MC& MPL:
dTC dTVC dTC
MC = = (Remember that MC =
dQ dQ dQ
d (W .L )
MC =
dQ
dL
MC = W. dQ ……… (b/c w is constant)
dL
MC = W. dQ
1
MC = W. dQ
dL
1 dQ
MC = W. (b/c = MPL). Hence, MC and MPL have also an inverse relation.
MPL dL
Figure 2.14: Relationship b/n Production and Cost Curves

AP, MP
APL
MPL
AVC, MC L
MC
AVC
2.2.4: Analysis of Long Run Cost Functions

In the long run, all inputs or factors are variable. There are no fixed factors of production.
As a result, all costs are variable. In fact, we define the long run as that period long enough
to vary all inputs.
The long run decision focuses on a determination of which size plant to build. Each plant
size is represented by a short run AC curve, so the long-run decision is the selection of the
desired short run cost curve. The decision will be based on the output the firm expects to
produce (see figure 2.15). Suppose that the technological factors (given by the production
function) are such that only three plant sizes are feasible. These plants are represented by
AC1, AC2, and AC3 in figure 2. 15. The long run decision of which short run curve to be
on would depend on the planned output of the firm. If output is to be less than Q1, then the
plant represented by AC1 should be built because it represents the plant size that will
produce any output level between zero and Q1 at a per-unit cost which is lower than it
would be for any other plant size. Likewise, if output between Q1 and Q2 are planned, the
plant represented by AC2 should be built. In the long run, the average cost curve facing this
firm is DEFGHI.
It is likely that more than three alternative plant sizes are available, and in the planning
stage they would all be examined. Assume the firm faces all the alternative short-run curves
as depicted in figure 2.15 below.
Figure 2.5: Alternative Plant Sizes Firms Production Decision in the Long run

Cost
D
AC1
AC2
AC3 Q
F
H
E
G
I
Q1 Q2
The long run decision of the firm is the determination of which size plant to build. This
decision is the selection of the desired short-run cost curve.
All the possible short run curves are tangent to a curve that is sometimes referred to as a
planning curve. It is called a planning curve because in the planning stage any point on the
curve could be chosen by building a certain size plant. Such a planning curve, more
commonly called the long run average cost curve (LRAC), is shown in figure1.5. The long
run average cost curve then represents the lowest attainable average cost of producing any
given output. For example, if you knew you were going to produce exactly Q units of
output, plant size AC4 would have the lowest average cost of doing so.
Only at point A on figure 2.16, which represent an output of Q1 units, is a tangency
between the minimum point on the short-run average cost curve and the minimum point on

the LRAC curve. This point is referred to as the optimum plant size. This is the optimal
size plant because it represents the short run AC curve with the lowest attainable per unit
costs.
Figure 2.16: Long run Average Cost Curve
LRAC
Cost
AC1
AC2
AC3
AC4
0
Q Q1
All the possible short run cost curves are tangent to a curve called the planning curve. This
planning curve is the long run average cost curve and represents the lowest attainable
average cost of producing any level of output. The optimal plant size would be found at
point A where the minimum point on the short-run average cost curve is tangent to the long
run average cost curve at its minimum point.
In the long run, the optimum plant size is a point where LAC is at minimum (point A in
figure 2.16). The shape of the LAC reflects the laws of returns to scale. According to this
law the unit cost of production decreases as plant size increases due to economics of scale.
Economics of scale result in cost saving arising from increasing the size of a firm.
Economics of scale is decreasing unit cost of production arising from increasing the size of
a firm. If the plant increases beyond the optimum size, there are diseconomies of scale

arising from managerial inefficiencies. Management become highly complex, managers are
over worked and the decision making process become less efficient as the plant size
increases beyond its optimum.
Generally, economics of scale give rise to the negatively sloped portion of the LAC (cause
the LAC to decreases). After certain point of output, LAC starts to rise because of
diseconomies of scale.
Figure 2.17: Scales of Production
Economies of Diseconomies of
scale scale
Constant returns to scale
Q1 Q2
2.3: Equilibrium of the firm: Choice of Optimal Combination of Factors of

Production
An isoquant denotes efficient combination of labor and capital required to produce a given
level of out put.This does not mean that the monetary cost of producing a given level of out
put is constant along an isoquant. That is, though different combinations of labor and
capital on a given isoquant yield the same level of out put, the cost of these different
combinations of labor and capital could differ because the prices of the inputs can differ.
Thus, isoquant shows only technically efficient combinations of inputs, not
economically efficient combinations.
Technical efficiency takes in to account the physical quantity of inputs where as economic
efficiency goes beyond technical efficiency and seeks to find the least cost (in monetary
terms) combination of inputs among the various technically efficient combinations. Hence,

technical efficiency is a necessary condition, but not a sufficient condition for economic
efficiency. To determine the economically efficient input combinations we need to have the
prices of inputs.
Assumptions of Optimal Input Combination
1. Goal of the firm is maximization of profit

2. Price of the product is given (constant)
3. Prices of inputs are given (constant)
Now before we go to the discussion of optimal input combination (or economically
efficient combination), we need to know the isocost line, because optimal input is defined
by the tangency of the isoquant and isocost line.
Isocost Line
Isocost lines have the same properties as that of budget lines. An isocost line is the locus of
points denoting all combination of factors that a firm can purchase with a given monetary
outlay, given prices of factors of production.
Suppose the firm has C amount of cost out lay (budget) and prices of labor and capital are
w and r . The equation of the firm’s isocost line is given as:
C =rk+wL ……………………………. 2. 16
Given the cost outlay C , the maximum amounts of capital and labor that the firm can
C C
purchase are equal to and , respectively. The straight line that connects these points
r w
is the isocost line. Note that just like a budget line; the slope of the isocost line is given by
w
the factor price ratios. That is Slope of isocost equals to  (see figure 2.18).
r
Figure 2.18: Isocost Line
Capital
C/r
Isocost
line
Labor
C/w
Isocost line shows different combinations of labor and capital that the firm can buy given
the cost out lay and prices of inputs.
Now we are in a position to determine the firm’s optimal in put combination. However, the
problem of determining optimal input combination (economic efficiency) takes two forms.
Some times, situations may happen when a firm has a constant cost outlay and seek to
maximize its out put, given this constant cost outlay and prices of inputs. Still, there are
also situations when the goal of the firm is to produce a predetermined (given) level of
output with the least possible cost. The two situations are to be discussed below:
Case1: Maximization of Output Subject to Cost Constraint
Suppose a firm having a fixed cost outlay (money budget) which is shown by its isocost
line. Here, the firm is in equilibrium when it produces the maximum possible out put, given
the cost outlay and prices of inputs. The equilibrium point (economically efficient
combination) is graphically defined by the tangency of the firm’s isocost line (showing the
budget constraint) with the highest possible isoquant. At this point, the slope of the isocost
w MPL
line ( ) is equal to the slope of the isoquant ( ).The condition of equilibrium is:
r MPK
w MPL MPL MPK

 or  …………………………. 2.17
r MPK w r
This is the first order (necessary) condition. The second order (sufficient) condition is that
isoquant must be convex to the origin (tangent to the isocost) (see figure 2.19).
Figure 2.19: Optimal Combination of Inputs
Capital
Q3
K1 E
Q2
Q1

A Isoquant: x=100kg
L1 B Labor
Optimal combination of inputs is defined by the tangency of the isocost line (AB) and the
w
highest possible isoquant ( X 2 ), at point E. At this point the slope of isocost line ( ) is
r
MPL
equal to the slope of isoquant ( ).The second order condition is also satisfied by the
MPK
convexity of the isoquant.
The equilibrium condition can be derived mathematically:
Maximize X  f ( L, K )..........................Objective function
Subject to C  wL  rK ..........................Constra int function
or C  wL  rK  C  0
We use the lagrangian method to solve the problem. The lagrangian equation is written as:
  X   (C )
  
Then we find , , and and set all of them equal to zero to solve for
L K 
L and K .
 X MPL
That is,   X   ( wL  rK  C ) and   wL  0  MPL  w   
L L w
 X MPK
  r  0  MPK  r   
K K r

  wL  rK  w  0  wL  rK  C

Solving these equations simultaneously, we obtain the equilibrium condition as:
MPL MPK w MPL

 or 
w r r MPK
The second order condition (the convexity of isoquant) would be insured when:
2
2 X 2 X  2 X   2 X   2 X 
 0 , 0 and  2      
L2 K 2  L   K   LK
2

Example 2.5:Suppose the production function of a firm is given as X  0.5 L1 / 2 K 1 / 2

prices of labor and capital are given as $ 5 and $ 10 respectively, and the firm has a
constant cost out lay of $ 600.Find the combination of labor and capital that maximizes the
firm’s out put and the maximum output.

Answer
MPL MPK MPL w
The condition of equilibrium is  or 
w r MPK r
X
MPL   0.25L1 / 2 K 1 / 2
L
X
MPK   0.25L1 / 2 K 1 / 2
K
Thus, the equilibrium exists when:
0.25 L1 / 2 K 1 / 2 $5
1 / 2 1 / 2

0.25 L K $10
K 1
  L  2 K ...................................(1)
L 2
The constraint equation is:
wL  rK  C
5 L  10 K  600......................................(2)
Solving equation (1) and (2) would give us the optimal combination of L and K.
L  2K
5 L  10 K  600
 L=60 units and K=30 units.
Thus, the firm should use 60 units of labor and 30 units of capital to maximize its
production (Check the second order condition).The maximum output can be found by
substituting 60 and 30 for L and K in the production process.
Case 2: Minimization of Cost for a Given Level of Output
Consider an entrepreneur (a firm) who wants to produce a given output (for example a
bridge or a building or x tones of a commodity) with minimum cost outlay. That is, we
have a single isoquant which denotes the desired level of output, but there are a set of
isocost lines which denotes the different cost outlays. Higher isocost lines denote higher
production costs. The production costs of a desired level of output will therefore be
minimized when the isoquant line is tangent to the lowest possible isocost line (see

figure 2.20). At the point of tangency, the slope of the isoquant and isocost lines are
w MPL
identical. That is 
r MPK
Figure 2.20: Equilibrium Combination of Factors
Capital
e
c
K1
a
E
L1 b d f
Labor
The equilibrium combination of factors is K1 and L1 amounts of capital and labor
respectively. Lower isocost lines such as ‘ab’ are economically desirable but unattainable
given the desired level of output. So point E shows the least cost combination of labor and
capital to produce X amount of output.
Now let us see the mathematical derivation of the equilibrium condition. As mentioned
earlier, we minimize the cost of producing a given level of output.
Thus, the problem can be stated as:
Minimize C = f (q) = WL + rK -------------------------------------- (Objective function)
Subject to q = f (L, K) ------------------------------------------------ (Constraint function)
Or f (L, K) – q = 0
We use the Lagrangean method to obtain the equilibrium condition. The Lagrangean
function will be:
  C   ( f ( L, K )  q )
  WL  rK   ( f ( L, K )  q )

  
The condition of equilibrium will be obtained by finding , and and then
L K 
solving them simultaneous after equating each to zero.
 f ( L, K )
 w 0
L L
w
w  MPL  0   
MPL
 f ( L, K )
 r  0
K K
r
r  MPK  0   
MPK

 f ( L, K )  q  0

w r MPL w
Thus, the equilibrium condition is  or 
MPL MPK MPK r
 MPL W 
This condition    is only a necessary condition.
 MPK r 
The sufficient condition is that the isoquant must be convex to the origin. That is:
2
 2q  2q   2 q   2 q    2 X 
 0,  0 and  2  2    
L2 k 2  L  k   LK 
Example 2.6: Suppose a certain contractor wants to maximize Profit from building a
bridge. The contractor uses both labor and capital, and efficient combinations of Labor and
1 1
capital that are sufficient to make a bridge is given by the function 0.25 L 2 K 2 . If the
prices of labor (w) and capital (r) are $ 5 and $ 10 respectively, find the least cost
combination of L and K, and the minimum cost.
Answer
The contractor wants to build one bridge. Thus, the constraint equation can be written as
1 1
0.25 L 2 k 2 =1
1 1
MPL = 0.125 L 2 K2

1 1
MPK = 0.125 L 2 K 2
MPL W
The equilibrium condition is 
MPK r
1 1
0.125 L 2 K 2 $5
1 1

$10
0.125L K 2 2
K 1
  L  2K
L 2
Substituting L = 2K in the constraint equation we obtain
1 1
0.125 (2K) 2 K 2 =1
0.125 2 . K=1
1 8
K= K 
0.125 2 2
16
L = 2K 
2
16 8
Therefore, efficient combination (least cost combination) of L and K are and
2 2
respectively.
 16   8  160
The least cost is C = 5   + 10  =$
 2  2 2

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Adigrat University Department of Economics Microeconomics 2016

2. Theory of Producer Behavior

Chapter – II Producer Behavior Page 1 of 44

Chapter II Theory of Producer Behavior Page 2 of 44

Chapter II Theory of Producer Behavior Page 3 of 44

L1 L2 L3 Labor L (Variable input)

Chapter II Theory of Producer Behavior Page 4 of 44

Chapter II Theory of Producer Behavior Page 5 of 44

Chapter II Theory of Producer Behavior Page 6 of 44

Stage I Stage II Stage III

0 Units of labor (variable input)

Chapter II Theory of Producer Behavior Page 7 of 44

Chapter II Theory of Producer Behavior Page 8 of 44

 7  20 L  3L2  0 Using Quadratic solution method, a= 3, b= -20 and c= -7

c. The stages of production for the above production function is:

Chapter II Theory of Producer Behavior Page 9 of 44

Stage I Stage II Stage III

Chapter II Theory of Producer Behavior Page 10 of 44

Chapter II Theory of Producer Behavior Page 11 of 44

Chapter II Theory of Producer Behavior Page 12 of 44

Chapter II Theory of Producer Behavior Page 13 of 44

Special Shapes of isoquants

Figure 2.7: L-shaped isoquant when isoquants are L-shaped

Chapter II Theory of Producer Behavior Page 14 of 44

Figure 2.8: Kinked Isoquant

Figure 2.9: Smooth and Convex Isoquant

Chapter II Theory of Producer Behavior Page 17 of 44

q= f (L, K) ………………………………………… 2.6

Total differential of q measures the total change in q that happens as a result of a

Chapter II Theory of Producer Behavior Page 18 of 44

Elasticity of Substitution: MRTS as a measure of the degree of substitutability of factors

From this production function:

2. Marginal rate of technical substitution

Chapter II Theory of Producer Behavior Page 20 of 44

Chapter II Theory of Producer Behavior Page 21 of 44

Efficient Region of Production in the Long run

Lower ridge line

Chapter II Theory of Producer Behavior Page 22 of 44

Chapter II Theory of Producer Behavior Page 23 of 44

Chapter II Theory of Producer Behavior Page 24 of 44

Example 2.1: If a production function is given by Q 0=100 L0.3K 0.4

Chapter II Theory of Producer Behavior Page 25 of 44

Chapter II Theory of Producer Behavior Page 26 of 44

Chapter II Theory of Producer Behavior Page 27 of 44

Table 2.0: Different Types of Short run Costs

Q TFC TVC TC AFC AVC ATC MC

Figure 2.12: TC and TFC

Short Run Average Costs and Marginal Costs

Chapter II Theory of Producer Behavior Page 28 of 44

Chapter II Theory of Producer Behavior Page 29 of 44

Relationship between MC, AC, AVC and AFC

Figure 2.13: Average and Marginal Short run Cost Curves

Chapter II Theory of Producer Behavior Page 30 of 44

Chapter II Theory of Producer Behavior Page 31 of 44

Figure 2.14: Relationship b/n Production and Cost Curves

Chapter II Theory of Producer Behavior Page 32 of 44

2.2.4: Analysis of Long Run Cost Functions

Chapter II Theory of Producer Behavior Page 33 of 44

Chapter II Theory of Producer Behavior Page 34 of 44

Chapter II Theory of Producer Behavior Page 35 of 44

Figure 2.16: Long run Average Cost Curve

Chapter II Theory of Producer Behavior Page 36 of 44

Constant returns to scale