Production Analysis and Compensation Policy

OVERVIEW
          Production Functions Total, Marginal, and Average Product Law of Diminishing Returns to a Factor Input Combination Choice Marginal Revenue Product and Optimal Employment Optimal Combination of Multiple Inputs Optimal Levels of Multiple Inputs Returns to Scale Production Function Estimation Productivity Measurement

KEY CONCEPTS
             production function discrete production function continuous production function returns to scale returns to a factor total product marginal product average product law of diminishing returns isoquant technical efficiency input substitution marginal rate of technical ridge lines marginal revenue product economic efficiency net marginal revenue isocost curve (or budget line) constant returns to scale expansion path increasing returns to scale decreasing returns to scale output elasticity power production function productivity growth labor productivity multifactor productivity

Production Functions
 Properties of Production Functions  Production functions are determined by technology, equipment and input prices.  Discrete production functions are lumpy.  Continuous production functions employ inputs in small increments.

Returns to Scale and Returns to a Factor

 Returns to scale measure output effect of increasing all inputs.  Returns to a factor measure output effect of increasing one input.

Total, Marginal, and Average Product

 Total Product
 Total product is total output.

Marginal Product
 Marginal product is the change in output caused by increasing input use.  If MPX=Q/X> 0, total product is rising.  If MPX=Q/X< 0, total product is falling (rare).

 Average product
 APX=Q/X.

Law of Diminishing Returns to a Factor

 Diminishing Returns to a Factor Concept
 MPX tends to diminish as X use grows.  If MPX grew with use of X, there would be no limit to input usage.  MPX< 0 implies irrational input use (rare).

 Illustration of Diminishing Returns to a Factor

Input Combination Choice

 Production Isoquants
 Technical efficiency is least-cost production.

 Input Factor Substitution

 Isoquant shape shows input substitutability.  C-shaped isoquants are common and imply imperfect substitutability.

Marginal Rate of Technical Substitution

 MRTSXY=-MPX/MPY

 Rational Limits of Input Substitution

 MPX<0 or MPY<0 are never observed.

Marginal Revenue Product and Optimal Employment

 Marginal Revenue Product
 MRPL is the revenue gain after all variable costs except labor costs.  MRPL= MPL x MRQ = TR/L.

 Optimal Level of a Single Input

 Set MRPL=PL to get optimal employment.

 Illustration of Optimal Employment

Optimal Combination of Multiple Inputs

 Budget Lines
 Least-cost production occurs when MPX/PX = MPY/PY and PX/PY = MPX/MPY

 Expansion Path
 Shows efficient input combinations as output grows.

 Illustration of Optimal Input Proportions

 Input proportions are optimal when no additional output could be produce for the same cost.  Optimal input proportions is a necessary but not sufficient condition for profit maximization.

Optimal Levels of Multiple Inputs

 Optimal Employment and Profit Maximization
 Profits are maximized when MRPX = PX for all inputs.  Profit maximization requires optimal input proportions plus an optimal level of output.

 Illustration of Optimal Levels of Multiple Inputs

Returns to Scale
 Evaluating Returns to Scale
 Returns to scale show the output effect of increasing all inputs.

 Output Elasticity and Returns to Scale  Output elasticity is Q = Q/Q Xi/Xi where Xi is all
inputs (labor, capital, etc.)  Q > 1 implies increasing returns.  Q = 1 implies constant returns.  Q < 1 implies decreasing returns.

 Returns to Scale Estimation

Production Function Estimation

 Cubic Production Functions
 Display variable returns to scale.  First increasing, then decreasing returns are common.

 Power Production Functions

 Allow marginal productivity of each input to vary with employment of all inputs.

Productivity Measurement
 How Is Productivity Measured?
 Productivity measurement is the responsibility of the Bureau of Labor Statistics (since 1800s).  Productivity growth is the rate of change in output per unit of input.  Labor productivity is the change in output per worker hour.

 Uses and Limitations of Productivity Data

 Quality changes make productivity measurement difficult.