Session 13

Production Theory

Dr. Sarbjit Singh

Assistant Professor
Economics and Business Environment
Indian Institute of Management Jammu
Jammu, India
ssingh@iimj.ac.in
 Basic model of supply side economics through
input-output relations in the short and long
Learning run
Objectives
Why increase in firm size is considered good in
terms of lowering average cost?
 Agenda Items

 The organization of Production and the Production Function

 The Production Function with one Variable Input (Short Run)
 Returns to Factor

 The Production Function with Two Variable Inputs (Long Run)

 Firm’s Hiring Decision(s) in the Long Run
 Output Elasticity
 Returns to Scale
 Production Function
The maximum output of a commodity that a firm can produce with the
each set of inputs.

Short Run
𝑂𝑢𝑡𝑝𝑢𝑡 = 𝑓 𝐿, 𝐾

Long Run
𝑂𝑢𝑡𝑝𝑢𝑡 = 𝑓 𝐿, 𝐾

Time
Long Run
 Production Function
All/both the factors are Variable
𝑄 = 𝑓 𝐿, 𝐾 Production function
is represented by an
Labor Isoquant
Capital 1 2 3 4 5 6
A Curve depicting all
1 3 8 12 14 14 13
2 7 18 28 30 30 28 Output the possible
3 10 23 33 36 36 33 combinations of
4 12 28 36 40 40 38
inputs that yield the
5 13 28 36 40 42 40
6 10 24 31 38 40 39 same level of output
6
 Production Function
All/both the factors are Variable
𝑄 = 𝑓 𝐿, 𝐾

Labor Isoquant: A Curve

Capital 1 2 3 4 5 6 showing all the
1 12
2 28 28 possible
Output
3 36 36 combinations of
4 12 28 36
inputs that yield the
5 36
6 same level of output
7
 Production Function
All/both the factors are Variable
𝑄 = 𝑓 𝐿, 𝐾

Few of the Combinations Producing Same level of Output

Output Combination Combination Combination Combination Isoquant: A Curve
Level 1 2 3 4
showing all the
Labor = 2 Labor = 1
12
Capital = 1 Capital = 4 possible
Labor = 3 Labor = 6 Labor = 2 combinations of
28
Capital = 2 Capital = 2 Capital = 4
inputs that yield the
Labor = 3 Labor = 3 Labor = 4 Labor = 5
36
Capital = 4 Capital = 5 Capital = 3 Capital = 3 same level of output
8
 Isoquant Map

A set of isoquants, or isoquant map,

𝐶𝑎𝑝𝑖𝑡𝑎𝑙
describes the firm’s production function.

Output increases as we move from:

 Isoquant Q1 (at which 12 units are
produced),
 To isoquant Q2 (28 units), and
 To isoquant Q3 (33 units)
 Slope of an Isoquant

 Slope of an Isoquant is represented by

Marginal Rate of Technical Substitution

𝐶𝑎𝑝𝑖𝑡𝑎𝑙
(MRTS)

 MRTS is the rate at which one factor

must decrease so that the same level of
production can be maintained when
another factor is increased -2
+1
∆𝐾 𝑑𝐾 𝑀𝑃𝐿 -1
𝑀𝑅𝑇𝑆 = − =− =− +1
∆𝐿 𝑑𝐿 𝑀𝑃𝐾

 Diminishing MRTS
 Isoquants

Why are we only taking into

account the negatively sloped
portion of Isoquants?
 Ridge Lines

 Ridge lines separate the relevant

(negatively sloped) and irrelevant
(positive sloped) portions of isoquant
Ridge Lines
 Ridge Lines: OVI and OZI

 Firms will not produce in the positively

sloped portion of Isoquants because they
can produce the same with lesser
amount of labor and capital
 Ridge Lines

 Ridge lines separate the relevant

(negatively sloped) and irrelevant
(positive sloped) portions of isoquant

 Ridge Lines: OVI and OZI

 Firms will not produce in the positively

sloped portion of Isoquants because they
can produce the same with lesser
amount of labor and capital

 Area covered by the Ridge lines represent

economic region of production Economic Region of Production
 Isocost Line
 The Budget Constraint for a firm while buying factors of production.

 It represents all combinations of two inputs that a firm can purchase with the same
total cost.

𝐶: Total Cost
Isocost Line 𝐶 = 𝑤𝐿 + 𝑟𝐾
𝑤: Per unit Cost of Hiring Labor
𝐿: Units of Labor employed
𝐶 𝑤 𝑟: per unit Cost of Hiring Capital
𝐾= − 𝐿
𝑟 𝑟 𝐾: Units of Capital Employed

Intercept Slope of Isocost Line

 Isocost Line

Assume that a firm bi-weekly budget of Rs.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙
60,000 which needs to be spent on hiring
labor and capital for the production
purposes. The biweekly rental cost of
capital of capital is Rs. 20,000 and of labor 1
is Rs. 10,000. Draw the Isocost line for the 0,3
𝑆𝑙𝑜𝑝𝑒 = −
2
producer.

10,000𝐿 + 20,000𝐾 = 60,000

6,0
𝐿 + 2𝐾 = 6
Firm’s Hiring Decision
 Firm’s Hiring Decision (Long Run)

Output Cost Profit

Maximization Minimization Maximization

The highest
Minimizing Difference
production
the cost of between the
with in the
current total revenue
allocated
production and total cost
budget
 Firm’s Hiring Decision (Long Run)

Output
Slope of Maximization
Slope of
Isocost
Isoquant Cost
Line minimization

Profit
Maximization
𝑴𝑷𝑳 𝒘
− −
𝑴𝑷𝑲 𝒓

For more details, see Appendix to Chapter 7 on page 303

 Firm’s Hiring Decision (Long Run)
How much to produce given the input prices?
Isoquant
𝑄 = 𝑓 𝐿, 𝐾 Decision

𝐶𝑎𝑝𝑖𝑡𝑎𝑙
1
𝑀𝑅𝑇𝑆 = −
Isocost Line 2
𝐿 + 2𝐾 = 6

Demand for Capital

𝐼𝑄3
𝐼𝑄2

Demand for Factors of Production

Labor = 3
Capital =1.5 ≈ 2 Demand for Labor
Home Exercise

1. What would happen if price of Labor goes Up/Down?

2. What would happen if price of Capital goes up/Down?

3. What would happen if both Capital and Labor are perfect

substitutes of each other?

4. What would happen if both Capital and Labor are perfect

Compliments of each other?
Output Elasticity
 Output Elasticity
Responsiveness of Output due to change in Labor/Capital.

Output elasticity of Labor (𝐸𝐿 )can be calculated as:

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑂𝑢𝑡𝑝𝑢𝑡 ∆𝑄 𝑄

𝐸𝐿 = =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝐿𝑎𝑏𝑜𝑟 ∆𝐿 𝐿
𝐶ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑂𝑢𝑡𝑝𝑢𝑡 (∆𝑄)
𝑂𝑢𝑡𝑝𝑢𝑡(𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑜𝑟 𝐸𝑛𝑑 𝑉𝑎𝑙𝑢𝑒)
𝐸𝐿 =
𝐶ℎ𝑛𝑎𝑛𝑔𝑒 𝑖𝑛 𝐿𝑎𝑏𝑜𝑟 (∆𝐿)
𝐿𝑎𝑏𝑜𝑟 (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑜𝑟 𝐸𝑛𝑑 𝑉𝑎𝑙𝑢𝑒)
∆𝑄 ∆𝐿 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑜𝑓 𝐿𝑎𝑏𝑜𝑟
𝐸𝐿 = =
𝑄 𝐿 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑜𝑓 𝐿𝑎𝑏𝑜𝑟
 Output Elasticity
Take the end values of Output and
Total Marginal Average Labor and calculate the output
Sl. No. Labor Product Product Product elasticity of Labor for each Point
A 1 3 3 3 Point A to B
B 2 8 5 4 𝐸𝐿 =
∆𝑄 ∆𝐿
=
5 1
= = 1.25
5
𝑄 𝐿 8 2 4
C 3 12 4 4 𝑀𝑃 5
𝐸𝐿 = = = 1.25
D 4 14 2 3.5 𝐴𝑃 4
E 5 14 0 2.8
F 6 12 -2 2
 Output Elasticity
Take the end values of Output and
Total Marginal Average Labor and calculate the output
Sl. No. Labor Product Product Product elasticity of Labor
A 1 3 3 3
B 2 8 5 4
C 3 12 4 4
D 4 14 2 3.5
E 5 14 0 2.8 Point B to C
F 6 12 -2 2 ∆𝑄 ∆𝐿 4 1 4
𝐸𝐿 = = = =1
𝑄 𝐿 12 3 4
𝑀𝑃 4
𝐸𝐿 = = =1
𝐴𝑃 4
 Output Elasticity
Take the end values of Output and
Total Marginal Average Labor and calculate the output
Sl. No. Labor Product Product Product elasticity of Labor
A 1 3 3 3 Point C to D
∆𝑄 ∆𝐿 2 1 2
B 2 8 5 4 𝐸𝐿 = = = = 0.57
𝑄 𝐿 14 4 3.5
C 3 12 4 4 𝑀𝑃 2
𝐸𝐿 = = = 0.57
D 4 14 2 3.5 𝐴𝑃 3.5
E 5 14 0 2.8
F 6 12 -2 2
 Output Elasticity
Take the end values of Output and
Total Marginal Average Labor and calculate the output
Sl. No. Labor Product Product Product elasticity of Labor
A 1 3 3 3
B 2 8 5 4
C 3 12 4 4
D 4 14 2 3.5
E 5 14 0 2.8 Point D to E
F 6 12 -2 2 ∆𝑄 ∆𝐿 0 1
𝐸𝐿 = = =0
What is the Role of Output elasticity in 𝑄 𝐿 14 5
𝑀𝑃 0
Managerial decision making? 𝐸𝐿 = = =0
𝐴𝑃 2.8
Returns to Scale
 Returns to Scale
Change in output of a firm/industry resulting from a proportionate
increase in all inputs

𝑄 = 𝑓 𝐿, 𝐾 Increasing Returns to Scale

12 Output, 12
𝜆𝑄 = 𝑓 ℎ𝐿, ℎ𝐾 10
8
Inputs
6
Inputs (L,K), 4 Output, 4
4 (L,K), 2
Increasing Returns to Scale (𝝀>h) 2
0
Output is changing more than INPUTS (L,K) OUTPUT

proportionately to change in Inputs Prior Post

 Returns to Scale
8 Output, 8

Constant Returns to Scale (𝝀 =h) 6 Inputs(L,K)

,4 Output, 4
Output is changing in the same 4 Inputs(L,K)
,2

proportion to change in Inputs 2

0
INPUTS(L,K) OUTPUT

Prior Post

6 Output, 6
5
Decreasing Returns to Scale (𝝀<h) 4
Inputs, 4 Output, 4

3
Output is changing Less than 2
Inputs, 2

proportionately to change in Inputs 1

0
INPUTS OUTPUT

Prior Post
Thank You