PRODUCTION

OUTLINE
 The Technology of Production
 Production with One Variable Input (Labor)

 Production with Two Variable Inputs

 Returns to Scale

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 PRODUCTION DECISION OF A FIRM
 The theory of the firm describes how a firm makes
cost minimizing production decisions and how the
firm’s resulting cost varies with its output.
 Production decision of a firm

The production decisions of firms are analogous to the

purchasing decisions of consumers, and can likewise be
understood in three steps:
1. Production Technology

2. Cost constraints

3. Input choices

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 Production Function
● factors of production Inputs into the production process (e.g., labor,
capital, and materials).

 The Production Function q  F ( K , L) (6.1)

Inputs Process Output

Land
Product or
Labor service
generated
Capital
– value added
PRODUCTION FUNCTION

Function showing the highest output that a firm can produce for
every specified combination of inputs.
q = F (K, L)

Production functions describe what is technically feasible when

the firm operates efficiently.
Long-run and short run:
short run Period of time in which quantities of one or
more production factors cannot be changed.
●fixed input: Production factor that cannot be varied.
●long run: Amount of time needed to make all
production inputs variable. 5
Periods of Production, Inputs, and Costs
DIFFERENT TYPES OF PRODUCTION
CURVE

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 Short-Run Technology Constraint

To increase output in the short run, a firm must increase

the amount of labor employed.
Three concepts describe the relationship between output
and the quantity of labor employed:
1. Total product
2. Marginal product
3. Average product

© 2012 Pearson Addison-Wesley

 Short-Run Technology Constraint

Product Schedules
Total product is the total output produced in a given
period.
The marginal product of labor is the change in total
product that results from a one-unit increase in the
quantity of labor employed, with all other inputs remaining
the same.
The average product of labor is equal to total product
divided by the quantity of labor employed.

© 2012 Pearson Addison-Wesley

Average & Marginal Products
• Average product of labor
AP = Q/L
• Marginal product of labor
MP = Q/L
• When AP is rising, MP is greater than AP
• When AP is falling, MP is less than AP
• When AP reaches it maximum, AP = MP
• Law of diminishing marginal product
As usage of a variable input increases, a point is reached
beyond which its marginal product decreases
© 2012 Pearson Addison-Wesley
USE OF THE CURVES SHOWN EARLIER
 When to stop hiring new employees?
Ans: If marginal productivity declines, it doesn’t mean that we have to
stop hiring new people. Hiring may continue as long as marginal
productivity is greater than average productivity even though MP
has started declining.

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 Production with one variable input
(contd.)

 Marginal Product of Capital

 MPk = ΔQ/ ΔK
 Using Cobb-Douglas:
 Q =AKαLβ
 MPL = dQ/dL = βAKαLβ-1
 MPk = dQ/dK= αAKα-1Lβ
 Average Product of Labor
 APL =TPL/L
 Average Product of capital
 APK =TPK/K
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

 The 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.
 Labor productivity (output per
unit of labor) can increase if
there are improvements in
technology, even though any
given production process exhibits
diminishing returns to labor. As
we move from point A on curve
O1 to B on curve O2 to C on
curve O3 over time, labor 13
productivity increases.
 Why MPL Diminishes
.

 In general, MPL diminishes as L rises

whether the fixed input is land or capital (equipment,
machines, etc.).
 Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal).
 The law of diminishing returns states that: As a firm
uses more of a variable input with a given quantity of
fixed inputs, the marginal product of the variable input
eventually diminishes.
THE COSTS OF PRODUCTION 14
 Three important relationships can be found

1. Substitutability between Factors: There are a variety of

ways to produce a particular rate of output (example: to produce
a fixed units, any combination can be used). Therefore, the
question of labor or capital-intensive production arises.

2. Return to Scale: If input rates are doubled, the output rate

also doubles. [example: 200 = 1K + 4L, if 2K + 8L the Q would be
= 400]. The relationship between output change and proportionate
changes in both inputs is referred to Return to Scale.

3. Returns to Factor: When output changes because one

input changes while the other remains constant, the changes in
the output rates are referred to as Return to Factor. [example: 200
= 1K + 4L → 1K + 8L = 250
 PRODUCTION WITH TWO VARIABLE INPUTS
AND ISO-QUANT CURVE
 Iso-quant Curve
showing all
possible
combinations of
inputs that yield
the same output.

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 ISO-QUANT MAP AND DMR
 A set of isoquant that describe
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).
 DMR: Holding the amount of
capital fixed at a particular
level—say 3, we can see that
each additional unit of labor
generates less and less
additional output. 17
 CONCEPT OF MRTS
 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.
 (MPL ) / (MPK ) = (change
in K /change in L ) =
MRTS
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 Marginal rate of Substitution
(MRTS)
 The MRTS is the slope of an isoquant &
measures the rate at which the two
inputs can be substituted for one
another while maintaining a constant
level of output K
MRTS  
L
The minus sign is added to make MRTS a positive
number since K L , the slope of the isoquant, is
negative
Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
 PRODUCTION FUNCTIONS: TWO SPECIAL
CASES
 1. When factors are perfect
substitutes: MRTS will be equal
(constant) at each point of the
iso-quant.
 2. The Leontief production
function or fixed proportions
production function is a
production function that
implies the factors of
production will be used in fixed
(technologically pre-determined)
proportions, as there is no
substitutability between factors.
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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

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EXAMPLES
Do the following functions exhibit increasing, constant, or
decreasing returns to scale? What happens to the
marginal product of each individual factor as that factor
is increased and the other factor held constant?
1. q = 3L + 2K
2. q = (2L + 2K)1/2
3. q = 3LK2

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MATHEMATICAL EXAMPLES

1. Wheat is produced according to the production function

q = 100(K0.8L0.2), where K is capital and L is labor.
a. Derive the marginal product of labor and the marginal
product of capital.
b. Show that the marginal product of labor and the
marginal product of capital are both decreasing (hint:
beginning with K = 4, and L = 49).
c. Does this production function exhibit increasing,
decreasing, or constant returns to scale?

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PRACTICE EXAMPLES
The production function for the personal computers of
Company A, Inc., is given by q = 10K0.5L0.5, where q is
the number of computers produced per day, K is hours of
machine time, and L is hours of labor input. A’s
competitor, Company B, Inc., is using the production
function q = 10K0.6L0.4.
 If both companies use the same amounts of capital and
labor, which will generate more output?
 Assume that capital is limited to 9 machine hours, but
labor is unlimited in supply. In which company is the
marginal product of labor greater? Explain.
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 Expansion Path
 Expansion path gives the efficient (least-
cost) input combinations for every level
of output
 Derived for a specific set of input prices
 Along expansion path, input-price ratio is
constant & equal to the marginal rate of
technical substitution

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
 Expansion Path

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
Economies of Scale, Diseconomies of Scale, and Constant
Returns to Scale
• Economies of Scale exist when inputs are increased by some
percentage and output increases by a greater percentage,
causing unit costs to fall.
• Constant Returns to Scale exist when inputs are increased by
some percentage and output increases by an equal
percentage, causing unit costs to remain constant.
• Diseconomies of Scale exist when inputs are increased by
some percentage and output increases by a smaller
percentage, causing unit costs to rise.
• Minimum Efficient Scale is the lowest output level at which
average total costs are minimized. Efficient scale:
The quantity that minimizes ATC.