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Intermediate Microeconomics
Production

Sebastian J. Goerg
Department of Economics, Florida State University
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Outline for today

Firms and Their Production Decisions

Production with One Variable Input (Labor)

Production with Two Variable Input (Labor, Capital)

Return to Scale
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Production

theory of the firm

Explanation of how a firm makes cost-minimizing production

decisions and how its cost varies with its output.
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Production

theory of the firm

Explanation of how a firm makes cost-minimizing production

decisions and how its cost varies with its output.

Production decisions of a firm depend on:

1. Production Technology
2. Cost Constraints
3. Input Choices
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Why Do Firms Exist?

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Why Do Firms Exist?

Coordination
Extremely important and would be sorely missing if workers
operated independently.

Reduced Transaction Costs

Firms eliminate the need for every worker to negotiate every
task that he or she will perform, and bargain over the fees
that will be paid for those tasks.
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Firms and Their Production Decisions

factors of production

Inputs into the production process (e.g., labor, capital, and

materials).
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Firms and Their Production Decisions

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Firms and Their Production Decisions

Labor:
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Firms and Their Production Decisions

Labor:

Materials:
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Firms and Their Production Decisions

Labor:

Materials:

Capital:
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Production Function
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Production Function

production function

Function showing the highest output that a firm can produce for
every specified combination of inputs.

q = F (K, L)
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Production Function - Short Run vs. Long Run

short run

Period of time in which quantities of one or more production

factors cannot be changed.
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Production Function - Short Run vs. Long Run

short run

Period of time in which quantities of one or more production

factors cannot be changed.

long run

Amount of time needed to make all production inputs variable.

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Production Function - Short Run vs. Long Run

short run

Period of time in which quantities of one or more production

factors cannot be changed.

long run

Amount of time needed to make all production inputs variable.

fixed input

Production factor that cannot be varied.

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Production with One Variable Input (Labor)

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Production with One Variable Input (Labor)

average product

Output per unit of a particular input.

marginal product

Additional output produced as an input is

increased by one unit.
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Production with One Variable Input (Labor)

Average product of labor = Output/labor input = q/L

Marginal product of labor = Change in output/change in labor input = Δq/ΔL

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The Slopes of the Product Curve

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The Slopes of the Product Curve

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The Slopes of the Product Curve

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The Slopes of the Product Curve

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The Slopes of the Product Curve

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The Slopes of the Product Curve

20!
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The Slopes of the Product Curve

20!
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Production with One Variable Input (Labor)

average product

Output per unit of a particular input.

marginal product

Additional output produced as an input is

increased by one unit.
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Production with One Variable Input (Labor)

average product

Output per unit of a particular input.

In general, the average product of

labor is given by the slope of the line
marginal product drawn from the origin to the
corresponding point on the total
product curve.

Additional output produced as an input is

increased by one unit.

In general, the marginal product of labor at a

point is given by the slope of the total product
at that point.
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Production with One Variable Input (Labor)

Relationship between average and marginal products

When the marginal product of labor is greater than the

average product, the average product of labor increases.

At C, the average and marginal products of labor are equal.

Finally, as we move beyond C toward D, the marginal product

falls below the average product.
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The Slopes of the Product Curve

20!
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The Effect of Technological Improvement

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The Effect of Technological Improvement

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The Effect of Technological Improvement

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Law of Diminishing Marginal Returns

law of diminishing
marginal returns
Principle that as the use of an input increases with other
inputs fixed, the resulting additions to output will eventually
decrease.
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Law of Diminishing Marginal Returns

20!
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Law of Diminishing Marginal Returns

Increasing returns Decreasing returns

20!
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Labor Productivity
labor productivity

Average product of labor for an entire industry or for the

economy as a whole.

stock of capital

Total amount of capital available for use in production.

technological change

Development of new technologies allowing factors of

production to be used more effectively.
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Labor Productivity

Consumers in the aggregate can increase their rate of

consumption in the long run only by increasing the total
amount they produce.

Thus, understanding the causes of productivity growth is an

important area of research in economics.

We do know that one of the most important sources of

growth in labor productivity is growth in the stock of capital
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Labor Productivity and the Standard of Living

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Labor Productivity and the Standard of Living

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Production with Two Variable Inputs

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Production with Two Variable Inputs

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Production with Two Variable Inputs

isoquants

Curve showing all possible combinations of inputs that yield

the same output.

isoquant map

Graph combining a number of isoquants, used to

describe a production function.
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Production with Two Variable Inputs

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Production with Two Variable Inputs

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Production with Two Variable Inputs

Isoquants do not cross!

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Production with Two Variable Inputs

Input Flexibility:

Isoquants show the flexibility that firms have when making

production decisions: They can usually obtain a particular
output by substituting one input for another. It is important for
managers to understand the nature of this flexibility.
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Production with Two Variable Inputs

Diminishing Marginal Returns:

Labor and capital are variable in the long run

But what happens to output if one input is increased while the

other input held fixed.

Because adding one factor while holding the other factor

constant eventually leads to lower and lower incremental
output, the isoquant must become steeper.

We call this diminishing marginal returns to capital and labor.

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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

= ( K)/( L), for a fixed level of q

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Marginal Rate of Technical Substitution (MRTS)

Additional output from increased use of labor = (M PL )( L)

Reduction in output from decreased use of capital = (M PK )( K)

Because we are keeping output constant by moving along an

isoquant, the total change in output must be zero. Thus,
(M PL )( L) + (M PK )( K) = 0
Now, by rearranging terms we see that

(M PL )/(M PK ) = ( K)/( L)
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Marginal Rate of Technical Substitution (MRTS)

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Marginal Rate of Technical Substitution (MRTS)

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Marginal Rate of Technical Substitution (MRTS)

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Example: A Production Functions for Wheat

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Example: A Production Functions for Wheat

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Returns to Scale

returns to scale
Rate at which output increases as inputs are increased
proportionately.
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Returns to Scale

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

Decreasing returns to scale is NOT THE SAME

THING as the Law of Diminishing Returns

Decreasing returns to scale measures the effect

on output when all inputs are varied proportionally.
Law of Diminishing Returns deals with changing
only one input, keeping all others unchanged
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Constant Returns to Scale

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Increasing Returns to Scale

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Returns to Scale

Returns to scale need not be uniform across all possible levels

of output.

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.
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Returns to Scale

F (aK, aL) = aF (K, L): constant returns to scale

F (aK, aL) > aF (K, L): increasing returns to scale
F (aK, aL) < aF (K, L): decreasing returns to scale
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Example: Input

Which of the following inputs are variable in the long run?

A) labor.
B) capital and equipment.
C) plant size.
D) all of these.
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Example: Output

A function that indicates the maximum output per unit of time that
a firm can produce, for every combination of inputs with a given
technology, is called

A) an isoquant.
B) a production possibility curve.
C) a production function.
D) an isocost function.
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Example: Returns to Scale

A farmer uses M units of machinery and L hours of labor to

produce C tons of corn, with the following production function
C = L0.5M0.75. This production function exhibits

A) decreasing returns to scale for all output levels

B) constant returns to scale for all output levels
C) increasing returns to scale for all output levels
D) no clear pattern of returns to scale
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Example: Returns to Scale

C(L, K) = L0.5 M 0.75

C(aL, aK) = (aL)0.5 (aM )0.75

= (a)0.5 (L)0.5 (a)0.75 (M )0.75
= a1.25 L0.5 M 0.75
= a1.25 C(L, K) > aC(L, K)

) increasing returns to scale

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Example: Returns to Scale

A farmer uses M units of machinery and L hours of labor to
produce C tons of corn, with the following production function
C = L0.5 + M0.75.
This production function exhibits

A) decreasing returns to scale for all output levels.

B) constant returns to scale for all output levels.
C) increasing returns to scale for all output levels.
D) no clear pattern of returns to scale.
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Example: Returns to Scale

C(L, K) = L0.5 + M 0.75

0.5 0.75
C(aL, aK) = (aL) + (aM )
= a0.5 L0.5 + a0.75 M 0.75

C(aL, aK) < aC(L, K)?

a0.5 L0.5 + a0.75 M 0.75 < a(L0.5 + M 0.75 )
0.5 0.5 0.75 0.75 0.5 0.75
a L +a M < aL + aM
a0.5 L0.5 aL0.5 + a0.75 M 0.75 aM 0.75 < 0
(a0.5 a)L0.5 + (a0.75 a)M 0.75 < 0
) decreasing returns to scale
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Example: Production
Trisha's Fashion Boutique production function for dresses is
y(K, L) = K1/2L1/3,
where K is the number of sewing machines and L is the amount of
labor hours employed. Trisha pays $15 per labor hour and sells
each dress for $87.50. Also, Trisha currently has 4 sewing
machines. Fill in the table below. How many units of labor will
Trisha employ before the value of the marginal product of labor is
less than the cost of a labor hour?
y L K MPL value of the marginal product
2 4
4 4
6 4
8 4
10 4
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Example: Production

y L K MPL value of the marginal product

2.520 2 4 0.420 36.748
3.175 4 4 0.265 23.150
3.634 6 4 0.202 17.666
4.000 8 4 0.167 14.583
4.309 10 4 0.144 12.568