On Production Function

PPA 723: Managerial
Economics
Lecture 10:
Production
Managerial Economics, Lecture 10: Production
Outline

Production Technology in the Short Run

Production Technology in the Long Run


Production
A production process transform inputs
or factors of production into outputs.

Common types of inputs:
capital (K): buildings and equipment
labor services (L)
materials (M): raw goods and processed
products.

Production Functions
A production function specifies:

the relationship between quantities of
inputs used and the maximum quantity of
output that can be produced

given current knowledge about technology
and organization.

For example, q = f(L, K)

Short Run versus Long Run
Short run: A period of time so brief that at
least one factor of production is fixed.

Fixed input: A factor that cannot be varied
practically in the short run (capital).

Variable input: a factor whose quantity can
be changed readily during the relevant time
period (labor).

Long run: A time period long enough so that
all inputs can be varied.

Total, Average, and Marginal
Product of Labor
Total product: q

Marginal product of labor: MP
L
= q/L

Average product of labor: AP
L
= q/L

The graphs for these concepts appear
smooth because a firm can hire a
"fraction of a worker" (part time).
Managerial
Economics
Lecture 10:
Production

Output,
q ,
Units per day
B
A
C
11 6 4 0
L , Workers per day
Marginal product, MP
L
Average product, AP
L
AP
L
, MP
L
110
90
56
(a)
b
a
c
11 6 4 0
L , Workers per day
20
15
(b)
Figure 6.1
Production
Relationships with
Variable Labor
AP
L
= Slope of
straight line
to the origin
MP
L
= Slope of
total product
curve
AP
L
= MP
L
at
maximum AP
L


Effects of Added Labor
AP
L

Rises and then falls with labor.
Equals the slope of line from the origin to
the point on the total product curve.

MP
L

First rises and then falls.
Cuts the AP
L
curve at its peak.
Is the slope of the total product curve.


Law of Diminishing Marginal Returns
As a firm increases an input, holding all
other inputs and technology constant,

the marginal product of that input will
eventually diminish,

which shows up as an MP
L
curve that
slopes downward above some level of
output.

Long-Run Production: Two Variable Inputs
Both capital and labor are variable.

A firm can substitute freely between L
and K.

Many different combinations of L and K
produce a given level of output.

Isoquant
An isoquant is a curve that shows efficient
combinations of labor and capital that can
produce a single (iso) level of output
(quantity):

Examples:
A 10-unit isoquant for a Norwegian printing firm
10 = 1.52 L
0.6
K
0.4

Table 6.2 shows four (L, K) pairs that produce q =
24
( , ) q f L K


Figure 6.2 Family of Isoquants
K , Units of
capital per day
e
b
a
d
f c
6 3 2 1 0
L , Workers per day
6
3
2
1
q = 14
q = 24
q = 35

Isoquants and Indifference Curves
Isoquants and indifference curves have
most of the same properties.

The biggest difference:
An isoquant holds something measurable
(quantity) constant
An indifference curve holds something that
is unmeasurable (utility) constant

Three Key Properties of Isoquants
1. The further an isoquant is from the
origin, the greater is the level of output.

2. Isoquants do not cross.

3. Isoquants slope downward.

The Shape of Isoquants
The slope of isoquant shows how
readily a firm can substitute one input
for another
Extreme cases:
perfect substitutes: q = x + y
fixed-proportions (no substitution):
q = min(x, y)
Usual case: bowed away from the origin

Figure 6.3a Perfect Substitutes: Fixed Proportions
y , Idaho potatoes
per day
x , Maine potatoes per day
q = 3 q = 2 q = 1

Figure 6.3b Perfect Complements
Boxes
per day
Cereal per day
q = 3
q = 2
q = 1
45 line

Figure 6.3c Substitutability of Inputs
q = 1
K , Capital per
unit of time
L , Labor per unit of time

Marginal Rate of Technical Substitution
The slope of an isoquant tells how much a
firm can increase one input and lower the
other without changing quantity.

The slope is called the marginal rate of
technical substitution (MRTS).

The MRTS varies along a curved isoquant,
and is analogous to the MRS.

Figure 6.4 How the Marginal Rate of
Technical Substitution
Varies Along an Isoquant
K , Units of
capital per year
e
b
K
=

18
7

4
2
L
=
1
d
c
6 3
1
1
1
4 5 2 0 L , Workers per day
39
21
14
10
8
q = 10
a

The Slope of an Isoquant
If firm hires L more workers, its output
increases by MP
L
= q/L
A decrease in capital by K causes
output to fall by MP
K
= q/K
To keep output constant, q = 0:

or
( ) ( ) 0
L K
MP L MP K
L
K
MP K
MRTS
MP L

Returns to Scale
Returns to scale (how output changes
if all inputs are increased by equal
proportions) can be:
Constant: when all inputs are doubled,
output doubles,
Increasing: when all inputs are
doubled, output more than doubles, or
Decreasing: when all inputs are
doubled, output increase < 100%.


K
capital per year
q = 100
q = 200
q = 251
500 400 300 200 100 450 350 250 150 50 0
L , Units of labor per year
600
500
400
300
200
100
(c) Concrete Blocks and Bricks: Increasing Returns to Scale
, Units of

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PPA 723: Managerial

Managerial Economics, Lecture 10: Production

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