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1. Managerial Economics- Economic Tools
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Keat and Others- Chapters 6

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Practice by Tomas J webster -Chapter 5.

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Managerial Economics
1
What is Production?

A) Production is basically an activity of transformation ,

which connects factor inputs and outputs.

B) The process of transforming inputs into outputs can

be any of the following kinds:
• Change in the Form(Raw material transformed to
finished goods )
•Change in Place( Supply chain, Factory to Retailer)

C) Production is an activity of transformations, that

increases usability of the good or materials.

2
 THE THEORY OF
PRODUCTION
• Production involves transformation of
inputs such as capital, equipment,
labor, and land into output - goods and
services

• In this production process, the

manager is concerned with efficiency
in the use of the inputs
Technical vs. Economical efficiency
3
 Two Concepts of Efficiency
• Economic efficiency:
• occurs when the cost of producing a
given output is as low as possible

• Technological efficiency:
• occurs when it is not possible to increase
output without increasing inputs

4
You will see that basic production
theory is simply an application of
constrained optimization:

the firm attempts either to minimize

the cost of producing a given level of
output
or
to maximize the output attainable with
a given level of cost.

Both optimization problems lead to

same rule for the allocation of inputs
and choice of technology
5
 Short-Run and Long-Run
Production-Fixed and Variable
inputs

• In the short run some inputs are fixed and

some variable
• e.g. the firm may be able to vary the amount of
labor, but cannot change the amount of capital
• in the short run we can talk about factor
productivity / law of variable proportion/law of
diminishing returns

6
• In the long run all inputs become variable
• e.g. the long run is the period in which a firm
can adjust all inputs to changed conditions
• in the long run we can talk about returns to
scale

Production Function

A production function is purely technical

relation which connects factor inputs &
outputs. It describes the transformation of
factor inputs into outputs at any particular time
period. 7
Mathematical form of production function

Q = f( L,K,R,Ld,T,t)

where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time
For our current analysis, let’s reduce the inputs to
two, capital (K) and labor (L):

Q = f(L, K)
8
 Production Table
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed
Same Q can be produced with different combinations of
inputs, e.g. inputs are substitutable in some degree
9
 Short-Run Changes in Production
Factor Productivity
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q change,

when the quantity of L is increased?
10
 Long-Run Changes in
Production
Returns to Scale
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q change, when

the quantity of both L and K is increased?
11
 Relationship Between Total, Average, and
Marginal Product: Short-Run Analysis

• Total Product (TP) = Total quantity of output

• Average Product (AP) = Output per unit of

input

• Marginal Product (MP) = Change in

quantity/TP when one additional unit of input
used
12
 The Marginal Product of
Labor
• The marginal product of labor is the increase in
output obtained by adding 1 unit of labor but holding
constant the inputs of all other factors

Marginal Product of L:
MPL= Q/L (holding K constant)
= Q/L

Average Product of L:
APL= Q/L (holding K constant)

13
 The Marginal Product of
Capital
• The marginal product of capital is the increase in
output obtained by adding 1 unit of capital but
holding constant the inputs of all other factors

Marginal Product of K:
MPk= Q/K (holding L constant)
= Q/K

Average Product of K:
APk= Q/K (holding L constant)

14
 Law of Diminishing Returns
(Diminishing Marginal Product)
The law of diminishing returns states that when more
and more units of a variable input is applied to a
given quantity of fixed inputs, the total output may
initially increase at an increasing rate and then at a
constant rate but it will eventually increases at
diminishing rates.
Assumptions. The law of diminishing returns is based
on the following assumptions: (i) the state of
technology is given (ii) labour is homogenous and (iii)
input prices are given.
15
Short-Run Analysis of Total,
Average, and Marginal Product
• If MP > AP then AP
is rising
• If MP < AP then AP
is falling
• MP = AP when AP
is maximized
• TP maximized
when MP = 0
16
Three Stages of Production in Short
Run
AP,MP
Stage I Stage II Stage III

APL
L
•TP Increases at MPL
•TP Increases at
increasing rate. diminshing rate. • TP begins to
•MPL Increases at •MPL Begins to decline. decline
decreasing rate. •TP reaches maximum •MPL becomes
level at the end of negative
•APL is increasing stage II, MPL = 0.
and reaches its •APL continues to
maximum at the •APL declines
decline 17
end of stage I
Three Stages of Production
Stages
Labor Total Average Marginal of
Unit Product Product Product Production
(X) (Q or TP) (AP) (MP)
1 24 24 24
2 72 36 48 I
3 138 46 66 Increasing
4 216 54 78 Returns
5 300 60 84
6 384 64 84
7 462 66 78
8 528 66 66 II
9 576 64 48 Diminishing
10 600 60 24 Returns

11 594 54 -6 III
12 552 46 -42 Negative Returns

18
 Application of Law of Diminishing
Returns
• It helps in identifying the rational and irrational
stages of operations. It gives answers to
questions –
1.How much to produce?
2. What number of workers to apply to a given
fixed inputs so that the output is maximum?

If a firms wants to produce 100 units, and

already invested the capital 25 units. How
many labour units need to be employed?
19
 Cobb – Dougles Production function

Q= A Kα Lβ Q= 5 K0.5 L0.5
Q= Out put Q= 100
K = qty of Capital K = 25
L = qty of Labour L=?

A -Constant
α – Capital Coefficient
β – Labour Coefficient
20
 Production in the Long-
Run
• All inputs are now considered to be variable
(both L and K in our case)
• How to determine the optimal combination of
inputs?

To illustrate this case we will use production

isoquants.
An isoquant is a locus of all technically efficient
methods or all possible combinations of inputs for
producing a given level of output.

21
 Production Table
Units of KK
Units of
Employed
Employed Output Quantity (Q) Isoquant
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of
of KL Employed

22
 Isoquant

Graph of Isoquant

Y
7

0
1 2 3 4 5 6 7 X

23
Marginal Rate of Technical Substitution
(MRTS)

• The degree of imperfection in substitutability is

measured with marginal rate of technical
substitution (MRTS- Slope of Isoquant):

MRTS = -K/L

(in this MRTS some of L is removed from the

production and substituted by K to maintain the
same level of output)

24
 Isoquant Map

• Isoquant map is a set of

isoquants presented on a Figure : Isoquant Map

two dimensional plain. Y

Each isoquant shows

various combinations of

Capital Y
IQ4

two inputs that can be IQ3

used to produce a given

IQ2
IQ1

level of output. O Labour X X

25
 Isoquant Map

C
a
p y1 a

i
b 300
t y2 200
c
a y3
100
l

o
x1 x2 x3
Labour
 Properties of Isoquants

• Isoquants have a negative slope.

• Isoquants are convex to the origin.

• Isoquants cannot intersect or be tangent to each

other.

• Upper Isoquants represents higher level of output

27
 Iso-cost Line
Various combinations of inputs that a firm can buy
with the same level of expenditure

The cost line is defined by cost equation

• C= (r) (k) + (w) (L)

Where C is a given money outlay.

w= wage rate
r = price of capital service
 Slope of Iso-cost Line
Capital

c/r

Slope = -w/r

0 c/w Labor
 We will use isoquant map (1) and isocost
line (2)

Figure : Isoquant Map (1)

Figure : Isocost Line (2)

K K
C/r
A
Capital Y

3x
2x
x1 C/W

O B L
O L

The cost line is defined by cost equation

C= (r) (k) + (w) (L)
W wage rate r= price of capital service
30
Case I
Maximization of output subject to
cost constraint

A
Capital

K1 C x3
x2
X1
0 L1 B
Labour

31
 Condition for Equilibrium

• At point of tendency
• slope of iso-cost line=slope of isoquant
-(w/r) = -(MPL/MPK)
• The isoquants should be convex to origin
• Slope of Isoquant = - K / L
• Slope of Isoquant in Marginal product terms
• MPK= Q/K; K= Q/ MPK
• MPL= Q/L; L= Q/ MPL
• Hence, - K / L=>-(Q/ MPK)/ (Q/ MPL)=> -(MPL/MPK)
32
Case II
Minimization of cost for given level
of output

K1 e
X

0 L1 L

33
 Producer’s
equilibrium

 A producer can attain equilibrium by

applying the least cost combination of
factors of production to attain maximum
profit.

 In both the cases the producer is able to

identify the least cost combination. Hence it
is known as Producer’s equilibrium.

34
 EXPANSION PATH
(Choice of optimal expansion
path)
When the financial resources of a firm increases, it would like
to increase its output. In other words, the output produced by a
firm increases with increase in its financial resources.

By using different combinations of factors(inputs) a firm can

produce different levels of output. Among these, the
combination of factors which is optimum will be used by the
firm and it is called as “Expantion path”.

It is also called as ‘scale-line’ .

According to Stonier and Hague “Expantion path is that line

which reflects least cost method of producing different levels of
output”.
Expansion path-graphical
diagram
K

C P
e3
e2 IQ3 (3000)
A
e1 IQ2 (2000)
IQ1(1000)
P

O B D G
L
LABOUR
1. Units of labour employed is measured along the X axis and capital
employed is measured along the Y axis.

2. The first iso-cost line of the firm is AB. It is tangent to IQ1 at point ‘e1’,
which is the initial equilibrium of the firm.

3. Supposing the price per unit of labour and capital remains unchanged
and the financial resources of the firm increases, the firm’s new iso-cost line
shifts to right as CD.

4. In this situation new iso-cost line CD will be parallel to the initial iso-cost
line AB and tangent to IQ2 at point e2 which will be the new equilibrium
point now.

5. If the financial resources of the firm further increases, but the price of
the factors remaining the same, the iso-cost line will be FG. It will be
tangent to the iso-quant IQ 3 at point e3 which will be the new equilibrium
point of the firm.

6. By joining all the equilibrium points we get a line(PP) called scale-line or

expansion path. It is called so because a firm expands its output or scale of
production in conformity with this line.
 Laws of Returns to Scale(RTS)
• It explains the behavior of output in response to a
proportional and simultaneous change in input.
• When a firm increases both the inputs at a certain
proportion, there are three technical possibilities:
(i) TP may increase more than proportionately –
Increasing RTS
(ii) TP may increase proportionately – constant RTS
(iii) TP may increase less than proportionately –
diminishing RTS

38
Production function of Firm1 is given by Q= 5 K0.5 L0.5
Q= 100
K = 25
L = 16
Doubling the inputs: K=50; L=32
Q=5*5√2*4√2
Q=200 -----------------Constant Returns to Scale
Production function of FIrm2 is given by Q= 5 K2 L0.5
K=25; L=16;Q=12500;

Doubling the inputs: K=50 and L=32

K=50; L=32; Q=5*2500*4*1.414

Q=70700------------------Increasing Returns to scale

Production function of FIrm3 is given by Q= 5 K0.25 L0.5

K=25; L=16;Q=12500;

39
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