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Microeconomics

PGP-I

Session 6

Session Six Overview

1. The Production Function

Marginal and Average Products


Isoquants
The Marginal Rate of Technical Substitution
Elasticity of Substitution
2. Returns to Scale

The Production & Utility Functions

The Production & Utility Functions

Key Concepts
Productive resources, such as labor and capital
equipment, that firms use to manufacture goods and
services are called inputs or factors of production.
The amount of goods and services produces by the firm is
the firms output.
Production transforms a set of inputs into a set of
outputs
Technology determines the quantity of output that is
feasible to attain for a given set of inputs.
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Key Concepts
The production function tells us the maximum possible
output that can be attained by the firm for any given
quantity of inputs.

Production Function:
Q = output
K = Capital
L = Labor

Q f ( L, K )

The production set is a set of technically feasible


combinations of inputs and outputs.
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The Production Function & Technical Efficiency


Q

Production Function
Q = f(L)

Production Set

L
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The Production Function & Technical Efficiency

Technically efficient: Sets of points in the


production function that maximizes output
given input (labor)
Q f ( L, K )
Technically inefficient: Sets of points that
produces less output than possible for a
given set of input (labor) Q f ( L, K )

The Production Function & Technical Efficiency

Labor Requirements Function


Labor requirements function

L g (Q)
Example:

LQ

for production function


2

Q L

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The Production Function & Technical Efficiency

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Total Product
Total Product Function: A single-input production
function. It shows how total output depends on the
level of the input
Increasing Marginal Returns to Labor: An increase
in the quantity of labor increases total output at an
increasing rate.
Diminishing Marginal Returns to Labor: An
increase in the quantity of labor increases total output
but at a decreasing rate.
Diminishing Total Returns to Labor: An increase in
the quantity of labor decreases total output.
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Total Product

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The Marginal Product


Definition: The marginal product of an input is the change in
output that results from a small change in an input holding the
levels of all other inputs constant.
MPL = Q/L
(holding constant all other inputs)
MPK = Q/K
(holding constant all other inputs)
1/2 1/2
Example:
Example:QQ==KK1/2LL1/2
-1/2 1/2
MP
MPLL==(1/2)L
(1/2)L-1/2KK1/2
-1/2 1/2
MP
MPKK==(1/2)K
(1/2)K-1/2LL1/2
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The Average Product & Diminishing Returns


Definition: The average product of an input is equal to the
total output that is to be produced divided by the quantity of
the input that is used in its production:
APL = Q/L
APK = Q/K
Example:
APL = [K1/2L1/2]/L = K1/2L-1/2
APK = [K1/2L1/2]/K = L1/2K-1/2

Definition:
The law of diminishing marginal
returns states that marginal products (eventually)
decline as the quantity used of a single input increases.
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Total, Average, and Marginal Products


L

APL

MPL

30

12

96

11

18

162

11

24

192

30

150

-7

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Total, Average, and Marginal Magnitudes

TP
TPLL maximized
maximized where
where
MP
MPLL isis zero.
zero. TP
TPLL falls
falls
where
where MP
MPLL isis negative;
negative;
TP
TPLL rises
rises where
where MP
MPLL isis
positive.
positive.

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Total, Average, and Marginal Products

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Production Functions with 2 Inputs


Marginal product: Change in total product
holding other inputs fixed.
Change in the quantity of output, Q
MPL
Change in the quantity of Labor, L

Q
MPL
L

K is held const

Q
MPK
K

K is held const

L is held const

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Isoquants
Definition: An isoquant traces out
all the combinations of inputs
(labor and capital) that allow that
firm to produce the same quantity
of output

And
And

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Isoquants

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Isoquants
K

All
Allcombinations
combinationsof
of(L,K)
(L,K)along
alongthe
the
isoquant
isoquantproduce
produce20
20units
unitsof
ofoutput
output..

Example:

Q = 20
Slope=K/L

Q = 10
L
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Marginal Rate of Technical Substitution


Definition: The marginal rate of technical substitution measures the
amount of an input, L, the firm would require in exchange for using a
little less of another input, K, in order to just be able to produce the
same output as before.
MRTSL,K = -K/L (for a constant level of output)
Marginal products and the MRTS are related:
MPL(L) + MPK(K) = 0
=>

MPL/MPK = -K/L = MRTSL,K

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Marginal Rate of Technical Substitution


The rate at which the quantity of capital that can be
decreased for every unit of increase in the quantity of labor,
holding the quantity of output constant,
Or
The rate at which the quantity of capital that can be
increased for every unit of decrease in the quantity of labor,
holding the quantity of output constant

Therefore
Therefore
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Marginal Rate of Technical Substitution


If both marginal products are positive, the slope of the isoquant
is negative.
If we have diminishing marginal returns, we also have a
diminishing marginal rate of technical substitution - the marginal
rate of technical substitution of labor for capital diminishes as the
quantity of labor increases, along an isoquant isoquants are
convex to the origin.
For many production functions, marginal products eventually
become negative. Why don't most graphs of Isoquants include the
upwards-sloping portion?
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Isoquants
Isoquants

MPK < 0

Example:
Example: The
The Economic
Economic and
and the
the
Uneconomic
Regions
of
Uneconomic
Regions
of
Production
Production

Q = 20
MPL < 0
Q = 10
0

L
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Marginal Rate of Technical Substitution

Q (K ) MU K (L) MU L

Q
MPK
K

L is held const

Q
MPL
L

K is held const

MPL

MRTS L , K
MPK

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Elasticity of Substitution
A measure of how easy is it for a firm to
substitute labor for capital.
It is the percentage change in the capitallabor ratio for every one percent change in
the MRTSL,K along an isoquant.

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Elasticity of Substitution
Definition:
Definition: The
The elasticity
elasticity of
of substitution,
substitution, ,
, measures
measures how
how
the
the capital-labor
capital-labor ratio,
ratio, K/L,
K/L, changes
changes relative
relative to
to the
the change
change in
in
the
.
theMRTS
MRTSL,K
L,K.

Percentage change in capital - labor ratio

Percentage change in MRTS L , K


K
%

%MRTS L , K
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Elasticity of Substitution
K
"The
"The shape
shape of
of the
the isoquant
isoquant
indicates
indicates the
the degree
degree of
of
substitutability
of
the
substitutability
of
the
inputs"
inputs"

=0
=1
= 5
=
0

L
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Returns to Scale

How much will output increase when ALL


inputs increase by a particular amount?

%(quantity of output)
Returns to Scale
%(quantity of all inputs)
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Returns to Scale
Let represent the amount by which both inputs, labor
and capital, increase.

Q f (L, K ) for 1
Let represent the resulting proportionate increase in
output, Q

Increasing returns:
Decreasing returns:
Constant Returns:




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Returns to Scale
How much will output increase when ALL inputs increase by a
particular amount?
RTS = [%Q]/[% (all inputs)]
If a 1% increase in all inputs results in a greater than 1% increase in
output, then the production function exhibits increasing returns to
scale.
If a 1% increase in all inputs results in exactly a 1% increase in output,
then the production function exhibits constant returns to scale.
If a 1% increase in all inputs results in a less than 1% increase in
output, then the production function exhibits decreasing returns to
scale.
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Returns to Scale
K

2K
Q = Q1

K
Q = Q0
0

2L

L
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Returns to Scale

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Returns to Scale vs. Marginal Returns


Returns to scale: all inputs are increased
simultaneously
Marginal Returns: Increase in the quantity
of a single input holding all others constant.
The
The marginal
marginal product
product of
of aa single
single factor
factor may
may diminish
diminish
while
whilethe
thereturns
returnsto
toscale
scaledo
donot
not
Returns
Returns to
to scale
scale need
need not
not be
be the
the same
same atat different
different levels
levels of
of
production
production
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