Theory of Production

Reference Book:
Keat, Young & Erfle
Ma’am Covered the Lecture on:
1. Production Possibility Frontier
2. Supply Function
3. Demand Function
4. Consumer & Producer Surplus
5. Elasticity

And Today! Production Function

 Production Function Defined:
• The PF is a statement of the relationship between
a firm’s scarce resources (inputs) and the output
that results from the use of these resources.
• In mathematical terms, the PF can be expressed
as: Q= f (X1, X2…………Xk) where,

• Q= Output,
• X1…………Xk = inputs used in the production
process
 Formal Definition of PF
• A PF 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.
• For the purposes of analysis, we write the PF
as follows: Q= f (L, K)
• Where Q= output, L= labor, K= capital
A Short-Run Analysis of Total, Average
and Marginal Product
• Marginal product of Labor = MPL= ∆Q/∆L,
holding K constant.
• Average product of Labor= APL= Q/L, holding K
constant.
• Marginal Product of Capital= MPk= ∆Q/∆K,
holding L constant
• Average Product of Capital= APk= Q/ K, holding
L constant
 Short Run Changes in Production, What means
Short Run Mahmud! Think
Units of Output quantity
K
employ
ed
8
7
6
5
4
3
K=2 8 18 29 39 47 52 56 52
1
1 2 3 4 5 6 7 8
(Units of L
employed)
Variable input (L) Total Product (TP) Marginal Product Average Product

1 8 8 8
2 18 10 9
3 29 11 9.67
4 39 10 9.75
5 47 8 9.4
6 52 5 8.67
7 56 4 8
8 52 -4 6.5
 The Three Stages of Production in the
Short-run

• Stage I runs from zero to four units of variable input

(where average product reaches its maximum and AP
and MP are approximately equal).
• Stage II begins from this point and proceeds to seven
units of input L (to the point where TP is maximized).
• Stage III continues on from that point.
Which stage is economical or rational?

• 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.
• However, it may not be as apparent why stage I is
also considered irrational.
• The reason is that if a firm were operating in stage
I, it would be grossly under-using 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
simply by adding more variable inputs to this
capacity.
 Derived Demand and the optimal level of
variable input case (The case of one input
case)

Optimal decision rule: A profit maximizing firm

operating in perfectly competitive output and
input markets will be using the optimal amount of
an input at the point at which the monetary value
of input’s marginal product (MR) is equal to the
additional cost (MC) of using that input---in other
word’s when MRP=MLC.
Optimal Input Usage Rule (one input Case when
price of product=$2 and labor cost=$10)

Labor Unit Total Marginal Total Marginal Total Marginal

(L) Product of Product of Revenue Revenue labor cost Labor Cost
Labor Labor Product Product
1 10 10 20 20 10 10
2 25 15 50 30 20 10
3 45 20 90 40 30 10
4 60 15 120 30 40 10
5 70 10 140 20 50 10
6 75 5 150 10 60 10
7 78 3 156 6 70 10
8 80 2 160 4 80 10
 Law of Diminishing Returns

• The key to understanding the pattern of

change in Q, AP and MP is the phenomenon
known as the Law of diminishing returns. The
Law states –

‘’As additional units of variable input are combined with a

fixed input, at some point the additional output (the MP)
starts to diminish.’’
 Optimal input usage (Multiple input
case)

• In the multiple input case, we must consider

the relationship between the ratio of the MP
of one input and its cost to the ratio of the MP
of other input and its cost. Expressed
mathematically for “k” inputs:
• MP1/W1=MP2/W2=MPk/Wk
• Suppose you are the production manager of a
company that makes computer parts and
peripherals in Malaysia and China. At the
current levels of production and input
utilization in two countries, you find that:
• MP of labor in Malaysia (MPmal)=18
• MP of labor in China(MPch)=6
• Wage rate in Malaysia(Wmal)=$6/hr
• Wage rate in China (Wch)= $3/hr
• How much would you produce in each
manufacturing facility? Because labor is
cheaper in China you might be tempted to
produce most of your output in that country.
However, a close look at the MP/wage ratio
reveals the opposite conclusion. That is,
• MPmal/Wmal>MPch/Wch
• Or 18/6 > 6/3
• This means that at the margin , the last dollar
on a unit of labor in china would yield 2 units
of output (6/$3) while in Malaysia the last
dollar spent would result in 3 additional units
of output (18/$6).
• This inequality implies that the firm should
begin to shift more of its production from
china to Malaysia , until the two ratios are
equalized
 But Mahmud!

• Once the implication of the basic model is

understood, other factors can be brought in. If
these factors outweigh the MP-input cost
criteria, a company may well modify its
decision.
• For example, despite Malaysia’s higher
MP/wage ratio, there may be political and
economic risk factors to consider.
• This was indeed the case when the Malaysian
government imposed foreign exchange controls
in 1998 by requiring foreign investors to keep their
profits in Malaysia for at least 1 year before they
could be repatriated .
• In contrast, China is a fairly stable economy with
leaders who do not seem to want to impose any
such trade restrictions. Its proximity to Indian
markets would also reduce transportation costs.
Call centers: Applying the Production
Function to a Service

• Let us consider the example of a call center

represented by the following production function:
Q = f (X,Y) where
• Q= number of calls
• X= variable input (this includes call center
representatives and complementary hardware such as
PCs, desks, and software)
• Y= fixed input (this includes call center building,
hardware such as servers and telecommunications
etc.)
 Three Stages of production

• Stage I could be a situation in which there is so

much fixed capacity relative to number of variable
inputs that many representatives sit around idle,
waiting for calls to come in.
• Stage II could be a situation in which
representatives are constantly occupied and
callers are connected to representatives
immediately after the call is answered or are kept
waiting for no more than a certain amount of time
(3 min).
• Stage III could be a situation in which callers
begin to experience a busy signal on a more
frequent basis or all call representatives may
begin to experience a slower computer
response or more frequent computer ‘down
times’.
 Now Mahmud!
The Long Run Production Function

• In the long run, a firm has time enough to

change the amount of all inputs. The following
Table illustrates what happens to total output
as both inputs L and K increase one unit at a
time.
 Returns to Scale
Units of K Output Quantity
employed
8 125
7 119
6 90
5 75
4 60
3 41
2 18
1 4
1 2 3 4 5 6 7 8 Units
of L
employ
ed
 What this Guy RTS Mean

• The resulting increase in output as both inputs

vary is known as Returns to Scale.
• Returns to scale are of three types:
1. Increasing returns to scale= IRTS
2. Constant returns to scale
3. Decreasing returns to scale
• If an increase in a firm’s input by some
proportion results in an increase in output by
a greater proportion, the firm experiences
IRTS.
• If output increases by the same proportion as
the inputs increase, the firm experiences
CRTS.
• A less than proportional increase in output is
called decreasing returns to scale.
• One way to measure RTS is to use the
coefficient of output elasticity:
• EQ= % change in Q (output)/% change in
inputs
• If EQ>1, we have IRTS: 50%/25%= 2>1
• If EQ<1, we have DRTS: 20%/30%= .5<1
• If EQ=1, we have CRTS: 20%/20%= 1
• Another way of looking at the concept of RTS is based
on the production function:
Q = f (L, K)
• Now if we increase both inputs by r times and output
increases by t times, that is
• tQ= f(rL, rK)
then
• If t>r, we have IRTS
• If t<r, we have DRTS
• If t=r, we have CRTS.
 Self Extension
IRS:
Q= L*K
12= 4x3
If we increase input by r=2 times
Then, Q= 4(2)x3(2)=48
Output increase by 4times.
CRS:
Q= L*K
1= 11/3 X 12/3
If we increase input by r=2 times
Then, Q=21/3 x 22/3 =2
Output increase by 2 times.
DRS:
Q= L*K
7.63= 10.5X 20.5
If we increase input by r=2 times
Then, Q=20.5 x 40.5 =10.71
Output increase by times. ;
 The Cobb-Douglas Production Function
(not included in Mid)

• The C-D production function was introduced in

1928 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
function.
• The formula for production function which
was suggested by Cobb, was of the following
form: Q= aLbK1-b
 Why is this production function so
useful?

1. To make this equation useful, both inputs must

exist for Q to be a positive number. This makes sense
because total product is a result of combining two or
more factors.
2. The function can exhibit increasing, decreasing or
constant returns. Originally, cobb-douglas assumed
RTS are constant. Later they relaxed this assumption
and rewrote the equation as follows: Q= a LbKc
 • Under this assumption if b+c>1, RTS are
increasing, if b+c<1, RTS are decreasing and if
b+c=1, RTS are constant.
3. The function permits us to investigate the MP for
any factor while holding all others constant. MP of
labor turns out to be MPL=bQ/L and MP of capital is
MPk=cQ/K.
• In the C-D function, the elasticities of the factors
are equal to their exponents, in this case b and c.
4. Because a power function by using
logarithms, it can be estimated by linear
regression analysis, which makes for a relatively
easy calculation with any software package.
5. Cobb-Douglas can accommodate any number
of independent variables as follows:
Q=aXb1Xc2Xd3..Xmn
7. A theoretical production function assumes
technology is constant. However, the data fitted
by the researcher may span a period over which
technology has progressed. One of the
independent variables in the previous equation
could represent technological change and thus
adjust the function to take any technology into
consideration.
Shortcomings of C-D production Function

• This function cannot show the MP going

through all three stages of production in one
specification.
• Similarly, it cannot show a firm or industry
passing through increasing, constant and
decreasing returns to scale.
 Careful Planning Can Help a Firm Use Its
Resources in a Rational Manner

• In our discussion of the short-run, we state that a firm

is expected to have three stages of production.
• Stage I represents the underutilization of a firm’s fixed
inputs relative to its variable ones.
• Stage III represents an overutilization of its fixed
inputs relative to variable one. Indeed, firms operating
in this stage would find their total output decreasing
as they increased their variable input.
• The only stage for a rational firm to be in
stage II. Assuming this information is well
known to managers, why would a firm find
itself in Stage I and III?
• The answer is of, course, that production
levels do not depend how much a company
wants to produce but on how much its
customers want to buy.
 .

• Good capacity planning requires two basic

elements: accurate forecasts of demand and
effective communication between production
and marketing functions.
• The first element is rather obvious but not easy to
achieve.
• The second element may not be so obvious,
especially for those who have not had work
experience in large organizations.
• It is not uncommon for manufacturing people to
proceed merrily with their production plan on a
purely technical basis without fully incorporating
the marketing plans of those whose main
responsibility is to sell the products.
• It is also quite possible for marketing people to try
to sell as many units of the product as possible
without consulting the production people as to
whether the firm has the capacity to meet the
increase in demand.
 Increasing, decreasing and constant
returns to scale by graph
output output
output
.
IRTS
CRTS
DRTS

inputs
inputs inputs