Production Economics

Managers must decide not only what to produce for the market, but also how to produce it in the most efficient or least cost manner. Economics offers widely accepted tools for judging whether the production choices are least cost. A production function relates the most that can be produced from a given set of inputs.
Production functions allow measures of the marginal product of each input.
Slide 1

The Production Function

A production function describes the quantity produced as input(s) change. Designating L as labor and K as capital, a popular functional form is known as the Cobb-Douglas Production Function: Q = a K 1 L 2 The number of inputs is often larger than just K and L. But economists simplify by suggesting some, like materials or labor, is variable, whereas plant and equipment is fairly fixed in the short run.
Slide 2

Short Run Production Function

Quantity of Output (cookies per hour) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 Number of Workers Hired Production function

Lets begin by analyzing a production function with only one variable input, labor, L.

Slide 3

 Average Product of labor = Q / L output per labor Marginal Product of labor =x Q / x L output attributable to last unit of labor applied When MP = AP, were at the peak of the AP curve
Slide 4

Numerical Example
L
0 1 2 3 4 5

Q
0 20 46 70 92 110

MP
--20 26 24 22 18

AP --20 23 23.33 23 22

Marginal Product
Average Product

Labor Elasticity is greater then one, for labor use up through L = 3 units

5
Slide 5

 When MP > AP, then AP is RISING If your marginal grade is higher in the class than your average GPA, then your GPA will improve (rise) When MP < AP, then AP is FALLING If your marginal grade is lower in the class than your average GPA, then your GPA will fall Therefore MP will cut the AP at its maximum point

Slide 6

Law of Diminishing Returns

Usually, when we increase one factor of production while keeping other factors fixed, after some point, you can expect marginal product to start diminishing.
MP A SHORT RUN LAW

point of diminishing returns Variable input

Slide 7

Three stages of production

Stage 1: average Total Output product rising. Stage 2: average Stage 1 product declining (but marginal product positive). Stage 3: marginal product is negative, or total product is declining.
Stage 2

Stage 3

L
Slide 8

Optimal Use of the Variable Input

Hire, if REVENUE is MRP L | MP L P Q = W higher than COST That is, if wage (TR/(L > (TC/(L Or, what is the same thing, if marginal revenue product > marginal factor W | MFC W cost MRP L > MFC L MRPL At the optimum, MPL MRP L = W | MFC L optimal labor
Slide 9

Long Run Production Functions

All inputs are variable greatest output from any set of inputs Q = f( K, L ) is two input example MP of capital and MP of labor are the derivatives of the production function MPL = xQ /xL MP of labor declines as more labor is applied. Also the MP of capital declines as more capital is applied.
Slide 10

Isoquants & LR Production Functions

Say Q = f ( K, L ) Isoquants -- locus of input combinations which produces the same output (A & B are on the same isoquant representing same quantity of output = Q1.) The slope of the isoquant is the ratio of the marginal products and is called the MRTS, the marginal rate of technical substitution K / L = MPL / MPK

ISOQUANT MAP

B A

Q3 Q2 Q1

Slide 11

Optimal Combination of Inputs

The objective is to minimize cost for a given output Isocost lines are the combination of inputs for a given cost, C0 C0 = CLL + CKK K = C0/CK - (CL/CK)L Optimal where:
MPL/MPK = CL/CK Rearranged, this becomes the equimarginal criterion

Equimarginal Criterion: Produce where

MPL/CL = MPK/CK
where marginal products per dollar are equal at D, slope of isocost = slope of isoquant C(1) Q(1)

L
Slide 12

Production Functions with Fixed Proportions

If a firm has five computers and just one person, typically only one computer is used at a time. You really need five people to work on the five computers. The isoquants for processes with fixed proportions are L-shaped. Small changes in the prices of input may lead to no change in the process. M is the process ray of one worker and one machine computers 5 4 3 2 1
1 2 3 4 5 6 7 8 9

people
Slide 13

Returns to Scale
If multiplying all inputs by P (lambda) increases the dependent variable by P, the firm has constant returns to scale (CRS).

Q = f ( K, L) So, f(PK, P L) = P Q is Constant Returns to

Scale Also, if 10% more all inputs leads to 10% more output the firm is constant returns to scale. Cobb-Douglas Production Functions are constant returns if

E + F !
Slide 14