Lecture 6: THEORY OF THE FIRM

November 9, 2021

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Motivation: Scale of Bahuan production

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Content

Long-run production

The production function

Production with two variable inputs (production in the long-run)

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Theory of production

Production function

A production function: Function showing the highest output that a firm

can produce for every specified combination of inputs applies to a given
technology.

Given technology is a given state of knowledge about the various methods

that might be used to transform inputs into outputs.

As the technology becomes more advanced and the production function

changes, a firm can obtain more output for a given set of inputs.

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Theory of production

Figure: Production function

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Theory of production

Production function

Production function is a compact description of how inputs (capital K, L

labor) are turned into output Q.

Q = f(K,L) (1)

In fact, the inputs can include materials and land.

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Short-run versus Long-run

Short-run production
The short-run production is the production in which one input, labor, is
variable, and the other, capital, is fixed

Long-run production
The long-run production is the production in which both labor and
capital are variable .

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Production with two variable inputs

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Production with two variable inputs

Isoquant
An isoquant is a curve that shows all the possible combinations of inputs
that yield the same output.

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Isoquants

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Isoquants

Production isoquants show the various combinations of inputs necessary

for the firm to produce a given output.

A set of isoquants, or isoquant map, describes the firm’s production

function. Output increases as we move from isoquant q1 (at which 55
units per year are produced at points such as A and D), to isoquant q2 (75
units per year at points such as B), and to isoquant q3 (90 units per year
at points such as C and E).

Isoquants show the flexibility that firms have when making production
decisions: They can usually obtain a particular output by substituting one
input for another.

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Substitution Among Inputs

Marginal rate of technical substitution (MRTS)

Amount by which the quantity of one input can be reduced when one
extra unit of another input is used, so that output remains constant.

MRTS = − Change in capital input/change in labor input

MRTS = −∆K /∆L(for a fixed level of q)

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Marginal rate of technical substitution (MRTS)

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Marginal rate of technical substitution (MRTS)

The slope of the isoquant at any point measures the marginal rate of
technical substitution—the ability of the firm to replace capital with labor
while maintaining the same level of output. On isoquant q2, the MRTS
falls from 2 to 1 to 2/3 to 1/3.

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Diminishing MRTS

The MRTS falls as moving down along an isoquant. The mathematical

implication is that isoquants, like indifference curves, are convex, or bowed
inward. This is indeed the case for most production technologies.

The diminishing MRTS tells us that the productivity of any one input is
limited. As more and more labor is added to the production process in
place of capital, the productivity of labor falls. Similarly, when more
capital is added in place of labor, the productivity of capital falls.
Production needs a balanced mix of both inputs.

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Diminishing MRTS

Additional output from increased use of labor = % (MPL ∆L)

Reduction in output from decreased use of capital = & (MPK ∆K )

Because we are keeping output constant by moving along an isoquant, the

total change in output must be zero. Thus,
(MPL ∆L) + (MPK ∆K ) = 0

The marginal rate of technical substitution between two inputs is equal to

the ratio of the marginal products of the inputs:
(MPL )/(MPK ) = −(∆K /∆L) = MRTS

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Special isoquant: inputs are perfect substitutes

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Chatbot vs Livechat in Customer Services

* Sophia: Almost human

https://www.youtube.com/watch?v=7fnCQC7bLs0

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Special isoquant: fixed-proportions production function

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Special isoquant: fixed-proportions production function

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Returns to Scale

Changing the scale of the operation by increasing all of the inputs to

production in proportion
If it takes one farmer working with one harvesting machine on one acre of
land to produce 100 bushels of wheat, what will happen to output if we
put two farmers to work with two machines on two acres of land?
Output will almost certainly increase, but will it double, more than double,
or less than double?

* Why Did Forever 21 File For Bankruptcy?

https://www.youtube.com/watch?v=DxlkvrbRvqI

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Returns to Scale

Returns to scale: Rate at which output increases as inputs are

increased proportionately.
Increasing returns to scale: Situation in which output more than
doubles when all inputs are doubled.
Constant returns to scale: Situation in which output doubles when all
inputs are doubled.
Decreasing returns to scale: Situation in which output less than
doubles when all inputs are doubled.

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Returns to Scale

Q = f (K , L) (2)

Increasing returns to scale :

f (2K , 2L) > 2f (K , L) (3)

Constant returns to scale:

f (2K , 2L) = 2f (K , L) (4)

Decreasing returns to scale:

f (2K , 2L) < 2f (K , L) (5)

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Returns to Scale

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Returns to Scale

When a firm’s production process exhibits constant returns to scale as

shown by a movement along line 0A in Figure (a), the isoquants are
equally spaced as output increases proportionally.

However, when there are increasing returns to scale as shown in Figure (b),
the isoquants move closer together as inputs are increased along the line.

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Returns to Scale

Returns to scale vary considerably across firms and industries.

Other things being equal, the greater the returns to scale, the larger the
firms in an industry are likely to be.

Because manufacturing involves large investments in capital equipment,

manufacturing industries are more likely to have increasing returns to scale
than service-oriented industries.

Services are more labor-intensive and can usually be provided as efficiently

in small quantities as they can on a large scale.

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