This version: September 8, 2003

ECON6021 Microeconomic Analysis

Lecture 2: Production

I. The Theory of Production

What is Production? To layman, production would mean producing things. A natural
question is, by what means? The theory of productions studies the relationship between
output and the “inputs” that are responsible for its realization. For example, to make a
cake, we require egg, flour, fruit, cream, labor, an oven, so on and so forth. The intricate
relationship between them is represented by a function called “production function.” For
the case of cake production, it takes the following form:
Q=f(E, FL, FR, C, L, O)
where Q is the quantity of cake produced, and E is the quantity of egg used, FL quantity
of flour, FR quantity of fruit, C quantity of cream, …. And finally f(.) itself is a function
which will give you the quantity of cake once the quantities of various inputs are plugged
into it. Note that we are talking about production in a period of time; the time aspect is
usually ignored in the representation.
Since we want our theory to be applicable not only for cake production, but also for
other sorts of production, we will try to make our theory as simple and flexible as
possible. You will encounter production functions of only two inputs – which are also
known as factors of production. Considering the following representation:
Q=A*f (K, L)
This equation says that there is a functional relationship between output and its various
inputs, and in this case, we have only two of them. K is the amount of capital used and L
is the amount of labor used. Without further data, we are absolutely silent as to the exact
form of f(.) for a particular firm. Yet it will suffice for our purpose of general analysis.
The ‘technological constant’, A, represents the general technology level of the
firm/industry/country. It is useful in a comparative setting in which one firm with higher
A has more advanced technology. That is, given the same K and L, one firm with a
greater A produces a greater output. The term is generally suppressed unless an explicit
comparison is anticipated.
Why should we study this funny function? What can it help in economic analysis?
Cost and production seem pretty boring to us, as we Hong Kongers seem to be in a
post-manufacturing society. In the following section, we demonstrate that the knowledge

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of production analysis is helpful for us to understand long term economic growth, in
particular in understanding the so called ‘Asian economic miracle’ (a term still quite
popular even a few year ago) is no miracle at all.
After that, we will introduce some concepts in production theory and its application.
The last part would be formal. It is about the mathematical representation of production
theory.

II. A Motivating Story: Asian Miracle is no Miracle

The economic growth in Singapore, Hong Kong, Taiwan and Korea during the period
of 1960 through 1985 has often been described as a miracle. Many western countries
started to wonder that if these Asian countries possessed of any important factor that was
absent from its western competitors? Was it Confucianism? Was it authoritarian state? Is
there any secret technology? Would the miracle be sustainable?
Paul Krugman, a famous economist now at Princeton, made his fame out of his
refutation of the above question. Inspired by the empirical findings of other economists
such as Young, Kim and Lau, Krugman contended that the economic miracle was simply
a result of continual productivity growth due to massive capital influx and heightened
labor participation ratio. However impressive it was, there was no magic technology in it.
What is more important is that, there is a limit to capital and labor increase. One country
cannot continue to increase its labor participation ratio unlimitedly, as there is an upper
bound (100%) to it. Thus, growing at an abnormal high rate is not sustainable.
Translated into our production function terminology, the four tiger’s impressive
growth rate of Q is solely attributed to either the growth of K or L. There is no change in
A. Yet K an L has a natural limit. Therefore, the growth rate of Q has to slow down once
these resources are exhausted. We will demonstrate the mathematical derivation of the
above argument in class.
Note that in Krugman’s exercise, he is treating a society as a grand firm
characterized by a production function with a plausibly varying (increasing)
“technological constant” A over time. Thus it is a generalization of the production theory
which is originally devoted to the study of the production of the individual firms.

III. Basic concepts of production theory

Fixed Costs:
Firms typically incur costs that do not vary with output and costs that do. A fixed
cost (F) is an expense that does not vary with the level of output. A good example of a
fixed cost is the fee a government charges for a firm to incorporate and conduct business.

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Whether the firm produces a lot or a little, it must pay the fee. Another example is the
monthly rent that a lawyer must pay for an office after signing a one-year lease. The
monthly rent must be paid regardless of how much business the lawyer does.

Sunk Costs and Avoidable Costs

If the firm and the lawyer decide to go out of business, they would not renew their
incorporation or rental agreement for the next year. But what if they decide to go out of
business just one month after they began? Are they still stuck paying their fee or monthly
rental? If they have paid in advance, can they get a refund? The answer depends on the
law or contract. The firm probably prepaid the entire incorporation fee, which is not
refundable. The lawyer, although obligated to pay a monthly rent, may be able to rent to
someone else and recoup some if not all of the cost. The portion of fixed costs that is not
recoverable is a sunk cost. A sunk cost is like spilt milk: once it is sunk, there is no use
worrying about it, and it should not affect any subsequent decisions. In contrast, a fixed
cost that is not sunk should influence decisions. For example, whether or not the lawyer
should go out of business depends in part on how costly it is to get out of the lease (the
financial penalty for breaking the lease). Costs, including fixed costs, that are not
incurred if operations cease are called avoidable costs.

Variable costs
Variable costs (VC) are costs that change with the level of output (q). Because VC
varies with output, we normally write them as a function of output: VC(q). Typically, as
output increases, so does the need for labor, electricity, and materials, so variable costs
depend on the wages and prices that a firm must pay.

Total Costs
Total costs (C) are the sum of all fixed and variable costs: C = F + VC. Associated
with the concepts of total cost and variable cost is marginal cost (MC), which is the
increment, or addition, to cost that results from producing one more unit of output.
Because fixed cost does not change as output increases, the increase in total cost when
output increases is identical to the corresponding increase in variable cost.

The division between fixed costs and variable costs is closely related to short run
and long run. Consider the following example. There are two kinds of factors, the fixed
one and the variable one. Simply put, the factors whose quantity will vary when you
increase output are variable factors. Those whose quantity do not change are fixed factors.

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For example, when you receive an urgent order of 100 shirts to be delivered tomorrow,
you will most probably demand your workers to work overnight and paid them more
accordingly. You will not hire more machine right? In this case, the worker’s effort is
variable factor and the machine is fixed factor. The cost forsaken in order to induce
workers to stay at night is variable cost (e.g. wages paid). The rent paid for the machine
every month is fixed cost, since no matter how the output change you pay the same rent.
Yet another example, if you receive an order of 5000 shirts for the next 10 years
monthly, what will you do? I think you should buy more machines and hire more labor.
Now both factors become variable, and both the wages and rent become variable cost. We
have two economic terminologies to describe the above two situation. The first situation
where one factor is fixed and one is variable is called short run. More formally, short run
describe a situation where you have at least one factor fixed. The second type of situation
is called long run, where all the factors are variable.
The division between short run and long run should not be understood literally.
Short run and Long run are models constructed to facilitate our analysis. We utilize either
model as we see fit. To a certain extent, it is a matter of assumption. Sometimes we want
to leave out the intricate influence of one factor’s demand upon other, maybe we think
that it is not important, we simply assumes some factors to be fixed, even in reality it is
capable to change. Therefore, run is to a certain extent a matter of assumption.

Law of diminishing returns:

This is an empirical postulate on the productivity of factors. It says that in short run,
that is, where at least one factor is fixed, as you successively employed more and more of
one other factor, the marginal productivity of the latter factor will eventually diminish.
Sounds incomprehensible? Lets do it on graph and you will picture it better.

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 output

f (K*,L)

law of diminishing (marginal) return

Consider a production function with only two factors of production, K and L. This
graph depicted the relationship between output and the labor employed. A special feature
is that the amount of capital is being held fixed at K*, i.e., a short run is considered. From
the graph you can see that the curve slopes upward at first then downward eventually.
That is to say, when you hire more and more labor, they will contribute to the output
positively at first and thwart the production eventually. Isn’t it the law of diminishing
return? No, not yet. We still haven’t made use of the concept ‘marginal’. The marginal
productivity of labor is simply the slope of the above curve. Why? Marginal product is
defined as the change in total output that is induced by an infinitesimal change in labor
employed. That is, the definitions of slope in the above graph.
Keep an eye on the slope. The slope is increasing at first and decreasing
eventually, this is a graphical depiction of the law of diminishing marginal product. If we
draw the marginal product directly, we can obtain the following graph:

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 MP

AP

Marginal product will increase for a while then diminishes. And from that
diminishing portion we can derive lots of results. The AP stands for average product, it is
defined as the total product of a firm divided by the number of that factor. In terms of
graph, it is the slope of the ray from the origin drawn towards the total product curve.
What is the difference between MP and AP? MP measures the effect of an additional
factor: how many outputs were created by this marginal factor. AP measures how many
products this kind of factor can produce on average. MP must penetrate AP at the top of it.
Consider to the left of the maximum point, where AP slopes upward. MP must lies above
AP since the average mark can only goes up when the additional mark is greater than the
original average. Consider to the right of that maximum, where the AP is sloping
downward. MP must lies below AP because the average mark can only drop when an
additional mark is below the original average. So where will MP and AP are equalized? It
can only be achieved at the maximum point.
From MP and AP curve, we can derive MC and AC curve. MC stands for
marginal cost, AC stands for average cost. This characteristic is due to the fact that total
cost curve is just a mirror image of total product curve (See appendix)

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Returns to scale:
We shall start with the scale of production. When we increase our scale of
production, we employed more of every factor by the same proportion, the same scale.
We can either have increasing return to scale, decreasing return to scale and constant
return to scale. What does that means? Increasing return means what an increase in 10
percent of scale will yield more than ten percent of output. Decreasing return would yield
a less than 10 percent increase of output. Constant return of scale will yield exactly a 10
percent rise in output. In production function, we have this representation:
Let t be the factor of change in scale
Increasing return: f( tK, tL)> tf( K, L)
Decreasing return: f( tK, tL)< tf( K, L)
Constant return: f( tK, tL)= tf( K, L)

The above definitions presume that the returns to scale is a global property – a
production function exhibits the same returns to scale at any level of production. This is
clearly not the case in the real world. Therefore, a better set of definitions is needed.
Anyway this concludes our informal discussion of production and cost.

Before ending our informal discussion, I want to draw to your attention that so far
we have been using a black box approach. We have not discussed how different factors of
production can be combined to produce goods. Issues such as motivation, authority,
cooperation, information, etc. within the firm are completely missing. Another way put, a
theory of the firm is lacking.