Theory and Estimation of

Production

Naheed Memon
EMBA
Fall 2021
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Production Function
• The production function is a statement of the relationship between a firm’s scarce resources (i.e., its
inputs) and the output that results from the use of these resources.
• In mathematical terms, the production function can be expressed as:
Q = f(X1, . . . , Xk)
where Q = Output
X1, . . . , Xk 5 Inputs used in the production process
• we assume this relationship between inputs and output exists for a specific period.
• we are assuming some given “state of the art” in the production technology. Any innovation in
production
(e.g., the use of robotics in manufacturing or a more efficient software package for financial analysis)
would cause the relationship between given inputs and their output to change.
Second, we are assuming whatever input or input combinations are included in a particular function,
the output resulting from their utilization is at the maximum level.
• A production function defines the relationship between inputs and the maximum amount that can be
produced within a given period of time with a given level of technology.
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Shot-Run and Long-Run Production
Function
• in economic analysis the distinction between the short run and the long run is not related to any
measurement of time (e.g., days, months, or years).
• Instead, it refers to the extent to which a firm can vary the amounts of the inputs in its production
process.
• Thus, a short-run production function shows the maximum quantity of a good or service that can be
produced by a set of inputs, assuming the amount of at least one of the inputs used remains
unchanged.
• A long-run production function shows the maximum quantity of a good or service that can be
produced by asset of inputs, assuming the firm is free to vary the amount of all the inputs being used.

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• TP, MP, and AP resulting from increases in X, while holding Y constant at 2 units.
• These tables and the figure indicate that the total product is 7 when 1 unit of X is
used, it increases to a maximum of 54 when 7 units of X are used, and it decreases
to 52 units when unit 8 of the X input is added.
• Also notice in Table 6.3 that MP begins at 7 units, increases to a maximum of 12,
and falls off to an ultimate value of −2.
• Average product also begins at 7, increases to a maximum of 10, and then drops to
6.5 units when 8 units of X are combined with the fixed amount of Y.
• We can observe that when Q, the quantity of the total product, reaches its
maximum, MP 5 0.
• We see also that initially (as more units of X are added to the production process),
MP is greater than AP, and it then becomes less than AP.
• Furthermore, MP 5 AP at AP’s highest point. The maximum AP line in Figure 6.1a
allows you to see where this occurs on the TP curve.

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Law of Diminishing Returns
• This law states : As additional units of a variable input are combined with a fixed input, at some
point the additional output (i.e., marginal product) starts to diminish.
• the “marginal product” of an input such as labor is the change in output resulting from an additional
unit of input.
• Notice in Table 6.3 that we have placed the marginal product between each interval of input and the
resulting output. For example, the marginal product of the first unit of input, 7, is placed between 0
and 1 input.
• Continuing, we see that marginal product reaches its maximum of 12 between the second and third
units of input.
• It is precisely at this point, 2.5 units of input, that we can say the law of diminishing returns will begin
to take effect.
• there is nothing in the law that states when diminishing returns will start to take effect.
• The law merely says that if additional units of a variable input are combined with a fixed input, at
some point, the marginal product of the input will start to diminish.

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Three Stages of Production

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• Stage I runs from zero to four units of the variable input X (i.e., to the point at which average product
reaches its maximum).
• Stage II begins from this point and proceeds to seven units of input X (i.e., to the point at which total
product is maximized). Stage III continues from that point.
• According to economic theory, in the short run, “rational” firms should only be operating in Stage II.
• It is clear why Stage III is irrational: The firm would be using more of its variable input to produce less
output.
• Stage 1 is also considered irrational as if a firm were operating in Stage I, it would be grossly
underusing its fixed capacity.
• That is, it would have so much fixed capacity relative to its usage of variable inputs that it could
increase the output per unit of variable input (i.e., average product) simply by adding more variable
inputs to this capacity.

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 • In the long run, a firm has time enough to change
Long Run Production the amount of all its inputs. Thus, there is really
no difference between fixed and variable inputs.
Function • The resulting increase in the total output as the
two inputs increase is called returns to scale.

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• According to economic theory, if an increase in a firm’s inputs by some proportion results in an
increase in output by a greater proportion, the firm experiences increasing returns to scale. If output
increases by the same proportion as the inputs increase, the firm experiences constant returns to
scale.
• A less than proportional increase in output is called decreasing returns to scale.
• A larger scale of production might enable a firm to divide tasks into more specialized activities,
thereby increasing labor productivity.
• Also, a larger scale of operation might enable a company to justify the purchase of more
sophisticated(hence, more productive) machinery.
• These factors help explain why a firm can experience increasing returns to scale. In contrast,
operating on a larger scale might create certain managerial inefficiencies (e.g., communications
problems, bureaucratic red tape) and hence cause decreasing returns to scale

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• One way to measure returns to scale is to use a coefficient of output elasticity, EQ:

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• Another way of looking at the concept of returns to scale is based on an equation that was first
presented at the outset of this chapter:
Q = f(X, Y )
• Recall in the original specification of this equation that it may include as many input variables as
necessary to describe the production process (i.e., n variables).

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Various forms of a Production Function

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Cobb- Douglas Function
• The Cobb-Douglas production function was introduced in 1928,10 and it is still a common functional
form in economic studies today.
• It has been used extensively to estimate both individual firm and aggregate production functions.
• This function represents the technological relationship between the amounts of two or more inputs
(particularly physical capital and labour) and the amount of output that can be produced by those
inputs. The function is mentioned below:

• Under this construction, if b+c>1, returns to scale are increasing and if b+c <1, returns are decreasing.
Constant returns exist when b+c = 1.

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