270 PART THREE Production and Cost Analysis

months or weeks. For others, such as the construction of a new electricity-generating plant, it
may be many years. In the short run, a firm can increase output only by using more of the
variable inputs (say, labor and raw materials) together with the fixed inputs (plant and equip-
ment). In the long run, the same increase in output could likely be obtained more efficiently
by also expanding the firm's production facilities (plant and equipment). Thus, we say that
the firm operates in the short run and plans increases or reductions in its scale of operation in
the long run. In the long run, technology usually improves, so that more output can be
obtained from a given quantity of inputs, or the same output from less inputs.

The Production Function

Just as demand theory centers on the concept of the demand function, production theory
revolves around the concept of the production function. A production function is an
equa-tion, table, or graph showing the maximum output of a commodity that a firm can
produce per period of time with each set of inputs. Both inputs and outputs are measured
in physi-cal rather than in monetary units. Technology is assumed to remain constant
during the period of the analysis.
For simplicity we assume here that a firm produces only one type of output
(commod-ity or service) with two inputs, labor (L) and capital (K). Thus, the general
equation of this simple production function is

Q = f(L, K) [7-1]

Equation 7-1 reads: the quantity of output is a function of, or depends on, the quantity of
labor and capital used in production. Output refers to the number of units of the com-
modity (say, automobiles) produced, labor refers to the number of workers employed, and
capital refers to the amount of the equipment used in production. We assume that all units
of L and K are homogeneous or identical. An explicit production function would indicate
precisely the quantity of output that the firm would produce with each particular set of
inputs of labor and capital. Although our discussion will be in terms of a single output
produced with only two inputs, the principies that we will develop are general and apply
to cases in which the firm uses more than two inputs and produces more than one output
(the usual situation).
Table 7-1 gives a hypothetical production function that shows the outputs (the Q's) that
the firm can produce with various combinations of labor (L) and capital (K). The table

TABLE 7-1 d

Capital (K) 6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36 Output (Q)
3 10 23 33 36 36 33
2 7 18 28 30 30 28
K 1 3 8 12 14 14 12

1 2 3 4 5 6
L Labor (L)
 CHAPTER 7 Production Theory and Estimation 271

shows that by using 1 unit of labor (1L) and 1 unit of capital (1K), the firm would produce
3 units of output (3Q). With 2L and 1K, output is 8Q; with 3L and 1K, output is 12Q; with
3L and 2K, output is 28Q; with 4L and 2K, output is 30Q, and so on. Note also that labor
and capital can be substituted for each other in production. For example, 12Q can be
produced either with 3L and 1K or with 1L and 4K.1 Input prices will determine which of
these two combinations of labor and capital. is cheaper. The output that the firm will want
to produce is the one that maximizes its total profits. These questions will be examined
and answered later in the chapter.
The production relationships given in Table 7-1 are shown graphically in Figure 7-1,
which is three-dimensional. In Figure 7-1, the height of the bars refers to the maximum

FIGURE 7-1 Discrete Production Surface The height of the bars refers to the
maximum output (Q) that can be produced with each combination of labor (L) and
capital (K) shown on the axes. Thus, the tops of all the bars form the production
surface for the firm.

112Q could also be produced with 1K and 6L instead of 1K and 3L (see the last entry in the first row of the
table), but the firm would certainly not want to use this combination of labor and capital. Similarly, 12Q could
be produced with 1L and either 4K or 5K, but the firm would not want to use the latter input combination.
272 PART THREE Production and Cost Analysis

output that can be produced with each combination of labor and capital shown on the
axes. Thus, the tops of all the bars form the production surface for the firm.
If we assume that inputs and outputs are continuously or infinitesimally divisible
(rather than being measured in discrete units), we would have an infinite number of out-
puts, each resulting from one of the infinite number of combinations of labor and capital
that could be used in production. This is shown in Figure 7-2, in which the axes forming
the base of the figure measure the labor and capital inputs, while the height of the surface
gives the (maximum) level of output resulting from each input combination, all assumed
to be continuously divisible.
For example, by keeping the quantity of capital used at K1 in Figure 7-2 and increasing
the quantity of labor used from zero to L„ units (so that we are in the short run), the firm
generates the output shown by the height ofcross section K1AB (with base parallel to the
labor axis). On the other hand, by increasing the amount of labor used from zero to L„ units
but keeping capital constant at K2 rather than K1 (so that we are still in the short run), the firm
generates the output shown by the top of cross section K2CD. If instead the firm kept labor
constant at L1 and increased the quantity of capital used from zero to K2 units, the firm's
output would be the one shown by the top of cross section L1EF (with base parallel to the
capital axis). With labor constant at L2, on the other hand, the firm's output generated by
changing the quantity of capital used from zero to K„ units would be the one shown by the
height of cross section L,CD.

o
Labor

FIGURE 7-2 Continuous Production Surface The horizontal and inclined axes
measure, respectively, the labor and capital inputs, while the vertical axis measures the
height of the surface or the maximum level of output resulting from each input
combination—all assumed to be continuously divisible. The output generated by holding
capital constant at K i and increasing labor from zero to L2 units is given by the height of
cross section K 1AB (with base parallel to the labor axis).