PRODUCTION: CH 6

OUTLINE
 The Technology of Production
 Production with One Variable Input (Labor, Capital
is fixed)
 Production with Two Variable Inputs [ K, L ]

 Iso-Quants

 Returns to Scale [RTS]

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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 ( Similar like budget constraint)

3. Input choices [ Q =100; 2k+5L; 3k+2L]

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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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 THREE STAGES OF PRODUCTION
 Three stages of Production:
 Stage 1: From origin to the point where AP of labor is
highest.[ MP ( Marginal product) of Capital is Negative
for capital intensive production function, but MPL is
positive]
 Stage 2: From Highest point of AP of labor to the point
where MP of labor is Zero.[MP of labor and MP of
capital, both are positive, this stage is the
optimal/efficient stage of production]
 Stage 3: The point where MP of labor starts to be
negative. [MP of labor is negative]
At Labor 4, AP of labor is highest [see. previous figure]
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APL AND MPL RELATIONSHIP
Relationship Between AP and MP. [ Page 209]
 As long as MPL is increasing, APL is also increasing
(MPL is above of APL).
 When APL = MPL; APL is optimum

 When MPL is decreasing, APL also starts decreasing

[ APL is above of MPL]

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AVERAGE & MARGINAL PRODUCTS
 Average product of labor
AP = Q/L
 Marginalproduct 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
EXERCISE 3. PAGE 227 .

Labor Output MPL APL [ Q/L]

0 0 - - -
1 225 225 225
2 600375300

3* ?900 300 300

4 1140 240285

At L = 3; APL = MPL = 300

L* = 3 [ Average product of labor is highest]

Change of output = 225 -0 =225

Change of labor = 1 -0 = 1

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LET US USE DERIVATION
Q = 30L^2 – 0.5L^3
At what Labor, Average Product is highest?
APL = MPL [ at this intersection point, APL is highest]
APL = Q/L = 30L - 0.5L^2
MPL = dQ/dL = 60L – 1.5L^2
APL = MPL
30L - 0.5L^2 = 60L – 1.5L^2
30L -0.5L^2 - 60L + 1.5L^2 = 0
-30L +L^2 = 0
L (-30 + L) = 0 [ L = 0; -30+ L = 0, L = 30]
L = 0; 30
L*= 30; At L = 30, MPL = 60L – 1.5L^2 = 450,
APL = 30L - 0.5L^2 = 450
If you add one more labor say 31, APL and MPL both start decreasing. Say 12
if you use 31 labor, MPL and APL both would decrease.
 Short-Run Technology Constraint

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

the amount of labor employed.[ capital is fixed]
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 [ Total Output = Q ] 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. [ MPL = Change of Output/ Change of labor]
The of labor is equal to total product divided average
product by the quantity of labor employed[ APL = Q/L].

© 2012 Pearson Addison-Wesley

USE OF THE CURVES SHOWN EARLIER
[AS LONG AS MP LABOR > AP LABOR, WE SHOULD HIRE
WHEN MP LABOR < AP LABOR, WE SHOULD NOT HIRE]

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: [CHARLES C. COBB & ; PAUL H. DOUGLAS; 1920]
Q = AKαLβ [ ALPHA+ BETA = 1; Constant Returns to Scale]

RTS: CRS; IRS; DRS

A = TECHNOLOGY PARAMETER; TFP = Total factor productivity;

 MPL =Marginal product of labor = dQ/dL = βAKαLβ-1
 MPk = Marginal product of Capital = dQ/dK= αAKα-1Lβ
………………………………………………………………………..
 Average Product of Labor
 APL =TPL/L
 Average Product of capital
 APK =TPK/K
 Production with one variable input
(contd.)
 Marginal Product of Capital
 MPk = ΔQ/ ΔK
Using Cobb-Douglas: [CHARLES C. COBB AND ; PAUL H. DOUGLAS; 1920-1930]
Q K L LNQ LNK LNL
Q = AKαLβ [ NON-LINEAR FUNCTION]

LNQ = LnA+ αLnK + β LnL

= 2.32+ 0.19LNK + 0.88LNL [[α + β = 0.19 + 0.88 = 1.07; IRS ; If we increase capital and labor by 1%, output increases by more than 1% (1.07%)

Q = AKαLβ [ PRESS SHIFT LNX; 2.32 IT BECOMES 10.17]

= 10.17K^0.19*L^0.88

MPL = Marginal product of labor = dQ/dL =10.17*0.88*K^0.19*L ^0.88-1 = 8.95*K^0.19*L^-0.12

MPK = Marginal product of capital = dQ/dk = 10.17*0.19*K^0.19-1*L^0.88

= 1.93*K^-0.81*L^0.88

Put a value a given value of Labor [20] and Capital [5], you would get MPL, MPK
 Returns to scale [RTS]
Input increases output increase RTS
1% [K,L] = 1% CRS
1% [K,L] >1% IRS
1% [K, L] <1% DRS
CRS= Constant Returns to scale
IRS = Increasing Returns to scale
DRS = Decreasing Returns to scale

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PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

 The Law of Diminishing Marginal

Returns [DMR]: Principle that as
the use of an input increases with
other inputs fixed [K], 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 productivity increases.
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 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 [LABOR] with a given
quantity of fixed inputs [CAPITAL], the marginal
product of the variable input eventually diminishes.

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 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. Q = 100; 2K, 10L; OR 4K, 8L ( WE
SUBSITUTUTED LABOR FOR CAPITAL]

2. Returns 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. In this case we have CRS. [ IF 450 = IRS; IF
less than 400 = DRS]

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; CHANGE OF LABOR = 4; CHANGE OF OUTPUT = 50; MPL = MARGINAL
Product of Labor = CHANGE OF OUTPUT/CHANGE OF LABOR = 50/4 = 12.5 [ per
worker output has increased by 12.5 Units]
 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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CHARACTERISTICS OF ISO-QUANT
Properties of Iso-quant: [ SAME LIKE INDIFFERENCE CURVE]

1. Iso-quant is downward sloping.

2. Iso-quant is convex to the origin
3. Two Iso-quants can not cross (intersect)
4. Higher Iso-quant is better than lower Iso-quant.

[ If we like to draw figures, use the figures of indifference

curves and use L on the horizontal axis and K on the vertical
axis]
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 ISO-QUANT MAP AND DMR
 A set of isoquants 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 24
additional output.
 CONCEPT OF MRTS: [MRTS IS THE NEGATIVE SLOPE OF
ISO-QUANT]

 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 Technical
Substitution (MRTS)
 The MRTS is the slope (-) of an isoquant.
 The rate at which the two inputs can be
substituted for one another while maintaining
a constant level of output. [ MRTS = MPL/MPK]

K
MRTS  
L
The minus sign is added to make MRTS a positive
number since K L , the slope of the isoquant, is
negative
 PRODUCTION FUNCTIONS: TWO SPECIAL
CASES
 1. When factors are perfect
substitutes: MRTS will be equal
(constant) at each point of the iso-
quant.[two inputs are perfect
substitute]
 2. The Leontief production function
[ L shaped] 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. .[two
inputs are perfect complements;
MRTS = 0 or Infinite ]
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ANY RELATIONSHIP BETWEEN THESE FIGURES: IN LEFT FIGURE 2 INPUTS ARE USED
AT A FIXED PROPORTION AND IN RIGHT FIGURE NOT AT A FIXED PROPORTION/

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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.
 EXERCISE: 2, 3, 7, 8, 9, 10.

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EX 7
MRTS = MPL/MPK = 50/MPK
¼ = 50/MPK ; MPK = 200

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RETURNS TO SCALE

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EXAMPLES
8. 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 [ let L = 3 = k = 3; Q = 15;

L = 6 = K; Q = 30 ; CRS

2. q = (2L + 2K)1/2
3. q = 3LK2

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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
LET L =K = 2; Q = 3L + 2K = 10
LET L =K = 4; Q = 3L + 2K = 20
CRS: INPUTS ARE DOUBLED, AND
OUTPUT IS ALSO DOUBLED.
……………………………………
q = 3L + 2K
dq/dL = 3 = MPL [ CAPITAL IS FIXED]
dq/dK = 2 = MPK [ LABOR IS FIXED] 33
RTS; MPL; MPK

Q = (2L + 2K)1/2
LET L = K = 2

Q = (2*2+ 2*2)^1/2 = 2.83

LET L = K = 4

Q = (2*4+ 2*4)^1/2 = 4 ;
DRS: DECREASING RETURNS TO SCALE AS OUTPUT
INCERASED BUT DID NOT DOUBLE.
………………………………………………………………..

MPL = dQ/dL = ½((2L + 2K)1/2 -1* dQ/dL (2L)

= ½(2L + 2K)^-1/2 *2

= (2L + 2K)^-1/2

= 1/(2L +2K)^1/2 ; AS LABOR IS INCERASED MPL IS DECREASED

Similarly

MPk = dQ/dk = ½((2L + 2K)1/2 -1* dQ/dK (2k)

= ½(2L + 2K)^-1/2 *2

= (2L + 2K)^-1/2
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MPK = 1/(2L +2K)^1/2
RTS ; MPL; MPK

Q = 3LK2
LET L = K= 2; Q = 24 ;

LET L = K= 4 ; Q = 192 ; IRS

dQ/dL = 3k^2 = MPL

dQ/dK = 3L*2*K^2 -1 = 6LK

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MATHEMATICAL EXAMPLES
10. 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.
MPL = dQ/dL = 100K^.8*.2L^.2 -1 = 20K^0.8L^-0.8
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? [ ALPHA + BETA
= 0.8 +0.2 =1 = CRS]
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Managerial Economics, BUS-525
37
L = 49; K =4 ; Q = 100(K0.8L0.2 = 660.21

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EXERCISE 10.

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PRACTICE EXAMPLES: EX 9. PAGE.227
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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ANSWER
a)

41
Q1(FIRM 1) = 10K^0.5*L^0.5 = 10*9^0.5*L^0.5 = 30L^0.5
Q2 (FIRM 2) = 10K0.6L0.4. = 37.372L^0.4

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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
Expansion Path
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.
 Ch. 7. Cost Minimization Principle [ P.
278]
Q = 100KL; Labor ,Capital
Wage = Taka 30; Rent = Taka 120, Production
target is 1000 units. Find the minimum cost to
produce 1000 units?
ANS:
WL + rK = C [ Iso-cost equation]
Slope of cost equation = wage/ rent = W/ R = Taka 30/
Taka 120 = ¼ = Price ratio of two inputs
 Cost Minimization Principle
Q = 100KL [ Iso-quant: different combinations of labor
and capital produce same output ]
dQ/dL = MPL = marginal product of labor = 100K
dQ/dK = MPK = 100L
Slope of Iso-quant = MPL/MPK = 100k/100L = K/L
Apply two step approach:
MPL/MPK = W/R = wage/ rent ; [ Slope of Iso-quant =
Slope of Iso-cost; This is the cost minimization principle]
K/L = ¼
L = 4K
 Cost Minimization Principle
1000 = 100KL [ Iso-quant]
1000 = 100K*4K = 400K^2
K^2 = 1000/400 = 2.5
K* = 1.58
L* = 4K = 4*1.58 = 6.32
wL* + rK* = C* [ Px*X + Py*Y = M]
30*6.32 + 120*1.58 = 379.2.