Technology and Production

Technology determines how inputs can be transformed into

outputs. Inputs can be generalized to two classes.
Capital K Physical resources, materials, assets, etc.
Labor L Man hours, number of workers, sweat and toil.
Brett Devine Production Theory
Production Functions
A production function expresses the technology by mapping a pair
(K, L) to a quantity of output q. Mathematically we have
q = f (K, L)
Production functions have important properties like returns to
scale. Isoquants for production functions are like indierence
curves for utility functions. An isoquant is all the combinations of
K and L that can be combined to produce a specic output q.
Brett Devine Production Theory
Marginal Product and Average Product
The marginal impact of an input on output can be found through
partial derivatives. If we increase capital by one unit, or if we hire
one more person, how many more units will we produce?
Marginal Product of Capital Denoted MP
K
=
f (K,L)
K
Marginal Product of Labor Denoted MP
L
=
f (K,L)
L
Sometimes we want to know on average how many units of q we
are producing per unit of capital or labor.
Average Product of Capital Denoted AP
K
=
f (K,L)
K
Average Product of Labor Denoted AP
L
=
f (K,L)
L
Brett Devine Production Theory
Common Isoquants
Some common production functions and their isoquants are:
Cobb-Douglass Convex bowed in isoquant.
CES Convex bowed in isoquant, some what special
curve.
Fixed Proportion L shaped, or kinked isoquants.
Perfect Substitutes Straight, parallel lines for isoquants.
Brett Devine Production Theory
Law of Diminishing Returns and the MRTS
In general many production functions adhere to the Law of
Diminishing returns. If MP
K
and MP
L
get smaller as we increase
K and L then they diminish.
The slope of the isoquant has an important interpretation, just the
the slope of indierence curves. The slope of the line expresses the
tradeos between capital and labor that can produce the same q.
The ratio of marginal products is called the Marginal Rate of
Technical Substitution.
MRTS
K,Y
=
MP
L
MP
K
Brett Devine Production Theory
Returns to Scale
Returns to scale describes how output changes as we scale the
inputs up or down.
Increasing Returns Doubling inputs more than doubles output.
Constant Returns Doubling inputs exactly doubles output.
Decreasing Returns Doubling inputs less than doubles output.
How do you determine the returns to scale?
Brett Devine Production Theory
Checking Returns to Scale
Let q = f (K, L) be our production function. Now let t > 0. We
proceed as follows: multiply all inputs by t, i.e., f (tK, tL). Now
pull the ts out and check the exponent. Suppose q = AK
0.75
L
0.50
then
A(tK)
0.75
(tL)
0.50
= At
0.75
K
0.75
t
0.50
L
0.50
= t
0.75
t
0.50
AK
0.75
L
0.50
= t
0.75+0.50
f (K, L)
= t
1.25
f (K, L)
Since exponent is greater than 1, we have increasing returns to
scale.
Brett Devine Production Theory
Prot Maximizing Firms
Firms seek to maximize their prot. If p is the price of the good
they sell, w the wage rate, and r the rental rate of capital, then
= pf (K, L) rK wL
The rm takes p as given and needs to choose K and L to
maximize prot.
Brett Devine Production Theory
Cost
Firms cannot produce for free. They experience several types of
costs.
Explicit Costs Labor costs: wage rate and Capital costs: rental
rate.
Implicit Costs Economics keeps track of opportunity cost which is
implicit in economic decisions.
Sunk Costs Costs that have already been incurred. You cant
recover them.
Long Run Costs No xed costs, all costs are variable in long run.
Brett Devine Production Theory
Cost Minimization
Firms that prot maximize also cost minimize.
When maximizing prots, the rm has to payout rK + wL in
costs.
Firms nd a prot maximizing quantity q

to produce and
then need to choose the best (K, L) combo to produce q

.
The best (K, L) pair is the cheapest one that still produces
q

.
The cost function, C(r , w, q

) tells us the minimum possible

cost of producing q

units at input prices r and w.

Brett Devine Production Theory
Finding Cost Functions
We nd the cost function by solving the Cost Minimization
Problem (CMP). The problem is solved using the Lagrangian
function. The process is similar to utility maximization with the
Lagrangian.
min rK + wL

costs
s.t. q

= f (K, L)

prod constraint
L = rK + wL + (q

f (K, L))
Brett Devine Production Theory
Necessary Conditions
Take the partial derivatives of the Lagrangian with respect to K, L,
and .
L
K
= r
f (K,L)
K
= 0 (1)
L
L
= w
f (K,L)
L
= 0 (2)
L

= q

f (K, L) = 0 (3)
Brett Devine Production Theory
Necessary Conditions
Manipulating equations 1,2, and 3 from the last slide we can reduce
the 3 conditions down to 2 conditions that should look familiar.
MRTS
K,L
=
MP
L
MP
K
=
w
r
Tangency Condition
q

= f (K, L) Production Constraint Satised

Use the above conditions to solve for K

and L

as functions of
(r , w, q

).
Brett Devine Production Theory
Properties of Cost Functions
Cost functions are functions of input prices r ,w and a
production constraint q

.
Cost is increasing in q

.
Cost is increasing in (r , w) together, not necessarily
individually.
Note: The cost function is frequently called the Total Cost
function and may only be a function of q in some problems.
Brett Devine Production Theory
Expansion Paths
Given r and w as xed, whenever we give the rm a production
quota q, the cost function will return the minimum cost of
producing q and will implicity choose the cheapest combination of
K and L. The rms expansion path is the set of cost minimizing
tangencies. We can trace out the expansion path be seeing where
all the optimal choices of (K, L) are for all levels of production q.
Brett Devine Production Theory
The Other Cost Functions
There are several important manipulations of the cost function
that are used for economic analysis.
Marginal Cost This is dened as MC =
C(r,w,q)
q
.
Average Cost This is dened as AC = C(r , w, q)/q which is just
average cost per unit produced.
Brett Devine Production Theory
Very Shortrun, Shortrun and Long Run
Decisions made by rms often require careful planning and are
aected by limitations on resources and time. It is important to
realize how a rm is capable of reacting to changes in the market
within certain time frames.
Very Shortrun Both capital K and labor L are xed.
Shortrun Only capital K is xed, labor L is free to be adjusted.
Longrun Neither capital K, nor labor L is xed, both are free
to move and be adjusted.
Brett Devine Production Theory
Shortrun Average Cost Curves
It can often be easier to analyze costs on a per unit produced basis
rather than just the total cost overall. The Shortrun idea
mentioned previously can yield us a Shortrun Total Cost function
by xing k. We dene the per-unit produced basis as Shortrun
Average Cost:
SAC =
shortrun total costs
total shortrun output
=
STC
q
In the Longrun nothing is xed and so capital and labor are
perfectly adjustable.
Brett Devine Production Theory