Production

ECO61 Microeconomic
Analysis
Udayan Roy
Fall 2008
 What is a firm?
• A firm is an organization that converts
inputs such as labor, materials, energy,
and capital into outputs, the goods and
services that it sells.
– Sole proprietorships are firms owned and run
by a single individual.
– Partnerships are businesses jointly owned and
controlled by two or more people.
– Corporations are owned by shareholders in
proportion to the numbers of shares of stock
they hold.
 What Owners Want?
• Main assumption: firm’s owners try
to maximize profit

• Profit (π ) is the difference between

revenues, R, and costs, C:

π =R–C
 What are the categories of
inputs?
• Capital (K) - long-lived inputs.
– land, buildings (factories, stores), and equipment
(machines, trucks)

• Labor (L) - human services

– managers, skilled workers (architects,
economists, engineers, plumbers), and less-skilled
workers (custodians, construction laborers,
assembly-line workers)

• Materials (M) - raw goods (oil, water,

wheat) and processed products (aluminum,
plastic, paper, steel)
 How firms combine the
inputs?
• Production function is the
relationship between the quantities
of inputs used and the maximum
quantity of output that can be
produced, given current knowledge
about technology and organization
 Production Function

Production
Inputs Function Output
(L, K) q
q = f(L, K)

• Formally,
q = f(L, K)

– where q units of output are produced using

L units of labor services and K units of
capital (the number of conveyor belts).
The production function may
simply be a table of numbers
The production function may
be an algebraic formula

Q = 15 L K 0.6 0 .4

Q = 24 L + 12 K
Q = 18 × min{24 L,12 K }
Just plug in
numbers for L and
K to get Q.
 Marginal Product of Labor
• Marginal product of labor (MPL ) - the
change in total output, ∆ Q, resulting
from using an extra unit of labor, ∆ L,
holding other factors constant:

∆Q
MPL =
∆L
 Average Product of Labor
• Average product of labor (APL ) - the
ratio of output, Q, to the number of
workers, L, used to produce that output:

Q
APL =
L
 Production with Two Variable
Inputs
• When a firm has more than one
variable input it can produce a given
amount of output with many different
combinations of inputs
– E.g., by substituting K for L

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 Isoquants
• An isoquant identifies all input
combinations (bundles) that
efficiently produce a given level of
output
– Note the close similarity to indifference
curves
– Can think of isoquants as contour lines
for the “hill” created by the production
function

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Family of
Isoquants
K, Units of capital per day

6 a

The production function

above yields the isoquants
on the left.

b
3

e c f
2
q = 35

d
1 q = 24

q = 14

0 1 2 3 6 L, Workers per day

Figure 7.8: Isoquant
Example
Productive
Inputs Principle:
Increasing the
amounts of all
inputs increases
the amount of
output. So, an
isoquant must be
negatively sloped

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 Properties of Isoquants

• Isoquants are thin

• Do not slope upward
• Two isoquants do not cross
• Higher-output isoquants lie farther
from the origin

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Figure 7.10: Properties of
Isoquants

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Figure 7.10: Properties of
Isoquants

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Substitution Between Inputs
• Rate that one input can be substituted for
another is an important factor for managers in
choosing best mix of inputs
• Shape of isoquant captures information about
input substitution
– Points on an isoquant have same output but different
input mix
– Rate of substitution for labor with capital is equal to
negative the slope

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 Marginal Rate of Technical
Substitution
• Marginal Rate of Technical Substitution for
labor with capital (MRTSLK ): the amount of
capital needed to replace labor while keeping
output unchanged, per unit of replaced labor
– Let ∆ K be the amount of capital that can replace ∆ L
units of labor in a way such that total output ― Q =
F(L,K) ― is unchanged.
– Then, MRTSLK = - ∆ K / ∆ L, and
– ∆ K / ∆ L is the slope of the isoquant at the pre-change
inputs bundle.
– Therefore, MRTSLK = - slope of the isoquant
 Marginal Rate of Technical
Substitution
• marginal rate of technical
substitution (MRTS) - the number of
extra units of one input needed to
replace one unit of another input that
enables a firm to keep the amount of
output it produces constant
increase in capital ∆K
− MRTS = =
increase in labor ∆L
Slope of Isoquant!
 How the Marginal Rate of Technical
Substitution Varies Along an Isoquant

MRTS in a Printing and Pu blishing U.S. Firm

K, Units of capital per d ay

a
16

∆ K = –6

b
10
∆L= 1
–3
1 c
7
–2 1 d
5 e
4 –1
1 q = 10

0 1 2 3 4 5 6 7 8 9 10
L, Workers per d ay
Substitutability of Inputs and Marginal
Products.
• Along an isoquant output doesn’t change (∆ q =
0), or:
Extra units Extra units
of labor of capital

(MPL x ΔL) + (MPK x ΔK) = 0.

Increase in q per Increase in q per
extra unit of labor extra unit of capital

– or MPK × ∆K = 0 − MPL × ∆L
MPL
∆K = − × ∆L
MPK
∆K MPL
=− = − MRTS = slope of isoquant
∆L MPK
Figure 7.12: MRTS

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MRTS and Marginal Product
• Recall the relationship between MRS
and marginal utility
• Parallel relationship exists between
MRTS and marginal product
MPL
MRTS LK =
MPK
• The more productive labor is relative to
capital, the more capital we must add to
make up for any reduction in labor; the
larger the MRTS

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 Figure 7.13: Declining
MRTS
• We often assume
that MRTSLK
decreases as we
increase L and
decrease K
• Why is this a
reasonable
assumption?

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 Extreme Production
Technologies
• Two inputs are perfect substitutes if
their functions are identical
– Firm is able to exchange one for another at a
fixed rate
– Each isoquant is a straight line, constant MRTS
• Two inputs are perfect complements
when
– They must be used in fixed proportions
– Isoquants are L-shaped

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Substitutability of Inputs
Substitutability of Inputs
 Returns to Scale

Types of Returns to Scale Proportional change in ALL What happens when all
inputs yields… inputs are doubled?

Constant Same proportional change in Output doubles

output
Increasing Greater than proportional Output more than doubles
change in output
Decreasing Less than proportional change Output less than doubles
in output

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Figure 7.17: Returns to
Scale

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 Returns to Scale
• Constant returns to scale (CRS) -
property of a production function
whereby when all inputs are increased
by a certain percentage, output
increases by that same percentage.

f(2L, 2K) = 2f(L, K).

 Returns to Scale (cont).
• Increasing returns to scale (IRS)
- property of a production function
whereby output rises more than in
proportion to an equal increase in all
inputs

f(2L, 2K) > 2f(L, K).

 Returns to Scale (cont).
• Decreasing returns to scale
(DRS) - property of a production
function whereby output increases
less than in proportion to an equal
percentage increase in all inputs

f(2L, 2K) < 2f(L, K).

 Productivity Differences and
Technological Change
• A firm is more productive or has
higher productivity when it can
produce more output use the same
amount of inputs
– Its production function shifts upward at each
combination of inputs
– May be either general change in productivity
of specifically linked to use of one input
• Productivity improvement that leaves
MRTS unchanged is factor-neutral

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The Cobb-Douglas Production Function

• It one is the most popular estimated

functions.

q = ALα Kβ
 Cobb-Douglas Production
Function
Q = F ( L, K ) = AL K
α β

• A shows firm’s general productivity level

• α and β affect relative productivities of
labor and capital
MPL = αALα −1 K β
MPK = β ALα K β −1
• Substitution between inputs:
 α  K 
MRTS LK =   
 β  L 
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Figure: 7.16: Cobb-Douglas
Production Function

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