# UNIVERSITATEA “TRANSILVANIA” DIN BRAŞOV

FACULTATEA DE STIINTE ECONOMICE SI ADMINISTRAREA AFACERILOR

Stratulat Dan-Gabriel 12.01.2011

Profesor Coordonator: Tache Ileana

. As such. materials) to outputs. the technology available to the firm. The production function thus contains the limitations that technology places on the firm. Much of the literature in the past half century has been devoted to solving this endogeneity problem. and if the observed inputs are chosen as a function of these unobserved inputs (as will typically be the case for a profit-maximizing or cost-minimizing firm).e. the change in output from one additional unit of that factor). In economics. starting in the early 1800’s. they think first of production. It describes. an abstract way of discussing how the firm gets output from its inputs.1.g. The production function can thus answer a variety of questions. It states the amount of product that can be obtained from every combination of factors. Unfortunately.this history cannot be deemed an unqualified success. Perhaps the major econometric issue confronting estimation of production functions is the possibility that some of these inputs are unobserved. measure the marginal productivity of a particular factor of production (i. of course. A production function can be represented in a table such as the one below. always possible to waste resources and to produce fewer than 34 units with five units of labor and two of capital. When most people think of fundamental tasks of a firm. labor.. equation that expresses the relationship between the quantities of productive factors (such as labour and capital) used and the amount of product obtained. It can. then there is an endogeneity problem and OLS estimates of the coefficients on the observed inputs will be biased. estimation of production functions has a long history in applied economics. Economists describe this task with the production function. In this table five units of labor and two of capital can produce 34 units of output. but the table indicates that no more than 34 can be produced with the technology available. capital. Production functions relate productive inputs (e. Two of the earliest solutions to the problem are instrumental variables (IV) and fixedeffects estimation (Mundlak (1961)). in mathematical terms. If this is the case. as many of the econometric problems that hampered early estimation are still an issue today. assuming that the most efficient available methods of production are used. Concept of production functions
Production functions are a fundamental component of all economics. for example. It is. It can also be used to determine the cheapest combination of productive factors that can be used to produce a given output.

it is called a law. In one case. one must follow a column or row. The law of diminishing returns says that adding more of one input while holding other inputs constant results eventually in smaller and smaller increases in added output. This graph looks exactly like a graph of indifference curves because the mathematical forms of the production function and the utility function are identical. These lines are called isoquants. To see the law in the table above. the increases in production gradually fall. in the other. and as more labor is added.
. and because it always seems to hold. If one can visualize this as a three-dimensional graph. inputs of resources combine to produce goods or services. As one moves to the right. one reaches higher levels of production. The firm must operate on or below this surface.A Production Function Labor 5 30 34 37 4 26 30 33 3 21 25 28 2 16 20 23 1 10 13 15 1 2 3 Capital The production function can also be illustrated in a graph such as that below.
There is one rule that seems to hold for all production functions. inputs of goods and services combine to produce utility. one can see that the production surface rises increasingly high above the surface of the page. the marginal output of labor (which economists usually call marginal product of labor) is shown in the table below. The first unit of labor increases production by 13. the isoquants indicate a hill. If capital is held constant at two. A curved line in the graph shows all the combinations of inputs that can produce a particular quantity of output.

The presence of increasing returns means
. the idea had an influence on the work of Charles Darwin and traces of it still float around today among environmentalists. and the third to add seven. It is possible for the first unit of labor to add only four units of output. Although history has shown the gloomy expectations wrong. f(kX1.kX2) = knf(X1. It is not ability that changes. and the second is more able than the third. one would predict that (in equilibrium) there would always be some people almost starving.
The law of diminishing returns
The law of diminishing returns does not take effect immediately in all production functions. the environment becomes less and less favorable to the additional worker. as economists thought it did. Eventually. but also on the work environment they are in. eventually adding one more person would result in very little additional food production.The Marginal Product of Labor Labor Marginal Output First 13 Second 7 Third 5 Fourth 5 Fifth 4 2.X2). and it exhibits decreasing returns to scale if n < 1. They saw the amount of land as fixed. all workers are the same.X2) is said to be homogeneous of degree n. It is not caused because the first worker has more ability than the second worker. if given any positive constant k. By assumption. If a production function had this pattern. but rather the environment into which workers (or any other variable input) are placed. As additional workers are added to a firm with a fixed amount of equipment. the function exhibits increasing returns to scale.
3. it exhibits constant returns to scale. the equipment must be stretched over more and more workers. If the number of people expanded. and the number of people who could work the land as variable. And if population had a tendency to expand rapidly. People's productivity depends not only on their skills and abilities. If it is homogeneous of degree 1. The law was a central piece of economic theory in the 19th century and accounted for economists' gloomy expectations of the future. What the law of diminishing returns says is that as one continues to add workers. eventually one will reach a point where increasing returns stop and decreasing returns set in. The production function Q = f(X1. If n > 1. the second to add six. it would have increasing returns between the first and third worker. Homogeneous and homothetic production functions
There are two special classes of production functions that are often analyzed.

it is sometimes called "linearly homogeneous". energy of various sorts. < 1.412-414 Homothetic functions are functions whose marginal technical rate of substitution (the slope of the isoquant... then this form does not encompass joint production.. and constant if b + c + . Products require various types of labor and capital. A linearly homogeneous production function with inputs capital and labour has the properties that the marginal and average physical products of both capital and labour can be expressed as functions of the capital-labour ratio alone. if f maps from Rn to Rk then it is a joint production function expressing the determination of k different types of output based on the joint usage of the specified quantities of the n inputs.X2. Moreover.X2) is a homogeneous function of any degree. and the function h(X1. along rays coming from the origin.. and raw materials. = 1.X2. the firm's revenues will be exactly exhausted and there will be no excess economic profit.[4]:pp. in this case if each input is paid at a rate equal to its marginal product... Due to this. Constant returns to scale is the inbetween case. the presence of decreasing returns means that it would result in a less than one percent increase in output. In the Cobb-Douglas production function referred to above.. especially in larger firms. If a production function is homogeneous of degree one.. Homothetic functions are of the form F(h(X1. labour.X3.Xn = quantities of factor inputs (such as capital.. a curve drawn through the set of points in say labour-capital space at which the same quantity of output is produced for varying combinations of the inputs) is homogeneous of degree zero. which is a production process that has multiple co-products.. returns to scale are increasing if b + c + .
4.Specifying the production function
A production function can be expressed in functional form as the right side of
Q = f(X1. > 1.X3. One of the key inputs..that a one percent increase in the usage levels of all inputs would result in a greater than one percent increase in output. land or raw materials).X2)) where F(y) is a monotonically increasing function (the derivative of F(y) is positive (dF / dy > 0)).. but showing a production function with more than two inputs with graphs or tables is difficult. is managerial ability.. the slopes of the isoquants will be the same.
Most products require many more than two inputs. On the other hand. If Q is a scalar. Inputs do not combine by
. decreasing if b + c + ..Xn)
where: Q = quantity of output X1.

themselves to produce output.
. the latter reaching a maximum at point B (since the average physical product is at its maximum at that point). the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. In Stage 2. In this stage. In Stage 1 (from the origin to point B) the variable input is being used with increasing output per unit. although a firm facing a downward-sloped demand curve might find it most profitable to operate in Stage 1. a price-taking firm will always operate beyond this stage. In either case. and the average and marginal physical product are declining. In explaining the theory of the firm. economists conventionally assume that the production function is fixed and that the firm operates on the surface of the production function. it is common to divide its range into 3 stages. Or if morale is bad in a firm. The optimum input/output combination for the price-taking firm will be in stage 2. If business decision-makers lack information or are incompetent. However the average product of fixed inputs (not shown) is still rising. Stages of production
To simplify the interpretation of a production function. In Stage 3. a major challenge of management is to make decisions so that the firm will be on or close to the production function. Because the output per unit of the variable input is improving throughout stage 1. output increases at a decreasing rate. The output per unit of both the fixed and the variable input declines throughout this stage." Although economists assume that the firm will be on the production function. but may view it as a variable that it can alter through research and development. At the boundary between stage 2 and stage 3. the firm will not make the best use of available resources. Creativity in the form of new technology or new management techniques may loosen the boundary that the production function represents and may make possible greater profit. the firm will produce below the maximum that the production function allows. The firm need not consider the production function as fixed.
5. Economist Harvey Liebenstein has called losses of these sorts "X-inefficiency. at least temporarily. because output is rising while fixed input usage is constant. Someone must have knowledge of how to combine inputs and to coordinate the production process. too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. the highest possible output is being obtained from the fixed input. people may work poorly and produce less than they could.

and if it wants to produce two units of output then it has to use 2 machines and 4 workers.z . since z > y/b. the number of cars that may be produced from the vector (z . may be to use 1 machine and 2 workers.1} = 1 unit of output 2 machines and 4 workers yield min{2.6. Extra units of either input cannot be put to use. The only way to produce a unit of output. more generally. For example.
1 2 2 2 2 2
If there are more than two inputs.2/2} = min{2. a single-technique technology can be modeled by a production function with a similar form. for example.2} = 2 units of output
A general fixed proportions production function for two inputs has the form min{az . For example. and no substitution between the inputs is possible.z /2}. Examples of production functions
Fixed proportions
An important family of production functions models technologies involving a single technique of production. For example. y units of output from y/a units of input 1 and y/b units of input 2.z }. z ) of inputs. where input 1 is wheels.bz } = min{y. if four wheels.1} = 1 unit of output 2 machines and 2 workers yield min{2. one engine. or with 50g of
. one hamburger may be made with 100g of Canadian beef.4/2} = min{2. Check out the logic of this formula by considering the output it assigns to various combinations of machines and workers:
1 2 1 2
• • •
1 machine and 2 workers yield min{1. and one body are needed to make a car. and input 3 is bodies. input 2 is engines. is
1 2 3
min{z /4.
1 2 3
Perfect substitutes
A technology whose character is exactly the opposite to that of a fixed proportions technology allows one input to be substituted freely for another at a constant rate.2/2} = min{1. if the firm has available 2 machines and 2 workers then the extra machine simply sits idle. The technology this production function models involves a single technique that produces one unit of output from 1/a units of input 1 and 1/b units of input 2.bz } = y. the minimum of z and z /2. and.bz } for some constants a and b. z . if the firm has y/a units of input 1 and more than y/b units of input 2---say z units---then its output is min{a(y/a). Such a production function has fixed proportions. How can we describe such a technology precisely? If the only way to produce y units of output is to use y machines and 2y workers then the output from z machines and z workers is
1 2
min{z .

reducing the amount of labor time needed to 30 minutes.
1 2 1 u 2 v
An example of such a function is F (z . but cannot be substituted at a constant rate.
1 2 1 2
More generally. the same 100 units of output can be produced in 45 minutes using 150 units of raw material. Suppose that one person operating a machine for an hour can produce 100 units of output using 100 units of raw material. or any combination of the two inputs that sums to 100g. contains functions of the form F (z . u. either on the firm level or the aggregate level. however. and v. Some non-mainstream economists. Such a production function models a technology in which one unit of output can be produced from 1/a units of input 1. reject the very concept of an aggregate production function. In this case we can describe the technology precisely by the production function F (z .
1 2 1 2 1 2 1 2
A production function modeling smooth but not perfect substitution between inputs
Many technologies allow inputs to be substituted for each other. z ) = z z . Such a production function is known as a Cobb-Douglas production function. In this sense. z ) = az + bz for some nonnegative numbers a and b is one in which the inputs are perfect substitutes.
1 2 1 1/2 2 1/2
The production function is an assumed technological relationship. the amount of raw material needed may increase by much more than 50 units. but not at a constant rate. Almost all economic theories presuppose a production function. or from 1/b units of input 2. more raw material being needed since some is now wasted. z ) = Az z for some constants A. one input can be substituted for the other at a constant rate. any production function of the form F (z . it does not represent the result of economic choices. the production function is one of the key concepts of mainstream neoclassical theories. That is. based on the current state of engineering knowledge.Canadian beef and 50g of US beef. But if the speed is increased again.
. A class of production functions that models situations in which inputs can be substituted for each other to produce the same output. Perhaps if the speed of the machine is increased. since wastage may greatly increase. z ) = z + z . or from any combination of z and z for which az + bz = 1. but rather is an externally given entity that influences economic decisionmaking.