Chapter 6

Production
 Production: One Variable Input

©2005 Pearson Education, Inc. Chapter 6 2

 Production: One Variable Input

 Average product of Labor - Output per

unit of a particular product
 Measures the productivity of a firm’s
labor in terms of how much, on average,
each worker can produce

Output q
AP  
Labor Input L

©2005 Pearson Education, Inc. Chapter 6 3

 Production: One Variable Input

 Marginal Product of Labor – additional

output produced when labor increases by
one unit
 Change in output divided by the change
in labor

Output q
MPL  
Labor Input L

©2005 Pearson Education, Inc. Chapter 6 4

 Production: One Variable Input

©2005 Pearson Education, Inc. Chapter 6 5

 Production: One Variable Input
Output
per
Month D
112

C Total Product

At point D, output is
60 maximized.
B

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

©2005 Pearson Education, Inc. Chapter 6 6
 Production: One Variable Input
Output •Left of E: MP > AP & AP is increasing
per •Right of E: MP < AP & AP is decreasing
Worker •At E: MP = AP & AP is at its maximum
•At 8 units, MP is zero and output is at max
30
Marginal Product

E Average Product
20

10

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

©2005 Pearson Education, Inc. Chapter 6 7
 Product Curves
AP is slope of line from
q origin to point on TP
q/L curve
112

30
C

60 20
B

10

0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor Labor

©2005 Pearson Education, Inc. Chapter 6 8

 Product Curves
MP is slope of line tangent to
corresponding point on TP
q curve
q
D
112

30

60
15
30 10
A

0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor Labor

©2005 Pearson Education, Inc. Chapter 6 9

 The Effect of
Technological Improvement
As move from A to B to
Output
C C labor productivity is
increasing over time

100 O3
B

A
O2
50

O1

Labor per
time period
0 1 2 3 4 5 6 7 8 9 10
©2005 Pearson Education, Inc. Chapter 6 10
 Labor Productivity

 Macroeconomics are particularly

concerned with labor productivity
The average product of labor for an entire
industry or the economy as a whole
Links macro and microeconomics
Can provide useful comparisons across time
and across industries

q
Average Productivity 
L
©2005 Pearson Education, Inc. Chapter 6 11
 Production: Two Variable Inputs

©2005 Pearson Education, Inc. Chapter 6 12

 Isoquant Map
Capital 5 E
Ex: 55 units of output
per year can be produced with
3K & 1L (pt. A)
4 OR
1K & 3L (pt. D)
3
A B C

2
q3 = 90
D q2 = 75
1
q1 = 55
1 2 3 4 5 Labor per year

©2005 Pearson Education, Inc. Chapter 6 13

 Diminishing Returns
Capital 5 Increasing labor
per year holding capital
constant (A, B, C)
4 OR
Increasing capital
holding labor constant
3 (E, D, C
A B C
D
2
q3 = 90

1 E q2 = 75
q1 = 55
1 2 3 4 5 Labor per year

©2005 Pearson Education, Inc. Chapter 6 14

 Production: Two Variable Inputs

 The marginal rate of technical

substitution equals:

Change in Capital input

MRTS 
Change in Labor input
MRTS   K (for a fixed level of q )
L

©2005 Pearson Education, Inc. Chapter 6 15

 Marginal Rate of
Technical Substitution
Capital 5
per year
Slope measures MRTS
2 MRTS decreases as move down
4 the indifference curve

1
3
1
1
2
2/3 1
Q3 =90
1/3 Q2 =75
1 1
Q1 =55
1 2 3 4 5 Labor per month
©2005 Pearson Education, Inc. Chapter 6 16
 MRTS and Marginal Products

 If we increase labor and decrease capital

to keep output constant, we can see how
much the increase in output is due to the
increased labor
Amount of labor increased times the
marginal productivity of labor

 ( MPL )(L)
©2005 Pearson Education, Inc. Chapter 6 17
 MRTS and Marginal Products

 Similarly, the decrease in output from the

decrease in capital can be calculated
Decrease in output from reduction of capital
times the marginal produce of capital

 ( MPK )(K )
©2005 Pearson Education, Inc. Chapter 6 18
 MRTS and Marginal Products

 If we are holding output constant, the net

effect of increasing labor and decreasing
capital must be zero
 Using changes in output from capital and
labor we can see

(MP L)(  L)  (MP K)(  K)  0

©2005 Pearson Education, Inc. Chapter 6 19

 MRTS and Marginal Products

 Rearranging equation, we can see the

relationship between MRTS and MPs

(MPL)( L)  (MPK)( K)  0

(MPL )(L)  - (MPK)( K)
(MPL ) K
  MRTS
( MPK ) L
©2005 Pearson Education, Inc. Chapter 6 20
 Perfect Substitutes
Capital
per A
Same output can be
month reached with mostly
capital or mostly labor
(A or C) or with equal
amount of both (B)
B

C
Q1 Q2 Q3
Labor
per month

©2005 Pearson Education, Inc. Chapter 6 21

 Fixed-Proportions
Production Function
Capital
per Same output
month can only be
produced with
one set of
inputs.
Q3
C
Q2
B

K1 Q1
A

Labor
per month
L1
©2005 Pearson Education, Inc. Chapter 6 22
 Increasing Returns to Scale
Capital
(machine The isoquants
hours) A
move closer
together

30

2 20
10
Labor (hours)
5 10
©2005 Pearson Education, Inc. Chapter 6 23
 Returns to Scale
Capital
(machine
A
hours)
6
30

4 Constant
Returns:
2 Isoquants are
0 equally spaced
2

10
Labor (hours)
5 10 15
©2005 Pearson Education, Inc. Chapter 6 24
 Returns to Scale
Capital
(machine A
hours)

Decreasing Returns:
Isoquants get further
4 apart

30
2
20
10

5 10 Labor (hours)
©2005 Pearson Education, Inc. Chapter 6 25
 Chapter 7

The Cost of Production

 Fixed and Variable Costs

 Total output is a function of variable

inputs and fixed inputs.
 Therefore, the total cost of production
equals the fixed cost (the cost of the fixed
inputs) plus the variable cost (the cost of
the variable inputs), or…

TC  FC  VC
©2005 Pearson Education, Inc. Chapter 7 27
 Measuring Costs

 Marginal Cost (MC):

The cost of expanding output by one unit.
Fixed cost have no impact on marginal cost,
so it can be written as:

ΔVC ΔTC
MC  
Δq Δq

©2005 Pearson Education, Inc. Chapter 7 28

 Measuring Costs

 Average Total Cost (ATC)

Cost per unit of output
Also equals average fixed cost (AFC) plus
average variable cost (AVC).

TC
ATC   AFC  AVC
q
TC TFC TVC
ATC   
q q q
©2005 Pearson Education, Inc. Chapter 7 29
 A Firm’s Short Run Costs

©2005 Pearson Education, Inc. Chapter 7 30

 Determinants of Short-run Costs
– An Example

 Assume the wage rate (w) is fixed

relative to the number of workers hired.
 Variable costs is the per unit cost of extra
labor times the amount of extra labor: wL

VC wL
MC  
q q

©2005 Pearson Education, Inc. Chapter 7 31

 Determinants of Short-run Costs
– An Example

 Remembering that
Q
MPL 
L
 And rearranging

L 1
L for a 1 unit Q  
Q MPL
©2005 Pearson Education, Inc. Chapter 7 32
 Determinants of Short-run Costs
– An Example

 We can conclude:

w
MC 
MPL
 …and a low marginal product (MP) leads
to a high marginal cost (MC) and vise
versa.

©2005 Pearson Education, Inc. Chapter 7 33

 Cost Curves for a Firm
TC
Cost 400
($ per Total cost
year) VC
is the vertical
sum of FC
and VC.
300
Variable cost
increases with
production and
the rate varies with
200 increasing &
decreasing returns.

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output

©2005 Pearson Education, Inc. Chapter 7 34

 Cost Curves
120
100
MC
Cost ($/unit)

80
60
ATC
40
AVC
20
AFC
0
0 2 4 6 8 10 12
Output (units/yr)
©2005 Pearson Education, Inc. Chapter 7 35
 Cost Curves

 When MC is below AVC, AVC is falling

 When MC is above AVC, AVC is rising
 When MC is below ATC, ATC is falling
 When MC is above ATC, ATC is rising
 Therefore, MC crosses AVC and ATC at
the minimums
The Average – Marginal relationship

©2005 Pearson Education, Inc. Chapter 7 36

 Cost Curves for a Firm
 The line drawn from
the origin to the P TC
variable cost curve: 400
VC
 Its slope equals AVC
 The slope of a point 300
on VC or TC equals
MC 200
 Therefore, MC = AVC A
at 7 units of output 100
(point A) FC

1 2 3 4 5 6 7 8 9 10 11 12 13
Output

©2005 Pearson Education, Inc. Chapter 7 37

 Producing a Given Output at
Minimum Cost
Capital
per Q1 is an isoquant for output Q1.
year There are three isocost lines, of
which 2 are possible choices in
which to produce Q1
K2

Isocost C2 shows quantity

Q1 can be produced with
combination K2L2 or K3L3.
However, both of these
A are higher cost combinations
K1 than K1L1.

Q1
K3

C0 C1 C2
Labor per year
L2 L1 L3
©2005 Pearson Education, Inc. Chapter 7 38
 Input Substitution When an
Input Price Change

 If the price of labor changes, then the

slope of the isocost line change, w/r
 It now takes a new quantity of labor and
capital to produce the output
 If price of labor increases relative to price
of capital, and capital is substituted for
labor

©2005 Pearson Education, Inc. Chapter 7 39

 Input Substitution When an
Input Price Change
Capital
per If the price of labor
year rises, the isocost curve
becomes steeper due to
the change in the slope -(w/L).

The new combination of K

and L is used to produce Q1.
B Combination B is used in
K2 place of combination A.

A
K1

Q1

C2 C1

L2 L1 Labor per year

©2005 Pearson Education, Inc. Chapter 7 40
 Cost in the Long Run

 How does the isocost line relate to the

firm’s production process?

MRTS  - K  MPL
L MPK

Slope of isocost line  K  w

L r
MPL
w when firm minimizes cost
MPK r

©2005 Pearson Education, Inc. Chapter 7 41

 Cost in the Long Run

 The minimum cost combination can then

be written as:

MPL  MPK
w r
 Minimum cost for a given output will occur
when each dollar of input added to the
production process will add an equivalent
amount of output.

©2005 Pearson Education, Inc. Chapter 7 42

 A Firm’s Expansion Path
Capital
per The expansion path illustrates
the least-cost combinations of
year
labor and capital that can be
150 $3000 used to produce each level of
output in the long-run.

Expansion Path
$200
100 0
C
75
B
50
300 Units
A
25
200 Units

Labor per year

50 100 150 200 300
©2005 Pearson Education, Inc. Chapter 7 43
 A Firm’s Long-Run Total Cost
Curve
Cost/
Year
Long Run Total Cost
F
3000

E
2000

D
1000

Output, Units/yr
100 200 300
©2005 Pearson Education, Inc. Chapter 7 44
 The Inflexibility of Short-Run
Production
Capital E Capital is fixed at K1
per To produce q1, min cost at K1,L1
year If increase output to Q2, min cost
C is K1 and L3 in short run

In LR, can
Long-Run
change
Expansion Path
A capital and
min costs
falls to K2
K2 and L2
Short-Run
P Expansion Path
K1 Q2

Q1
Labor per year
L1 L2 B L3 D F
©2005 Pearson Education, Inc. Chapter 7 45
 Long-Run Average and Marginal
Cost
Cost
($ per unit
of output LMC

LAC

Output

©2005 Pearson Education, Inc. Chapter 7 46

 Economies and Diseconomies
of Scale
 Economies of Scale
Increase in output is greater than the
increase in inputs.
 Diseconomies of Scale
Increase in output is less than the increase in
inputs.
 U-shaped LAC shows economies of
scale for relatively low output levels and
diseconomies of scale for higher levels

©2005 Pearson Education, Inc. Chapter 7 47

 Long Run Costs

 Increasing Returns to Scale

Output more than doubles when the
quantities of all inputs are doubled
 Economies of Scale
Doubling of output requires less than a
doubling of cost

©2005 Pearson Education, Inc. Chapter 7 48

 Long Run Costs

 Economies of scale are measured in

terms of cost-output elasticity, EC
 EC is the percentage change in the cost
of production resulting from a 1-percent
increase in output

EC  C C  MC
Q Q AC

©2005 Pearson Education, Inc. Chapter 7 49

 Long Run Costs
 EC is equal to 1, MC = AC
 Costs increase proportionately with output
 Neither economies nor diseconomies of scale
 EC < 1 when MC < AC
 Economies of scale
 Both MC and AC are declining
 EC > 1 when MC > AC
 Diseconomies of scale
 Both MC and AC are rising

©2005 Pearson Education, Inc. Chapter 7 50

 Long-Run Cost with Economies
and Diseconomies of Scale

©2005 Pearson Education, Inc. Chapter 7 51

 Production with Two Outputs –
Economies of Scope

 Advantages
1. Both use capital and labor.
2. The firms share management
resources.
3. Both use the same labor skills and type
of machinery.

©2005 Pearson Education, Inc. Chapter 7 52

 Production with Two Outputs –
Economies of Scope

 Firms must choose how much of each to

produce.
 The alternative quantities can be
illustrated using product transformation
curves
Curves showing the various combinations of
two different outputs (products) that can be
produced with a given set of inputs

©2005 Pearson Education, Inc. Chapter 7 53

 Product Transformation Curve
Number Each curve shows
of tractors combinations of output
with a given combination
of L & K.

O2
O1 illustrates a low level
of output. O2 illustrates
a higher level of output with
two times as much labor
O1 and capital.

Number of cars

©2005 Pearson Education, Inc. Chapter 7 54

 Product Transformation Curve
 Product transformation curves are
negatively slope
To get more of one output, must give up
some of the other output
 Constant returns exist in this example
Second curve lies twice as far from origin as
the first curve
 Curve is concave
Joint production has its advantages

©2005 Pearson Education, Inc. Chapter 7 55

 Production with Two Outputs –
Economies of Scope
 The degree of economies of scope (SC) can be
measured by percentage of cost saved
producing two or more products jointly:
C(q1 )  C(q 2 )  C(q1,q2 )
SC 
C(q1,q 2 )
 C(q1) is the cost of producing q1
 C(q2) is the cost of producing q2
 C(q1,q2) is the joint cost of producing both products

©2005 Pearson Education, Inc. Chapter 7 56

 Production with Two Outputs –
Economies of Scope

 With economies of scope, the joint cost is

less than the sum of the individual costs
 Interpretation:
If SC > 0 – Economies of scope
If SC < 0 – Diseconomies of scope
The greater the value of SC, the greater the
economies of scope

©2005 Pearson Education, Inc. Chapter 7 57