Production Function with two variable inputs

The optimum combination of factors: the marginal product approach

The optimum combination of factors: the marginal product approach

Long run all factors are variable Profit maximizing firm will want to use the least costly combination of factors to produce any output What is the optimum combination of factors?

The simple two factor case

Firm uses just two factors: Labour:l & Capital:k Least cost combination will be where MPPl/Pl = MPPk/Pk If they were not equal it would be possible to reduce cost per unit of output by using a different combination of labor & capital

The multi-factor case

Where a firm uses many factors least cost combination of factors will be where: MPPa/Pa =MPPb/Pb =MPPc/Pc.MPPn/Pn

The optimum combination of factors: the isoquant/isocost approach

The Technology of Production

The production function for two inputs: Q = F(K,L) Q = Output, K = Capital, L = Labor For a given technology

Isoquants or Equal Product curves

Isoquants
 Curves showing all possible combinations of inputs that yield the same output  It is the production function of a product with two factors variable  It represents the technical conditions of production  Some similarities with indifference curves  Also called production indifference curves  Indifference curves no attempt made to specify the level of satisfaction to a consumer but in isoquants we can label in physical units of output

An isoquant
40 35

45

Units of capital (K)

30 25 20 15 10 5 0 0 5 10 15 20

Units of K 40 20 10 6 4 b

Units of L 5 12 20 30 50

Point on diagram a b c d e

c d e

25 fig 30

35

40

45

50

Units of labour (L)

Production Function for Food

Labor Input 3 Capital Input 1 2 4 5

1 2 3 4 5

20 40 55 65 75

40 60 75 85 90

55 75 90 100 105

65 85 100 110 115

75 90 105 115 120

Production with Two Variable Inputs (L,K)

Capital per year E

5 4 3 2

The Isoquant Map

The isoquants are derived from the production function for output of of 55, 75, and 90.

Q3 = 90 1 1 2 3
D

Q2 = 75 Q1 = 55 4 5
Labor per year

Assumptions
Producer uses only two inputs- L & K L & K can be substituted for one another at a diminishing rate Constant Technology L & K are perfectly divisible & substitutable- continuous isoquant

Isoquants: Properties
Slope downwards from left to rightnegative slope No two equal product curves can intersect each other Convex to the origin: diminishing MRTS

Marginal Rate of Technical Substitution

MRTS of factor X for factor Y may be defined as the amount of factor Y which can be replaced by a unit of factor X, the level of output remaining unchanged It can be known from the slope of the isoquant Diminishing MRTS: As the quantity of X is increased and the quantity of Y is decreased the amount of factor Y that is required to be replaced by an additional unit of X so as to keep the output constant will diminish

Diminishing marginal rate of 14 factor substitution

12

g MRS = 2
(K = 2

Units of capital (K)

MRS = (K / (L

10 8 6 4 2
(L = 1

isoquant
0 0 2 4 6 8 10
fig

12

14

16

18

20

22

Units of labour (L)

Diminishing marginal rate of 14 factor substitution

12

g MRS = 2
(K = 2

Units of capital (K)

MRS = (K / (L

10 8 6 4 2
(L = 1

j
(K = 1 (L = 1

MRS = 1 k

isoquant
0 0 2 4 6 8 10 fig 12 14 16 18 20

Units of labour (L)

Isocost lines
Shows various combinations of two factors that the firm can buy with a given or same outlay/cost Assume that prices of factors are given and constant for the firm Isocost line will shift if the total outlay of the firm changes or the prices of factors change

An isocost
25

30

Assumptions PK = 20 000 W = 10 000 TC = 300 000 a b

Units of capital (K)

20

15

10

c TC = 300 000 d
0 5 10 15 20 fig 25 30 35 40

Units of labour (L)

ISOQUANT- ISOCOST ANALYSIS

Least-cost combination of factors for a given output  point of tangency of the isoquant with an iso cost line  At this point MRTS = Px/Py  Minimizing cost when he uses a factor combination for which his MRTS is equal to the price ratio of the factors  Tangency point of the given isoquant with an iso cost line represents the least cost combination of factors for producing a given output

Finding the least-cost method 35 of production Assumptions

30

PK = 20 000 W = 10 000
25

Units of capital (K)

20 15

TC = 200 000 TC = 300 000 TC = 400 000

10 5 0 0 10 20
fig

TC = 500 000

30

40

50

Units of labour (L)

Finding the maximum output for a given total cost

r s
Units of capital (K)

K1

u v
O L1

TPP1 Units of labour (L)

fig

TPP5 TPP4 TPP3 TPP2

Production Function with all variable inputs

Production Function with all variable inputs

A situation where all inputs are subject to variation In case of law of variable proportions some inputs are constant while in Returns to scale all inputs change in the same proportion

The Long run production Function The long-run production function describes the maximum quantity of good or service that can be produced by a set of inputs, assuming that the firm is free to adjust the level of all inputs.

Production in the Long Run

In the long run, all inputs are variable. The long run production process is described by the concept of Returns to Scale. Returns to scale describes what happens to total output as all of the inputs are changed by the same proportion. Q = f(K,L)

Production Function & Returns to Scale

Production function is homogeneous means that all inputs are increased in same proportion If all inputs are increased in a certain proportion (say k) & output increases in the same proportion the production function is homogeneous of degree 1- also known as Linear Homogeneous Production Function Can be expressed as kQx = f(kK, kL) = k (K, L) This implies constant returns to scale Cobb-Douglas production function is homogeneous of degree 1

Production Function & Returns to Scale

If all inputs are increased in a certain proportion total output may not increase in the same proportion, it may increase by less than or more than double This can be expressed as hQx = f (kK, kL) where h denotes h increase in Qx due to k increase in inputs K, L The proportion h may be greater than, equal to, or less than k

Production Function & Returns to Scale

Accordingly there are three Returns to scale The word to scale means that all inputs increase by the same proportion If h = k, production function reveals constant returns to scale If h is greater than k it reveals increasing returns to scale If h is less than k it reveals decreasing returns to scale

What are Increasing returns to scale or Economies of scale?

 Output changes disproportionately more in comparison to a change in the scale of input  Output can more than double if inputs are doubled  A situation in which the costs per unit of output fall as the scale of production increases

Causes of Economies of Scale

INTERNAL ECONOMIES OF SCALE : REAL & PECUNIARY Real Economies: when quantity of inputs used decreases for a given level of output Pecuniary Economies: savings in expenses due to relatively lower prices for inputs & lower cost of distribution due to bulk buying & selling

REAL ECONOMIES
Production Economies:
Division of labor Specialization & time saving Cumulative volume experience in technical work Technical economies- specialization of capital, indivisibilities, economies of large machines Dimensional relations: e.g. when size of a room (15 feet x 10 feet = 150 sq ft) is doubled to 30 x 20 then the area of the room is more than doubled i.e. 30 feet x 20 feet = 600 sq ft Inventory economies for raw materials & final goods

INTERNAL ECONOMIES OF SCALE : REAL Economies.

Marketing Economies: Advertising & selling activities Exclusive dealers with after sales service obligations Variations in models & designs- more of R & D Managerial economies: Specialization of management Teamwork experience Decentralization Modern managerial & organizational techniques Transport & Storage economies

INTERNAL ECONOMIES OF SCALE: PECUNIARY ECONOMIES Discounts a firm can get due to its large size Discounts in raw materials Lower cost of funds Lower cost of advertising Lower transport cost

External Economies of Scale:

Where a firms costs per unit of output decrease as the size of the whole industry grows Where a firm whatever its size benefits from the whole industry being large Specialized firms for working up the byproduct & waste materials Specialized units to supply raw materials , research etc

External Economies of Scale

Industry's Infrastructure: The network of supply agents: communications, skills, training, distribution channels, specialized financial services etc

What are Constant returns to scale?

 Output changes in a fixed proportion to the change in total inputs.  Output can exactly double if inputs are doubled  A situation in which the long-run average cost curve does not change as the firm increases output

Causes of Constant returns to scale

Limits of the economies of scale When economies disappear & diseconomies are yet to begin then constant returns

What are decreasing returns to scale or diseconomies of scale?

 Output changes disproportionately less compared to a change in the scale of inputs  Output can less than double if inputs are doubled  A situation in which the long-run average cost curve rises as the firm increases output

Diseconomies of Scale
Technical factors unlikely to produce diseconomies of scale Diseconomies more associated with human & behavioral problems of managing a large enterprise Control loss- quantity of information received & transmitted per unit of output is less after expansion Spirit in large firm is less than small firm due to lack of personal touch

Causes of Decreasing returns to scale

Managerial diseconomies- diminishing returns to management As size of firm increases managerial efficiency decreases Limitedness or exhaustibility of natural resources

Rs80 Rs70 Rs60 Rs50 Rs40 Rs30 Rs20 Rs10

Long-run Average Cost Curve

Constant returns to scale Economies of scale Diseconomies of scale

2 4 6

Q 8 10 12 14 16 18

Modern view: L shaped Long Run Average Cost curve

Long run cost can be divided into Production cost & Managerial cost Modern theory says long run cost curve likely to be L shaped than U shaped Production costs fall continuously with increases in output while Managerial costs may rise at very large scales of output The fall in production costs more than offsets the increase in managerial costs, so that LAC continuously falls with increases in scale

Pause for a Thought

What economies of scale is a large department store likely to experience?

Pause for a Thought

Specialised staff for each department (saving on training costs and providing a more efficient service for customers); being able to reallocate space as demand shifts from one product to another and thereby reducing the overall amount of space required; full use of large delivery lorries which would be able to carry a range of different products; bulk purchasing discounts; reduced administrative overheads as a proportion of total costs.

Pause for a Thought

Name some industries where external economies of scale are gained. What are the specific external economies in each case?

Pause for a Thought

Two examples are: Financial services: pool of qualified and experienced labour, access to specialist software, one firm providing specialist services to another. Various parts of the engineering industry: pool of qualified and experienced labour, access to specialist suppliers, possible joint research, specialised banking services.

Pause for a Thought

Would you expect external economies to be associated with the concentration of an industry in a particular region?

Pause for a Thought

Yes. There may be a common transport and communications infrastructure that can be used; there is likely to be a pool of trained and experienced labour in the area; joint demand may be high enough to allow economies of scale to be experienced in the supply of some locally extracted raw material.