Micro I CH 6 2018

Chapter 6
Production
Cookie Factory
No. of Kitchens No. of Workers Output MPL=ΔQ/ΔL

1 0 0
1 1 50
1 2 90
1 3 120
1 4 140
1 5 150
1 6 150
*Fixed Capital: 1 Kitchen
©2005 Pearson Education, Inc.

Cookie Factory
No. of Kitchens No. of Workers Output MPL=ΔQ/ΔL

1 0 0 -
1 1 50 50
1 2 90 40
1 3 120 30
1 4 140 20
1 5 150 10
1 6 150 0

Cookie Factory
No. of Kitchens No. of workers Output
2 1 50
2 2 100
2 3 140
2 4 180
2 5 210
2 6 240

If 1 worker in 1 kitchen makes 50 cookies (from
last slide), then 2 workers in 2 kitchens (one
kitchen per worker) can make 100 cookies.

Cookie Factory – different ways of
producing output
Workers
0 1 2 3 4 5 6
0 0 0 0 0 0 0 0
1 0 50 90 120 140 150 150
Kitchens
2 0 50 100 140 180 210 240
3 0 50 100 150 190 230 270
Can make 140 cookies with either 1 kitchen & 4 workers, or

with 2 kitchens & 3 workers.
Can make 150 cookies with 1 kitchen & 5 workers, or 3
kitchens & 3 workers.

Now consider q= KL
Labor
0 1 2 3 4
0 0 0 0 0 0
1 0 1 2
Capital
2 0 2
3 0 3
4 0 2 4
*There’s flexibility between K and L in production

Q= KL
Labor
0 1 2 3 4
0 0 0 0 0 0
1 0 1 1.41 1.73 2
Capital
2 0 1.41 2 2.45 2.83
3 0 1.73 2.45 3 3.46
4 0 2 2.83 3.46 4
*There’s flexibility between K and L in production

Topics to be Discussed
 The Technology of Production
 Isoquants
 Production with One Variable Input

(Labor)
 Production with Two Variable Inputs
 Returns to Scale
©2005 Pearson Education, Inc. Chapter 6 8

Introduction
 Our study of consumer behavior was

broken down into 3 steps:
Describing consumer preferences
Consumers face budget constraints
Consumers choose to maximize utility
 Production decisions of a firm are similar
to consumer decisions
Can also be broken down into three steps

Production Decisions of a Firm
1. Production Technology
 Describe how inputs can be transformed
into outputs
 Inputs: land, labor, capital and raw materials
 Outputs: cars, desks, books, etc.
 Firms can produce different amounts of

outputs using different combinations of
inputs

2. Cost Constraints
 Firms must consider prices of labor, capital
and other inputs
 Firms want to minimize total production
costs partly determined by input prices
 As consumers must consider budget
constraints, firms must be concerned about
costs of production

3. Input Choices
 Given input prices and production
technology, the firm must choose how much
of each input to use in producing output
 Given prices of different inputs, the firm
may choose different combinations of inputs
to minimize costs
 If labor is cheap, firm may choose to produce
with more labor and less capital

 If a firm is a cost minimizer, we can also

study
How total costs of production vary with
output
How the firm chooses the quantity to
maximize its profits
 We can represent the firm’s production
technology in the form of a production
function

The Technology of Production
 Production Function:
Indicates the highest output (q) that a firm
can produce for every specified combination
of inputs
For simplicity, we will consider only labor (L)
and capital (K)
Shows what is technically feasible when the
firm operates efficiently

 The production function for two inputs:

q = F(K,L)
where K is the amount of capital, and L is the
amount of labor (# of workers or hours
worked by employees)
The production function is true for a given
technology
 Iftechnology increases, more output can be
produced for a given level of inputs

Example
A construction company builds apartments. It uses
two inputs, namely labor and capital (like
bulldozers). Suppose that the production function is
given by
Q = K1/2L1/2

Q is the number of apartments the company built.
K is the amount of capital, and
L is the amount of labor


Exercise
Q1) If the company employs 16 units of

labor and 4 units of capital, then how
many apartments can the company
build? Q=8
Q2) If the company employs 4 units of

labor and 16 units of capital, how many
apartments can the company build?Q=8

ISOQUANT CURVES
 An Isoquant curve shows all combinations of
inputs that can produce the same amount of
output.
 An isoquant shows the flexibility that

firms have when producing: it shows
that firms can obtain the same
amount of output using different
combinations of inputs.
Isoquant Map
E Ex: 55 units of
Capital 5 output can be
per year produced with 3K & 1L
(pt. A) OR 1K & 3L (pt.
4
D)
The higher the
isoquant, the greater
3 the output quantity
A B C
2
q3 = 90
D q2 = 75
1
q1 = 55
1 2 3 4 5 Labor per year

 Short Run versus Long Run

The isoquant shows how one input can be
substituted for another. However, in practice,
the substitution can take time because some
inputs, like capital inputs (factories, etc)
cannot be changed in a short amount of time.
Firms must consider not only what inputs can

be varied but over what period of time that
can occur

 Short Run
Period of time in which quantities of one or
more production factors cannot be changed
These inputs are called fixed inputs
 Long Run
Period of time long enough for firms to be
able to change all the input quantities.

Defining fixed inputs and
variable inputs
 We define fixed inputs and variable inputs with a bit
of caution.
o Fixed inputs  Inputs the quantities of which cannot
be changed in the short run e.g., capital inputs
o Variable inputs  Inputs whose quantities can be
changed
Notice that, in the long run, ALL inputs are variable
inputs.

Long versus short run
 Long-run: Both inputs variable
 Short run: Here, K is fixed

Production: One Variable Input
 Firms make decisions based on the

benefits and costs of production
 Sometimes useful to look at benefits and
costs on an incremental basis
How much more can be produced when at
incremental units of an input?
 Sometimes useful to make comparison
on an average basis

 Suppose a construction company builds
apartments using two types of inputs,
namely capital and labor.
 Further, suppose that capital is fixed and
labor is variable
Output can only be increased by increasing
labor
Must know how output changes as the
amount of labor is changed (Table 6.1)

Table 6.1 Observations:
1. When labor is zero,
output is zero as
well
2. With additional
workers, output (q)
increases up to 8
units of labor
3. Beyond this point,
output declines
o Increasing labor can
make better use of
existing capital
initially
o After a point, more
labor is not useful and
can be
counterproductive
 We are interested in how the quantity of output
varies when one input, for example labor, varies
holding other inputs constant.
 Product curve  A curve that shows how total

output varies when one input varies, holding
other inputs constant.

# of
compartments
built D
112
C Total Product
At point D, output is
60 maximized.
B
0 1 2 3 4 5 6 7 8 9 10 Amount of Labor
 Average product of Labor – Total Output

per unit of labor input
 Measures the productivity of a firm’s
labor in terms of how much, on average,
each worker can produce
Output q
APL  
Labor Input L

 Marginal Product of Labor – slope of the
product curve i.e. change in output divided
by the change in labor. Also, the partial
derivative of the production function with
respect to L
 Simply put, it is the additional output
produced when labor increases by one unit
Output q
MPL  
Labor Input L

# of
compartments
built D
112
C Total Product
At point D, output is
60 maximized.
B
0 1 2 3 4 5 6 7 8 9 10 Amount of Labor
Output •Left of E: MP > AP & AP is increasing
per •Right of E: MP < AP & AP is decreasing
Worker •At E: MP = AP & AP is at its maximum
•At 8 units, MP is zero and output is at max
30
Marginal Product
E Average Product
20
10
0 1 2 3 4 5 6 7 8 9 10 Amount of Labor
Marginal and Average Product
 When marginal product is greater than the
average product, the average product is
increasing
 When marginal product is less than the average
product, the average product is decreasing
 When marginal product is zero, total product
(output) is at its maximum
 Marginal product crosses average product at
AP’s maximum

Product Curves
 Geometric relationship between the total

product and the average product
Slope of line from origin to any point on the
total product curve is the average product
Example: At point B, AP = 60/3 = 20 which is
the same as the slope of the line from the
origin to point B on the total product curve

Product Curves
AP is slope of line from
q origin to point on TP
q/L curve
112
TP
30
C
60 20
B
AP
10
MP
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor Labor

Product Curves
 Geometric relationship between total

product and marginal product
The marginal product is the slope of the line
tangent to any corresponding point on the
total product curve
Example: For 2 units of labor, MP = 30/2 =
15 which is slope of total product curve at
point A

Product Curves
MP is slope of line tangent to
corresponding point on TP
q q curve
112
TP 30
60 15
AP
30 10
A MP
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor Labor

 From the previous example, we can see

that as we increase labor the additional
output produced declines
 Law of Diminishing Marginal Returns:
As the use of an input increases with
other inputs fixed, the resulting additions
to output will eventually decrease

Law of Diminishing Marginal
Returns
 Terminology: Marginal returns = Marginal product.
 The marginal product can be defined not only for
labor but also for other inputs, like capital.
 The law of diminishing marginal returns states
that marginal product will eventually decrease as
the total quantity of the input increases. This is
shown in the downward sloping part of MPL
curve.
 This is often explained as due to congestion. For example,
consider a wheat farm: as the farm employs more and more
workers, the farm will start being congested and the
additional output that additional employee brings eventually
diminishes
Returns
 Typically applies only for the short run

when one variable input is fixed
 Easily confused with negative returns –
decreases in output
 Explains a declining marginal product,
not necessarily a negative one
Additional output can be declining while total
output is increasing

Returns
 Assumes a constant technology

Changes in technology will cause shifts in
the total product curve
More output can be produced with same
inputs
Labor productivity can increase if there are
improvements in technology, even though
any given production process exhibits
diminishing returns to labor

The Effect of Technological
Improvement
Moving from A to B to
Output
C C, labor productivity is
increasing over time
100 O3
B
A
O2
50
O1
Labor per
time period
0 1 2 3 4 5 6 7 8 9 10
Malthus and the Food Crisis
 Malthus predicted mass hunger and

starvation as diminishing returns limited
agricultural output and the population
continued to grow
 Why did Malthus’ prediction fail?
Did not take into account changes in
technology
Although he was right about diminishing
marginal returns to labor

Labor Productivity
 The Average Product of Labor (Q/L) is also
referred to as Labor Productivity.
 Macroeconomics is particularly concerned
with labor productivity
The average product of labor for an entire
industry or the economy as a whole
Links macro- and microeconomics
Can provide useful comparisons across time and
across industries
q
Average Productivity 
L
Labor Productivity
 Link between labor productivity and
standard of living
 Consumption can increase only if
productivity increases
 Growth of Productivity
1. Growth in stock of capital (or more precisely,
increasing K/L ratio) – total amount of capital
available for production
2. Technological change – development of new
technologies that allow factors of production to
be used more efficiently

Labor Productivity
 Trends in Productivity
Labor productivity and productivity growth
have differed considerably across countries
 Given the central role of productivity in

standards of living, understanding
differences across countries is important

Labor Productivity in Developed
Countries

Another important linkage between
macro and micro is Total Factor
Productivity or TFP
 Total Factor Productivity (TFP) is that

fraction of a country’s economic growth
which is unexplained by capital and
labor.
It indicates the efficiency of a production
system in translating inputs into outputs.
Klenow and Rodriguez-Clare (1997) find that
TFP growth explains 90 percent of the cross-
country differences in output growth.

Dispersion across firms of TFPQ (output based
measure of TFP), the “A” in the firm’s
production function
-Hsieh and Klenow show that
greater spread of TFPQ
lowers the aggregate TFPQ
for the country.
-Also note the longer left
tails (more low productivity
firms) for India and China
compared to U.S.
Source: Hsieh and Klenow (2009)

TFPQ in Punjab by M. Haseeb
(Lahore School Mphil student)
**notice scale compared to previous
slide**

Dispersion of TFPQ for Punjab
Pakistan

Production: Two Variable Inputs
 Firm can produce output by combining

different amounts of labor and capital
 In the long run, capital and labor are both
variable
 We can look at the output we can
achieve with different combinations of
capital and labor – Table 6.4

Table 6.4

 The isoquants shows all possible

combinations of inputs that yield the
same amount of output
 Curves are smooth to allow for use of
fractional inputs
Curve 1 shows all possible combinations of
labor and capital that will produce 55 units of
output

Diminishing Returns
Capital 5 Increasing labor
per year holding capital
constant (A, B, C)
4 OR
Increasing capital
holding labor constant
3 (E, D, C)
A B C
D
2
q3 = 90
1 E q2 = 75
q1 = 55
1 2 3 4 5 Labor per year

 Diminishing Returns to Labor with

Isoquants
 Holding capital at 3 and increasing labor
from 0 to 1 to 2 to 3
Output increases at a decreasing rate (0, 55,
20, 15) illustrating diminishing marginal
returns from labor

 Diminishing Returns to Capital with

Isoquants
 Holding labor constant at 3 increasing
capital from 0 to 1 to 2 to 3
Output increases at a decreasing rate (0, 55,
20, 15) due to diminishing returns from
capital

 Substituting Among Inputs

Companies must decide what combination of
inputs to use to produce a certain quantity of
output
There is a trade-off between inputs, allowing
them to use more of one input and less of
another for the same level of output

 Substituting Among Inputs

Slope of the isoquant shows how one input
can be substituted for the other and keep the
level of output the same
The negative of the slope is the 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

 The marginal rate of technical

substitution (for capital to labor) equals.
Change in Capital Input
MRTS 
Change in Labor Input
MRTS  K (for a fixed level of q)
L
Note that the slope of the isoquant is always negative.

 As labor increases to replace capital

Labor becomes relatively less productive
Capital becomes relatively more productive
Need less capital to keep output constant
Isoquant becomes flatter

Marginal Rate of
Technical Substitution
Capital
5
per year
Negative Slope measures MRTS;
2 |MRTS| decreases as we move down
4 the isoquant
1
3
1
1
2
2/3 1
Q3 =90
1/3 Q2 =75
1 1
Q1 =55
1 2 3 4 5 Labor per month
Exercise
Suppose that a wheat producing farm has
the following production function.
Q = 12KL
Q1. Derive the equation for the isoquant
associated with the output level 24.
Q2. For the isoquant you derived for Q1,
calculate the marginal rate of technical
substitution when the amount of labor is 1, 2,
3 and 4.

MRTS and Isoquants
 We assume there is diminishing |MRTS|
 Increasing labor in one unit increments from 1 to 5
results in a decreasing |MRTS| from 1 to 1/2
 Productivity of any one input is limited
 Intuitively, when a firm is using a lot of capital and
few workers, the firm may have a congestion
problem with capital input and scarcity problem
with labor input. On the other hand, when the firm
is using a lot of workers but few units of capital,
labor will have a congestion problem.
 Diminishing |MRTS| occurs because of diminishing
returns and implies isoquants are convex
MRTS and Marginal Products
 There is a relationship between MRTS and
marginal products of inputs
 If we increase labor and decrease capital to
keep output constant, we can see how much
the increase in output is due to the
increased labor
Amount of labor increased times the marginal
productivity of labor
 ( MPL )(L)
 Similarly, the decrease in output from the

decrease in capital can be calculated
Decrease in output from reduction of capital
times the marginal produce of capital
 ( MPK )(K )

 If we are holding output constant, the net

effect of increasing labor and decreasing
capital must be zero
 Using changes in output from capital and
labor we can see
(MPL )( L)  (MPK )( K)  0

 Rearranging equation, we can see the

relationship between MRTS and MPs
(MPL )( L)  (MPK )( K)  0

(MPL )(L)  - (MPK )( K)
(MPL ) K
   MRTS
( MPK ) L
Exercise
Suppose that production function is given by:
Q=12K1/3L2/3
Q1.When Q=12, the isoquant goes through the
point (K,L)=(1,1). Using the above result,
calculate the MRTS at this point.
Q2.By deriving the equation for the isoquant for
Q=12, we can also calculate MRTS by calculating
the slope at L=1. Calculate MRTS that way and
verify that it indeed coincides with the result you
obtained for Q1.

Another measure: Elasticity of
substitution
σ = %Δ(K/L)/%ΔMRTS
How responsive is the K/L ratio change to a change in

the |MRTS|?
It is a measure of curvature.
A high σ implies that the isoquant is relatively flat.

©2005 Pearson Education, Inc. 6-71
Another way of expressing:
© 2008 Pearson Addison Wesley.

©2005 Pearson Education, Inc. All rights reserved. 6-72
The “constant elasticity of substitution”
(CES) production function

CES Production with a,b,d=1

MRTS of CES production function

Elasticity of substitution for CES

Cobb-Douglas production function
q = LaKb

Cobb-Douglas production function
q = LaKb

Isoquants: Special Cases
 Two extreme cases show the possible

range of input substitution in production
1. Perfect substitutes
 The isoquant is a straight line
 MRTS is constant at all points on isoquant
 Same output can be produced with a lot of
capital or a lot of labor or a balanced mix

Perfect Substitutes
Capital
per A
Same output can be
month reached with mostly
capital or mostly labor
(A or C) or with equal
amount of both (B)
B
C
Q1 Q2 Q3
Labor
per month

Isoquants: Special Cases
2. Perfect Complements
 Fixed proportions production function
 There is no substitution available between
inputs
 The output can be made with only a specific
proportion of capital and labor
 Cannot increase output unless increase
both capital and labor in that specific
proportion

Fixed-Proportions
Production Function
Capital
per Same output can
month only be produced
with one set of
inputs.
Q3
C
Q2
B
K1 Q1
A
Labor
per month
L1
Returns to Scale
 In addition to discussing the tradeoff

between inputs to keep production the
same
 How does a firm decide, in the long run,
the best way to increase output?
Can change the scale of production by
increasing all inputs in proportion
If double inputs, output will most likely
increase but by how much?

Returns to Scale
 Rate at which output increases as inputs

are increased proportionately
Increasing returns to scale
Constant returns to scale
Decreasing returns to scale

Returns to Scale
 Increasing returns to scale: output

more than doubles when all inputs are
doubled
Larger output associated with lower cost
(cars)
One firm is more efficient than many (utilities)
The isoquants get closer together

Increasing Returns to Scale
Capital
(machine The isoquants
hours) A
move closer
together
30
2 20
10
Labor (hours)
5 10
Returns to Scale
 Constant returns to scale: output
doubles when all inputs are doubled
 Size does not affect productivity
 May have a large number of producers
 Isoquants are equidistant apart

Returns to Scale
Capital
(machine
A
hours)
6
30
4 Constant
Returns:
2 Isoquants are
0
2 equally spaced
10
Labor (hours)
5 10 15
Returns to Scale
 Decreasing returns to scale: output
less than doubles when all inputs are
doubled
 Decreasing efficiency with large size
 Reduction of entrepreneurial abilities
 Isoquants become farther apart

Returns to Scale
Capital
(machine A
hours)
Decreasing Returns:
Isoquants get further
4 apart
30
2
20
10
5 10 Labor (hours)
https://www.youtube.com/watch?v=ybobE0ijbeY&feature=youtu.be

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Chapter 6

No. of Kitchens No. of Workers Output MPL=ΔQ/ΔL

*Fixed Capital: 1 Kitchen

©2005 Pearson Education, Inc.

No. of Kitchens No. of Workers Output MPL=ΔQ/ΔL

*Fixed Capital: 1 Kitchen

©2005 Pearson Education, Inc.

*Fixed Capital: 2 Kitchen

©2005 Pearson Education, Inc.

Can make 140 cookies with either 1 kitchen & 4 workers, or

©2005 Pearson Education, Inc.

*There’s flexibility between K and L in production

©2005 Pearson Education, Inc.

*There’s flexibility between K and L in production

©2005 Pearson Education, Inc.

 Production with One Variable Input

 Production with Two Variable Inputs

©2005 Pearson Education, Inc. Chapter 6 8

 Our study of consumer behavior was

©2005 Pearson Education, Inc. Chapter 6 9

 Firms can produce different amounts of

©2005 Pearson Education, Inc. Chapter 6 10

©2005 Pearson Education, Inc. Chapter 6 11

©2005 Pearson Education, Inc. Chapter 6 12

 If a firm is a cost minimizer, we can also

©2005 Pearson Education, Inc. Chapter 6 13

©2005 Pearson Education, Inc. Chapter 6 14

 The production function for two inputs:

©2005 Pearson Education, Inc. Chapter 6 15

©2005 Pearson Education, Inc. Chapter 6 16

Q1) If the company employs 16 units of

Q2) If the company employs 4 units of

©2005 Pearson Education, Inc. Chapter 6 17

 An isoquant shows the flexibility that

©2005 Pearson Education, Inc. Chapter 6 19

 Short Run versus Long Run

Firms must consider not only what inputs can

©2005 Pearson Education, Inc. Chapter 6 20

©2005 Pearson Education, Inc. Chapter 6 21

©2005 Pearson Education, Inc. Chapter 6 22

 Long-run: Both inputs variable

 Short run: Here, K is fixed

©2005 Pearson Education, Inc. Chapter 6 23

 Firms make decisions based on the

©2005 Pearson Education, Inc. Chapter 6 24

©2005 Pearson Education, Inc. Chapter 6 25

 Product curve  A curve that shows how total

©2005 Pearson Education, Inc. Chapter 6 27

 Average product of Labor – Total Output

©2005 Pearson Education, Inc. Chapter 6 29

©2005 Pearson Education, Inc. Chapter 6 31

©2005 Pearson Education, Inc. Chapter 6 34

 Geometric relationship between the total

©2005 Pearson Education, Inc. Chapter 6 35

©2005 Pearson Education, Inc. Chapter 6 36

 Geometric relationship between total

©2005 Pearson Education, Inc. Chapter 6 37

©2005 Pearson Education, Inc. Chapter 6 38

 From the previous example, we can see

©2005 Pearson Education, Inc. Chapter 6 39

 Typically applies only for the short run

©2005 Pearson Education, Inc. Chapter 6 41

 Assumes a constant technology