UNIVERSITATEA “TRANSILVANIA” DIN BRAŞOV

FACULTATEA DE STIINTE ECONOMICE SI ADMINISTRAREA

AFACERILOR

Stratulat Dan-Gabriel Profesor Coordonator:

12.01.2011 Tache Ileana

 1. Concept of production functions
Production functions are a fundamental component of all economics. As such,
estimation of production functions has a long history in applied economics, starting in the
early 1800’s. Unfortunately,this history cannot be deemed an unqualified success, as
many of the econometric problems that hampered early estimation are still an issue today.
Production functions relate productive inputs (e.g. capital, labor, materials) to outputs.
Perhaps the major econometric issue confronting estimation of production functions is
the possibility that some of these inputs are unobserved. If this is the case, and if the
observed inputs are chosen as a function of these unobserved inputs (as will typically be
the case for a profit-maximizing or cost-minimizing firm), then there is an endogeneity
problem and OLS estimates of the coefficients on the observed inputs will be biased.
Much of the literature in the past half century has been devoted to solving this
endogeneity problem. Two of the earliest solutions to the problem are instrumental
variables (IV) and fixedeffects estimation (Mundlak (1961)).

In economics, equation that expresses the relationship between the quantities of

productive factors (such as labour and capital) used and the amount of product obtained.
It states the amount of product that can be obtained from every combination of factors,
assuming that the most efficient available methods of production are used.

The production function can thus answer a variety of questions. It can, for
example, measure the marginal productivity of a particular factor of production (i.e., the
change in output from one additional unit of that factor). It can also be used to determine
the cheapest combination of productive factors that can be used to produce a given
output.

When most people think of fundamental tasks of a firm, they think first of
production. Economists describe this task with the production function, an abstract way
of discussing how the firm gets output from its inputs. It describes, in mathematical
terms, the technology available to the firm.

A production function can be represented in a table such as the one below. In this
table five units of labor and two of capital can produce 34 units of output. It is, of course,
always possible to waste resources and to produce fewer than 34 units with five units of
labor and two of capital, but the table indicates that no more than 34 can be produced
with the technology available. The production function thus contains the limitations that
technology places on the firm.
 A Production Function
Labor
5 30 34 37
4 26 30 33
3 21 25 28
2 16 20 23
1 10 13 15
1 2 3
Capital

The production function can also be illustrated in a graph such as that below. This
graph looks exactly like a graph of indifference curves because the mathematical forms
of the production function and the utility function are identical. In one case, inputs of
goods and services combine to produce utility; in the other, inputs of resources combine
to produce goods or services. A curved line in the graph shows all the combinations of
inputs that can produce a particular quantity of output. These lines are called isoquants.
As one moves to the right, one reaches higher levels of production. If one can visualize
this as a three-dimensional graph, one can see that the production surface rises
increasingly high above the surface of the page; the isoquants indicate a hill. The firm
must operate on or below this surface.

There is one rule that seems to hold for all production functions, and because it
always seems to hold, it is called a law. The law of diminishing returns says that adding
more of one input while holding other inputs constant results eventually in smaller and
smaller increases in added output. To see the law in the table above, one must follow a
column or row. If capital is held constant at two, the marginal output of labor (which
economists usually call marginal product of labor) is shown in the table below. The first
unit of labor increases production by 13, and as more labor is added, the increases in
production gradually fall.
 The Marginal Product of Labor
Labor Marginal Output
First 13
Second 7
Third 5
Fourth 5
Fifth 4

2. The law of diminishing returns

The law of diminishing returns does not take effect immediately in all production
functions. It is possible for the first unit of labor to add only four units of output, the
second to add six, and the third to add seven. If a production function had this pattern, it
would have increasing returns between the first and third worker. What the law of
diminishing returns says is that as one continues to add workers, eventually one will
reach a point where increasing returns stop and decreasing returns set in.

It is not caused because the first worker has more ability than the second worker,
and the second is more able than the third. By assumption, all workers are the same. It is
not ability that changes, but rather the environment into which workers (or any other
variable input) are placed. As additional workers are added to a firm with a fixed amount
of equipment, the equipment must be stretched over more and more workers. Eventually,
the environment becomes less and less favorable to the additional worker. People's
productivity depends not only on their skills and abilities, but also on the work
environment they are in.

The law was a central piece of economic theory in the 19th century and accounted
for economists' gloomy expectations of the future. They saw the amount of land as fixed,
and the number of people who could work the land as variable. If the number of people
expanded, eventually adding one more person would result in very little additional food
production. And if population had a tendency to expand rapidly, as economists thought it
did, one would predict that (in equilibrium) there would always be some people almost
starving. Although history has shown the gloomy expectations wrong, the idea had an
influence on the work of Charles Darwin and traces of it still float around today among
environmentalists.

3. Homogeneous and homothetic production functions

There are two special classes of production functions that are often analyzed. The
production function Q = f(X1,X2) is said to be homogeneous of degree n, if given any
positive constant k, f(kX1,kX2) = knf(X1,X2). If n > 1, the function exhibits increasing
returns to scale, and it exhibits decreasing returns to scale if n < 1. If it is homogeneous of
degree 1, it exhibits constant returns to scale. The presence of increasing returns means
that a one percent increase in the usage levels of all inputs would result in a greater than
one percent increase in output; the presence of decreasing returns means that it would
result in a less than one percent increase in output. Constant returns to scale is the in-
between case. In the Cobb-Douglas production function referred to above, returns to scale
are increasing if b + c + ... > 1, decreasing if b + c + ... < 1, and constant if b + c + ... = 1.

If a production function is homogeneous of degree one, it is sometimes called "linearly

homogeneous". A linearly homogeneous production function with inputs capital and
labour has the properties that the marginal and average physical products of both capital
and labour can be expressed as functions of the capital-labour ratio alone. Moreover, in
this case if each input is paid at a rate equal to its marginal product, the firm's revenues
will be exactly exhausted and there will be no excess economic profit.[4]:pp.412-414

Homothetic functions are functions whose marginal technical rate of substitution (the
slope of the isoquant, a curve drawn through the set of points in say labour-capital space
at which the same quantity of output is produced for varying combinations of the inputs)
is homogeneous of degree zero. Due to this, along rays coming from the origin, the slopes
of the isoquants will be the same. Homothetic functions are of the form F(h(X1,X2)) where
F(y) is a monotonically increasing function (the derivative of F(y) is positive (dF / dy >
0)), and the function h(X1,X2) is a homogeneous function of any degree.

4.Specifying the production function

A production function can be expressed in functional form as the right side of

Q = f(X1,X2,X3,...,Xn)
where:
Q = quantity of output
X1,X2,X3,...,Xn = quantities of factor inputs (such as capital, labour, land or raw
materials).

If Q is a scalar, then this form does not encompass joint production, which is a
production process that has multiple co-products. On the other hand, if f maps from Rn to
Rk then it is a joint production function expressing the determination of k different types
of output based on the joint usage of the specified quantities of the n inputs.

Most products require many more than two inputs, but showing a production
function with more than two inputs with graphs or tables is difficult. Products require
various types of labor and capital, energy of various sorts, and raw materials. One of the
key inputs, especially in larger firms, is managerial ability. Inputs do not combine by
themselves to produce output. Someone must have knowledge of how to combine inputs
and to coordinate the production process.

If business decision-makers lack information or are incompetent, the firm will

not make the best use of available resources. Or if morale is bad in a firm, people may
work poorly and produce less than they could. In either case, the firm will produce below
the maximum that the production function allows. Economist Harvey Liebenstein has
called losses of these sorts "X-inefficiency." Although economists assume that the firm
will be on the production function, a major challenge of management is to make
decisions so that the firm will be on or close to the production function.

In explaining the theory of the firm, economists conventionally assume that the
production function is fixed and that the firm operates on the surface of the production
function. The firm need not consider the production function as fixed, but may view it as
a variable that it can alter through research and development. Creativity in the form of
new technology or new management techniques may loosen the boundary that the
production function represents and may make possible greater profit, at least temporarily.

5. Stages of production
To simplify the interpretation of a production function, it is common to divide its
range into 3 stages. In Stage 1 (from the origin to point B) the variable input is being used
with increasing output per unit, the latter reaching a maximum at point B (since the
average physical product is at its maximum at that point). Because the output per unit of
the variable input is improving throughout stage 1, a price-taking firm will always
operate beyond this stage.

In Stage 2, output increases at a decreasing rate, and the average and marginal
physical product are declining. However the average product of fixed inputs (not shown)
is still rising, because output is rising while fixed input usage is constant. In this stage,
the employment of additional variable inputs increases the output per unit of fixed input
but decreases the output per unit of the variable input. The optimum input/output
combination for the price-taking firm will be in stage 2, although a firm facing a
downward-sloped demand curve might find it most profitable to operate in Stage 1. In
Stage 3, too much variable input is being used relative to the available fixed inputs:
variable inputs are over-utilized in the sense that their presence on the margin obstructs
the production process rather than enhancing it. The output per unit of both the fixed and
the variable input declines throughout this stage. At the boundary between stage 2 and
stage 3, the highest possible output is being obtained from the fixed input.
 6. Examples of production functions
Fixed proportions
An important family of production functions models technologies involving a single
technique of production. The only way to produce a unit of output, for example, may be
to use 1 machine and 2 workers; if the firm has available 2 machines and 2 workers then
the extra machine simply sits idle, and if it wants to produce two units of output then it
has to use 2 machines and 4 workers. Such a production function has fixed proportions.

How can we describe such a technology precisely? If the only way to produce y units of
output is to use y machines and 2y workers then the output from z machines and z
1 2

workers is

min{z ,z /2},
1 2

the minimum of z and z /2. Check out the logic of this formula by considering the output
1 2

it assigns to various combinations of machines and workers:

• 1 machine and 2 workers yield min{1,2/2} = min{1,1} = 1 unit of output

• 2 machines and 2 workers yield min{2,2/2} = min{2,1} = 1 unit of output
• 2 machines and 4 workers yield min{2,4/2} = min{2,2} = 2 units of output

A general fixed proportions production function for two inputs has the form
min{az ,bz }1 2

for some constants a and b. The technology this production function models involves a
single technique that produces one unit of output from 1/a units of input 1 and 1/b units
of input 2, and, more generally, y units of output from y/a units of input 1 and y/b units of
input 2. Extra units of either input cannot be put to use. For example, if the firm has y/a
units of input 1 and more than y/b units of input 2---say z units---then its output is
2

min{a(y/a),bz } = min{y,bz } = y, since z > y/b.

2 2 2

If there are more than two inputs, a single-technique technology can be modeled by a
production function with a similar form. For example, if four wheels, one engine, and one
body are needed to make a car, and no substitution between the inputs is possible, the
number of cars that may be produced from the vector (z , z , z ) of inputs, where input 1 is
1 2 3

wheels, input 2 is engines, and input 3 is bodies, is

min{z /4,z ,z }.
1 2 3

Perfect substitutes
A technology whose character is exactly the opposite to that of a fixed proportions
technology allows one input to be substituted freely for another at a constant rate. For
example, one hamburger may be made with 100g of Canadian beef, or with 50g of
Canadian beef and 50g of US beef, or any combination of the two inputs that sums to
100g. In this case we can describe the technology precisely by the production function
F (z , z ) = z + z .
1 2 1 2

More generally, any production function of the form

F (z , z ) = az + bz
1 2 1 2

for some nonnegative numbers a and b is one in which the inputs are perfect substitutes.
Such a production function models a technology in which one unit of output can be
produced from 1/a units of input 1, or from 1/b units of input 2, or from any combination
of z and z for which az + bz = 1. That is, one input can be substituted for the other at a
1 2 1 2

constant rate.

A production function modeling smooth but not perfect substitution

between inputs
Many technologies allow inputs to be substituted for each other, but not at a constant rate.
Suppose that one person operating a machine for an hour can produce 100 units of output
using 100 units of raw material. Perhaps if the speed of the machine is increased, the
same 100 units of output can be produced in 45 minutes using 150 units of raw material,
more raw material being needed since some is now wasted. But if the speed is increased
again, reducing the amount of labor time needed to 30 minutes, the amount of raw
material needed may increase by much more than 50 units, since wastage may greatly
increase.

A class of production functions that models situations in which inputs can be substituted
for each other to produce the same output, but cannot be substituted at a constant rate,
contains functions of the form

F (z , z ) = Az z
1 2 1
u
2
v

for some constants A, u, and v. Such a production function is known as a Cobb-Douglas

production function.

An example of such a function is

F (z , z ) = z z .
1 2 1
1/2
2
1/2

The production function is an assumed technological relationship, based on the

current state of engineering knowledge; it does not represent the result of economic
choices, but rather is an externally given entity that influences economic decision-
making. Almost all economic theories presuppose a production function, either on the
firm level or the aggregate level. In this sense, the production function is one of the key
concepts of mainstream neoclassical theories. Some non-mainstream economists,
however, reject the very concept of an aggregate production function.