Inputs and

Production Functions
Mrs. WAJEEHA BATOOL, MSc
ECONOMICS AND ADMINISTRATIVE SCIENCES
ALA-TOO INTERNATIONAL UNIVERSITY
A Firm’s Input Substitution Opportunities
Graphically
A Firm’s Input Substitution Opportunities
Graphically
 In Figure (a), start from point A and move along the isoquant Q = 1
million (i.e., holding output constant). If the firm increases one input
significantly (either L or K), it will only be able to reduce the other
input by a small amount.
 In Figure (b) the firm has abundant substitution opportunities—a
significant increase in one input would allow the firm to reduce the
other input by a significant amount, holding output constant.
Input Substitution Opportunities and the
Shape of Isoquants
 In Figure (a), the MRTSL,K changes dramatically as we move through point A,
by contrast, in Figure (b), the MRTSL,K changes gradually.
 When the production function offers limited input substitution opportunities,
the MRTSL,K changes substantially as we move along an isoquant making the
isoquants nearly L-shaped, as in Figure (a).
 When the production function offers abundant input substitution
opportunities, the MRTSL,K changes gradually as we move along an isoquant.
In this case, the isoquants are nearly straight lines, as in Figure(b)
 Elasticity of Substitution

 The elasticity of substitution measures how quickly the marginal rate

of technical substitution of labor for capital changes as we move
along an isoquant.
 In simple words, a measure of how easy it is for a firm to substitute
labor for capital.
 It is equal to the percentage change in the capital–labor ratio for
every 1 percent change in the marginal rate of technical substitution
of labor for capital as we move along an isoquant.
 The ratio of the quantity of capital to the quantity of labor, known as
the capital–labor ratio, K/L.
 Elasticity of Substitution

 As the firm moves from point A to point B, the capital–labor ratio K/L changes
from 4 to 1 (−75%), as does the MRTSL,K. Thus, the elasticity of substitution of
labor for capital over the interval A to B equals 1.
 Elasticity of Substitution

 The elasticity of substitution, often denoted by σ, measures the

percentage change in the capital–labor ratio for each 1 percent
change in MRTSL,K as we move along an isoquant
 Significance of the Elasticity of
Substitution
In general, the elasticity of substitution can be any number greater than
or equal to 0.
 If the elasticity of substitution is close to 0, there is little opportunity
to substitute between inputs. σ will be close to 0 when the
percentage change in MRTSL,K is large.
 If the elasticity of substitution is large, there is substantial
opportunity to substitute between inputs. σ will be large if the
percentage change in MRTSL,K is small.
Calculating the Elasticity of Substitution
from a Production Function
 Problem
Consider a production function whose equation is given by the formula
Q=√KL, which has corresponding marginal products, MPL=1/2√K/L and
MPK=1/2√L/K. Show that the elasticity of substitution for this production
function is exactly equal to 1, no matter what the values of K and L are.
Calculating the Elasticity of Substitution
from a Production Function
 Special Production Function

 The relationship between the curvature of isoquants, input

substitutability, and the elasticity of substitution is most apparent
when we compare and contrast a number of special production
functions. Considering four special production function:
 Linear Production Function
 The Fixed-Proportions Production Function
 The Cobb–Douglas Production Function
 The Constant Elasticity of Substitution Production Function
 Linear Production Function (Perfect
Substitutes)
 A production function of the form Q = aL + bK, where a and b are
positive constants.
 Isoquants are straight lines. Thus, the slope of any isoquant is
constant, and the MRTS does not change as we move along the
isoquant.
 Because MRTS does not change as we move along an isoquant,
ΔMRTSa,b= 0. This means that the elasticity of substitution for a linear
production function must be infinite (σ = ∞). When we have a linear
production function, we say that the inputs are Perfect Substitutes.
 Isoquants for a Linear Production
Function

 The isoquants for a linear production function are straight lines. The
MRTSL,H at any point on an isoquant is thus a constant.
 Fixed-Proportions Production Function
(Perfect Complements)
 A production function where the inputs must be combined in fixed
proportions is called a fixed-proportions production function, and the
inputs in a fixed-proportions production function are called perfect
complements.
 When inputs are combined in fixed proportions, the elasticity of
substitution is zero (i.e., σ = 0), because the marginal rate of
technical substitution along the isoquant of a fixed-proportions
production function changes from ∞ to 0.
 Isoquants for a Fixed-Proportions
Production Function

 Two atoms of hydrogen (H) and one atom of oxygen (O) are needed to make
one molecule of water. The isoquants for this production function are L-
shaped, which indicates that each additional atom of oxygen produces no
additional water unless two additional atoms of hydrogen are also added.
 Cobb–Douglas Production Function

 Cobb–Douglas production function is intermediate between a linear

production function and a fixed-proportions production function.
 Q = ALα Kβ, where Q is the quantity of output from L units of labor and
K units of capital and where A, α, and β are positive constants.
 With the Cobb–Douglas production function, capital and labor can be
substituted for each other. The elasticity of substitution for a Cobb–
Douglas production function falls somewhere between 0 and ∞.
Isoquants for a Cobb–Douglas Production
Function

 The isoquants for a Cobb– Douglas production function are nonlinear

downward-sloping curves.
 Constant Elasticity of Substitution
Production Function
 A type of production function that includes linear production
functions, fixed proportions production functions, and Cobb– Douglas
production functions as special cases.

 Where a, b, and σ are positive constants (σ is the elasticity of

substitution). σ varies between 0 and ∞, the shape of the isoquants of
the CES production function changes.
 Isoquants for the CES Production
Function

 This figure depicts the Q = 1 isoquant for five different CES production
functions, each corresponding to a different value of the elasticity of
substitution σ. At σ = 0, the isoquant is that of a fixed-proportions production
function. At σ = 1, the isoquant is that of a Cobb–Douglas production function.
At σ = ∞, the isoquant is that of a linear production function
Characteristics of Production Functions
 Returns to Scale

 The concept of returns to scale tells us the percentage increase in

output when a firm increases all of its input quantities by a given
percentage amount:

 Suppose that a firm uses two inputs, labor L and capital K, to produce
output Q. Now suppose that all inputs are “scaled up” by the same
proportionate amount λ, where λ > 1 (i.e., the quantity of labor
increases from L to λL, and the quantity of capital increases from K to
λK). Let ϕ represent the resulting proportionate increase in the quantity
of output Q (i.e., the quantity of output increases from Q to ϕQ).
 Increasing, Constant & Decreasing
Returns to Scale
 If ϕ > λ, we have increasing returns to scale. In this case, a
proportionate increase in all input quantities results in a greater than
proportionate increase in output.
 If ϕ = λ, we have constant returns to scale. In this case, a
proportionate increase in all input quantities results in the same
proportionate increase in output.
 If ϕ < λ, we have decreasing returns to scale. In this case, a
proportionate increase in all input quantities results in a less than
proportionate increase in output.
 Increasing, Constant, and Decreasing
Returns to Scale

 In panel (a), doubling the quantities of capital and labor more than doubles
output. In panel (b), doubling the quantities of capital and labor exactly
doubles output. In panel (c), doubling the quantities of capital and labor less
than doubles output.
 Returns to Scale for a Cobb–Douglas
Production Function
 Problem
Does a Cobb–Douglas production function, Q = ALαKβ , exhibit increasing,
decreasing, or constant returns to scale?
Solution
Let L1 and K1 denote the initial quantities of labor and capital, and let Q1
denote the initial output, so Q1=AL1αK1β . Now let’s increase all input
quantities by the same proportional amount λ, where λ > 1, and let Q2
denote the resulting volume of output: Q2=A(λL1)α (λK1)β = λα+β AL1α K1β =
λα+βQ1. From this, we can see that if:
 Returns to Scale for a Cobb–Douglas
Production Function
 α + β > 1, then λα+β > λ, and so Q2 > λQ1 (increasing returns to scale).
 α + β = 1, then λα+β = λ, and so Q2 = λQ1 (constant returns to scale).
 α + β < 1, then λα+β < λ, and so Q2 < λQ1 (decreasing returns to scale).

This shows that the sum of the exponents α + β in the Cobb–Douglas

production function determines whether returns to scale are increasing,
constant, or decreasing. For this reason, economists have paid
considerable attention to estimating this sum when studying production
functions in specific industries
 Diminishing Marginal Returns versus
Returns to Scale
 Returns to scale pertains to the impact of an increase in all input
quantities simultaneously, while marginal returns (i.e., marginal
product) pertains to the impact of an increase in the quantity of a
single input, such as labor, holding the quantities of all other inputs
fixed.
 Diminishing Marginal Returns versus
Returns to Scale

 This production function exhibits constant returns to scale but diminishing

marginal returns to labor.
 Technological Progress

 A change in a production process that enables a firm to achieve more

output from a given combination of inputs or, equivalently, the same
amount of output from less inputs.
 We can classify technological progress into three categories
 Neutral Technological Progress
 Labor-Saving Technological Progress
 Capital-Saving Technological Progress.
 Neutral Technological Progress
(MRTSL,K Remains the Same)
 Technological progress that decreases the amounts of labor and
capital needed to produce a given output, without affecting the
marginal rate of technical substitution of labor for capital.
 Labor-Saving Technological Progress
(MRTSL,K Decreases)
 Technological progress that causes the marginal product of capital to
increase relative to the marginal product of labor.
 Capital-Saving Technological Progress
(MRTSL,K Increases)
 Technological progress Technological progress that causes the
marginal product of labor to increase relative to the marginal product
of capital.
 Technological Progress

 A firm’s production function requires that it use at least 1 unit of

labor and 1 unit of capital, i.e., L ≥ 1 and K ≥ 1. Initially, the
production function is Q=√KL, with MPK = 0.5 (√L/√K) and MPL =
0.5(√K/√L). Over time, the production function changes to Q= L√K,
with MPK= 0.5(L/√K) and MPL = √K.

Problem:
(a) Verify that this change represents technological progress.
(b) Show whether this change is labor-saving, capital saving, or neutral.
 Technological Progress

Solution:
(a) With any quantities of K and L greater than or equal to 1, more Q
can be produced with the final production function. So there is
technological progress.
(b) With the initial production function, MRTSL,K = MPL/MPK = K/L. With
the final production function, MRTSL,K = MPL/MPK = (2K)/L. For any
ratio of capital to labor (i.e., along any ray from the origin), MRTSL,K
is higher with the second production function. Thus, the
technological progress is capital saving.
Thank You!