Beruflich Dokumente
Kultur Dokumente
Reading
BFD Chapters 6 and 7.
LC Chapter 6.
Production functions
Reading
LC Chapter 6 p.117.
Previously we have
used the letter C to
refer to Capital; from
here on we will use the
letter K, which is the
normal convention in
economics.
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02 Introduction to economics
is divisibility, we can talk of any fraction of a unit that can affect output.
While some may have difficulties with this, we shall not consider it as a
serious problem. Substitutability is a much more difficult problem.
Consider linear production processes, and assume that we have three
different such production processes, or technologies: T1, T2 and T3. Each
technology requires different combinations of inputs in the production
process, as indicated by the slope of the rays through the origin.
Furthermore, assume that we cannot increase output by merely increasing
one of the inputs. We must use both and maintain the same proportions
between them. (This is called a Leontief-style production function.) So,
in the case of A in process 1, you need L10 units of labour and K10 units of
capital to produce 1 unit of X (Figure 3.2).
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02 Introduction to economics
96
b. The marginal product (MP) of Capital and Labour: Defines the increase
in output for a one-unit increase of a particular input, keeping the
other one constant:
at L0 for a given level of the other input (K)
We typically assume that the marginal product is increasing for low levels
of an input, but decreasing for high levels. This is referred to as increasing
and diminishing returns to a factor, respectively. This assumption yields
a graph as in Figure 3.4, which depicts the level of output attainable
for every level of one input (here, Labour), keeping the level of the other
input (here, Capital) constant
c. Isoquants: Combinations of K and L which yield the same level of
output are arranged on a curve going through regions IV and II in
Figure 3.3 above. This curve is called the isoquant, and is defined
for every level of output.
d. The slope of the isoquant is defined as dK/dL when X is
unchanged. If we change L by dL, output will change by dL MPL[HS1],
given property (b) above. In the same way, if we change K by dK,
output will change by dK MPK. Along the isoquant, the change in
output as a result of a change in K has to equal the change in output as
a result of a change in L. Hence:
dL MPL = dK MPK
which implies
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02 Introduction to economics
Returns to scale
Let X denote output. K and L denote the two factors of production, capital
and labour respectively, and f represents the production function:
X = f(L,K).
Returns to scale is a measure of how effective an increase in the scale
of operation would be.
Increasing returns to scale means that the proportionate increase
in output is greater than the proportionate expansion of operations.
Constant returns to scale means the increase in output is
proportionately the same as the increase in operations.
Decreasing returns to scale means that the proportionate increase
in output is less than the proportionate expansion of operation.
In the context of production functions, the scale of operation is
captured by the amount of inputs used. When we talk about changes in
scale we normally mean a change across all inputs. However, you will see
later on that the composition of inputs depends on their relative price, so
the scale of operation would normally relate to the price of the output.
Therefore, a change in scale does not alter the composition of inputs, it
only affects the level of their use. An increase in the scale of production
means that we have increased all inputs by a certain proportion. The
return of this change is measured by the proportionate increase in
output.
98
At point B, output too has increased. Let us suppose that XB = XA, which
means that output increased by . Whether or not there are increasing,
constant or decreasing returns to scale depends now on whether is
greater, equal, or less than .
A simple way to look at this issue is by examining functions which have a
special property: homogeneity. This can be defined as follows:
Definition 6
f (X1, , Xn) will be called homogenous of degree t if for all X1, , Xn in its domain
and for all , f (X1, , Xn) = tf (X1, , Xn).
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02 Introduction to economics
Notice (in the right-hand diagram) that at first, fixed increments in output.
require ever-decreasing increases in inputs (which means increasing
returns to scale). Later, one can see that fixed increases in output require
ever-increasing increases in inputs (in other words decreasing returns to
scale).
The corresponding points in the left-hand diagram depict the firms growth
of output when all inputs are increased by the same proportion, along the
ray through the origin. When production functions have the property of
homogeneity, this ray will also become the firms expansion path. This
path depicts all the optimal combinations of inputs with which one can
produce a chosen level of output for given factor prices. As both inputs
change here, this is called the long-run expansion path. We will
discuss the difference between long run and short run in a little while.
M
!
In the short run we assume that not all inputs are variable, unlike the
case considered above, when we looked at the long-run expansion path.
In this case, where there are only two inputs, it means, for instance, that
the quantity of capital (K) is given and we can only change output by
changing the other input, labour. Figure 3.8 depicts the production
function when capital is fixed at a level K0.
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02 Introduction to economics
M
In the right-hand graph of Figure 3.8, the slope of the ray from the origin
to any of the three points A, B, C is of the form X/L. This is precisely the
average product of an input, the AP. We can see how it increases between
A and B and diminishes afterwards. At point B, where the slope (the AP), is
at its highest, the slope of the ray equals the gradient of f, and thus equals
MPL. Figure 3.9 depicts these relationships.
102
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For a given level of cost c0, the firm can choose all combinations of labour
(L) and capital (K) that are within its budget constraint. The rate at
which the firm can substitute capital for labour is given by the market
exchange rate, which is the relative prices of capital and labour,
here defined as w0/r0 units of capital per labour.
The highest level of output which is now feasible is given by the highest
isoquant. The choice of input combinations is therefore determined at
the point where the isoquant (derived from the production function) is
tangential to the isocost (the firms budget constraint). At that point,
the slope of the isocost, which is the market rate of exchange between
capital and labour, is the same as the slope of the isoquant. The latter is
really the technological rate of substitution between capital and labour.
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02 Introduction to economics
This solution implies that at the optimal point, the firm will gain no extra
profit by exchanging labour and capital at the margin. If the firm gives
up some labour, but wants to keep the level of output constant, then the
amount of extra capital needed will cost exactly the amount saved by
reducing labour, leaving the total cost of production unchanged. Point B in
Figure 3.10 is clearly not optimal. If the firm gave up one unit of labour
it would need units of capital to remain at the same level of output. But
in the market place, it can get ( + ) units of capital per unit of labour.
This means that the firm can improve its performance through market
operations, changing the technology it uses.
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"
For any given relative factor prices we can get the set of all points where
the firm is producing optimally. These points, captured in Figure 3.11,
are what we call the firms expansion path. It is a long-run expansion
path as all means of production vary in the process of expansion.
In the case where the production function is homogeneous, the expansion
path will be a straight line.
So far, however, we have only talked about the choice of technology (input
composition) which constitutes optimal choice. We have not yet dealt with
the question of how much X to produce. The answer to this depends on
the relationship between output (X) and the isocost lines. This relationship
is explored in the next section.
"
For higher level of outputs (beyond point A), we assume the process
exhibits decreasing returns to scale. Every further increase in output
will require ever-increasing increases in inputs. This means that, for
fixed prices, the total cost of production will increase faster and faster.
See Figure 3.12 for the derivation of the total cost curve from the
production function.
3. Marginal costs: the change in total cost C that results from a change
in output X.
MC is therefore dC/dX. We can clearly see that this is the gradient
of the cost function in the above diagram. Notice that Marginal
Cost and Returns to Scale are inversely related. When there are
increasing returns to scale, there will be diminishing marginal cost.
The production of every extra unit of output will require decreasing
increases in inputs and thus, decreasing cost per extra unit.
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02 Introduction to economics
5. Short run: In the short run, one of the means of production is fixed (the
capital used to set up the production facility, for example) and its costs
are independent of the quantity produced, because we cannot change
the quantity of it that is used. The cost function, therefore, is divided
into two elements:
Fixed Costs (FC), and Variable Costs (VC), which remain a function of
output: VC(X). Hence, we define the Short Run Total Cost as:
SRC = FC + VC(X)
To see how the SRC function behaves, we only have to recall the shortrun production function. The short-run production function has the same
shape as the long-run production function, though for different reasons.
Translating it into a cost function repeats the argument we had for the
long-run. Assume that the amount of capital used is fixed, and that we
can only vary the amount of labour used in the production process.
Whenever marginal product is rising, the cost of an extra unit (the
marginal cost) will be decreasing. This is so because increased
productivity means that one would need less labour than one needed
before for an extra unit of output.
Therefore, the VC(X) part of the SRC behaves in exactly the same
way as the LRC, and has the same general shape. The only difference,
therefore, will be the position of the SRC. Figure 3.13 depicts the
relationship between the long- and the short-run cost functions:
*
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1
1
!
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"
*
Given input prices w0 and r0, our long-run level of output X would have
been produced using a K/L ratio (representing a particular choice of
technology) according to the long-run expansion path, which connects
all points where the slope of the isocost lines is equal to the slope of
the isoquants (points such as A or B). If, say, K is fixed at K0 in the
short run, the short-run expansion path is given by the horizontal line
at K0. Clearly, only at point A (and, associated with it, an output level
X0) would the firm be able to use the same combination of K and L in
both the long run and the short run (so for this output level, the level
at which capital is fixed in the short run is exactly the level that would
have been chosen without such a constraint, i.e. in the long run).
106
At other levels of output, say a lower level such as X1, the combinations
of K and L used would be different in the long and short run, due to
the fixed amount of capital available. Given the shape of isoquants,
this means that the cost of producing X1 in the short run (at C) must be
higher than the cost of producing the same amount in the long run (at
B): C is on a higher isocost line than B.
Show that this holds true for output levels above X0 as well.
We can see the intuition behind this by noting that firms try to
maximise profits given a number of constraints, such as their available
technologies, input prices and the price they can charge for the output
they produce. If we now introduce an extra constraint (for example the
constraint that capital is fixed in the short run), it is clear that we are
not making the firms job any easier. That is, we cannot be lowering
its cost of production. At best (for an output level X0), the cost stays the
same; for other output levels, it will increase.
6. The relationship between long-run and short-run average cost (LRAC
and SRAC):
&
&
The top part of Figure 3.14 again shows the Long-Run and Short-Run
Total Cost functions. As before, we can find the average costs for each
level of output by calculating the slope C/X of a ray from the origin. Given
the shape and position of the SRC and LRC discussed before, we can see
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02 Introduction to economics
that for any given level of output, the slope of the ray that reaches the SRC
must be at least as great as that of a ray reaching the LRC. Therefore, the
SRAC will be greater than or equal to the LRAC. Equality is achieved only
when the long run and the short run use the same input combinations.
Application
Let us analyse the effects of a fall in the wage rate on the long-run cost.
where dP/dX is the derivative of the demand function. It shows how the
price will change if output is changed. As dP/dX <0, it is clear that MR(X)
< PX(X); that is, the MR(X) curve will normally lie below the demand
schedule.
Are there any situations in which this would not be true?
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02 Introduction to economics
Now that we have studied the revenue function, we can add it to the cost
function which we studied before. Recall that (X) = R(X) C(X). For a
firm in a perfectly competitive market, we can thus derive the following
profit function:
Figure 3.16: Cost, revenue and the profit function for a perfectly competitive
market.
110
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02 Introduction to economics
A numerical example
Production functions
Consider the production circumstances of a good X which requires only
one input (labour) for production. The technology available has the
following results:
L
TP = X
AP = X/L
MP = dX/dL
24
12
15
42
14
18
60
15
18
75
15
15
87
14.5
12
96
13.7
101
12.6
101
11.2
10
95
9.5
Figure 3.18 depicts how total product (TP), average and marginal
product (AP and MP) change with the change in input (L). You can also
see how they relate to each other.
Notice that as long as the marginal product is greater than the average
product, the latter is rising. This is because the marginal product describes
the contribution of the last unit of input. As long as this contribution
112
is greater than the average, the average will have to rise. In brief, what
you see is that the AP is at its highest when it is the same as the marginal
product. If the marginal product is diminishing, every extra unit of output
will require more and more inputs. Thus, the product per input will have
to fall. The reason why it does not fall immediately when marginal product
begins to fall is that the increases in output at the beginning were so great
that it takes a much sharper decline in productivity to change the direction
of the average product.
Cost functions
Suppose now that the production of X requires a licence which costs
1,130.
A labour unit costs 900 (for the duration of the production process). We
can therefore distinguish between fixed costs (FC) which are unaffected
by the level of output produced, and variable costs (VC), which reflect the
level of production. Together, these give the total cost (TC) of producing a
given level of output X:
TC = FC + VC
The average cost (AC) is simply TC/X. Naturally, average cost is the sum
of the AFC (= FC/X) and AVC (= VC/X). The marginal cost (MC) is the
change in cost per extra unit of output. Evidently, this change will depend
on the productivity of labour. The more productive labour is, the less
labour units will be required for the production of one unit of output.
For instance, one unit of labour may produce 9 units of X. Hence, one X
would require 1/9 units of labour. Note from the previous table that 9 is
the marginal product of the first labour unit. Hence, the amount of labour
required for the production of one unit is always 1/MP. As we pay W =
900 per labour unit, the cost of one unit of output will be [900 1/9] =
100. In general, therefore, we can write:
Given this information, we can calculate the cost functions for the firm:
L
TP = X
FC
VC
TC
AFC
AVC
AC
MC
1130
900
2030
125.6
100.0
225.6
100
24
1130
1800
2930
47.1
75.0
122.1
60
42
1130
2700
3830
26.9
64.3
91.2
50
60
1130
3600
4730
18.8
60.0
78.8
50
75
1130
4500
5630
15.1
60.0
75.1
60
87
1130
5400
6530
13.0
62.1
75.1
75
96
1130
6300
7430
11.8
65.6
77.4
100
101
1130
7200
8330
11.2
71.3
82.5
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02 Introduction to economics
Profit maximisation
Suppose now that the firm can sell a unit of X for 100. We shall also assume
that whatever the firm does, it will not affect the market price as the firm is
too small. Hence, the revenue of the firm is PXX and the marginal revenue
(the revenue of the last unit sold) will be the price PX. The following table
describes the situation of the firm under various levels of production.
TP
TVC
TC
MR
MC
AVC
AC
100
1130
130
100
900
900
2030
1130
100
100
100.0
225.6
24
100
2400
1800
2930
530
100
60
40
75.0
122.1
42
100
4200
2700
3830
370
100
50
50
64.3
91.2
60
100
6000
3600
4730
1270
100
50
50
60.0
78.8
75
100
7500
4500
5630
1870
100
60
40
60.0
75.1
87
100
8700
5400
6530
2170
100
75
25
62.1
75.1
96
100
9600
6300
7430
2170
100
100
65.6
77.4
101
100
10100
7200
8330
1770
100
180
80
71.3
82.5
Since our purpose in using economics is to describe the world around us,
we have to be aware that the firm is a much more complicated structure
than the abstract notion of a profit maximiser might suggest. This does not
necessarily mean that our representation of those firms as simple profit
maximisers is not true: it might be a fairly good description of how firms
actually behave. Nonetheless, it is useful for us to spend some time looking
at how the organisation of a firm might influence (and be influenced by)
its economic environment.
There are two separate issues which we have to consider when we
examine the organisation of the firm. First, given the current structure of
corporations, where ownership is in the hands of shareholders who are not
the managers, it is not obvious that the managers would necessarily have
the interest of the shareholders close to their hearts.
There is little doubt that the shareholders would want the managers to
maximise profit. Most shareholders are not involved in the firm, and
they have no other consideration apart from profit maximisation. The
managers, on the other hand, are working in the corporation and must
consider the interests of other groups with whom they are in daily contact.
They are salaried, and so their earnings may be slightly less sensitive to
changes in the performance of the corporation than the income of the
shareholders would be (shareholders receive their income in the form of
dividends or of capital gains from selling shares).
Consequently, the shareholders, who have the power to appoint or sack
the managers, will face what is called the principal-agent problem. The
shareholders are the principals who want their agents (the managers) to
maximise profit. The managers have a great informational advantage over
the shareholders, who are less familiar with the issues associated with
running the corporation and are therefore susceptible to all kind of excuses
and stories which the managers can put forward to justify their actions
(and the subsequent reduced profit). The question for the shareholders,
therefore, is how to write a contract that would give the managers the
incentive to maximise profits. One of the most common incentives is some
form of performance-related pay, but whether this actually provides a
sufficient incentive for the managers is a different story.
The second and far more important issue is how the firm (or corporation)
evolved and how it might change. Put differently, why do we have
corporations in the first place?
These are very difficult and important questions to which all economists
must pay attention. Unfortunately, economic theory has not produced any
theories that would do justice to the importance of the question. If we
understood why corporations exist, we would be able to understand how
they operate, what will make them succeed and what will change them.
In this context, I would like to draw your attention to two approaches
to the problem. First we have the real evolutionary approach. This
approach examines how and why corporations have been formed over
the years. For instance, when comparing the evolution of Russian and
Indian village communities, some authors have found that while the
sense of kinship among Indian village communities has decreased, that
among Russian communities remains very strong. A possible explanation
for this phenomenon is that while Indian village communities are located
in relatively populated areas, the Russian villages were located in a vast,
much emptier area. This allowed dissenting groups of people to move
away from existing village communities and set up new ones.
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02 Introduction to economics
Self-assessment
Check your knowledge
Check back through the text if you are not sure about any of these.
Define the concepts of productive efficiency, isoquants and iso-cost,
marginal and average product, constant returns to scale, transaction
costs, diminishing marginal return fixed and variable costs, the
relationship between marginal and average costs.
Use these definitions to give examples of increasing returns to scale, the
interrelation between marginal cost and returns to scale, homogeneous
production function, and profit maximisation with respect to output
and the firms supply curve.
Construct cost-functions and derive their relation to the production
function.
Use diagrams to analyse problems involving short-run and long-run
average cost schedule.
Give an example of:
increasing returns to scale
the inverse relationship between marginal cost and returns to scale
a homogeneous production function.
02 Introduction to economics
Answers
Question 1
a. Deriving long-run average cost. The key issues here are:
associating the shape of the long-run cost function with the relevant
properties of the production function; recognising that average costs
can be depicted by the ray from the origin; deriving the average cost
from the change in the slope of that ray from the origin. All of these are
in the domain of testing ones familiarity with various models.
b. Here, as in part (a), we need a simple exposition of material which is
covered in great detail in the present chapter. First, students should
demonstrate that they recognise the role of fixed costs in the distinction
between the long and the short run. An explanation of the short-run
cost curve and its position relative to the long-run curve is essential.
c. The derivation process should be explained carefully, where we
compare the ray from the origin (the average cost) which is associated
with the long-run cost curve with that ray which is associated with the
short-run curve.
d. Here, the more analytical part of the question begins. The statement
suggests that as we can always produce less with those means of
production which we have, there is no reason why producing less
than the level of output for which both short- and long-run cost
coincide, should cost more than it would if we could vary all means of
production.
The choice of framework here is crucial and, as you see below, it is the
firms optimal choice in the production factors plane:
Figure 3.20
118
Figure 3.21
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02 Introduction to economics
Figure 3.22
The answers to (b) and (c) are self-evident from Figure 3.22.
Question 3
a. The issue here is a recurring one: why should the short-run cost lie
everywhere above the long-run cost except at one point only? I am
sure that many of you will produce here the familiar picture shown in
Figure 3.23.
Figure 3.23
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Figure 3.24
"
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Figure 3.25
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02 Introduction to economics
Figure 3.26
Figure 3.27
While the long-run average cost will be falling, the short-run average
cost should have its normal U-shape as increasing returns to scale is a
long-run property of the cost function.
123