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CHAPTER 6

CHAPTER OUTLINE

Production Theory and Estimation

6-1 The Organization of Production and the Production Function • The Organizat i on of

Production • The Production Function

6-2 The Production Function with One Variable Input • Total, Average, and Marginal Product

• The Law of Diminishing Returns and Stages of Production

6- 3

Optimal Use of the Variable Input

6-4

The Production Function with Two Variable Inputs • Production Isoquants • Economic

Reg i on of Production • Marginal Rate ofTechnical Substitution • Perfect Substitutes and Complementary Inputs

6-5

Optimal Combination of Inputs • Isocost Lines • Optimal Input Combination for Minimizing Costs or Maximizing Output • Profit Maximization • Effect of Change in Input Prices • Case Study 6 - 1: Substitutability between Gasoline Consumption and Driving Tlme

6-6

Returns to Scale • Case Study 6-2: Returns to Scale in U.s. Manufacturing Industries

Case Study 6-3: Bajaj Auto Limited-Smaller Is Better

6- 7

Empirical Production Functions • Case Study 6-4: Output Elasticities in U.s. Manufacturing Industries

6-8

The Innovation Process • Meaning and Importance

of Innovations • Case Study 6-5: How

Do Firms Get New Technology? • The Open Innovation Model

6-9

Innovation and Global Competitiveness • Innovations and the International

Competitiveness

Competitiveness

of U.S. Firms • Case Study 6-6 : How Xerox Lost and Regained International

and Became a Leader in Information Technology • Case Study 6-7: The New

U.s. Digital Factory • Case Study 6-8: The Euro and the International Competitiveness of

European Firms • The New Computer-Aided Production Revolution and the International Competitiveness of U . S. Firms

Summary • Problems

215

21 6

PAR TTHREE Production a nd C o st An a ly sis

Appendix to Chapter 6: Production Analysis with Calculus • C o nstrained Output

Ma x imizati on • Constrai n e d C ost Minimization • Pro f it Ma x imization • A p pen di x Proble ms

Supplementar y Readin gs • Internet Site Addresses

KEY TERMS

Production Inputs Fixed inputs Variable inputs Short run Long run Production function Total product (TP) Marginal product (MP) Average product (AP) Output elasticity Law of diminishing returns Stages I. II. III of production

(in t he o r de r of the ir appearance)

Marginal revenue product (MRP) Marginal resource cost (MRC) Isoquant Ridge lines Marginal rate oftechnical substitution (MRTS) Isocost line Expansion path Constant returns to scale Increasing returns to scale Decreasing returns to scale

Cobb-Douglas production function Product innovation Process innovation Closed innovation model Open innovation model Product cycle model Just-in-time production system Competitive benchmarking Computer-aided design (CAD) Computer-aided manufacturing (CAM)

n Chapter 1 , we d efi n e d th e firm as a n organization th a t combine s and o rg a nize s lab or,

good s a nd s er v i c e s for

sa l e . T h e a im of t h e firm i s t o m ax imize tota l profi ts or achieve s ome other relat e d a im,

suc h as maxi m izi n g sal es or grow th . The basic producti o n decis ion facin g the firm i s h ow

m u ch of th e c o mmodi t y or serv i ce to produce and how much l a b o r , c a pita l , a nd o th e r re-

s ou rc e s o r i nput s to u se t o pr o du ce that output mo s t ef f iciently . To an s wer th ese qu es t io n s ,

t h e firm r e qu ires eng i neeri n g or tec hn ol ogi c al d a ta o n pr o du c tion po ss ibilit ies ( th e produc- tionf u nction) as we l l as eco n o m ic d a t a on i nput a nd output prices . Thi s c hapte r pro vi d es

t he f r a m ew ork for under s tanding the economic s of production o f the firm and deriv e s a set of conditio n s for e f ficien t pr o du c t i on .

I cap ita l , a n d l an d or raw ma t eria l s for the purpo s e o f pr o ducing

T h e c h apter b egins wi th a di scussion o f th e pr o du c tio n f un c tion , which s ummarizes

the engineering a nd tech n ologica l pr o du c tio n po ss ibilitie s o pen to the firm. Thi s gen e r al

discussion is exte n ded

resource (Sectio n 6-2) an d exa m i n es h ow mu c h o f th e varia ble input the f i rm s h o ul d emp l oy to max i m i ze pr of it s ( S ec ti o n 6 -3). We then g o on to examine the produ c t io n function w h en t here are two varia bl e i npu ts ( S ec tion 6 -4) a nd t o de ve lop th e c ond i t ions for their effici ent combination i n p ro du c tio n ( S ec tio n 6-5 ). In S ec tion 6 - 6 , we d isc u ss ret u r ns to sca l e w h ere a ll reso ur ces or input s ar e variable . Section 6 - 7 di s cu ss e s th e empiri ca l e stim a tion of production f un ctio n s . S ec tio n 6- 8 d ea l s wi th th e inn ovation process . Finally, S ec t i on 6-9 deals wi th t ec hnologica l p rog r ess and inn ova tio n s and their imp o rtance for the d omestic an d glob a l c ompetitiven ess of firms. I n th e Ch apter App e ndi x (which is optional), we use simple c alc ulu s t o exa min e the conditio n s for

to t h e s p ec i f i c case w h e r e th e r e i s a s ingle var iable input or

CHAPTER6 Production Theory and Estimat i on

21 7

m ax imi z in g o utpu t , mini mi zi n g costs , or maximizing profits. Th e ni n e case studi es p re-

s ented thr o u g h out th e cha pt er highlight the impo r t a nce of produ c t ion th eory to the firm

a nd i t s g rea t releva n ce in managerial economics.

6-1

THE ORGANIZATION OF PRODUCTION AND THE PRODUCTION FUNCTION

In thi s s ect i on , w e e xa mine fir s t th e o r ga ni zation of p roduction a n d classify inputs into v ar - iou s bro a d c a t e gorie s, a nd th e n w e d efi n e th e meaning and u sefulness of the pr o du c tion fun c t i on in a n a ly z ing th e f i rm's production activity .

The Organization of Production

Production refers to th e transforma t io n of inputs o r resources into outputs of goods and

s ervice s . For example , IBM h ires workers to use mac h inery , parts, and raw material s in fac- tor i es to produce personal com pu ters . The output of a firm can either be a final commodity

( such as a personal compute r) or an intermediate prod u c t , such as semiconductor s (which

are used in the production of co mpute rs and other goo d s). The o u tput can also be a servic e rather than a good . Examples o f services are educa tion, medicine, banking , communica - tion, transportation, a nd many oth ers. Note that production refer s to all of the activitie s invol v ed in the production of go o d s a nd services, from borrowing to s etting up or expand -

i ng production fac i lities , to h i r ing workers, p u rchasing raw material s , running quality con -

trol, cost accounting, and s o on , ra t her t h an referrin g m erely to the p h ysical transformation of inputs into output s of good s a n d services. Inputs are the re s ou rces u sed in the pr o d uc t i on o f goo d s and services . A s a convenient

w ay to organi ze th e di scussion , inp u ts are classif i e d in t o labor (including entrepreneurial

t a lent ), capit al, a nd l a n d or natural resources. Eac h o f th ese b road categories, however , in -

c lude s a g re a t va ri ety of t h e basic i np u t . For exampl e, l a b or i nc l udes bus drivers, assembly - line worker s, accou n ta n ts, l awyers, d octors, scien tists, a nd man y others. Inputs are also

c la ssi fi e d as fixe d or varia b le. Fixed inputs ar e tho se th a t ca n not be readily changed dur -

ing the t i m e p eri o d u n d er co n si d eration, excep t p er h a p s at very great expense. Examples of fixed input s a r e th e fir m 's p la n t a nd specialize d e quip ment (it takes several years for IBM to build a n ew fac t o r y t o pr od u ce compu t er c hip s t o go into its computers) . On the other hand , variable inputs are th ose th a t ca n b e va ried ea s ily a nd on very s h ort notice . Exam - ple s of va ri a bl e input s a r e m ost raw mate r ia l s a nd un s kill ed l a b or. Th e t i m e p e ri o d d ur i n g which at least one in put is fixed is called the short run ,

w hil e the t i m e p e ri o d w h en a ll i n puts are varia bl e is ca l led the long run . The length o f the long run ( i . e., th e t i m e perio d required for all inp ut s to be variable) depends on th e

indu s tr y.

l o n g run m ay b e o nl y a few month s or we e ks. For others , s uch as the con s truction of a

n ew e l ect r icity-generating plant , it may be many years. In the short run , a firm ca n in-

c rea se o utpu t on l y by using more of the vari a ble inputs (say , labor a nd r a w m a t eria l s) t o-

g ether w ith t he fixe d input s (plant a nd equipment). In the long run , the sa m e in c r e a s e i n output co uld like l y be obt a ined m ore effi c ientl y by also expanding the firm's p ro du c t ion

F o r so me , s u c h as t h e setting up or expans i o n

of a dry - cleaning busine ss, th e

218 PARTT HREE P r o d uction and Cos t Analysis

facilitie s (plant a nd e qu ip m e nt ) . Thu s , we say t hat th e f irm operate s in the s hort run and plan s increases o r re du ct ion s i n i t s sca le o f operation in the long run . In the long run , technology u s u a ll y i mpr ov e s, s o th a t more output can be obtained from a given quanti t y of inputs , or t h e same o utpu t from l ess i nput s .

The Production Function

Ju s t a s d ema n d t h eory ce nt ers o n th e co n cept of the dema nd function , producti on theor y re - volves aro u n d th e co n ce pt o f the p ro duction f unction . A production function is an equa - tion, ta bl e, o r g r a ph s h ow in g t he ma xi mum output o f a commodity that a firm can produc e per period of t ime wit h eac h s et of i n p ut s . Both input s and outputs are mea s ured in ph ysi-

c a l rather than in monetary u n its. Tec hn o l ogy is assumed to rema i n con s tant during the p e-

riod of the a n alysis. For simplicity we a s sum e h ere t ha t a fir m p r oduc es only one type of output ( comm o d - ity or service) wi th two i nput s, l abor ( L ) a nd c apital ( K ) . Thus , the general equation of th is simp l e p r oduc t io n f un c ti o n is

Q

=f~ L , K )

[6 - 1 ]

Equation 6 - 1 r ea d s: Th e qu a nt ity of output is a f unction of , or depend s on , the quantity of labor and ca p ital u sed in p r oduc t i o n . Outp ut refer s to the number of units of th e c ommo d -

i ty ( say , a u tomo b i l es) produ c ed , labor re f er s to the number of w orkers emplo y ed , and

c apital refers to th e a m o unt o f t h e e qu i pm e nt u s ed in production . We as s ume that all un i t s of Land K are h om o g e neo u s o r i d e ntic a l . An explicit producti on function would indic ate

p rec ise l y t h e q u a n tity o f out put t h at th e firm w ou l d produce w i th each particular s et of i n - puts of la b or and ca p i t al . A l t hough o u r d is cu ssio n w ill be i n term s of a s ingle output pr o-

d uced with only t wo in p ut s, the pr incipl e s th a t w e w ill de v elop are gener a l and apply to

cases in which the fi r m u ses mo r e th a n t w o i nput s and produ c e s m ore than one output ( th e usual situation ). Table 6 - 1 gives a h ypo thet ica l p ro du c t i o n f uncti on wh i ch s how s the outputs ( the Q's)

t hat the fi rm ca n produ ce wi th va r i ou s c omb i nations of labor ( L ) and capital (K) . The table shows that b y using 1 u nit of la bo r ( 1L ) a nd 1 unit of capit al ( 1K ), the firm would produ ce 3 units of output ( 3Q ) . With 2 L a nd l K , output i s 8Q; with 3L and lK , output i s 12Q ; wi th 3L and 2K, output i s 28Q; wi t h 4 L a n d 2 K , output is 30Q , and s o on. Note als o that labor an d

_

Production Function with Two Inputs

 

C

a pit a l ( K )

6

10

24

31

36

40

39

 

5

12

28

36

40

42

40

4

12

28

36

40

40

36

O utput ( Q )

3

10

23

33

36

36

33

 

r

2

7

18

28

30

30

28

K

1

3

8

12

14

14

12

 

2

3

4

5

6

 

L~

L a bo r ( L )

CHAPTER 6 P r o ducti o n Theory and E stimat io n

Output (0)

5

4

CillJ/lill r.t;

FIGURE 6-1 Discrete Production Surface

that can be produced with each combin at ion of l a bo r (L) and cap i tal (K) s h o w n on t h e axes . Thus , the tops of all the bars form the produc ti on surfac e f o r the firm .

Th e he i g ht of th e ba r s re f e rs t o the max i mum output (Q)

219

c

a pit a l c an be s ub s t i tut e d for each o t her in prod u c t ion . For example , 12Q can be produced

e

ither w i th 3L and lK o r wi th lL a nd 4K . I Inpu t price s wi ll de t er m i n e which of

thes e two

comb i n a t io n s o f l a bor a nd ca p ita l is cheaper . The out p ut that t h e firm will want to produce is the one that m a x i m izes it s t ota l pr of i ts. T h ese q u es t ions wi ll be examined and answered later in the chapt e r . The productio n r e l atio n s hip s given in Table 6 - 1 are s h own graphically in Figure 6-1 , whi c h is three-dim e n sio n a l . In Fig u re 6-1 , the h eigh t of the b ar s refer s to the maximum output that c a n b e prod uc e d wit h each com b inatio n of lab or and capital s hown on the axe s. Thu s, the top s o f all th e b a r s for m th e pro du ctio n s u rface for t h e firm.

I f w e a ss um e th at i np uts and output s are conti n uous l y or infinitesimally di v i s ible

( rather th a n bein g m easur e d i n d iscrete u n i t s), we wou ld h ave an infinite number of out -

put s, e ach re s ult i ng f r om one of t h e infinite num b er of comb ination s of labor and capital that could be used in pr o du cti on . Th is is s h ow n i n Figu r e 6 -2, i n w h ich t h e axe s forming the

I 1 2Q c o uld a l so b e p ro du ced wit h lK and 6L in s te a d o f lK a n d 3L (s ee the las t entr y in th e f i rst r o w of th e

ta bl e) , b ut t h e fi rm wo uld ce r t a inly not w a nt t o u s e thi s c o mbination

of labor and c apit a l . Simi l a rl y , l 2 Q co uld

220 PARTTHREE Production and Cost Analysi s

a

.•

:::I

0 -

.•

:::I

o

I

I

~ --" Z I C

I I I I I I
I
I
I
I
I
I

~------------------------

I

I

I

I

I

I

I

I

I

------ ~D

I I I I I I / I I I I I I I I
I
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I
/
I
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I
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I
I
I
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~
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B
I
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o

Labor

FIGURE 6-2 Continuous Pro ducti o n Su r face The horizonta l and incl i ned a x e s mea s ure , re sp ect i v ely , the labor and c ap ital inputs, while the vertica l axis measures t he he i ght o f the su r face o r

t he max i mum l eve l of o u tput res ul t i ng from e ach i nput co mbination-a l l

divisible . The output g e ner a t ed b y hol ding capital c o n s ta n t at Kl an d in cre asing labor from zero to L2

u nits is g iv en by the height of c ross s e ction K1AB ( with base para l lel to t h e labor ax i s ).

assumed to be continuously

L

base o f th e fig ur e m ea s ur e th e lab o r an d ca pital inputs, w hile the height of th e s u rface gives

t h e ( m ax im u m) l e vel of output re s ultin g from ea c h input comb i n a tio n , a ll a ss umed t o b e

c ontinuou s l y di v i s ibl e .

For ex ampl e , b y k ee pin g th e qu a ntit y of c apit a l u s ed at KI i n F i g u re 6-2 a nd in c r eas- in g the quantit y of lab o r u sed from z er o to ~ units (so that we are in the short r un ) , th e f irm ge n e r ate the outpu t s hown b y th e hei g ht of c ross s ection KIA B (w ith base p a r a llel t o th e

l a bor ax i s). On th e oth e r hand , b y incre as ing the amount of l abor used fro m ze r o to ~ u nits

b ut k e epin g

capit a l c on s tant at K 2 rather than KI (so th at we are s till in t h e s h o rt r un ), t he

f irm gen e r a te s the output shown by the to p of cross secti o n K 2 CD . I f in s tea d th e f i rm ke p t labor con s tant at L I and in c rea sed the quan t ity of ca pi tal u sed fro m ze r o to K 2 units, th e

f irm ' s output w ou l d be the one shown by t he top of cross sec t io n LI E F (wi th b ase p a r a llel

t o th e c apit a l a x i s). With labor c on s tant at~ , on the ot h er ha nd , th e firm' s o utput ge n e r ated

by c h a nging the quantit y of c apital u se d from zero to K 2 units wo ul d be t h e o n e s h ow n by

t h e h e ight o f cro ss sec tion L 2 CD.

6-2

THE PRODUCTION FUNCTION WITH ONE VARIABLE INPUT

I n thi s sec tion , w e pr ese nt th e th eor y of production when on l y one inp u t is varia bl e . Thu s ,

we are in the s hort run . W e b e gin b y defining the tota l, the average, and the margi n al prod- uc t of the v a riable input and deri v ing from t h ese the outp u t e l as t icity of t h e v a ria bl e i n put .

 

CHAPTER 6 Production T heory and Estimation

2 21

 

Total, Marginal, and Avetage Product of labor, and Output Elasticltv

 

(1)

(2)

(3)

(4)

(5)

Labor

Output

Marginal

Average

Output

(number of

or

Product

Product

Elasticity

workers)

Total Product

of Labor

of Labor

of Labor

0

0

1

3

3

3

1

2

8

5

4

1 . 25

3

12

4

4

1

4

1 4

2

3 . 5

0 . 5 7

5

14

0

2.8

0

6

1 2

- 2

2

- I

We wil l t h e n exa min e th e l aw of d i mini shing returns a nd the m ea ning and importance of

t h e s t ag es of pro du c ti on . Th ese co ncept s wil l be u sed in S ec t io n 6-3 to de termine the opti- ma l u s e of t he v a ria bl e input f or the firm t o max i mize p rofi ts.

Total, Average, and Marginal Product

By h o l di n g the q u a nt it y of one input co n stant an d chang in g t he qu a ntit y used of the other

in put , we can deri v e t h e total produ c t ( TP) of th e var i a bl e in p ut . For ex a mp l e, by holding

capi tal co n stant at 1 uni t (i . e. , with K = 1 ) an d i n creasing th e un its of labor u sed from zero

to 6 un i t s , we ge n era t e th e tota l pro d uct of l ab o r g i v en b y t h e l as t row i n Tab le 6-1 , which

i s r e pr o du ced in co lu mn 2 of Tab l e 6 -2. N o t e that w hen n o l a b or is used , to tal output or

pro d uct i s z er o . With o ne unit

3L,

o f l a b or (lL) , tota l p ro du c t (TP) is 3 . Wit h 2L , TP = 8 . Wit h

TP = 12 , and so on . 2 Fro m th e to t a l pro d uct schedule we ca n de r i v e th e m argina l and average product

s

c h e dul e s of th e var i a bl e input . The m ar gi n al

p rod u ct

( MP) of labor (MP L ) i s the

c

h ange i n tot a l p ro du ct or e x tra o u t p ut per unit c ha ng e in lab o r used, while the av e rage

product (A P ) of l a b or ( AP L ) equal s t ota l product di v ided b y the qu an tit y of l abor u s e d. Th a t i s ,3

MP L = ! l . TP

s:

AP L = TP

L

[6-2]

[6 -3]

C o l umn 3 in T a bl e 6 -2 gives th e ma rg i n a l produc t of labor (MP L ) . Since l a bo r in cre a s es b y

1 un i t a t a t ime i n

co l umn 1 , t h e M P L in c o l umn 3 i s obtained by s ub t r acting successive

2 Th e r easo n f o r th e dec l ine in TP w h e n 6L i s used wi ll be di s cu ssed short l y . 3 In te rm s of c a l c u l u s, MP L = d TP ld L .

222 PARTTHREE Production an d Cost Analysis

quantities of TP in column 2. For example, TP increases from 0 to 3 units when the first

unit

of labor is used . Thus, MP L = 3 . For an increase in labor from lL to 2L, TP rises from

3 to

8 units,

so that MP L = 5 , and so on . Column 4 of Table 6-2 gives the AP L . This equals

TP (column 2) divided by L (column 1). Thus, with 1 unit of labor (IL), AP L = 3 . With 2L , AP L = 4 , and so on .

Column 5 in Table 6-2 gives the production or output elastici ty of labor (E L ) . Thi s measures the percentage change in output divided by the percentage change in the quantity of labor used . That is,

E

- %~Q

L- % M

[6-4]

By rewriting Equation 6 - 4 in a more explicit form and rearranging , we get

E _ ~Q/Q _ ~Q/M

L - MIL

-

QIL

_ MP L

- APL

[6-5]

That is , the output elasticity of labor is equal to the ratio of MP L to AP L . 4 For example ,

for the first unit of

TP or output grows proportionately to the growth in the labor input. For the second unit

of labor, EL = 1.25 (i.e., TP or output grows more than proportionately to the increase in L ), and so on. Plotting the total , marginal , and average product of labor of Table 6-2 gives the corre- sponding product c u rves shown in Figure 6-3 . Note that TP grows to 14 units with 4L ,

to 12 units with 6L (see the top panel of

Figure 6-3). The reason for this is that with the addition of the sixth worker, workers begin to get in each other's way and total product declines. In the bottom panel, we see that AP L rises to 4 units and then declines. Since the marginal product of labor refers to the change in total product per unit change in labor used , each value of the MP L is plotted halfway be- tween the quantities of labor used . Thus , the MP L of 3 units of output that results by going from OL to lL is plotted at O . 5L . The Mh of 5 that results from increasing labor from lL to

remains at 14 units with 5L, and then declines

labor, EL = ! = 1 . This means that from OL to lL (and with K = 1) ,

2L is plotted at 1 . 5L , and so on. The MP L curve rises to 5 units of output at 1 . 5L and then declines. Past 4.5L , the Mh becomes negative . Had the firm kept capital fixed at K = 2, increasing the amount of labor used from OL to 6L would have given the TP shown by the second row from the bottom in Table 6-

1 . This would correspond to the cross section at K = 2 in Figure 6 - 1 . From this TP func- tion and curve, we could then derive the MP L and AP L functions as done in Table 6-2 and shown in two-dimensional space in Figure 6-3. While the actual values of TP, MP L , and APL for K = 2 would differ from the corresponding ones with K = 1, the shape of the curves would generally be the same (see Problem 2).

4 In terms of c a l c ulu s,

aQ

EL =- . -

L

aL Q

CH APTER6 P roduction Theory and Estimation

2 2 3

0 E 14 12 / C ~ TP I t ::I " e • CL
0
E
14
12
/ C
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1
2
3
4
5
6
Quantity of labor
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Labor
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-2
::E'"

FIGURE 6 - 3 Total, Marg i nal , and Average Product of Labor Curves The top panel shows the t o tal pro d uct of labor curve. TP is highest between 4L and 5L. The bottom panel shows the marg i na l and t h e average product of labor curves . The MP L is plotted halfway between successive un i ts o f l a bor used . The MP L curve rises up to lo5L and then declines , and i t become s negat i ve pas t 4.5L. The AP L is h i g hest between 2L and 3L.

The law of Diminishing Returns and Stages of Production

In o rd e r to s ho w g r a phi ca l l y t h e re l a ti o n s hip b e t ween th e t o t a l p r o d uct, on t h e one hand ,

a nd th e m a r g in a l a nd ave r age pr o du c t s of l a b o r , o n th e o th er , we assu m e t h at labor tim e i s

T h e n t h e TP, MP L , and

AP L b eco m e s m o oth c ur ves as i n d i cate d in F i g ur e 6 - 4. Th e M P L a t a partic ul ar point on the TP cu r v e i s g i ve n b y t h e s l o p e of th e T P c ur ve a t th a t p o int. F r o m Fig ur e 6 - 4, we s ee that

th e s l ope o f th e TP c u rve r i ses u p t o p oi n t G ( th e p o int of infl ecti o n o n th e T P c u rve), i s zero

a t poi n t J , a nd i s n egative t h e r eafter . T hu s, t h e MP L r i ses up t o po in t G ' , is zero at point J' ,

co nt i nuou s l y di v i s ibl e ( i .e ., it ca n be h i re d fo r a n y p art of a day).

224 PARTTHREE Production and Cost Analysis

 

TP

 

J

14

12

8

3

o

I

 

o

1

2

3

4

I

5

 

i

i

MP

I

I

 

L

- - -- Stage

I of labor_ i _Stage

 

II of labor_ I

•• ---Stage

AP L

I

i G'

i

I

5

I H'

i

4

I

i

3

2

o

-2

6

TP

Labor

III of labor-- -- + -

Labor

FIGURE 6-4 Total, Marginal, and Average Product Curves, and Stages of Production With labor time continuously divisible , we have smooth TP, MP, and AP curves. The MP L (given by the slope of the

tangent to the TP curve) rises up to point G', becomes zero atr, and is negative thereafter. The AP L (g i ven by the s l ope of the ray from the origin to a po i nt on the TP curve) rises up to point H ' and decl i nes

thereafter (but remains positive as long as TP is positive). Stage I of production for

the rising portion of the AP L Stage II covers the range from maximum AP L to where MP L is zero. Stage III occurs when MP L is negative.

labor corresponds to

The AP L i s given by the s lope of a ra y from the origin to the TP curve . From Figure 6 - 4 ,

w e s ee that the slop e o f the TP curve rise s up to point H and falls thereafter but rema in s

po s itive a s long as TP is po s iti v e . Thus , the AP L ris e s up

Note that at point H the slope of a ray from the origin to the TP curve ( or AP L ) i s equa l to the slope of the TP curve (or Mh) . Thus, Ah = MP L at point H' (the highest point on the AP L curve) . Note also that AP L rises as long as MP L is above it and fall s when MP L i s below it .

can al so s ee that up to point G , the TP curve increa s e s at an in -

c reas ing rate s o that the MP L ri s e s . Labor i s u s ed s o sc-arcely w ith the 1 unit of capit al th at

to point H' and fall s a fterward .

From Figure 6-4, we

CHAPTER 6 Production Theory and Estimation

225

th e MP L ri ses as m o r e l a b o r i s u sed . P ast p o int G , how eve r , th e TP c ur ve rises a t a

d e creas in g r a t e so th a t th e MP L d ecli n es. T h e d ec linin g p o rti o n of th e MP L c ur ve is a

r ef l ecti o n of t h e law of diminishing return s . T h is p os tula t es t h a t as we u se m o r e a n d

more un i t s of th e v a r ia bl e i npu t wi th a give n amo un t of t h e fixe d i npu t, a fte r a p o in t , we

get d imi ni s h i n g ret urn s ( m a r gi n al p rod u c t ) f r o m th e va ria bl e input. In Fig ur e 6 - 4, t h e l aw

of d im ini s hin g r e turn s b eg in s to o p erate af t er 1.5L is u sed (aft er p oi nt

pa nel of F i gu r e 6-4). No t e t h a t dimini s hin g r e turn s i s n o t a th eo r e m th a t ca n b e pr ove d or

d i s pr oved w i t h l ogic bu t i s a ph ysi ca l l aw w hi c h h as b ee n fo und t o b e a l ways e mp i r ica lly

tr u e. I t s t ates t h a t a ft e r a p o int , w e w ill in va riabl y ge t diminis hin g

a bl e input . Th a t i s, as th e f irm u s e s m o r e a nd more units o f th e v a riabl e input with th e

sa m e a m o unt of t h e fi xe d input , eac h a dditi o n a l unit of th e va ria bl e input h as l ess a nd l e s s of th e f i xe d input t o wo r k w ith a nd , af t e r a p o int, th e m a r g in a l pr o duct o f th e va ria bl e inpu t de c line s.

b etwee n t h e MP L an d AP L c ur ves i n th e b ot t o m p a n e l of F i g-

re turn s f rom th e var i -

G ' in t h e b ot t om

T h e re l a ti o n s hip

ure 6 - 4 can be u s e d to defi n e t hr ee stages of pr o duction for l a b o r (th e v a riab l e i npu t ). The

range from th e orig in to t h e po in t w h e r e th e AP L i s m ax imum ( p o in t H' a t 2.5L) i s stage I of production fo r l a b o r . Stage II of production fo r l a b o r exte nd s f r o m t h e p oi n t w h ere th e

to p o in t J '

at 4.5L). Th e r a n ge ove r w hi c h th e MP L i s ne ga tive (i. e . , p as t p o int J ' o r with more th a n 4.5L) i s stage III of production f o r lab o r . Th e r a tional produ ce r w o uld n o t op e r a t e in s t ag e III

AP L i s m ax imum t o th e p o int w h e r e th e MP L i s ze ro

(i. e . , fro m po in t H ' at 2.5L

of lab o r , eve n if l a bor time we r e fr ee , b eca u s e MP L i s ne ga tiv e. Thi s mea n s th a t a g r ea t er

o utput o r TP co uld b e pr od u ce d b y u si n g less l a b o r ! Simila rly, h e o r s h e w ill n o t p ro du ce

in s t age I for l a b or b eca u se (as s h ow n in m o r e a d va n ce d t ex t s) this co r resp o n ds t o s t age III

of cap i tal ( w h e r e t h e MP of capita l i s n ega t ivej' Thu s, th e r a tio n al pr o du cer wi ll opera t e

i n s t age II wh e re t h e MP of b ot h fac t o r s i s p ositive but d e c l i n ing . Th e precis e poi n t within

stage II at w h ich th e r atio n a l pr o du ce r o p e r a t es w ill d e p e nd o n th e pr ices of i npu ts a n d o u t-

p ut . This is exami n e d i n t h e n ext sec ti o n.

6

- 3

I

OPTIMAL USE OF THE VARIABLE INPUT

H ow mu c h l a b o r ( the v a r i a bl e input in o ur pr ev i o u s di sc u ss i o n ) s h o uld th e firm u se i n o rd er

t o m axi m ize pr o f its ? Th e a n s we r i s th a t th e f irm s h o uld e mploy a n a dditi o n a l u n i t of l a b or

as l o n g as th e ext r a r eve nu e gene r ate d fr o m th e sa l e o f th e o u t put pr o du ce d excee d s t h e ex tra cost of hi ri n g th e u n it of l a b or ( i.e . , until th e ex tra re ve nu e e qu a l s th e ex tra cost). Fo r exam-

$3 0 in ex tra r eve nu e a nd cos t s a n extr a $20 to

hir e , it p ays f o r th e f i rm t o hir e thi s unit of lab o r. B y d o in g so , th e f i rm a dd s $3 0 t o its r ev-

enue s a nd $2 0 t o it s c o s t s , so

firm to hire an addition a l unit o f l a bor if the e xtra revenue it ge ner a tes f a lls s hort of the ex tra

c os t in c urr e d . Thi s is a n exa mpl e o r a ppli ca ti o n o f the ge n e r a l o ptimiza tion prin c iple exa m - in e d in C h a pt e r 2.

th a t it s tot a l pr of its incr e a se. It doe s n o t p ay, h oweve r , fo r th e

pl e , if a n a dditi o n a l unit of l abo r ge n e r a te s

5 Stage [ of l a b o r corre s pond s

output ch a n g e s in th e sam e pr o p or t io n as t h e c h a n g e i n a ll inputs (s e e Secti o n 6-6 ).

t o s t age III

of ca pit a l o nl y under consta n t returns to sc ale. This i s the cas e where

226 PARTTHREE Production and Cost Analysis

Marginal Revenue Product and Marginal Resource Cost of Labor

(1)

(2)

(3)

(4) = (2) x (3)

(5)

Units

Marginal

Marginal

Marginal

of

Marginal

Revenue

Revenue

Resource

Labor

Product

=p

Product

Cost=w

2.5

4

$10

$40

$20

3.0

3

10

30

20

3.5

2

10

20

20

4.0

1

10

10

20

4.5

0

10

0

20

T h e ext r a r even u e gene r a t e d b y th e u se of an additi o n a l unit o f l a bor i s ca lled the mar-

g inal r ev enue p r oduct of l a b o r ( MRP d . This e qu a l s th e m a r g in a l produ c t of labor (MP L ) times the margi n al r even u e (M R ) f r om t h e sa l e of th e ex tra o utput pr o du ced. T h at is,

R P L = ( MP d( MR )

O n t h e ot h e r ha nd , t h e ex t ra cost of h i r ing a n a dditional un i t o f labor o r marginal resource

co s t of l abor ( MRCd is eq u a l to t h e i n crease in t h e t o t a l c o s t t o th e firm r es ultin g f r o m hir- ing the additio n a l unit of la b or . That is ,

M

[6-6 ]

MR C L = ! 1TC

s

i .

[6 - 7]

T hu s, a firm s h o ul d con t inue to h i r e l a b or as l o n g a s MRP L > M R C L a nd until MRP L =

M R C L . W e ca n exa min e t h e o ptim a l u se o f l a bor (a nd profit maximizati o n )

fir m faci n g t h e s h or t -r un prod u ct i o n f un c tio n di sc u ssed in Se cti o n 6- 2 with th e a id of Table 6-3 .

by the

Co l umn 2 in Tab l e 6 - 3 g i ves t h e m a r g in al pr o d uct of l a b or

rea d off fro m th e MP L

c urv e i n stage n of produc ti on in t he b o ttom p a n e l s of Figu r e s 6 - 3 a nd 6 - 4 . The f r ac -

t i onal

or for ha l f a day . O nly the M P L in s t age II i s g i ve n in column 2 b eca u se the

n ever p rod u ce i n stage III of l a b or (w h ere th e MP L i s n ega tive) or in s tage I o f l a bor

t o th e stage o f ne ga tive mar g in a l product f o r capital). Column 3

gives t h e m a r g in a l r eve nu e of $ 10 f r o m th e sa l e of eac h addition a l unit of th e c ommod- ity prod u ce d , o n t h e ass u mp t ion t h at t h e f i r m i s s m a ll a nd ca n se ll th e a ddition a l units o f the com m o di ty at t h e g i ve n ma r ket p r i ce ( P ) of $ 10. Co lumn 4 g i ves th e m a r g in a l re v-

(w hi c h co rresp o nd s

uni t s of l a b or are b ased o n th e ass umpti o n t h at the firm c a n hire l a bor for th e f ull

firm wo uld

e nu e produc t o f l a b or o b ta in ed b y multipl y in g th e MP L in c olumn 2 by the MR = P of

t h e co mm o dity

Co lumn 5 g i ves t h e ma r g in a l resource cost of l a bo r o n th e assumption that th e f i rm i s

s m a l l a nd ca n h ire additio n a l u ni t s of l a b o r at t h e co n s t a n t m a rk e t wage r a t e (w) of $2 0 fo r eac h h a l f -d ay o f work .

F r o m T a bl e 6 - 3, we see t h a t th e fir m s h o uld hire 3 . 5 units o f l a b o r b eca u s e th a t i s

w h ere M RP L = M R C L = $20 . At l e ss th a n 3. 5L , MRP L > MRC L , a nd the firm wo uld b e

ad din g mo r e t o i ts tota l reve nu es t h a n t o i t s tota l cos t by hirin g m ore l a b or . F or exa mple ,

i n co lumn 3. Not e tha t the MRP L de c line s becau s e the MP L de c line s .

CHAPTER6 P r oducti on Theory and Estimation

2 2 7

40

$

30

20

I

""

10

o

 

o

2.5

3.0

3.5

4. 0

Un i ts of l abor used

MRC L = W = $20

4.5

I t pays f or the f ir m to h ire mor e l a bor a s long a s th e ma r g i na l

r e v enue p r o d uct of l a b or (MRPLl exceeds t h e margina l reso u rce cost of hiring l ab or (MRC L ), and un ti l

FIGURE 6 ·5

Op t im a l U s e o f L a bo r

L

MRP L = MRC L W ith MRC L = W= $20, the o ptimal amount of labo r for the fi r m to use i s 3. 5 un it s . A t 3 . 5 L , MRP L = MRC L = $20, and the fi r m max i m iz es total profits.

w ith 3 L , MRP L = $3 0 , a nd thi s excee d s th e MR C L o f $20. B y hirin g m o r e l a b o r , t h e firm

wo u l d i nc r ease it s tot a l profit s. On the oth e r h a nd , if t h e f irm u se d m o r e th a n 3.5 L , M RP L <

to its t o t a l r eve nu e , a n d

M R C L , an d t h e fir m wo ul d b e adding more to its t ot a l co s t s th a n

it s t o t a l p ro f it s wo uld be l ower . For exa m p l e , w i t h 4 L , MRP L = $ 10 , while MRC L = $ 2 0 .

Th e fir m cou l d t h en increa s e it s tota l p r ofit s by hirin g l ess l a bor . Onl y w ith 3.5L w ill

M RP L = M R C L = $ 20 , a n d t h e firm 's profit s a re m a ximi ze d . Thu s, th e o ptim a l use of l a b or

i s 3 . 5 unit s. N o t e t h a t th e m a r g in a l r eve nu e p r odu c t of l a b o r ( MRP d sc h e dul e i n colu m n 4

o

f Tab l e 6- 3 r e pr ese nt s th e firm ' s d e m a nd s c h ed u le for l a b o r . It g i v e s th e a m o unt of l a b o r

d

e manded

b y t he firm a t va ri o u s w a g e rat es. For exampl e , if the w a ge r a t e pe r day

(w)

were $ 40 , th e firm would hir e 2. 5 unit s of l a b o r b e ca u se t h a t wo uld b e w h ere M RP L =

of l a b o r . I f w = $20 , t h e f irm

w o u l d dem a nd 3 . 5L , and with w = $ 1 0, the firm would d e m a nd 4 L . Th i s i s show n i n

Fig u re 6-5, w h ere di. = MRP L repres e n ts t h e fir m 's dema nd c ur ve fo r l a b o r . Th e f i g ur e

s h ows t h a t if t h e wa g e r a t e p e r day ( w ) we r e co n s tan t at $ 20 , the firm w o uld d e m a nd 3.5 L ,

as in di cated abov e . Thi s d i sc u ssi o n i s a pp l i ca bl e t o a n y va ri a bl e input , n o t j u s t l a b o r . T o b e n o t e d i s th at

th e M R P of th e va ri a bl e input ca n be found not o n l y b y multipl y in g th e m a r g in a l pr o du ct

o f the input b y t h e m a r g in a l r eve nu e f r o m th e sa l e of th e o utput pr o du ced but i t ca n a l s o b e obtai n ed from t h e ch a n ge i n th e tota l reven u e t h at would re s ult p e r unit c h a n ge in th e va ri-

M R C L = W = $ 40 . If w = $3 0 , th e firm w ould dema n d 3 units

228 PART THREE P r oduc t ion and Cos t Analy si s

6-4

THE PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

We now examine the production function when there are two variable inputs . This can be represented graphically by isoquants. In this s ection we define i s oquants and discu ss their characteri s tics. Isoquants will then be u s ed in Section 6-5 to develop the condition s for the efficient combination of inputs in production.

Production Isoquants

An isoq u ant shows the various combinations of two inputs (say , labor and capital) that the firm can use to produce a specific level of output. A higher isoquant refers to a larger out- put , while a lower i s oquant refer s to a s maller output . Isoquant s can be derived from Table 6-4 , which repeats the production function of Table 6-1 with lines connecting all the labor - capital combinations that can be used to produce a specific level of output. For example, the table shows that 12 units of output (that is, 12Q) can be produced with 1 unit of capital (that is, 1K) and 3 units of labor (that is, 3L) or with lK and 6L . 6 The output of 12Q can also be produced with IL and 4K , and IL and 5K . The s e are s hown by the lowe s t isoquant in Figure 6-6. T h e isoquant is smooth on the assumption that labor and capital are continuously divisib l e. Tab l e 6 - 4 also shows that 28Q can be produced with 2K and 3L, 2K and 6L, 2L and 4K , and 2L and 5K (the second isoquant marked 28Q in Figure 6-6). The table also shows the various combinations of Land K that can be u s ed to produce 36Q and 40Q (shown by the top two isoquants in the figure). Note that to produce a greater output, more labor , more capital, or more of both labor and capital are required .

Economic Region of Production

While the isoquants in Fig u re 6-6 (repeated in Figure 6 - 7) have positively sloped portions, these portions are irrelevant . That is , the firm would not operate on the positively s loped portion of an isoquant because it could produce the same level of output with less capital and less labor . For examp l e , the firm wou l d not produce 36Q at point U in Figure 6 - 7 with

.

:

Production Function w i th Two Variable Inputs

Capital (K)

6

5

4

3

i

2

K

1

Output (Q)

6 Sin ce input s are not fr e e, a firm would produc e 12Q wi th lK a nd 3L r a th e r than with I K and 6L.

Capital

6

:]

3

2

1

0

M

N

0 1

2

5

3

CHAPTER 6 Production Theory and Estimation

4

5

T

6

400

360

280

120

229

Labor

FIGURE 6-6 Isoquants An isoquant shows the var i ous comb i nations of two i nputs tha t can be used to produce a specific level of output (Q). From Table 6·4, we can see that 12Q can be pro d uced

with 1L and SK (point M), 1L and 4K (point N), 2L and l.SK (po i nt R) , 3L a n d ( point 5) , or 6L and lK

( poi n t T ) . H i gher i soquants r efe r to higher l evels of output .

Capital

6

5

4

3

2

1

0

0 1

2

3

4

5

6

Labor

FIGURE 6-7 The Relevant Portion of Isoquants The economic region of production is given by the negatively sloped segment of isoquants between ridge lines OVI and OZI. The firm will not produce i n the pos i tively sloped portion of the isoquants because it could produce the same le v el of o ut p ut with bo th l es s l abor a n d l ess capi tal .

230 PART THREE P r oduction and Cost Analysis

6L a n d 4K b eca u se it cou l d p rod u ce 36Q by u s in g th e s m a lle r qu a ntities of l a b o r a nd ca pi -

ta

l indicated by p o in t V o n th e same iso qu a nt . Similarly , th e f irm wo uld n o t produ ce 3 6Q

at

point W with 4 L and 6K beca u se it co uld p r o du ce 36Q at p o in t Z w ith l ess La nd K . Sin ce

inputs are not free , t h e firm wo uld n ot

wa nt t o p r od u ce i n th e pos itivel y s l ope d r a n ge of

iso qu a nt s. Ridge li nes sepa r a t e th e r e l eva nt ( i . e . , n ega tive l y s l oped) f ro m th e irr e l eva nt (or p os i -

tively s l ope d ) po rti o n s of th e i soqu a nt s. In Fig u re 6-7, r id ge lin e OVI join s p oi n ts o n th e va r -

io u s i soq u a nt s w h ere th e i soqu a nt s h ave ze r o s lop e. Th e i so qu a nt s a r e n ega tive l y s l o p e d to

t h e left of thi s rid ge line a nd p ositi ve l y s l o p e d t o th e rig ht . Thi s m ea n s th a t sta rtin g, for ex -

amp l e , at po in t Von t h e i soq u a n t fo r 36 Q , i f th e fir m u sed mo r e l a b o r , it wo ul d a l so h ave

t o use m ore ca pit a l to r e m a in o n t h e sam e i soq u a n t (co mp a r e p o int U to poi n t V). S tartin g

fro m p o int V, if th e fi r m u sed m ore lab o r with th e sa m e a mount of ca pital, t h e leve l o f o ut -

put wo ul d fa ll (i . e. , t h e firm wo ul d fa ll b ack to a l ower i so qu a n t; see th e d as h e d h o r izo nt a l

l ine in th e f i g ur e) . T h e sam e i s tru e a t a ll o th e r p o in ts o n rid ge l i n e OVI. Th e refo r e, th e MP L

mu s t b e n ega ti ve t o the ri g ht of thi s rid ge lin e. Thi s c o rres po n d s to s t ag e III of pr o du c tio n for labor .

R idge l i n e OZI joi n s poi nt s w h e r e th e i so qu a nt s h ave i nf i nite s l o p e. Th e i so qu a nt s a r e

n

ega ti ve l y s l o p e d to t h e ri g ht of thi s r id ge lin e a nd po s iti v ely s lop e d to the l e ft. Thi s m ea n s

t

h a t s t a rtin g, f o r exa mpl e, a t p o int Z o n th e i so qu a nt fo r 36Q , if the firm u s ed m o r e ca pi-

t

a l , it wo uld a l so h ave t o u se m o r e la b o r to r ema in o n t h e sa m e i so qu a nt (co mp a r e p o int

W

w i t h po int Z ). St a rtin g a t point Z , i f th e f irm u se d m o re c a pita l w ith the sa me qu a ntit y of

l a b or, th e lev e l of o utput would fall (i . e. , the firm would fall back to a l o w e r isoquant ; s e e

th e das h ed ver ti ca l lin e i n th e f ig ur e) . Th e sa m e i s tru e a t all oth e r point s on rid ge lin e OZI.

T h erefore , th e MP K mu s t b e n egative

s p o n ds to s t age III o f pr o du ct i o n for ca pita l . Thu s , we co n c lud e t h a t th e n ega t ive l y s loped p o r tio n of the i so qu a nt s withi n th e ridg e

l i n es rep r ese nt s th e r e l eva n t eco n o mi c re g i o n of pr o du c tion . Thi s refe r s t o s t age II of pr o-

d u c t ion fo r l a b or a nd ca pit a l , w h e r e th e MP L a nd th e MP K a r e b o th po s itive but d ec linin g.

Produ ce r s w ill n e v e r w a nt to o p e r a t e out s id e this r eg i o n . A s a re s u l t , in the re s t of the c hap- ter we wi ll draw o nl y th e n ega ti v el y s l o p e d p or tion s of i so quant s .

to th e l eft of o r a b ove this rid ge l i ne. Thi s co rre-

Marginal

Rate of Technical Substitution

W e saw in t h e pr ev i o u s sec ti o n th a t i so qu a nt s ar e n ega tive ly s loped in th e e co n o mica l ly

rel evant ra n ge . Thi s m ea n s th a t i f the f i r m want s to reduce th e quantit y o f ca pita l that i t

u ses in pr o duction , it mu s t in c rea se th e qu a ntit y of l a bor i n order to rema in on the s ame

isoq u a n t ( i .e., produ ce th e sam e l eve l of output) . Fo r ex ampl e, th e m ove m e nt f r o m p oi nt

R o n i soqu a nt 1 2 Q in Fi g u re 6 -8 ind ica t es that the f irm c a n g i ve up 2. 5K b y

N t o p o int

a

ddin g 1L. Thu s, th e s l o pe o f i s oqu a nt l2Q b e tw e en p o ints Nand R i s -2 . 5K/ 1 L. Betwe en

p

oi nt s R a nd S, th e s lop e o f iso qu a nt ] 2 Q i s - ~ , a nd so o n . Th e a b so lut e va lu e : of th e s l o p e o f th e i so qu a nt i s ca l led th e m a r g i nal rate of t ec hni-

cal su b stitution (MRTS). F or a m ove m e nt d o wn a l o n g an i s oqu a nt , the m a rgin a l r a te of

t echni ca l s ub s tituti o n o f l a b or fo r ca pi ta l i s g i v en b y - ! 1 . K/M. W e multip l y ! 1 . K /M b y -I in

or d e r t o ex p ress th e MRTS as a p osi ti ve numb e r . Thu s, th e MRTS b e t wee n p oi nt s Na nd R

o n t h e i so qu a nt fo r 1 2Q i s 2.: . Simil a rl y, th e MRTS b e t we en point s R a nd S i s~.

at a n y po int o n a n i so qu a nt i s g iven b y the ab s o l ut e s lope of t h e i s oquant at that p o int. Thu s ,

Th e MRTS

Capital

4

3 . 5

3

N

-2.5K I

2 I

1

L

1L

CHAPTER6 Product i on Theory and Es ti ma ti o n

" --

-

1

280

20

400

360

231

o

o

1

2

3

3.5

4

l abo r

FIGURE 6·8 The Slope of Isoquants The ab s olute v alu e o f the sl o pe of an isoqua n t is called the

marginal rate of technical substitution (MRTS). Betw ee n points

Between points Rand S. MRTS = ~ . Th e MRTS a t any poin t o n an iso qu ant is given b y the a b solute slope of

t he t ange nt t o the i soquant at that p oint . T hu s . at point R. MRTS = 1 .

N an d Ron isoquant 12Q. MRTS = 2 . 5.

t h e MRTS

a t p oi n t R is 1 (t h e a b solu te s l o p e of th e t a n ge n t to the i s oqu a nt at p o int R; see

F

i g u re 6 -8). 7

 

T

h e MRTS of l abor for capital i s al s o eq u a l to MPJMP K . We can pro v e this b y reme m-

b

eri n g th at a ll p oint s o n an i s oquant refer to th e s a m e level of output. Thu s, for a m ov ement

d

ow n a given i soq u a n t, t h e ga i n i n o u tp ut res ulting f r o m th e u se o f more labor mu s t be equ a l

to th e lo ss i n o utput r esult i n g f r o m t h e u se of l ess ca pita l . S p ecifica l ly , th e i ncrea s e in the quan-

t

i t y of l abor u sed (M) t i m es th e margina l p r o du ct of l a b or (MP L ) mu s t equ a l the r e ducti o n in

t

h e amo un t of cap i ta l u s ed ( -b . K) times t h e ma r gin a l p r oduct of ca pita l (MPK). Th a t i s ,

(M)(MP L ) = -(IlK)(MPK)

[ 6-8]

7 The MRTS a t a pa r ti c u l a r p o int on a n i so q u a nt wh e n l a bor a nd capit a l a re c o n t inu o u s l y

i s oqu a nt i s a s m o o t h c urv e) ca n b e o bt a in e d b y t ak in g tbe t o t a l d i f f er e ntia l of t h e p rod u c t io n f un ction Q =

d i v i s ible (so that t he

f( L , K ), set tin g thi s to t a l dif fe r e n t i a l equ a l to ze r o (s in ce o ut p ut d o e s n ot c h a n ge along a given isoquant) , and

so l v in g f o r dKldL (t h e s lop e of t h e i so qu a nt ). Th a t i s ,

so th a t

Sin ce iJQliJL = MP L a nd iJQliJK = MP K ,

dQ = -·elL+-·dK iJQ iJL

iJQ

iJK

= 0

elK = (-) iJQ I iJL

iJQI iJK

.u.

elK = (_) MP L = MRTS

dL

MP K

232 PARTTHREE Pr o duction and Cost Analys i s

so th a t

M P L = -M ( = MRTS

Mh

st.

[6-9]

Thu s, MRTS i s equ a l to the ab s olute s lop e of the i s oquant and to the r a tio of the marginal produ c t ivi t i e s .

Within the economic a ll y rel eva nt ran g e , iso quant s ar e not onl y ne ga t iv ely s loped bu t

a l s o con v ex to the origin (see Fi g ure

do w n an i s oquant and uses more labor and les s ca pital , the MP L de c line s and the MP K in -

c r e as es (s ince the firm is in s tage II of product i on fo r both labor and capit a l ). With the MP L

d eclining and the MP K ri s ing a s we mo ve down a long a n i s oqu a nt , the MP d MP K = MRT S wi ll fall ( thu s , the i s oquant is c on v ex to the orig in ).

6-8 ). The re as on fo r this i s that a s the firm mo v e s

Perf e c t Substitutes and Complementary Inputs

The s hape of an i s oquant reflect s the d e gr ee to which one input can b e s ub s tituted for an- oth e r i n production . On one hand , t he s m a ller the c ur v ature of an i s oqu a nt , the g reater i s th e degree of s ubstitutability of input s in production . On the other hand , the g reater the cur v a - ture of an i s oquant , the smaller i s the degree of substitutability . At one extreme are is oquant s that a r e s tra ight line s , a s shown in the left panel of Fig - ure 6 - 9 . In th is ca s e , labor and c api ta l are perfect s ub s titute s. That is, the r a te at w hich labor can be s ub s tituted for cap i tal i n product i on ( i . e ., the ab s olute s lope of the i s oquant o r MRTS ) i s c on s tant . Thi s mean s th a t labor c an be s ub s tituted fo r capital ( or v ice v ersa ) a t th e constant rate gi v en by the ab s olute s lope of the isoquant . For example , in the left panel o f Fi g ure 6-9 , 2L can be substituted for lK regardless of the point of production on the i s o- qu a nt . In fa ct , po i nt A on the labor a xis s how s that the level of output indicated b y the m i ddle

Capital

6

4

2

o

o

2

4

6

8

10

12

Labo r

Cap i ta l

6

4

2

/

/

o o

2

4

6

L a bo r

FI GURE 6- 9 Pe rf e ct S u bstit u te s and its absolute slope or MRTS is constant),

for lKregardless of the po i nt of product i on on the isoquant. With the right-angled isoquants i n the right panel , efficient production can take place only with 2K/1L. Thus, l abo r and capital are perfect complements. Using only more lab o r or only more capital does not incr ea se output (that is, MP L =MP K = 0).

Complementar y Inpu t s Whe n an i soquant is a straight

inputs are perfect substitute s.

line (so that

In the left panel, 2L can be subst i tuted

CHAPTER 6 Pr o duct i on Theory and Estimation

233

iso qu an t can be p rod uce d wi th l abor a l one (i . e . , wi th out a n y ca pi tal) . S imila r ly, p oi n t B on

th e capi t al axis i nd icates th a t th e sam e l eve l of o ut p u t ca n b e p ro du ce d w ith ca p ital on l y

( i .e . , w ith o ut a n y l a b or). Exa mpl es of ne a r - p er f ec t i nput s ub s tituta b i l i t y a r e oi l a nd gas u se d

to o p e rate s ome h e atin g furn ac e s , e n e rgy and t i me in a dr yi n g pro cess, a nd fis h m ea l a nd soy b ean s u s ed to pr ovi d e prot e in i n a f e e d mi x. 8

A t th e o ther ex tr e m e of t he s p ect rum of i n p ut s ub s t i tuta bility i n p ro d uc t io n a r e i s o -

qu a nt s th a t a r e a t a ri g ht a n g l e, a s in t h e r ig h t p a n e l of Fig u re 6-9 . I n t h i s case , l a b or a nd

c

a pit a l are p e rfe c t c ompl e m e nt s . Th a t is, l a b or a nd ca p ita l m u st b e u se d in t h e fixed p r o -

p

o rtion of 2KI1 L . In thi s ca s e ther e i s ze r o

s ub s tituta bility betwee n l a b o r a nd ca p ital i n

pr

o duction . For example , s tartin g a t po i nt C o n the middle i s oqu a nt

in the right pan e l of

Fi

g ur e 6-9 , o utput re m a in s un c h a n g ed if o nl y th e qu a ntit y of l a b o r u se d i s i n crease d

( th at i s, MP L = 0 a lon g th e hori zo nt a l p o rt io n of the iso qu a nt ). S i mil a rly , o u t pu t r e m ain s

un c h a n g ed if o nly th e quant i t y of c ap i t a l is i n c r ease d (th a t is, MP K = 0 a l o n g t h e vertica l

p o rti o n of th e i so quant ) . Output ca n b e in c r eased o nl y b y i n c r easin g t h e q u a n tity of b ot h

l a b o r a nd cap i t a l u sed in th e pr o p o rti o n of 2 K / IL . Exa mples of p erfe c t co mpleme n tary input s a r e cert a in c h e mi c al pr o c esses th a t r e quire b as i c e lements (c hemi ca l s) t o b e co m- bin e d in a s pecified fi x ed proportion , en g ine a nd body f o r a ut o m o bile s , t wo whe e l s a nd

a

frame for bi cyc le s, a nd so on . In the se cases, inputs ca n b e u se d onl y i n th e f i xe d

pr

o p o rt i on s p ec ifi e d (i.e ., t h ere is n o p oss i b il it y o f s ub sti t u t i n g o n e i n p u t fo r ano th er in

pr

o du c tion ) .

A l th o u g h pe r f ec t s ub s t i tut a bilit y a nd p erfec t comp l eme ntar ity of i n pu t s i n pr oduc t io n

are po ss ible , in mo s t cases iso qu a nt s ex hib i t so me c ur va ture ( i . e., i npu ts are i mp erfect

s ub s t i tu tes),

labor c a n be s ubstituted f o r c a pit a l t o som e d eg ree . The s mall e r th e d eg r ee of c ur vatur e of

the i s oquant , th e m o r e easi l y input s ca n b e s ub s t i tute d f o r e ac h ot h er i n p ro d uc tio n . In ad-

dit i on , w h e n t h e iso qu a nt h as so m e curva tu re, th e a bi l ity t o s ub sti tu te l a b o r fo r ca p ita l ( or

as s hown in F igur e 6- 8 . Thi s mean s th a t i n the usual produ c tio n s itu a tio n ,

v

i ce versa) d i min is h es as m ore a nd mo r e l a b or is s ub s tituted fo r ca p i t al. Thi s is i nd ica t ed

b

y the de c l i nin g a b so lut e s lop e of t h e iso qu a nt

o r MRTS as we m ove do w n a lon g a n iso-

qu a nt (s ee Figure

tremel y import a nt in keeping pr o duction cost s d o wn wh e n the price o f a n input incr ea s es relative to the price of anothe r .

6-8 ). Th e a bili t y to s ub sti tut e o ne input for a n o th er i n p r oductio n i s ex -

~ OPTIMAL COMBINATION OF INPUTS

A s we hav e s een i n th e pr ev iou s s e c t i on , a n i s oqu a nt s h o w s the va r i ou s co mb i n atio n s of

to produce a given l eve l of output . In this s e c tio n we

e xa mine i s oco s t s . An isocost li n e s h o w s th e va riou s co mbinatio n s o f inputs that a fir m ca n

pur c ha s e or hir e at a g i v en cost . B y the u se of i s o c o s t s a nd i s oqu a nt s, we w ill th e n d eter- mine the optim a l input co mbin a ti o n f or th e fi rm to m a ximize pr o fit s. In t hi s sec t io n , we will a l s o examine input s ub s tituti o n in produ c tion a s a re s ult of a c han g e i n input pr ices .

labor and capital t h at a firm can

u s e

8 Th e MPL a l so d ec lin es b eca u s e l ess c apita l is u s e d. On th e o th e r ha nd , the MPK i n c r eases b ecau s e more l a bo r is a l so u se d .

234 PARTTHREE Production and Cost A na l ysis

Capital

 

14

A '

Capital

10

A

10

8

8

6

4

4

2

0

8

0

8 *

0

2

4

6

8

10 labor

0

4

8

10

14

20 l a bo r

FIGURE 6-10 Isocost L ines W ith total cost of e = $100 and W= r= $10 , we hav e isocost line AB in the left

panel , wi t h vertical intercept W= r= $1 0 , w e h ave isocost

of elr= $100 / $10 = 10K and s l ope of-w/r= - $10 / $10 = - 1 . With C = $140 and

line A ' a' i n t he ri ght panel . W i th C ' = $80 and W= r= $10, the i socost line is

Ana" in t he r i ght panel . On the o t her hand , with e = $100 and r= $10 but W= $5 , we have isocost lineAB * in

the right panel , with vertical intercept of 10K and slope of -!.

Isocost Lines

S u ppose t h at a f i rm u ses o nl y l a b or

a nd ca p i t a l i n produ c tio n . Th e t o t a l c os t s o r e xp e nd i -

t u res of th e fir m ca n t h e n b e re pr e s e n ted b y

C=w L+rK

[6 - 10]

w h e r e C i s to t a l costs , w i s th e wage r a t e o f l a b o r , L i s the qu a ntit y o f l a bor u s ed , r i s th e r e nt a l pri c e of ca pit a l , a nd K i s th e qu a ntity of capital used. Thu s , Equ a -

tio n 6 - 1 0 p ostu l ates th a t th e tota l costs of th e f irm ( C ) e qu a l s the s um of its e x penditur es o n

l abor (w L ) and capital ( rK) . E q u ation 6 - 10 i s t h e ge n e r a l equ a tio n of the f irm 's i s o c o s t line

o

r eq u a l -c o t l in e . I t s h ow s t h e vario u s co mbin a tio n s o f l a bor

a nd c a pital th a t th e firm can

h

ire or re nt at

a giv e n t o t a l cost . Fo r exa mple, if C = $ 100 , w = $ 10 , a nd

r = $ 10 , th e firm

co ul d eit h er h ire 10 L or ren t 10 K , o r a n y co mb i n a tio n of L a nd K s ho w n on i s o c o s t line AB

in t h e l eft p a n e l of F i g ur e 6- 10 . F or eac h unit o f ca pita l the firm g i v e s up , it can hire one ad-

di t i o n a l unit of l a b or . Thu s , th e s l o p e

B y s ubt rac tin g w L f r o m b ot h s i d e s o f E qu a tio n 6 - 10 a nd then di v idin g b y r , we ge t the

genera l e qu a ti o n of th e isocost lin e i n th e f o llow in g m o re u s eful f orm:

of th e i s o cos t lin e i s -1.

C

K= - - - L r

w

r

[6-11 ]

w h e r e C l r i s th e ve rti ca l int e r ce pt of the i s o cos t lin e a nd -wlr

$ 100 a nd w = r= $1 0 , th e ver ti ca l int e r ce pt i s Cl r = $ 1001 $ 10 = 10K , and

- $ 1 0 / $ 1 0 = -1 (see i s o cost l i n e A B i n the lef t p a n e l of Fi g ur e 6-10 ) . A d iffere nt t o t a l cost b y th e fi r m wo uld defin e a different but parallel i s oco s t line , w hile dif fe ren t re l a t ive input price s would de f in e a n i s o c o s t line with a different slope . For ex a mple ,

i s its s lop e. Thu s, for C =

the s lope i s - w lr =

Capital

14

A'

CHAPTER 6 Product i on Theory and Es ti mat i o n

235

11

1 0

8

5

140

2

o

o

2

3

5

8

10

12

14

B'

Labor

FIGURE 6-11 O ptim al Input Combination T he o p ti m a l in pu t c o m b ination is given by points D, E,

and Fat which isoquants 8Q , 10Q , and 14Q are tang e nt to isoco s ts A " 8 " , A8 , a nd A ' B ' , res p ec t ively . B y

joining the origin w i th points

combinations (tangency points), the absolute slope of the isoquants (MRTS = MPL!MP K ) e q uals the

absolute slope of the isocost lines (w i r), so that MP l [w = MPKI r.

D, E, and F, we get the e x pansion path of t he fi r m . At th e op t im a l i npu t

a n i n c rease in t o t a l expe ndi t ur es to C = $ 1 40 w ith un c h a n ge d w = r = $10 wo ul d g i ve i s ocost lin e A 'B ' in th e ri g ht p a n e l of F i g ur e 6- 1 0, w ith ve rti ca l inte r ce p t C'Ir = $140 1 $10 = 14K and s lope o f - w lr=- $ 101 $ 10= - I . If t o t a l ex p e ndit ur es d ec lin ed t o C' = $80 w ith un c h a n ged w= r =$ 1 0 , th e i s o c o s t lin e wo uld b eAI B" , w ith ve rti ca l inte r ce pt of C' l r= $801$10 = 8K a n d

s l o p e of -w i r = -$ 10/ $ 1 0 = - I . On

we wo uld h ave i socos t lin eA B *, w ith ve rti ca l i nt e r ceptofClr = $ l 001$10= 1 0K a n d s lope of -

w lr = -$ 5/ $ 10 = -!.

th e o th e r h a nd , w ith e = $ 1 00 an d r = $ 1 0 but w = $5 ,

Optimal Input Combination for Minimizing Costs or Maximizing Output

Th e optim a l c ombination of i nput s n ee ded fo r a firm t o minimize th e cost of producing a g i ve n le ve l of output o r m axi mi ze th e output for a g i ve n c o s t o u tlay i s given at the tan gency p oi nt of a n i so quant a nd a n i socos t . F or exa mpl e, Fi g ur e 6-11 s h ows th at t h e lowe s t co s t of pr o du c in g 10 unit s o f output ( i . e. , t o rea c h is oquant lOQ ) i s g i ve n b y p o in t E , w h e r e isoquant I OQ i s t a n ge nt to i s oc ost lin e AB. The firm u s e s 5L a t a c o s t o f $ 50 and 5 K a t a cost of $50 al s o , for a tot a l c o s t o f $ 100 (s h ow n b y i s o c o s t AB ). The output o f IOQ ca n a l so b e r ega rd ed as th e m axi mum output th a t ca n b e produ ce d w ith a n ex penditur e of $ 10 0 (i.e. , with i s ocost lin eA B ).

236 PART THREE Product i on and Cost Analysis

Note th at th e fi nn co uld a l so p r od u ce 1 0Q atpoint G(with 3La n d 11 K ) or at p oi ntH (wi th

12L a n d 2K) at a co t of $140 (isocost A 'B '). Bu t th is wo u l d not represe nt th e l east-cos t in pu t com b ina ti o n require d t o pr o du ce 10Q . In f act, w ith a n ex p e nd i ture o f$1 40 ( i. e . , w ith i s o cos t A' B '), th e f i rm co uld r eac h i so qu a nt 1 4 Q a t p o int F (se e Fig ure 6-11). Similarly, th e firm co uld

p r o du ce 8 Q e ffi c i e ntl y a t p o int D on i so co s t A "B" a t a c os t of $ 80 or ineff iciently at point s J

a nd M o n isocost A B a t a c os t of $ 10 0. Thu s, th e o ptim a l i nput co mbin a tion ne e d e d to mini -

m ize th e cos t of pr o du c in g a g i ve n le v el of output o r the maximum output that th e firm c an pro - duce at a give n cost o utl ay i s give n a t the t a n ge n cy of a n iso qu a nt a nd a n i socost .

J oi n i n g p o in ts of t a n ge n cy of iso quant s and iso cos t s ( i . e ., joining points of optim a l input com b i n ation ) gives t h e e x pansion path of the f irm . Fo r exa mple, l i n e ODEF in

F i g u re

iso q ua n ts ( i .e . , pr o du c in g) 8 Q , l OQ , a nd 1 4 Q a r e $80 , $ 100 , a nd $ 140 , giv en b y p o ints

D , E, a nd F , r esp ec ti ve ly . It al so s how s th a t w ith t o t a l c o s t s of $8 0 , $100 , a nd $ 140 ( i . e .,

wi th isocos t s A" B" , A B , a nd A' B ') th e m ax imum o utputs th a t t h e firm can produ ce ar e 8 Q ,

lOQ , a nd 1 4 Q , r espectively . To be noted i s that not a l l expan s ion paths are s tra ight line s

thr o u g h th e o ri g in a s in Figur e 6 - 11 , thou g h this i s the c a s e for mo s t production f un c tion s

es tim a ted empirically ( s e e Se c ti o n 6 - 7 ).

6- 1 1 is th e ex pan sio n p a th fo r the f irm . It h ows th at th e minimum c o s t of reachin g

W i th o pt i m a l input c omb i n a t io n s (i. e .,

at th e p o in ts of t a n ge n cy o f i so qu a nt s a nd i so -

cost l i n es), th e (a b so lute ) s lop e of th e iso qu a nt o r m a r g in a l r a t e of t ec hn i c a l s ub s tituti o n of

l a b or for ca p ita l i e qu a l t o th e (a b so lu te) s l o p e of th e i soc o s t line or r a t io o f i nput pr ice s. Th a t i s,

MRI S = w

r

[6-12]

Sinc e the MR TS = MPJMP K , w e c a n rewrite the condition for the optimal combination of input s as

 

MP L

W

[6 - 13 ]

MP K

r

Cr

oss-m ult i pl y in g , w e ge t

 

MP L

=

MP K

[6-1 4 ]

 

w

r

Equation 6 - 14 indic a t es th a t t o minimi ze pr o du c tion c os t s ( or t o m ax imize output for

a g i v en co s t o utl ay), the extra o utput or marginal product per do l lar s pent on labor mu s t be

equal t o the m a r g in a l product p e r do l lar s pent on capital. If MP L = 5 , MP K = 4 , a nd w = r ,

th e f i rm w o uld n o t be m axi mi zing o utput o r minimizin g c o s t s s ince it i s ge ttin g m o r e extra

o u t put fo r a d o ll a r s p e nt o n l a b o r th a n o n ca pita l . T o m a ximi ze output o r m i nimize c o s t s,

the firm w o uld h ave t o hir e m o r e l a b o r a nd r e nt l ess ca pital . A s th e f irm d oes this , th e MP L

de c l i n es and th e M P K in c r eases (s in ce th e f irm i s i n s t ag e II o f pr o du c tion fo r L a nd K ) . T he

pr ocess w ould h ave to c ont i nu e until c onditi o n 6-14 holds . Ifw we r e hi g her th a n r, th e MP L

wo uld h ave t o b e proporti o n a t e l y hi g h e r th a n th e MP K f o r c ondition 6 -14 t o h o ld. Th e sa m e

ge nera l condition for the optimal input combin a tio n would h ave to hold reg a rdless of th e

numb e r of input s. That i s, the MP per doll a r s pent on each input w ould have to be the sa m e

for a l l input s .

Profit Maximization

CHAPTER 6 Production Theory and Estimation

237

In order to maximize profit s, a firm s hould emplo y each input until the margin a l re v enue product of the input equ a ls the marginal re s ource co s t of hiring the input . With c on s t a nt input prices , this mean s that the firm should hire each input until the marginal re v enue product of the input equals the input price. Thi s i s a simple extension of the profit maxi- mization condition discussed in Section 6-3 for the case of a single variable input. With labor and capital as the variable inputs, the firm will maximize profits by hiring labor and capital until the marginal revenue product of labor (MRPd equals the wage rate (w ) and until the marginal revenue product of capital (MRPK) equals the rental price of c apit a l ( r ) . That i s, in order to maximize profits, a firm should hire labor and c a pital until

MRP L= w MRPK=r

[

[6 - 16]

6 - 15]

Hiring labor and capital so that Equations 6-15 and 6-16 hold implie s that condition 6-14 for optimal input combination will also be satisfied. To see this , remember from Section 6-3 and Equation 6-6 that the marginal revenue product (MRP) of an input equals the marginal product of the input (MP) times the marginal revenue (MR) generated from the sale of the out- put . Thus, we can rewrite Equations 6-15 and 6-16 as

(MPL)(MR) = w

[

6-17]

(MPK)(MR) = r

[6 - 18]

Dividing Equation 6 - 17 by Equation 6-18 gives

MP L =~

[6-19]

MPJ( .

r

Cross-multiplying in Equation 6-19 gives the condition for the optimal combination of in- puts given by Equation 6-14:

MP L = MP K r

w

[6-14 ]

Note that there is an optimal input combination for each level of output ( see points D, E, and F in Figure 6-11), but only at one of these outputs (the one where MRP of each input equals the input price) will the firm maximize profits. That is, to maximize profits, the firm must produce the profit-maximizing level of output with the optimal input combination. By hiring inputs so that Equations 6-15 and 6-16 are satisfied, however, both conditions are met at the same time. That is, the firm will be producing the best or profit-maximizing level of output with the optimal input combination .

Effect of Change in Input Prices

Starting from an optimal input combination ,

will substitute the cheaper input for other inputs in production in order to reach a new optimal input combination . For example, Figure 6-12 shows that with C = $ 100 and

if the price of an input decline s, the firm

238 PARTTHREE P r oduc ti o n a nd Cos t Analys i s

Capital

1

0

7

5

3

 

8

*

 

o

o

5

8

10

14

20

Labor

FIGURE 6-12 Inpu t S ubs ti tutio n in Product i on W i th C = $100 and w = r = $10 , t h e

com b i natio n t o pro d u ce 1 0Q is 5K and 5L ( po i n t E , where i s oqu a nt 10Q is tangent

point E, K / L = 1 . I f r re ma i ns at $ 10 b u t wf a lls t o $5 , t he f i r m can r eac h i soquant 1 0Q w it h C = $ 7 0 .

The optim a l

op t imal in put

to isocos t A8 ) . A t

c om b i n at i o n of Lan d K is th e n gi ve n b y po i n t R where i s ocos t A * 8 ' i s tangen t t o i soqu ant

10Q , andK / L =~.

CASE STUDY 6-1

Substitutability between Gasoline Consumption and Driving Time

Hi

g h er hi g h way

p eed re du ces

d r i v in g t ime but

If t h e pri ce o f g a s o l ine were $ 2 per ga llo n an d if

in

c r ea s e

ga s o lin e co n s umption

by redu c ing

ga s

the i n dividua l co uld h ave e a rne d $4 per h our b y

mi

l eage. T h e tr a d e-off b e twe e n gas oline c o n s ump -

worki n g rat h e r t h an drivi n g , t h e optima l combi n a-

tio

n a nd travelin g t im e f or a trip o f 3 60 mile s ca n be

ti

o n of th e inp u t s o f gas o l ine and tr a vel time would

repre se n te d

Th e i so qu a nt s h o w s th a t at 50 mi l e s per h o u r, the

3 60 mile s c an b e c overed i n 7 . 2 h o u r s (t h at i s , 7 h o u r s

a

36 m i l es p e r ga llon ( point A ). A t 60 mil es per h o u r , th e 3 60 mi l es can b e cove r e d in 6 h o ur s with 12 ga llon s

a t

b y th e iso quan t s h ow n i n Fi g ur e 6 - 1 3.

w i t h 10 g a ll on s of gas o lin e,

nd 12 minute s)

of gaso lin e, at 3 0 mile s p e r ga llon ( point B ). Dri v in g

a t 6 0 mil es p e r h o ur s aves I h o ur a nd 12 m in ute s

o f tr a v e l time but increa s e s ga s oline co n s umpt ion

b y 2 ga ll o n s. At 72

15 g a ll o n s of gaso l ine , at 2 4 mil es per ga l -

l o n ( p o in t C ). Dri v in g a t 7 2 mile s per hour sav e s a n-

h o ur s a nd

m i l e s per hour , the t r ip wil l t a ke 5

o th e r I h o ur of tra ve l time but increa s e s ga solin e

co n s umpti o n b y a not h er 3 ga l lon s.

be a t point B where t h e i s oq u a nt i s tangent to i s o- cost DE . At po i n t B , the a b s ol u te s l ope of i s ocost

DE i s ~ ( th e ra t io of t h e price of 1 ga ll o n of ga s o l i n e to the cost of 1 h o ur of d ri vi n g ti m e) . Th e mi ni m u m

c os t f or the trip i s t h en

at $ 4 per ho u r plu s 12 ga llon s of g a s oline a t $ 2 per

ga llon ).

p er g al l o n , t h e o pt imal co m b in a t io n of dr ivin g time

a n d gaso li ne wo ul d b e g i ve n i n s t ea d b y po in t C

w h ere t h e i so qu a n t i s tange n t to i socost l ine FG . At

p oi n t C the ab s o l ute s lo p e o f i s oco s t FG i s ± and reflect s the new rel a tive price of g a s oline ($ 1 per

ga l lon) a n d t r aveling time ( $ 4 per hour ) . The mini-

m u m cost of t h e t r i p wo u l d t h e n b e $35 (5 hour s of

$ 4 8 ( 6 hour s o f d r iv ing time

If th e pric e o f ga s oli n e fell from $ 2 to $ 1

CHAPTER 6 Production Theory and Estimation

239

Driving time (hours) 0 I 7 . 2 6 5 :L '" ~ : ••
Driving time
(hours)
0
I
7
. 2
6
5
:L
'"
~
: •• miles
E
I
I
I
I
Gasoline (gallons)
0
8
10
12
15

FIGURE 6 · 13 Th e Opt i m a l C omb ination of Gasoline and Driving Time At the gasol i ne pr i ce of $ 2 per gallon and foregone earnings of $4 pe r h ou r fo r dr i v i ng, the minimum cost of a 360 -m i l e tri p i s

g i ven by point 8 , at which the isoquant is ta n gent t o i socost DE. The opt i ma l dr i v i ng speed i s 6 0 mi les

per hour so that the trip would ta k e 6 hours and 1 2 gallons o f gaso li ne at a t ota l c os t o f $ 48. If t he pr i ce of gasoline falls to $1, the minimum cost of the tr i p is g i ven by po i nt C , at wh ic h th e is oquant i s tangent to isocost FG. The optimal dr i ving speed i s 72 miles per hour so that t he tri p would take 5 hours and 15 gallo n s of gasoline at a total cost o f $35 .

t r avelin g tim e a t $4 per h o ur plu s 15 g a ll on s of gaso lin e a t $ 1 per ga ll o n ) .

l aw in

of

t h e pet r ole um c r isis t o save gaso lin e ) was a ration a l

response to th e decline i n gas ol i n e pri ces ( in r e l at i o n

t o o th e r pr ices) a nd th e in crease in rea l w ages th a t

T hu s , the re p ea l o f th e 55-mil es - a n - h o u r

1987 ( w hi c h h a d b ee n imp o s e d in 1 9 7 4 a t th e s t art

ha d t a ke n p l a ce s i n ce 1981 . Opp os iti o n to the repe a l of t h e 55- m i l e s- a n - h o u r law came prim a ril y f r o m

th ose wh o b e li eve th a t l owe r s p e e d li mit s s ave liv es.

e l ative l y l ow gasol in e price s f rom 1986 t o 200 3

did , h owe v er , bring to a h a lt pro g re ss in e n e r gy

efficie n cy .

R

S o ur ce: C h a rl es A. L a ve , " Sp ee din g, Coordi n ati o n , and the 55 - MP H Lim i t , " Am e ri ca n E co n o mi c R e view ( D e c e mb e r

1

1998 ), p . 1 6 ; " L o oki n g for Ways to Save Gaso l ine , " Th e Wall Str ee t J o u rnal ( J u l y 12 , 2001 ) ,

985) , pp. 11 59 - 11 64 ;

" D ea th R a t e o n U . S.

R oad s R e po r ted a t a R e cord Low, " Th e N e w Y o rk Tim es (October 2 7 ,

p . AI ; " S e n ate Kills

E f f o rt to R a i s e Car s' Fue l Efficienc y , " Th e Wall Str eet J o urna l ( Mar c h 14 , 2 00 2), p . A 2; " Fu e l E co n o m y B e l ow 80's

L e vel s, E . P.A . Say s , " The N ew Y o rk T im es ( Octobe r 30 , 2002 ), p . C4; " H o w M u ch I s Y o u r Time W o rth ?" Th e New Y o r k

T im es (Fe bru a r y 26 , 2003), p. DI ; " A t $2 a G a ll on, Ga s I s S t i ll W or th G u z z lin g , " T h e New Y o rk Tim e s ( Ma y 1 6 ,

2004) , sec . 4, p. 1 4 ; a n d " New G as- M i l eage

2005 ), p. A2 .

S tandard s May V a ry by Ve h i c l e Weig h t , The Wa l l Str ee t J o urnal ( Jul y 1 0 ,

240 PART THREE Production and Cost Analysis

w = r = $10, the optimal input combination

is 5K and 5L given by point E , where iso-

quant 10Q i s tangent to isocost AB (as in Figure 6-11). At point E , the capital-labor ratio

( that is , KIL ) i s 1 . If r remains at $10 but w fall s to $5 , the isoco s t line become s AB *, and the firm can reach isoquant 14Q with C = $ 100 (point N in Figure 6-12 ). The firm can now reach iso- quant lOQ with C = $70. This i s given by isocost A * B' , which is parallel to AB * (that i s,

- w lr = -~ for both) and is tangent to isoquant lOQ at point R . At point R, the firm uses

3K at a cost of $30 and 8L at a cost of $40, for a total co s t of $70. At point R, KIL = ~

(as compared with KIL = 1 at point E before the reduction in w ). Thus , with a reduction in w ( and constant r ), a lower C i s required to produce a gi v en level of output. To mini- mize the production cost of producing lOQ , the firm will have to substitute L for K in production , so that KIL declines. The ease with which the firm can s ubstitute L for K in production depends on the shape of the isoquant . As we have seen in Section 6-4, the flatter the isoquant , the easier it is to substitute L for K in production. On the other hand, if the isoquant is at a right angle (as in the right panel of Figure 6-9) , no input substitution is possible (that is, MRTS = 0). Then , KI L will be constant regardless of input prices . Case Study 6-1 examines the trade-off between consumption and tra v eling time on the nation's highway.

j 6-6

RETURNS TO SCALE

Returns to scale refers to the degree by which output changes as a result of a given change in the quantity of all inputs used in production. There are three types of returns to scale:

constant , increasing, and decreasing. If the quantity of all inputs used in production is in- creased by a given proportion, we have constant returns to scale if output increases in the same proportion; increasing returns to scale if output increases by a greater proportion; and decreasing returns to scale if output increases by a smaller proportion. That is, sup- pose that starting with the general production function

Q=f(L,

K)

[6-1]

we multiply Land K by h , and Q increases by 1 , as indicate d in Equation 6-20:

AQ = f(hL , hK)

We have constant, increasing, or decreasing returns to scale, respectively, depending on whether A = h, A> h, or A < h. For example, when all inputs are doubled, we have constant, increasing, or decreasing returns to scale, respectively, if output doubles, more than doubles, or less than doubles. This is shown in Figure 6-14. In all three panels of Figure 6-14, we start with the firm using 3L and 3K and producing 100Q (point A) . By doubling inputs to 6L and 6K , the left panel shows that output also doubles to 200Q (point B), so that we have constant returns to scale. The center panel shows that output triples to 300Q (point C), so that we have increasing returns to scale, while the right panel show s that output only increases to 150Q (point D), so that we have decreasing returns to scale. Here h (the increase in Land K) is 100 percent , while (the increase in Q) is 100 percent in the left panel, 200 percent in the middle panel, and 50 per- cent in the right panel .

[6-20]

CHAPTER 6 Produ c tion Theory and Estimation

241

Capital Capital Capital 61-----V. 6 6 I 2000 3000 'tzf:± 3 3 i 1000 0
Capital
Capital
Capital
61-----V.
6
6
I
2000
3000
'tzf:±
3
3
i
1000
0
6
0
6
0
o 3
Labor
0
3
0
3

6

1500

Labor

FIGURE 6-14

we start with the firm using 3L and 3K and producing 100Q (point A). By doubling inputs to 6L and 6K,

the left panel shows that output also doubles to 200Q (point B), so that we have constant returns to

scale; the center panel shows that output triples

to scale; while the right panel shows that output only increases

decreasing returns to scale.

Constant, Increasing,

and Decreasing Returns to Scale

In all three panels of this figure

to 300Q (point C), so that we have increasing returns

to 150Q (point D), so that we have

CASE STUDY 6-2

Returns to Scale in U.S. Manufacturing Industries

in

indu s trie s in the United States in

1957 . A v a lue of I refer s to constant return s to sca le ,

a valu e great e r than J refers to increa s ing return s to

s c a le, and a v a lue less

turns to s cale. Th e t a ble show s that for a doubling of

(i . e ., with a 100 percent increa s e in) all input s, output

Table 6-5 reports the estimated return s to s c a le

18 manufacturing

th a n 1 refers to decrea s ing re-

w

b y 109 per c ent in chem i c a l s , but onl y by 95 percent

in petroleum (the la s t entry in the s econd column o f the table ). Although only the textile indu s try s eem s to f a ce con s tant return s to sc ale exactl y , mo s t other indu s tr i e s are very c lo s e to it .

o uld ri s e

by III percen t in the f urniture indu s tr y,

Estimated Returns to Scale in U.S. Manufacturing

Industry

Returns to Scale

Industry

Furniture

1 . 11

Stone, clay, etc.

Chemicals

1 . 09

Fabricated metals

Printing

1 . 08

Electrical machinery

Food, beverages

1 . 0 7

Transport equipment

Instruments

1 . 0 6 1 . 04

Textiles

Lumber

1 . 04

Paper and pulp

Apparel

1 . 04

Primary metals

Leather

1 . 04

Petroleum

Rubber, plastics

Nonelectrical machinery

Returns to Scale

1 . 03

1

. 03

. 03

. 02

. 02

. 00

1

1

1

1

0.

0 . 9 6

0. 95

9 8

S o ur ce : J . Moroney, " Co bb-D oug l a s Production Functions and Returns to Scale in U.S. Manufacturing

CASE STUDY 6-3

Bajaj Auto limited-Small Is Better

es tabli s h e d in 1 9 45 a s a

tra di ng c ompa n y an d o bt a in e d it s pr o duction lic e n se

i n 1959. It i s o n e of Indi a's l a r ges t two-wh e el e r

m a nu facturers a n d was a d o min a nt pla y er until th e

earl y 199 0 s. Th e tw o - w h ee l er indu s try thriv es in d e-

ve l oping co un tries , es p ec i a ll y in de ns ely p o pulat e d

co un tries lik e I n d i a. Bu t with i ncom e l eve l s r is in g,

peop l e are op ti ng for e n t r y -l e v e l m o torc yc l es r a th e r

B

aja j A u to L i m i te d was

B y doing this th e comp a ny w as abl e to impro ve

it s o utput/ e mployee/year f rom 67.7 in 1997 to 101 in

2 002 a nd then to 132 in 2004 , an increa se of almo s t

50 p e rcent in 7 ye a r s . The obviou s g oal to increa s e

th e pr o ducti v ity w a s made pos s ible , s ay s Mr M a dhur

Baj a j, vic e -ch a irman . Pr o ductivity has gone up s i g -

nif i cantly in the la s t few y ea r s , from the level of 67 . 7

v e hi c le s p e r employee/ye a r to the level o f 1 3 2 vehi-

t

h

a n scoo t ers.

c

le s per e mployee/ye a r in the year ended 2004 . Con -

 

The t wo - w h ee l er

indu s tr y

grew b y 11 . 6 p er -

s

equently , the comp a ny' s R&D w as fo c u s ed o n up -

t o 5 . 64

H o we v er , due to g l ob a l

compe t itio n , B a j aj's mar ket s h a re d ec lined fr o m 4 9.3

mi ll io n un its in 2 00 3 -04 .

cent-

f r o m

5.0 5 m illi o n unit s in 2002 - 03

p e r cent i n 1994 t o 3 8 . 9 p e rcent in 1 9 9 9 . In o rd er to

overco m e t hi s pr o bl e m , B a j a j Aut o h as decid e d th a t

s m a ll er i s b e t ter a nd re duced s ignif i cantly

un t , fi r st in 1998 a nd then in 2001 by m o re th a n

3, 00 0 p e r so n s. In 2000 - 01 , th e co mp a ny cut d o wn it s

s t a f f st r eng th f r o m 1 7 , 213 to 13 , 819 . B a j a j ha s of -

fer ed fo ur VRS sc h e m es till d a te for i t s s taff a nd two

it s he a d

co

g rading current product s , developing new sc o o ter s,

a nd co s t reduction mainly in the entry-level s e g -

m e nt s. Th e company i s s etting up a new f a c ili t y at the Akurdi complex near Pune for design , analy s i s , prototyping , a nd te s ting .

a

s

2 00 2 a s c ompared to market growth of 40 percent

durin g the previou s year . B a jaj Auto wa s al s o able to

o ff s et its high raw material co s t due to increased pro-

In terms of growth , the company

h a rp increase of 55 . 4

witnessed

percent in its sa l es in the year

s

u c h fo r i t s wo rk ers , a nd th e a tt e mpt c o mp a c t ed its

ducti vit y of it s emp l oyee s, which a l s o led to r edu c -

e

mpl oyee st r eng th b y 9 ,3 8 4 (f rom 21 ,373 in 1997 to

tion in l a bor co s t as percentage of n et s al es from 5 . 7

1

1 , 5 3 1 i n 2004 ), r es ul t in g i n a reduc t ion

of R s 70 . 6

per ce nt to 5 percent . In 2002 , Bajaj had a workforce

c

r o r e pe r a nnum in i t s w age bill .

of 13 , 000 emp l oyee s with a network of 422 de a lers

Year

and o v er 1 , 200 authorized service ce n ter s.

Production and Employee Size of Bajaj Auto Ltd

Production

No. of Employees

Output/Employee/Year

1

99 7

1 , 4 3 9 , 1 74

2 1 , 273

67.7

1998

1 , 354 , 4 82

1 8. 58 9

72

. 9

1999

1 , 38 1 , 765

1 8 , 585

7

4 .3

2000

1 , 4 32 , 4 7 1

17

, 21 3

83.2

2001

1 , 2 1 2 , 74 8

1 3,8 1 9

87.8

2002

1

, 35 6 , 4 63

1 3 , 4 8 2

100.6

2

003

1, 4 57, 0 66

12

, 33 8

11

8. 1

2004

1

, 5 16,876

11

, 5 3 1

1

3 1 . 5

Sour ce: Co m pa n y Annu a l R e p o r t 20 04 -05, In d i a In fo lin e 20 0 4, Th e Hindu Bu s in ess Lin e , Oc t o b e r 2 00 3.

242

CHAPTER 6 Production Theory and Estimation

243

Increa s ing return s to s cale ari s e bec a u se a s the sc ale of operation in cr e as e s, a g r ea ter division of labor a n d specialization can take place and more s pecialized and productiv e m a - chinery can be used . Decreasing returns to s cale, on the other hand, aris e prim a rily be ca u s e

a s the s cale of operation increa ses, it become s ev e r more diffic ult to manage the firm ef-

fec tively and coordin a te the v a riou s operati o n s and di v i s ion s o f th e firm. In th e re a l wo rld ,

the force s for in c rea s ing and de c rea s ing return s to sca le often op e r a te s ide by s ide, w ith th e former usually overwhelming the latter at s m a ll level s of output and the revers e occurri n g at very large levels of output . For example, in Table 6-1 , we saw that with lL and lK, we have 3Q. With 2L a nd 2K , we have 18Q. Th u s, we have increasing returns to scale over this range of outputs. How eve r , doubling t h e amount of labor and capit a l u s ed from 3L and 3K to 6L and 6K only in c rea s e s output from 33 to 39 unit s, s o that we have de c reasing return s to s c a le o v er this lar ge r r a n ge of output s. In the real world , mo s t indu s tries s eem to operate n ea r the r a n ge of con s t a nt r e - turns to scale where the for c e s of in c rea s ing a nd de c rea s ing return s to sca le a re more o r l ess in balance (s ee Cas e Study 6-2 ) . But , as Ca s e Study 6-3 s how s, B a jaj Auto Ltd fa ce s decreasing returns to s cale because of exce ss manpower and thu s r e duced its empl oy ee s over a time period .

I 6-7 I EMPIRICAL PRODUCTION FUNCTIONS

The production function mo s t commonly u s ed in empirical e s tim a t i on is th e powe r f un c - tion of the form

[6 - 21]

Q=AK a L b

where Q , K , and L refer, respectively , to the quantitie s of output , capital, a nd labor , a nd A, a, and b are the parameters to be e s timated empirically. Equation 6- 2 1 i s often referred

of Ch a rle s W . C o bb a nd P a ul H .

to as the Co bb-D o u g l as p ro du ction function in honor Douglas , who introduced it in the 1920s. 9

T h e Cobb-Dougla s production function has s everal useful propertie s. First, the m a r-

ginal product of capital and the marginal product of labor depend on both the quantit y of capital and the quantity of labor u s ed in production, a s i s often the ca s e in the re a l w o rld . 10 Second, the exponent s of K and L ( i . e. , a and b) repre s ent, re s pe c tivel y, the output e l as tic - ity of labor and capit a l (EK and E L ), and the sum of the exponents ( i . e. , a + b ) m e a s ur es the

9 S e e C . W . Cobb and P . H. Douglas, " A Theory of Pr o duction ," Am e ri c an E co n o mi c R ev i ew ( M a rch 1 928) , pp . 139 - 165 .

1 0 Th e e qu at ion for the mar g in a l pr o du c t o f ca pit a l i s

oQ

K

o

MP K = -

Q

= aA K a - I U = a· -

K

Simil a rl y , the equati o n for th e m a r g in a l pr o du c t of lab o r i s

MP L = oQ = bAK aU - 1 = b . g

o

L

L

Th e MP K a nd MP L a re p osi ti ve a nd dimini s h i n g t hr o u g h o ut (i.e ., t h e Co bb - D o u g l as pr od u c t io n f un c t io n ex- hibits only s ta ge II o f prod uc ti o n for c apit a l a nd l a b o r ).