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Lecture

1 Technology / Production Function

Items not covered in class


Types of production function / technology:
a) Cobb-Douglas: , = & '

b) Perfect substitutes: , = + .

Isoquants are flat.


Q: Whats the TRS of a perfect substitutes isoquant?
Types of production function / technology (continued):
c) Perfect complements: , = min {, }.
min { , } means that , takes the value of the smaller of K
and L.
Isoquants are L-shaped.
Q: Whats the TRS of a perfect complements isoquant?

Note: The Cobb-Douglas production function captures both the perfect substitute and
complement cases. Cobb-Douglas middle section looks similar in shape to perfect
substitutes and the extreme sections look similar in shape to perfect complements.
Elasticity
4 :4
%2 5677 ;2 3
4 4
a) Elasticity (generic definition) = = 8 :8 =
%3 5677 ;3 2
8 8

Econ: Whats the % change () in A for each 1% change () in B. In other words, if I increase
B by 1%, by how many percentages does A change?

b) Elasticity of total product with respect to:


?@
A CD > EFB = Econ: If I increase L by 1% by how many
=,> = ?B = = where > =
C> = 2FB > percentages does f increase?
B

?@
A CD I EFJ = Econ: If I increase K by 1% by how many
=,I = ?J = = where I =
CI = 2FJ I percentages does f increase?
J
Elasticity (continued)
:(JMB)
(JMB) EFB
c) Elasticity of substitution = = :(|PQR|) Recall that = EFJ
|PQR|

Percentage response in the capital/labor ratio to a 1% increase in TRS (its absolute value)
is a measure if how easily the firm can substitute K for L
A larger implies that its easier to substitute one input for the other (isoquants are flatter)
A smaller implies that its more difficult to substitute one input for the other (isoquants are
more curved, closer to L-shape)
Returns to scale
a) f displays constrant returns to scale (CRS) if:
> 1, , = (, )

b) f displays increasing returns to scale (IRS) if:


> 1, , > (, )

c) f displays decreasing returns to scale (DRS) if:


> 1, , < (, )

Note: Returns to scale is a completely different exercise to what we did when we


discussed about > and I. Why? Because in returns to scale we are changing all the
inputs at the same time, but with marginal products, one of the inputs is help constant.
Returns to scale (continued)

Note: The figure on the left shows the different shapes of the production function
depending on whether it displays decreasing, constant and increasing returns to scale. In
fact, we could have a production function like the one displayed on the right figure: at low
levels of input/output, it displays IRS, then very briefly CRS and finally it displays DRS at
high levels of input/output.
Short-run vs. Long-run
a) In the short-run, one input is fixed, and cannot be changed. Usually, we assume that K
\: (
is fixed at \, ). In that case, labor (L) is the only variable of choice.

b) In the long-run, all inputs can be changed: (, )

Note: We dont use a specific period of time to define what the short-run and long-run are.
It will depend on the nature of the technology / firm.