Chapter 8

Production Theory and Analysis

The Theory and Estimation of Production

The Production Function
COBBDOUGLAS PRODUCTION FUNCTION

Production in the Short Run

Total, Average, and Marginal Product Law of Diminishing Returns Stages of Production Optimal Input Usage

Production in the Long Run

Returns to Scale Isoquant Isocost

The Production Function A production function defines the relationship between inputs and the maximum amount that can be produced within a given time period with a given technology. Technically efficient vs. Technically inefficient Economic efficiency

The Production Function

Mathematically, the production function can be expressed as Q=f(X1,X2,...,Xk)

Q is the level of output X1,X2,...,Xk are the levels of the inputs in the production process f( ) represents the production technology

The Production Function For simplicity we will often consider a production function of two inputs: Q=f(X,Y) Q is output X is Labor Y is Capital

The Production Function

Designating L as labor and K as capital, a popular functional form is known as the Cobb-Douglas Production Function:

It is further assumed that

The Production Function

When discussing production, it is important to distinguish between two time frames. The short-run production function describes the maximum quantity of good or service that can be produced by a set of inputs, assuming that at least one of the inputs is fixed at some level.

The Production Function The long-run production function describes the maximum quantity of good or service that can be produced by a set of inputs, assuming that the firm is free to adjust the level of all inputs.

Returns to Input
The production function is also referred to as the total product function The increase in production due to an increase in input (such as labour) is called returns to the input (such as returns to labour) Generally the first few inputs are highly productive, but additional units are less productive (i.e.: computer programmers working in a small room)
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Example: Production as workers increase

Each Additional worker Is equally productive Each Additional worker Is more productive Each Additional worker Is less productive Each Additional worker Decreases Production

Total Product

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Production in the Short Run In the short run, capital is fixed

Only changes in the variable labor input can change the level of output

Short run production function

Q f ( L,K ) f ( L )

Production in the Short Run When discussing production in the short run, three definitions are important.
Total Product Marginal Product Average Product

Production in the Short Run Total product (TP) is another name for output in the short run. The total product function is the same as the short run production function.

Production in the Short Run The marginal product (MP) of a variable input is the change in output (or TP) resulting from a one unit change in the input. MP tells us how output changes as we change the level of the input by one unit.

Production in the Short Run The average product (AP) of an input is the total product divided by the level of the input. AP tells us, on average, how many units of output are produced per unit of input used.

Production in the Short Run

Consider the two input production function Q=f(X,Y) in which input X is variable and input Y is fixed at some level. The marginal product of input X is defined as Q MPX X holding input Y constant.

Production in the Short Run The average product of input X is defined as

Q APX X

holding input Y constant.

OUTPUT ELASTICITY OF A VARIABLE INPUT

coefficient of output elasticity of a variable input,

Production in the Short Run

The table below represents a firms production function, Q=f(X,Y):
Units of Y Employed 8 7 6 5 4 3 2 1 37 42 37 31 24 17 8 4 1 60 64 52 47 39 29 18 8 2 Output Quantity (Q) 83 96 107 117 127 128 78 90 101 110 119 120 64 73 82 90 97 104 58 67 75 82 89 95 52 60 67 73 79 85 41 52 58 64 69 73 29 39 47 52 56 52 14 20 27 24 21 17 3 4 5 6 7 8 Units of X Employed

Production in the Short Run

In the short run, let Y=2. The row highlighted below represents the firms short run production function.
Units of Y Employed 8 7 6 5 4 3 2 1 37 42 37 31 24 17 8 4 1 60 64 52 47 39 29 18 8 2 Output Quantity (Q) 83 96 107 117 127 78 90 101 110 119 64 73 82 90 97 58 67 75 82 89 52 60 67 73 79 41 52 58 64 69 29 39 47 52 56 14 20 27 24 21 3 4 5 6 7 Units of X Employed 128 120 104 95 85 73 52 17 8

Production in the Short Run

Rewriting this row, we can create the following table and calculate values of marginal and average product.
Variable Input Total Product (X) (Q or TP) 0 0 1 8 2 18 3 29 4 39 5 47 6 52 7 56 8 52

Calculation of Marginal Product

Variable Marginal Input Total Product Product (X) (Q or TP) (MP) 0 0 Q 8 X=1 Q=8 8 1 8 X 1 2 18 3 29 4 39 5 47 6 52 7 56 8 52

Calculation of Marginal Product

Variable Marginal Input Total Product Product (X) (Q or TP) (MP) 0 0 8 1 8 10 2 18 11 3 29 10 4 39 8 Q 5 5 47 X=1 Q=5 X 1 5 6 52 4 7 56 -4 8 52

Calculation of Average Product

Variable Total Average Input Product Product (X) (Q or TP) (AP) 0 0 --Q 8 8 1 8 1 8 8 X 1 1 2 18 3 29 4 39 5 47 6 52 7 56 8 52

Calculation of Average Product

Variable Total Average Input Product Product (X) (Q or TP) (AP) 0 0 --1 8 8 2 18 9 3 29 9.67 4 39 9.75 5 47 9.4 6 52 8.67 7 56 8 8 52 6.5

Production in the Short Run

The figures illustrate TP, MP, and AP graphically.

Production in the Short Run

If MP is positive then TP is increasing. If MP is negative then TP is decreasing. TP reaches a maximum when MP=0

Production in the Short Run

If MP > AP then AP is rising. If MP < AP then AP is falling. MP=AP when AP is maximized.

The Law of Diminishing Returns Definition

As additional units of a variable input are combined with a fixed input, at some point the additional output (i.e., marginal product) starts to diminish.

Diminishing Returns
Variable Marginal Input Total Product Product (X) (Q or TP) (MP) 0 0 8 1 8 10 Diminishing 2 18 11 Returns 3 29 Begins 10 4 39 Here 8 5 47 5 6 52 4 7 56 -4 8 52

The Law of Diminishing Returns

Reasons
Increasing Returns Teamwork and Specialization MP

Diminishing Returns Begins Fewer opportunities for teamwork and specialization

MP

The Three Stages of Production Stage I

From zero units of the variable input to where AP is maximized

Stage II
From the maximum AP to where MP=0

Stage III
From where MP=0 on

The Three Stages of Production

The Three Stages of Production

In the short run, rational firms should only be operating in Stage II. Why Stage II?
Why not Stage III?
Firm uses more variable inputs to produce less output!

Why not Stage I?

Underutilizing fixed capacity. Can increase output per unit by increasing the amount of the variable input.

Optimal Level of Variable Input Usage

Consider the following short run production process. Labor Total Average Marginal
Unit (X) 0 1 2 3 4 5 6 7 8 Product (Q or TP) 0 10,000 25,000 45,000 60,000 70,000 75,000 78,000 80,000 Product (AP) 10,000 12,500 15,000 15,000 14,000 12,500 11,143 10,000 Product (MP) 10,000 15,000 20,000 15,000 10,000 5,000 3,000 2,000

Where is Stage II?

Optimal Level of Variable Input Usage

Labor Total Average Marginal Unit Product Product Product (X) (Q or TP) (AP) (MP) 0 0 1 10,000 10,000 10,000 2 25,000 12,500 15,000 3 45,000 15,000 20,000 4 60,000 15,000 15,000 5 70,000 14,000 10,000 6 75,000 12,500 5,000 7 78,000 11,143 3,000 8 80,000 10,000 2,000

Stage II

Optimal Level of Variable Input Usage What level of input usage within Stage II is best for the firm? The answer depends upon how many units of output the firm can sell, the price of the product, and the monetary costs of employing the variable input.

Optimal Level of Variable Input Usage In order to determine the optimal input usage we assume that the firm operates in a perfectly competitive market for its input and its output.
Product price, P=$2 Variable input price, w=$10,000

Optimal Level of Variable Input Usage Define the following

Total Revenue Product (TRP) = QP Marginal Revenue Product (MRP) =
TRP (Q P) P Q P MP X X X

Total Labor Cost (TLC) = wX

TLC w Marginal Labor Cost (MLC) = X

Optimal Level of Variable Input Usage

Labor Total Unit Product (X) (Q or TP) 0 0 1 10,000 2 25,000 3 45,000 4 60,000 5 70,000 6 75,000 7 78,000 8 80,000 Average Marginal Product Product (AP) (MP) 10,000 12,500 15,000 15,000 14,000 12,500 11,143 10,000 10,000 15,000 20,000 15,000 10,000 5,000 3,000 2,000 Total Revenue Product (TRP) 0 20,000 50,000 90,000 120,000 140,000 150,000 156,000 160,000 Marginal Revenue Product (MRP) 20,000 30,000 40,000 30,000 20,000 10,000 6,000 4,000 Total Labor Cost (TLC) 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 Marginal Labor Cost TRP(MLC) TLC 0 10,000 10,000 10,000 30,000 10,000 60,000 10,000 80,000 10,000 90,000 10,000 90,000 10,000 86,000 10,000 80,000

MRPMLC 10,000 20,000 30,000 20,000 10,000 0 -4,000 -6,000

Optimal Level of Variable Input Usage

Labor Total Unit Product (X) (Q or TP) 0 0 1 10,000 2 25,000 3 45,000 4 60,000 Stage 5 70,000 6 75,000 II 7 78,000 8 80,000 Average Marginal Product Product (AP) (MP) 10,000 12,500 15,000 15,000 14,000 12,500 11,143 10,000 10,000 15,000 20,000 15,000 10,000 5,000 3,000 2,000 Total Revenue Product (TRP) 0 20,000 50,000 90,000 120,000 140,000 150,000 156,000 160,000 Marginal Revenue Product (MRP) 20,000 30,000 40,000 30,000 20,000 10,000 6,000 4,000 Total Labor Cost (TLC) 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 Marginal Labor Cost TRP(MLC) TLC 0 10,000 10,000 10,000 30,000 10,000 60,000 10,000 80,000 10,000 90,000 10,000 90,000 10,000 86,000 10,000 80,000

MRPMLC 10,000 20,000 30,000 20,000 10,000 0 -4,000 -6,000

Optimal Level of Variable Input Usage

A profit-maximizing firm operating in perfectly competitive output and input markets will be using the optimal amount of an input at the point at which the monetary value of the inputs marginal revenue product is equal to the additional cost of using that input. Where MRP=MLC.

Optimal Use of One Input - Example

Production in the Long Run

In the long run, all inputs are variable. The long run production process is described by the concept of returns to scale. Returns to scale describes what happens to total output as all of the inputs are changed by the same proportion.

Returns to Scale
Production Function Q = f(L, K)
Q = f(hL, hK) If = h, then f has constant returns to scale. If > h, then f has increasing returns to scale. If < h, the f has decreasing returns to scale.

Production in the Long Run If all inputs into the production process are doubled, three things can happen:
output can more than double
increasing returns to scale (IRTS)

output can exactly double

constant returns to scale (CRTS)

output can less than double

decreasing returns to scale (DRTS)

Production in the Long Run One way to measure returns to scale is to use a coefficient of output elasticity:
Percentage change in Q EQ Percentage change in all inputs

If E>1 then IRTS If E=1 then CRTS If E<1 then DRTS

Production in the Long Run Graphically, the returns to scale concept can be illustrated using the following graphs.
Q IRTS Q CRTS Q DRTS

X,Y

X,Y

X,Y

Production in the Long Run

Economists hypothesize that a firms long run production function may exhibit at first increasing returns, then constant returns, and finally decreasing returns to scale.

Production Isoquants
In the long run, all inputs are variable & isoquants are used to study production decisions
An isoquant is a curve showing all possible input combinations capable of producing a given level of output Isoquants are downward sloping; if greater amounts of labor are used, less capital is required to produce a given output Firms will only use combinations of two inputs that are in the economic region of production, which is defined by the portion of each isoquant that is negatively sloped.

The Isoquant Curve

Labor A B C D E F 3 4 6 10 15 20

Machines Pairs of Earrings 20 15 10 6 4 3 60 60 60 60 60 60

The Isoquant Curve

Production With Two Variable Inputs

Isoquants

Production With Two Variable Inputs

Economic Region of Production

If you move out from the origin along a ray with constant slope, the input combinations have a constant capital-labor ratio.
Quantity of capital used per unit of time

Each of the indicated points uses one-third as much capital as labor.

15 12 140 125

8
5 50 15 24 36

100

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Quantity of labor used per unit of time

Marginal Rate of Technical Substitution

The MRTS is the slope of an isoquant & measures the rate at which the two inputs can be substituted for one another while maintaining a constant level of output
K MRTS L
The minus sign is added to make MRTS a positive number since K L , the slope of the isoquant, is negative

Production With Two Variable Inputs

MRTS = -(-2.5/1) = 2.5

Substitutability of Inputs and Marginal Products Along an isoquant output doesnt change (q = 0), or:
Extra units of labor
Reduced units of capital

(MPL x L) + (MPK x -K) = 0.

Increase in q per extra unit of labor Increase in q per extra unit of capital

or

K MPL MRTS L MPK

MRTS

MRTSL,K is high; labour is scarce so a little more labour frees up a lot of capital

MRTSL,K is low; labour is abundant so a little more labour barely affects the need for capital
L
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When input substitution is easy, isoquants are nearly straight lines

170 130 100

When input substitution is hard when inputs are scarce, isoquants are more L-shaped

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100

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Extreme Production Technologies

Perfect Substitutes

Perfect Complements

Extreme Production Technologies

Two inputs are perfect substitutes if their functions are identical
Firm is able to exchange one for another at a fixed rate Each isoquant is a straight line, constant MRTS

Two inputs are perfect complements when

They must be used in fixed proportions Isoquants are L-shaped
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Isocost Line
Show various combinations of inputs that
may be purchased for given level of expenditure ( C ) at given input prices ( w, r )

C wL rK

C w K L r r

Slope of an isocost curve is the negative

of the input price ratio ( w r )

K -intercept is C r

Represents amount of capital that may be purchased if zero labor is purchased

The Isocost Line

Wage-rental ratio
With K on the y axis and L on the x axis, the slope of any isocost line equals W/R, the wagerental ratio. It is also the relative price of labor.

The y-intercept shows the number of units of K that could be rented for $C. The x-intercept shows the number of units of L that could be hired for $C.
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Changes in One Resource Price

Capital, K (machines rented)

10 8 6 4 2 0

Cost = $30; R = $3/machine The money wage, W = ...

A Change in W
$6
$10

h 2 3 4 5

f 6 7 8 9 10
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Labor, L (worker-hours employed)

Changes in Cost (Budget)

Capital, K (machines rented)

10 8 6 g 4 2 h 0 1 2 3 4 5 6 7 8 9 10
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Labor, L (worker-hours employed)
W = $6; R = $3;C = $30

A Change in Cost; every point between g and h costs $18.

Optimal Combination of Inputs

The point of tangency between the isocost line and the isoquant shows the minimum cost required to produce a given output.

Optimal Combination of Inputs

Minimize total cost of producing Q by choosing the input combination on the isoquant for which Q is just tangent to an isocost curve
Two slopes are equal in equilibrium Implies marginal product per dollar spent on last unit of each input is the same MPL w MPL MPK or MPK r w r

Optimization & Cost

Expansion path gives the efficient (leastcost) input combinations for every level of output
Derived for a specific set of input prices Along expansion path, input-price ratio is constant & equal to the marginal rate of technical substitution

Optimal Combination of Inputs

Effect of a Change in Input Prices
Case 1: w = r = $10 Case 2: w= $5, r= $10