TOPICS

Production and firm

The production function
Short run versus Long run
Production with one variable input(Labour)
Average product
Marginal product
The slopes of the production curve
Law of diminishing marginal returns
Production with two variable inputs
Isoquant
Isoquant Maps
Diminishing marginal returns
Substitution among inputs
Returns to scale
Describing returns to scale

Production and firm

The theory of the firm that describes

how a firm makes cost-minimizing
production decisions and how the
firms resulting cost varies with its
output.
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

The production function

Factors of production: inputs that are used into the
production(Ex-labour, capital, and materials)
The production function:
Q=F(K,L)
A production function indicates the highest output q
that a firm can produce for every specified
combination of inputs.
This equation relates the quantity of output to the
quantities of the two inputs, capital (K)and
labour(L).
inputs and outputs are flows.
Note that the above equation applies to a given
technology.
As the technology becomes more advanced and the
production function changes, a firm can obtain more
output for a given set of inputs.
Production functions describe what is technically
feasible when the firm operates efficiently

Short run versus Long 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.

Production with one variable

input(Labour)

Average product
The first column shows the amount of labour, the
second the fixed amount of capital, and the third
total output. When labour input is zero, output is also
zero. Output then increases as labour is increased
up to an input of 8 units.
The fourth column in Table shows the average
product of labour (APL) which is the output per unit
of labour input.
The average product is calculated by dividing the
total output q by the total input of labour L.
The average product of labour measures the
productivity of the firm's workforce in terms of how
much output each worker produces on average.

Marginal product
The fifth column of Table shows the marginal
product of labour (MPL).
This is the additional output produced as the labour
input is increased by 1 unit.
For example, with capital fixed at 10 units, when the
labour input increases from 2 to 3, total output
increases from 30 to 60, creating an additional
output of 30 (i.e., 60 - 30) units. The marginal
product of labour can be written as Q / L - in
other words, the change in output Q resulting from
a one-unit increase in labour input L.

The slopes of the production

curve
The total product curve in (a)
shows the output produced for
different amounts of labour input.
The average and marginal
products in (b) can be obtained
(using the data in Table) from the
total product curve.
At point A in (a), the marginal
product is 20 because the tangent
to the total product curve has a
slope of 20.
At point B in (a) the average
product of labour is 20, which is
the slope of the line from the
origin to B.
The average product of labour at
point C in (a) is given by the slope
of the line OC.

To the left of point E in (b),

the marginal product is
above the average product
and the average is
increasing; to the right of E,
the marginal product is
below the average product
and the average is
decreasing.
As a result, E represents
the point at which the
average and marginal
products are equal, when
the average product
reaches its maximum.
At D, when total output is
maximized, the slope of the
tangent to the total product
curve is zero, as is the
marginal product.

Law of diminishing marginal

returns
The law of diminishing marginal returns states that
as the use of an input increases in equal increments
(with other inputs fixed), a point will eventually be
reached after which the resulting additions in the input
will cause decrement in the output.
The law of diminishing marginal returns applies to a
given production technology.
Over time, however, inventions and other
improvements in technology may allow the entire total
product curve in to shift upward, so that more output
can be produced with the same inputs.
Figure in the next slide illustrates this principle.
Initially the output curve is given by O1 but
improvements in technology may allow the curve to
shift upward, first to O2 and later to O3.

Labour productivity
(output per unit of
labour) can increase if
there are
improvements in
technology, even
though any given
production process
exhibits diminishing
returns to labour.
As we move from point
A on curve O1 to B on
curve O2 to C on curve
O3 over time, labour
productivity increases.

Production with two

variable inputs
We have completed our analysis of the short-run
production function in which one input, labour, is
variable, and the other, capital, is fixed. Now we turn
to the long run, for which both labour and capital are
variable. The firm can now produce its output in a
variety of ways by combining different amounts of
labour and capital.

Isoquant
Isoquant : the term
may be defined as
Curve showing all
possible
combinations of
inputs that yield the
same output.

Isoquant map
Isoquant map: When a
number of isoquants are
combined in a single
graph, we call the graph an
isoquant map.
A set of isoquants, or
isoquant map, describes
the firms production
function.
Output increases as we
move from isoquant q1 (at
which 55 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).

Diminishing marginal returns

Holding the amount of capital
fixed at a particular levelsay
3, we can see that each
additional unit of labour
generates less and less
additional output.
For example, when labour is
increased from 1 unit to 2
(from A to B), output increases
by 20 (from 55 to 75). However,
when labour is increased by an
additional unit (from B to C),
output increases by only 15
(from 75 to 90).Thus there are
diminishing marginal returns to
labour both in the long and
short run.
There are also diminishing marginal returns to capital. With labour
fixed, the marginal product of capital decreases as capital is increased.
For example, when capital is increased from 1 to 2 and labour is held
constant at 3, the marginal product of capital is initially 20 (75 - 55) but
falls to 15 (90 - 75) when capital is increased from 2 to 3.

Substitution among inputs

The slope of each isoquant indicates how
the quantity of one input can be traded off
against the quantity of the other, while
output is held constant.
When the negative sign is removed, we call
the slope the marginal rate of technical
substitution (MRTS).
marginal rate of technical substitution
(MRTS): Amount by which the quantity of
one input can be reduced when one extra
unit of another input is used, so that output
remains constant.
The marginal rate of technical substitution
of labour for capital is the amount by which
the input of capital can be reduced when
one extra unit of labour is used, so that
output remains constant.

Keeping q= 75 (constant)
MRTS is equal to 2 when
labour increases from 1
unit to 2 and output is
fixed at 75.However, the
MRTS falls to 1 when
labour is increased from 2
units to 3, and then
declines to 2/3 and to 1/3.
Clearly, as more and
more labour replaces
capital, labour becomes
less productive and
capital becomes relatively
more productive.

MRTS is closely related to the marginal products of labour

MPL and capital MPK. To see how, imagine adding some
labour and reducing the amount of capital sufficient to
keep output constant.
The additional output resulting from the increased labour
input is equal to the additional output per unit of
additional labour (the marginal product of labour) times
the number of units of additional labour:
Additional output from increased use of labour = (MPL)(L)
Similarly, the decrease in output resulting from the
reduction in capital is the loss of output per unit reduction
in capital (the marginal product of capital) times the
number of units of capital reduction:
Reduction in output from decreased use of capital =
(MPK)(K)
Because we are keeping output constant by moving along
an isoquant, the total change in output must be zero. Thus,
(MPL)(L)+ (MPK)(K)=0

Case 1

Two special cases

In the first case,
shown in Figure
inputs to production
are perfect
substitutes for one
another.
Here the MRTS is
constant at all points
on an isoquant. As a
result, the same
output (say q3) can be
produced with mostly
capital (at A), with
mostly labour (at C),
or with a balanced
combination of both
(at B).

Case 2

fixed-proportions production
function: Production function
with L-shaped isoquants, so
that only one combination of
labour and capital can be
used to produce each level
of output.
The fixed-proportions
production function
describes situations in which
methods of production are
limited.
When the isoquants are Lshaped, only one
combination of labor and
capital can be used to
produce a given output (as at
point A on isoquant q1, point
B on isoquant q2, and point C
on isoquant q3). Adding more
labor alone does not
increase output, nor does
adding more capital alone.

Returns to scale
Returns to scale: Rate at which output
increases as inputs are increased
proportionately.
Incresing retuns to scale: Situation in which
output more than doubles when all inputs
are doubled.
Constant retuns 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.

Describing returns to scale

When a firms production
process exhibits constant
returns to scale as shown by a
movement along line OA in part
(a), the isoquants are equally
spaced as output increases
proportionally.

However, when there are

increasing returns to scale as
shown in (b), the isoquants
move closer together as
inputs are increased along
the line.

Empirical production
function
Cobb-Douglas Production Function
Q=ALaKb
A , a and b is to be estimated empirically
a and b are the output elasticity of labor and
capital, respectively. These values are
constants determined by available
technology.
a + b = 1, the production function has
constant returns to scale.
a + b < 1, decreasing returns to scale.
a + b > 1, increasing returns to scale.

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