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Production Theory

and Estimation

EC611--Managerial Economics

Dr. Savvas C Savvides, European University Cyprus


The Organization of Production

Inputs (the factors of production and material


things that go into the production of goods
and services):
ÎLabor, Capital, Land, Raw materials
Fixed Inputs (inputs that don’t vary with the
level of output):
ÎPlant, machinery, bank loan, permanent staff
Variable Inputs (inputs that vary with the
level of output):
Îhourly labour, raw materials

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Choosing output
COSTS REVENUES
Technology
& costs of Demand
hiring curve
factors of production

TC curves AC
(short & (short & AR
long run)
long run)
CHECK: produce in SR?
close down in LR?
MR
MC Choose output level
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The Production Function
The amount of output produced depends upon the
inputs used in the production process
The production function specifies the maximum
amount of output which can be produced with
specific level of inputs, given the level of existing
technological know-how (table, equation, or graph)
In general form, a production function may be
expressed as:
Q = f ( X1 , X2 , X3 , … , Xk )
where the X’s are the various inputs used
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Short-run vs. Long-run

The short run is the period in which a firm


can make only partial adjustment of inputs
e.g. the firm may be able to vary the amount
of labour, but cannot change capital.
The long run is the period in which a firm
can adjust all inputs to changed conditions.

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Prod. Function:One Variable Input
Let’s assume labour is the only variable factor (with capital fixed)

Total Product TP = Q = f(L)


∆TP dTP
Marginal Product MPL = = dL
∆L
The marginal product of labour is the partial derivative of output
with respect to the variable factor (in this case labour), but
holding constant the inputs of other factors.
Example: What is the MPL of Q = 6L2 – 0.2L3
Answer: We take first derivative of the equation w.r.t. L
Î MPL = dQ / dL = 12L – 0.6L2

Average Product Î APL = TP / L Î (6L2 – 0.2L3)/L = 6L – 0.2L2


Output Elasticity Î EL = MPL / APL Î (12L– 0.2L2)/(6L – 0.2L2)

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Prod. Function:One Variable Input
Q= MPL =
L 6L2 – 0.2L3 12L – 0.6L2
APL=
6L – 0.2L2
EL=
(12L– 0.2L2)
/(6L – 0.2L2)

0 0 0 - -
2 22.4 21.6 11.2 1.93
4 83.2 38.4 20.8 1.85
6 172.8 50.4 28.8 1.75
8 281.6 57.6 35.2 1.64
10 400 60 40 1.5
15 675 45 45 1
20 800 0 40 0
25 625 -75 25 -3
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Prod. Function:One Variable Input
1000

500
Output

-500
1 2 3 4 5 6 7 8 9 10
Labor 0 2 4 6 8 10 15 20 25 26
Output 0 22.4 83.2 172.8 281.6 400 675 800 625 540.8
MPL 0 21.6 38.4 50.4 57.6 60 45 0 -75 -93.6
APL 0 11.2 20.8 28.8 35.2 40 45 40 25 20.8
Labor

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The Law of Diminishing Returns

Holding all factors constant except one, the law


of diminishing returns says that:

Îbeyond some value of the variable input,


further increases in the variable input lead to
steadily decreasing marginal product of that
input.
e.g. trying to increase labour input without
also increasing capital will bring diminishing
returns.

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The Three Stages of Production
900
800
700
600 Stage I
Stage II
500
400 Stage III

300
200
100
0
-100 1 2 3 4 5 6 7 8 9 10
0 2 4 6 8 10 15 20 25
-200

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The Three Stages of Production

Stage I

Stage II
Stage III

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Marginal Revenue Product
The Marginal Revenue (or Value) Product of Labour is the
extra (additional) revenue (benefit) that the firm receives
from production by an extra (additional) worker.
Î MRPL = ∆TR /∆L = d TR / dL
Recall that TR = f(Q) and Q = f ( L)
ÎThen, by the “Function-in-a-function (Chain) Rule” of
differentiation, we have
Î dTR/dL = (dTR/dQ) * (dQ/dL)
(We get the same result if we multiply and divide by dQ).
Î = MR * MPL
In perfect competition, where firms are price-takers,
MR = P, then
Î MRPL = MPL * P
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Optimal Use of the Variable Input

Marginal Resource ∆TC dTC


MRCL = =
(Factor) Cost ∆L dL
As long as the incremental market value of the extra output
produced (that is, the marginal revenue brought in) is greater than
the cost of hiring the extra labour (the cost of wages), then the firm
should go ahead and employ the extra labour.
Remember that MRPL = MPL * P (the price of the product).

Profits are maximized where the marginal revenue brought in (the


MRPL) is exactly equal to the cost of labour to be employed, or
where: MRPL = w The simple case can be illustrated with a
constant wage rate (horizontal wage line w).

Optimal Use of Labor MRPL = MRCL


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Marginal Revenue Product
Assume that the selling price of the product (equal to MR
in perfect competition) is £10 and the wage rate is £600

Q= MPL =
L 6L2 – 0.2L3 12L – 0.6L2
MRPL=
MPL * P
W

0 0 0 0 600
2 22.4 21.6 216 600
4 83.2 38.4 384 600
6 172.8 50.4 504 600
8 281.6 57.6 576 600
10 400 60 600 600
15 675 45 450 600
20 800 0 0 600
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Optimal Use of the Variable Input
MRPL = MPL * MR
The marginal revenue product of labour is the revenue
obtained by selling the output produced by an extra worker
Wage, MRPL

With diminishing marginal productivity,


the firm maximizes profit when the
marginal cost of employing an extra
worker equals the MRPL...

W0 …this occurs at E where w = MRPL.


£600 Employment is L*.

Below L*, extra employment adds


more to revenue than to labour costs.
MRPL Above L*, the reverse is so.
This decision is consistent with the rule
10
L* Employment MR = SMC for maximizing profit.
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Optimal Use of One Input--Example
Example:
A producer of pocket calculators has a fixed amount of plant and
equipment (capital), but can vary the number of workers. The
production function is given by the following relationship:
Q = 98L – 3L2
Being a small producer, the firm can produce and sell all its output at £20
each (Î MR=20). It can also hire as many workers at £40 per day (Î
MC=40).
Question: How many workers should the firm hire per day?

Answer: The optimization Rule is: MRPL = MCL


Î MPL = dQ/dL = 98 – 6L
Î MRPL = 20(98 – 6L) since MR = 20
Î To max Profits: MRPL = MCL
Î 20(98 – 6L) = 40 since MC =40
L = 16
Thus, in order to max Profits, this firm should hire 16 workers per day.
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Representative Prod. Function
Assume two inputs, labour and capital:
Q = f(L, K)
C Output Quantity (Q)
a
6 10 24 31 36 40 29
p
i 5 12 28 36 40 42 40
t 4 12 28 36 40 40 36
a 3 10 23 33 36 36 33
l 2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6
Labour
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Prod. Function:Two Inputs
Q = f(L, K)
C Output Quantity (Q)
a 6 10 24 31 36 40 29
p
i 5 12 28 36 40 42 40
t 4 12 28 36 40 40 36
a 3 10 23 33 36 36 33
l 2 7 18 28 30 30 28
1 3 8 12 14 14 12

1 2 3 4 5 6
Labour
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Prod. with Two Inputs: Isoquants

Isoquants show combinations of two inputs


that can produce the same level of output.

Isoquants

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Prod. with Two Inputs: Isoquants
Firms will only use combinations of two inputs
that are in the economic (or “feasible”) region
of production, which is defined by the portion
of each isoquant that is negatively sloped.

Ridge Lines

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Marginal Rate of Technical Substitution

Recall that all points on an isoquant refer to the same level of


output. Therefore, moving down an isoquant, the gain in Q from
using more L must be equal to the loss in Q from using less K.
That is, (∆L)(MPL) = - (∆K) (MPK)
Î MRTS = MPL/MPK = -∆K/∆L (slope of isoquant)

Example
For Isoquant 12,
moving from point N to
point R: ∆K= -2.5 ∆L=1
MRTS = -(-2.5/1) = 2.5

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Substitute & Complement Inputs

Perfect Substitutes Perfect Complements

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Optimal Combination of Inputs

Isocost lines represent all combinations of


two inputs that a firm can purchase with the
same total cost. It is basically the budget line
of the firm.
C = wL + rK C = Total Cost
w = Wage Rate of Labor ( L)
C w
K= − L r = Cost of Capital ( K )
r r
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Optimal Combination of Inputs
Isocost Lines
With w = £1, r = £2 and a budget of £50 we have Isocost 1.
K = (50 / 2) – 1 / 2 ( L ) = 25 – 0.5 L Slope = - 0.5 Intercept = 25

If the budget increases to £60, then the isocost line shifts to the right.
The slope w / r (or relative price ratio of the two inputs) does not
change. Only the intercept (C / r ) changes.

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Optimal Combination of Inputs
Changes in Relative Prices of Inputs
If wages drop to w = £0.75, r = £2 (and original budget of £50), the
isocost line rotates outward to the right on the horizontal (labour) axis.
K = (50 / 2) – 0.75 / 2 ( L ) = 25 – 0.375 L
Slope = - 0.375 (vs. - 0.5 before) Intercept = 25 (same as before)
If w = 1.25 Î slope is 0.625. Isocost rotates inwards. (same intercept)

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Optimal Combination of Inputs
The optimum input combination is reached where the firm
is able to attain the highest possible isoquant with the
available budget (represented by the isocost).
MRTS = MPL/MPK = -∆K/∆L (slope of isoquant)
MRTS = w/r (slope of isocost)
MPL/MPK = w/r Î ( MPL/ w ) = ( MPK / r)

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Optimal Combination of Inputs
Example:
Assume that the MPL= 40 units of output and MPK=120 units.
Assume also that w= £20 and r = £30.
(a) Why is this firm not max. Q or min. Costs?
(b) How can the firm max. Q or min. Costs?
Answer:
(a) Because ( MPL/ w ) = 40/20 = 2
whereas ( MPK / r) = 120/30 = 4
(b) By hiring fewer workers and using more capital. This
way, MPL increases and MPK decreases. This process
will continue until Î ( MPL/ w ) = ( MPK / r)
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LR Production:Returns to Scale
Returns to Scale refers to the proportionate change in output
resulting from a certain change in inputs.This is a LR concept.
Production Function Q = f(L, K)
λQ = f(hL, hK)
If λ > h, we have increasing returns to scale.
If λ = h, we have constant returns to scale.
If λ < h, we have decreasing returns to scale.
Returns to scale can also and readily be measured using
the output elasticity:
EL = 1 (CRTS) EL > 1 (IRTS) EL < 1 (DRTS)
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Long Run: Returns to Scale
Constant Increasing Decreasing
Returns to Returns to Returns to
Scale Scale Scale

λ=h λ>h λ<h


100% = 100% 200% > 100% 50% < 100%
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Economies and Diseconomies of Scale
Reasons for Economies of Scale

Specialization: As a firm’s scale of operations increases, there are more


opportunities for developing specialization in the use of inputs as well. This
reduces unit costs

Dimensional Factors / Indivisibilities: As the scale of operations increase, firms


are able to economize on certain inputs which do not have to be employed in the
same proportion as the scale of operations has increased. This is true especially
of certain fixed costs (large capacity machinery, a large telephone electronic
switchboard, etc) or head office overhead expenses (marketing, accounting
managerial staff).

Reasons for Diseconomies of Scale


One of the major reasons firms may experience increasing unit costs as their
operations increase is that the complexities of management structures means that
they are less efficient (more bureaucratic) with many layers of supervision and
authority. Besides the costs of these management structures, decision-making is
inefficient. Think of the complex managerial structure of a multinational company.
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Empirical Production Functions
Cobb-Douglas Production Function
Q = AKaLb
Such production functions can be estimated using natural
logarithms to “linearize” the function in order to use
regression techniques:

ln Q = ln A + a ln K + b ln L
The values of a and b as estimated from the above equation
are the respective output elasticities of Labor and Capital.
If a + b = 1 Î constant returns to scale
If a + b > 1 Î increasing returns to scale
If a + b < 1 Î decreasing returns to scale
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Innovations and Global Competitiveness

Innovations are perhaps the single most important determinant of


a firm’s LR competitiveness
Product Innovation—introduction of new or improved products
Process Innovation—Introduction of new or improved production
process (process re-engineering)
Ægiven same resources there’s a shift outward of the isoquant
Both product and process innovation are, and should be, continuous
and may be in the form of small “doses” rather than through “big
bang” breakthroughs.
Keen competition at home and abroad usually stimulates
innovations.
There are frequently high risks in the introduction of innovations.

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Innovations and Global Competitiveness
Product Cycle Model—innovating companies eventually
lose market share (locally and internationally) due to
cheaper imitators. The lead time by innovators in
exploiting the benefits of their innovations is becoming
shorter.
Just-In-Time Production System—process innovation
often provides a much longer time for exploiting the
benefits and much bigger returns (ROCE) because of
long-lasting economies (higher efficiency, lower
inventories, etc)
Competitive Benchmarking

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