CHAPTER-5: PRODUCTION

MANAGERIAL ECONOMICS (BUS-525)

COURSE CONVENER:
DR. TAMGID AHMED CHOWDHURY
CHAPTER-5: OUTLINE
 The Technology of Production
 Production with One Variable Input (Labor)

Managerial Economics, BUS-525

 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.

Managerial Economics, BUS-525

 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

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

Managerial Economics, BUS-525

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. 4
 PRODUCTION WITH TWO VARIABLE INPUTS
AND ISO-QUANT CURVE
 Iso-quant Curve
showing all
possible

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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

Managerial Economics, BUS-525

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. 6
CONCEPT OF MRTS
 Marginal rate of technical
substitution (MRTS):
Amount by which the

Managerial Economics, BUS-525

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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PRODUCTION FUNCTIONS: TWO SPECIAL
CASES
 1. When factors are perfect
substitutes: MRTS will be equal
(constant) at each point of the
iso-quant.

Managerial Economics, BUS-525

 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.

Managerial Economics, BUS-525

 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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 Managerial Economics, BUS-525
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RETURNS TO SCALE
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

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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.

Managerial Economics, BUS-525

a. Derive the marginal product of labor and the
marginal product of capital.
b. 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

Managerial Economics, BUS-525

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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