Chapter 6

Analysis of Production

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 Production function
• A production function is a functional specification
that provides the most efficient combination of
input with which a chosen target level of output
can be produced
• It is specific to each industry and technology

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 Short and long run
• Short run: a period during which a firm has
to work with some fixed factors which
cannot be reduced or increased.
- has no correspondence to the calendar
period
- Long run: a period where no factor is fixed.

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 Production function with one
variable input
• Total Product: Q = 30L+20L2-L3
• Average Product : Q /L
• Marginal Product : MP = dQ/dL =
30+40L-L2
Also called Short run Production
function

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 Short run production function
• Law of diminishing returns

- Marginal Product of the variable input

eventually diminishes.

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 Three Stages of Production

• Stage 1: AP is increasing, MP is
increasing and Production Elasticity is >
1.
• Stage 2: AP and MP are decreasing and
Production Elasticity is 0 < Prod.Elas < 1
• Stage 3: MP and AP continue to decrease
and Production Elasticity < 0.

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 Production Elasticity

• ∆Q / ∆X * X / Q = MPx * 1 / APx

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 Optimal Input Levels

• With one variable input:

Marginal Revenue Product (MRP) =
Marginal Variable Cost.
MRP = MP * MR
• With many variable inputs:
MPL / PL = MPK / PK = ……….

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 Production Function with two
variable inputs

• Q = f (K , L) where K is capital and L is labour

Also called Long run Production function

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 Isoquants

• Graphical representation of production

function
• A curve drawn through the technically feasible
combinations of inputs to produce a target
level of output

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 Map of Isoquants

Output 260
Output 200
Output 160

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 Properties of Isoquants

• They are downward sloping – diminishing

Marginal Rate of Technical Substitution
MRTS

• They are convex to the origin

• They do not intersect

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 Elasticity of substitution

• ( % change in K/L) / ( % change in MRTS)

• Denoted by ‘σ’- All about the curvature of the

isoquant
• The ease with which a production process can
shift from labor intensive to capital intensive

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 Optimal combination of inputs
• The case of Long run Production function:

• Slope of the isocost line = MRTS

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 Returns to scale

• The rate at which output changes when all

inputs change by the same proportion-
called Scale change

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 Returns to Scale

• Increasing Returns to Scale When output

increases by a proportion greater than the
proportionate increase in all inputs.
• Decreasing returns to scale
• Constant returns to scale

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 Cobb – Douglas Production
Function

• Q = A Lα Kβ

Where, α + β indicates Returns to Scale

If > 1, it exhibits Increasing Returns to Scale
If < 1, it exhibits Decreasing Returns to Scale
If = 1, it exhibits Constant Returns to Scale

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 Estimation of Production functions

• Cobb Douglas function can be estimated

using the Linear Regression technique in
Log form.
• The coefficients will be the elasticities

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 Euler’s Theorem
• if the production function is linearly
homogeneous, and if each input is acquired
at a price equal to its marginal product,
then the total amount paid to all the inputs
put together will exactly exhaust the value
of the total output.

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Isoproduct curves and production
frontier
• ‘isoproduct’ curve would give the
combinations of outputs that these two
levels of inputs can produce, assuming
that production is most efficient and the
inputs are completely exhausted.
• Also called Production frontier

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