Chapter 11

PRODUCTION FUNCTIONS

MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS EIGHTH EDITION

WALTER NICHOLSON
Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved.

Production Function
The firms production function for a particular good (q) shows the maximum amount of the good that can be produced using alternative combinations of capital (K) and labor (L) q = f(K,L)

Marginal Physical Product

To study variation in a single input, we define marginal physical product as the additional output that can be produced by employing one more unit of that input while holding other inputs constant
xq ! fK marginal physical product of capital ! MPK ! xK m r i l i l r q t f l b r ! MPL ! ! fL L

Diminishing Marginal Productivity

The marginal physical product of an input depends on how much of that input is used In general, we assume diminishing marginal productivity
xMPK x 2q ! ! fKK xK xK xMPL x q ! ! fLL xL xL
2

0 0

Diminishing Marginal Productivity

Because of diminishing marginal productivity, 19th century economist Thomas Malthus worried about the effect of population growth on labor productivity But changes in the marginal productivity of labor over time also depend on changes in other inputs such as capital
we need to consider fLK which is often > 0

Average Physical Product

Labor productivity is often measured by average productivity
q f (K , L ) output APL ! ! ! L labor input L

Note that APL also depends on the amount of capital employed

A Two-Input Production Function

Suppose the production function for flyswatters can be represented by
q = f(K,L) = 600K 2L2 - K 3L3

To construct MPL and APL, we must assume a value for K

Let K = 10

The production function becomes

q = 60,000L2 - 1000L3

A Two-Input Production Function

The marginal productivity function is
MPL = xq/xL = 120,000L - 3000L2

which diminishes as L increases This implies that q has a maximum value:

120,000L - 3000L2 = 0 40L = L2 L = 40

Labor input beyond L=40 reduces output

A Two-Input Production Function

To find average productivity, we hold K=10 and solve
APL = q/L = 60,000L - 1000L2

APL reaches its maximum where

xAPL/xL = 60,000 - 2000L = 0 L = 30

A Two-Input Production Function

In fact, when L=30, both APL and MPL are equal to 900,000 Thus, when APL is at its maximum, APL and MPL are equal

Isoquant Maps
To illustrate the possible substitution of one input for another, we use an isoquant map An isoquant shows those combinations of K and L that can produce a given level of output (q0) f(K,L) = q0

Isoquant Map
Each isoquant represents a different level of output
output rises as we move northeast
K per period

q = 30 q = 20

L per period

Marginal Rate of Technical Substitution (RTS)

The slope of an isoquant shows the rate at which L can be substituted for K
K per period

- slope = marginal rate of technical substitution (RTS)

A

KA B KB

RTS > 0 and is diminishing for increasing inputs of labor

q = 20

L per period
LA LB

Marginal Rate of Technical Substitution (RTS)

The marginal rate of technical substitution (RTS) shows the rate at which labor can be substituted for capital while holding output constant along an isoquant
 dK RTS (L for K ) ! dL
q !q0

RTS and Marginal Productivities

Take the total differential of the production function:
xf xf dq ! dK ! MPL dL  MPK dK dL  xK xL

Along an isoquant dq = 0, so
MPL dL ! MPK dK
RTS L f  dK K) ! L MPL ! MPK

q !q0

RTS and Marginal Productivities

Because MPL and MPK will both be nonnegative, RTS will also be nonnegative However, it is not possible to derive a diminishing RTS from the assumption of diminishing marginal productivity alone

RTS and Marginal Productivities

To show that isoquants are convex, we would like to show that d(RTS)/dL < 0 Since RTS = fL/fK
dRTS d (fL / fK ) ! dL dL
dRTS [fK (fLL  fLK dK / dL )  fL (fKL  fKK dK / dL )] ! dL (fK )2

RTS and Marginal Productivities

Using the fact that dK/dL = -fL/fK along an isoquant and Youngs theorem (fKL = fLK)
dRTS (fK fLL  fK fL fKL  fL fKK ) ! dL (fK )3

Because we have assumed fK > 0, the denominator is positive Because fLL and fKK are both assumed to be negative, the ratio will be negative if fKL is positive

RTS and Marginal Productivities

Intuitively, it seems reasonable that fKL=fLK should be positive
if workers have more capital, they will be more productive

But some production functions have fKL < 0 over some input ranges
Thus, when we assume diminishing RTS we are assuming that MPL and MPK diminish quickly enough to compensate for any possible negative cross-productivity effects

A Diminishing RTS
Suppose the production function is
q = f(K,L) = 600K 2L2 - K 3L3

For this production function

MPL = fL = 1200K 2L - 3K 3L2 MPK = fK = 1200KL2 - 3K 2L3

These marginal productivities will be positive for values of K and L for which KL < 400

A Diminishing RTS
Because
fLL = 1200K 2 - 6K 3L fKK = 1200L2 - 6KL3

this production function exhibits diminishing marginal productivities for sufficiently large values of K and L
fLL and fKK < 0 if KL > 200

A Diminishing RTS
Cross differentiation of either of the marginal productivity functions yields
fKL = fLK = 2400KL - 9K 2L2

which is positive only for KL < 266

A Diminishing RTS
Thus, for this production function, RTS is diminishing throughout the range of K and L where marginal productivities are positive
for higher values of K and L, the diminishing marginal productivities are sufficient to overcome the influence of a negative value for fKL to ensure convexity of the isoquants

Returns to Scale
How does output respond to increases in all inputs together? Suppose that all inputs are doubled, would output double? Returns to scale have been of interest to economists since the days of Adam Smith

Returns to Scale
Smith identified two forces that come into operation as inputs are doubled
greater division of labor and specialization of function loss in efficiency because management may become more difficult given the larger scale of the firm

Returns to Scale
If the production function is given by q = f(K,L) and all inputs are multiplied by the same positive constant (m > 1), then
Eff t t t t r t st cr I cr si si t l

f(m ,mL) = mf( ,L) f(m ,mL) < mf( ,L) f(m ,mL) mf( ,L)

Returns to Scale
It is possible for a production function to exhibit constant returns to scale for some levels of input usage and increasing or decreasing returns for other levels
economists refer to the degree of returns to scale with the implicit notion that only a fairly narrow range of variation in input usage and the related level of output is being considered

Constant Returns to Scale

Constant returns-to-scale production functions have the useful theoretical property that that the RTS between K and L depends only on the ratio of K to L, not the scale of operation Geometrically, all of the isoquants are radial blowups of the unit isoquant

Constant Returns to Scale

Along a ray from the origin (constant K/L), the RTS will be the same on all isoquants
K per period

The isoquants are equally spaced as output expands

q=3 q=2 q=1

L per period

Returns to Scale
Returns to scale can be generalized to a production function with n inputs
q = f(X1,X2,,Xn)

If all inputs are multiplied by a positive constant m, we have

f(mX1,mX2,,mXn) = mkf(X1,X2,,Xn)=mkq If k=1, we have constant returns to scale If k<1, we have decreasing returns to scale If k>1, we have increasing returns to scale

Elasticity of Substitution
The elasticity of substitution (W) measures the proportionate change in K/L relative to the proportionate change in the RTS along an isoquant
%( K / L) d K / L) RTS x ln K / L) ! ! ! %(RTS dRTS K / L x ln RTS

The value of will always be positive because K/L and RTS move in the same direction

Elasticity of Substitution
Both RTS and K/L will change as we move from point A to point B
K per period

W is the ratio of these

proportional changes
RTSA A RTSB (K/L)A (K/L)B B q = q0

W measures the

curvature of the isoquant

L per period

Elasticity of Substitution
If W is high, the RTS will not change much relative to K/L
the isoquant will be relatively flat

If W is low, the RTS will change by a substantial amount as K/L changes

the isoquant will be sharply curved

It is possible for W to change along an isoquant or as the scale of production changes

The Linear Production Function

Suppose that the production function is
q = f(K,L) = aK + bL

This production function exhibits constant returns to scale

f(mK,mL) = amK + bmL = m(aK + bL) = mf(K,L)

All isoquants are straight lines

RTS is constant W=g

The Linear Production Function

Capital and labor are perfect substitutes
K per period

RTS is constant as K/L changes

W=g

slope = -b/a

q1

q2

q3

L per period

Fixed Proportions
Suppose that the production function is
q = min (aK,bL) a,b > 0

Capital and labor must always be used in a fixed ratio

the firm will always operate along a ray where K/L is constant

Because K/L is constant, W = 0

Fixed Proportions
No substitution between labor and capital is possible
K per period

K/L is fixed at b/a

W=0

q3/a q2 q1 q3/b

q3

L per period

Cobb-Douglas Production Function

Suppose that the production function is
q = f(K,L) = AKaLb A,a,b > 0

This production function can exhibit any returns to scale

f(mK,mL) = A(mK)a(mL) b = Ama+b KaLb = ma+bf(K,L) if a + b = 1 constant returns to scale if a + b > 1 increasing returns to scale if a + b < 1 decreasing returns to scale

Cobb-Douglas Production Function

Suppose that hamburgers are produced according to the Cobb-Douglas function
q = 10K 0.5 L0.5

Since a+b=1 constant returns to scale The isoquant map can be derived
q = 50 = 10K 0.5 L0.5 KL = 25 q = 100 = 10K 0.5 L0.5 KL = 100 The isoquants are rectangular hyperbolas

Cobb-Douglas Production Function

The RTS can easily be calculated
RTS L f fL 5L .5K K) ! ! fK 5L .5K 
.5 .5

K ! L

The RTS declines as L ises and K falls The RTS depends nly n the ati f K and L Because the RTS changes exactly in p p ti n t changes in K/L, W = 1

Cobb-Douglas Production Function

The Cobb-Douglas production function is linear in logarithms
ln q = ln A + a ln K + b ln L a is the elasticity of output with respect to K b is the elasticity of output with respect to L

CES Production Function

Suppose that the production function is
q = f(K,L) = [KV + LV] I/V V e 1, V { 0, I > 0 I > 1 increasing returns to scale I < 1 decreasing returns to scale

For this production function

W = 1/(1-V) V = 1 linear production function V = -g fixed proportions production function V = 0 Cobb-Douglas production function

Technical Progress
Methods of production change over time Following the development of superior production techniques, the same level of output can be produced with fewer inputs
the isoquant shifts in

Technical Progress
Suppose that the production function is
q = A(t)f(K,L)

where A(t) represents all influences that go into determining q other than K and L
changes in A over time represent technical progress
A is shown as a function of time (t) dA/dt > 0

Technical Progress
Differentiating the production function with respect to time we get
dq dt
dq dt

dA df (K , L ) f (K , L ) A dt dt
q xf d x dt f (K , L ) xf dL xL dt

dA q dt A

Technical Progress
Dividing by q gives us
dq / dt dA / dt xf / xK dk xf / xL dL !   q A f (K , L ) dt f (K , L ) dt dq / dt q dA / dt f K dK / dt f L dL / dt   A K f (K , L K L f (K , L L

Technical Progress
For any variable x, [(dx/dt)/x] is the proportional growth rate in x
denote this by Gx

Then, we can write the equation in terms of growth rates

xf K xf L Gq ! GA  GK  GL xK f (K , L ) xL f (K , L )

Technical Progress
Since
f K q K ! ! eq ,K K f K,L) K q f L q L ! eq,L ! L f ( , L) L q

Gq ! GA  eq ,K GK  eq ,LGL

Technical Progress in the Cobb-Douglas Function

Suppose that the production function is
q = 10e 0.05t K 0.5 L0.5

Taking logarithms yields

ln q = ln 10 + 0.05t + 0.5 ln K + 0.5 ln L

Differentiating with respect to t gives the growth equation

dq / dt dK / dt dL / dt ! 0.05  0.5  0.5 q K L

Technical Progress in the Cobb-Douglas Function

We can put this in terms of growth rates
Gq = 0.05 + 0.5GK + 0.5GL

When K and L are constant, output grows at 5 percent per period

GK = GL = 0 Gq = 0.05

Important Points to Note:

If all but one of the inputs are held constant, a relationship between the single variable input and output can be derived
the marginal physical productivity is the change in output resulting from a one-unit increase in the use of the input the marginal physical productivity of an input is assumed to decline as use of the input increases

Important Points to Note:

The entire production function can be illustrated by an isoquant map
The slope of an isoquant is the marginal rate of technical substitution
RTS measures how one input can be substituted for another while holding output constant RTS is the ratio of the marginal physical productivities of the two inputs

Isoquants are assumed to be convex

they obey the assumption of a diminishing RTS

Important Points to Note:

The returns to scale exhibited by a production function record how output responds to proportionate increases in all inputs
if output increases proportionately with input use, there are constant returns to scale if there are greater than proportionate increases in output, there are increasing returns to scale if there are less than proportionate increases in output, there are decreasing returns to scale

Important Points to Note:

The elasticity of substitution (W) provides a measure of how easy it is to substitute on input for another in production
a high W implies nearly straight isoquants a low W implies that isoquants are nearly Lshaped

Technical progress shifts the entire production function and isoquant map
may arise from the use of more productive inputs or better economic organization