Chapter 6 (production theory and analysis)

The general production problem facing the firm is to determine how much output to produce and
how much labor and capita to employ to produce that output most efficiently.to answer these
questions we use a) productions functions b) information on prices of outputs and inputs.

The production functions

The production function Q =f(K,L) defines the maximum rate of output Q per unit of time
obtainable from a given rate of capital (K) and labor(L) input. The production function is an
engineering concept that is devoid of economic content.it simply relates output and input rates.
The production function does not yield information on the least cost capital labor combination
for producing a given level of output nor does it reveal the output rate that would yield maximum
profit. Prices of the inputs and the price of output must be used with the production function to
determine which of the many possible input combination is best given the firm’s objective.

Linear production function =additive form

Non linear production function =multiplicative form

Cobb-Douglas production function

Q = AKα Lβ (multiplicative form)

Here Q = output

A =parameter (technology)

K =capital

L = labor

α+β ≤ 1

Let A=100 α =0.5 and β= 0.5

Then Q = 100 K0.5 L0.5

If K=4 and L=2 then Q = 100 √ 4 √2 = 100(2) (1.41) = 283

If K =8 and L =2 Q = 100 √ 8 √ 2 = 400

Three important relationships are shown by the data in the production table

1)There are a variety of ways to produce a particular rate of output.This implies tht there is
substitutability between the factors of production process characterized by combination a , a
labor intensive process such as d or a process that uses a resource combination somewhere
between these extremes such as b or c.

Capital intensive =a production system where the ratio of capital to labor is relatively high

Labor intensive = capital to labor ratio is relatively low

2)If input rates are doubled the output rate also doubles.for example , maximum production with
one unit of capital and four units of labor is 200.Doubling the input rates to K=2 , L=8 results in
the rate of output doubling to Q = 400.The relationship between output change and proportionate
changes in both inputs is referred to as returns of scale.If the production is characterized by
constant returns to scale this means that if both input rates increase by the same factor(eg. Both
input rates double),the rate of output will also will double.

[returns to scale =scale of production/quantity of production]

There are 3 types of returns to scale .

i)Constant returns to scale-if both K(capital) and L(labor) inputs are doubled then both outputs
rate are also doubled.

ii)Increasing returns to scale-if both input rates are increased by same factors and output rate
increases by more than that proportion then it is known as increasing returns to scale. Eg. if both
input rates are doubled and output increased by three times then we will say that increasing
returns to scale

iii)Decreasing returns to scale- both input rates are doubled by same factors but output increase
by less than double then we will say that decreasing returns to scale.

3)In contrast to the concept of returns to scale when output changes because one input changes
while the other remains constant, the changes in the out output rates are referred to as returns to
a factor. Note in the table that if the rate of one input is held constant while the other is increased,
output increases but the successive increments become smaller. For example from the table 6.1 it
is seen that if the rate of capital input is held constant at 2 and labor is increased from L=1 to
L=6,the successive increases in output are 59,45,38,33 and 30.This is the basis for an important
economic principle known as the law of diminishing marginal returns.

Diminishing marginal returns

The law states that when increasing amount of the variable inputs are combined with a fixed
level of another input, a point will be reached where the marginal product of the variable input
will decline.

MPL = (∆Q/∆L)

Here, ∆L =change in output when labor is increased by 1 unit.

MPL = marginal product of labor

If MPL is very small then

MPL = dQ/Dl

Production with one variable input

Production in the short run occurs where the rate of input of one factor of production is fixed.
That is period is not long enough to change the input rate of that factor. The period of time
during which one of the inputs is fixed in amount is defined as the short run. In contrast all inputs
are variable in the long run.

Short run -period of time in which at least one factor of production remains fixed. Generally,
capital remain fixed. Output increase by labor. (variable input)

Long run -period of time during which all inputs are variable inputs.It may increase labor or
capital input.

The product functions

For a two-input production process the total product of labor (TPL) is defined as the maximum
rate of output obtained from combibed varying rates of labor input with a fixed capital
input.denoting the fixed capital input as K, the total product of capital function is written as
TPL =f (K , L¿

Similarly ,the total product of capital function is

TPK =f (K,L)

Marginal product (MP) -is defined as the change in output per one unit change in the variable
input.thus the marginal product of labor is MPL =(∆Q/∆ L ¿

Marginal product of capital is MPK =(∆Q/∆K)

For infinitesimally small changes in the variable input, the marginal product function I the first
derivative of the production function with respect to the variable unit. That is for small change in
labor MPL will be dQ/dL and MPK will be dQ/dK for small change in K.For the general Cobb-
Douglas production function ,

Q = AKα Lβ

The marginal products are

MPK =dQ/dK

= αAKα-1 Lβ

MPL =dQ/dL

= βAKα Lβ-1

The average product of labor function is

APL =TPL/L

The average product of capital is

APK = TPK/K
Optimal employment of a factor of production
What principles guide the decisions about the level of employment? In general , to maximize
rofit, the firm should hire labor as log as the additional revenue associated with hiring of another
unit of labor exceeds the cost of employing that unit.

Formally stated the basic principle is that additional units of the variable output should be hired
until the marginal revenue product (MRP) of the last unit employed is equal to the cost of the
input. The MRP is defined as marginal revenue times marginal product and represents the value
of the extra unit of labor.

In general, MRP = MRxMP

P =MR (price =constant) ( mkt is perfectly competitive)

MRPL =MR X MPL

Thus, labor is hired until MRPL equals the wage rate (w)

MRPL = w

Similarly, if the labor input was fixed and the capital stock could be varied, capital would be
employed until the marginal revenue product of capital equaled the price of capital (r). That is

MRPK = r

MRP can be expressed in 2 ways.

1)MRP =MRx MP

2)MRP =PxMP

Example -the optimal labor input rate

the product function for global electronics is

Q = 2K0.5 L0.5

With marginal product function for labor and capital given by

MPL =dQ/dL = 2(1/2) K0.5 L0.5-1 = K0.5 /L0.5

Respectively. Assume that the capital stock if fixed at nine units(K=9). if the price of output (P)
is 6$ per unit and the wage rate (w) is 2 $ per unit. Determine the optimal or profit maximizing
rate of labor to be hired .what labor rate is optimal if the wage rate increased to 3 $.

Here MRPL =P x MPL

=P (K0.5 /L0.5 )

= 6(90.5 /L0.5 ) = 18/L0.5

Now equate the MRPL function and the wage rate and solve for L ,

MRPL =w

Or , 18/L0.5 = 2

Or , L =81

Therefore 81 units of labor should be employed.

If the wage rate increases to 3$ of labor the profit maximizing condition MRPL =w would be

18/L0.5 = 3

Or L =36

Production with two variables inputs

If both capital and labor inputs are variable, a different set of analytical techniques must be
applied to determine optimal input rates. There are 3 ways the firm may approach the problem of
efficient resource allocation in production. They are –

1)maximize production for a given $ outlay on labor and capital

2)maximize the dollar outlay on labor and capital inputs necessary to produce a specified rate of
output

3)produce the output rate that maximizes the profit.

The first two problems are called constrained optimization problems. In problem 1) the
constrained is a fixed dollar outlay for capital and labor.In problem 2) the constraint is a
specified rate of output that must be produced.
A standard managerial economics technique using the concept of production isoquants and
production isocosts is used to determine efficient input rate combinations for given production
rates.

The production isoquant

In general, isoquants are determined in the following way. First, a rate of output say Q0 is
specified. Then the production function is written as

Q0 =f(K ,L)

The combinations of K and L that satisfy this equation define the isoquant for output rate
Q0.

100 = 10K+20L

100 = 5K+30L

100 =8K+25L

Isoquants are smooth curve that are convex to the origin.

The shape of this isoquant implies that inputs are imperfectly substitutable and the rate of
substitution declines as one input is substituted for another .If it was perfectly substitutable then
the line will be straight.

The shape of the isoquants shows the rate at which one input can be substituted for the other such
that the level of output remains constant. This slope is referred to to as the marginal rate of
technical substitution (MRTS).

Slope of an isoquant (MRTS) is equal to the negative of the ration of the marginal product that is

MRTS = -(MPL/MPK)
The production isocost
The isoquant is a physical relationship that denotes different ways to produce a given rate of
output.The next step toward determining the optimal combination of capital and labor is to add
information on the cost of those inputs.This cost information is introduced by a function called a
production isocost.

Given the per unit prices of capital(r) and labor(w) the total expenditure (C) on capital and labor
input is

C = rK + wL

For example if r =3 and w=2 the combination of 10 units of capital and five units of labor will
cost $40.That is ,

40 = 3(10)+2(5)

For any given cost C0 the isocost line defines all combinations of capital and labor inputs that can
be purchased for C0.

eeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeee
Isocost – a straight line

Isoquant - curve

rewrite the equation (1) by solving for K as a function of L ,

C = rK +wL ……..(1)

Or rK = C0 – wL [C0 = specified level of cost]

C0 w
Or , K = − L ……(2)
r r

The above equation for a straight line where C0 /r is the vertical intercept and -w/r is the slope.

For example if w = 2 and r = 3 and C = 40 then the isocost line becomes

40 = 3K+ 2L

Solving for K yields

 40 2
K= − L
3 3

2
Or K = 13.33 - L [isocost line when budget constraint in $40]
3

*If the budget constraint is increased to $50 the equation for the isocost line becomes

50 = 3K+2L

Or 3K =50 -2L

Or K = 16.7 – (2/3) L

Budget constraint increase =isocost line shift to right

Budget constraint decrease = isocost line shifts to right

Optimal employment of two inputs

1)The objective is to minimize the cost of a given rate of output. Let that the firms objective is to
produce 10 units of output at minimum cost From the figure we can say that the point b is the
best of the three in the sense of being the lowest cost. It is the absolute minimum cost
combination of capital and labor. At point b the 10 unit isoquant is tangent to the $100 isocost
line. At the tangency of 10 units isoquant and the $100 isocost the slopes of the two functions are
equal. Thus, the marginal rate of substitution equals the price of labor divided by the price of
capital

2)The objective is to maximize output given a budget constraint of $150. Now the choice of
input combination is limited to points on $150 of isocost function. Three points are shown on
that isocost line – a,d and c.Here d is the preferred point among these three because a higher
rate of output is produced.The optimal point d ,the isoquant is tangent to the isocost.Hence the

W
same efficiency condition MRTS = applies
r

Productions and cost

A cost function relates cost to the rate of output. The basis for a cost function is the production
function and the prices of inputs. The minimum cost of a given rate of output is found by
multiplying the efficient rate of each input by their respective prices and summing the costs.

Table 7.2 shows a set of efficient labor-capital combinations. The rate of output associated with
each combination and the cost of these inputs. This schedule shows the total cost of producing
various rates of output.

In the short run at least one factor of production is fixed and the cost of that input is defined as
fixed cost. The costs associated with nonfixed inputs are called variable costs.

C =f(Q) [Q=total output and C=cost function]

Q= f(K,L)

TC =cost of capital +cost of labor

Short run cost function

In table 7.3 we consider a production process where capital is fixed input while labor is variable
input.Cost of labor is $100 per unit of labor and cost of capital is $100 per machine per
production period.The capital rate is fixed at 10 machines.

TC =total variable cost (TVC) + total fixed cost (TFC)

Finding minimum average variable cost

TC =1000 +10Q-0.9Q2 +0.04Q3

Find the rate of output that results in minimum average variable cost

d ( TC )
=MC
dQ
 = 10 -1.8Q+0.12Q2

Now find the TVC by substracting the FC component from the total cost component

TVC =TC- FC

=1000+10Q-0.9Q2+0.04Q3 -1000

=10Q -0.9 Q2 +0.04Q3

2 3
TVC
AVC = = 10Q−0.9 Q + 0.04 Q = 10 -0.9Q +0.04 Q2
Q Q

Because he minimum point of AVC occurs at the intersection with marginal cost ,equate the
AVC and MC fuctions to solve Q.That is

AVC =MC

10-0.9Q+0.04Q2 = 10 -1.8Q+0.12Q2

Or 0.9 Q -0.08 Q2 =0

Or Q(0.9 -0.08Q) = 0

Which has the roots Q1 =0 and Q2 =11.25

Characteristics of perfect competition

1)There must be a large number of sellers in the market with no single sellers in able to exert
significant influence over price .This criterion is sometimes described in terms of sellers being
price taker who can sell all that they can produce at the market determined price.graphically this
situation is depicted as sellers facing a horizontal demand curve.

2)similarly the second requirement for perfect competition is that there be a large number of
small buyers each buyer being unable to influence price. That is all buyers are price takers

3) there is easy entry and exit from an industry

4)Finally it is assumed that the product is totally undifferentiated. One firm’s output cannot be
distinguished from that of other producers,
Discussion Questions

6-6 what would the isoquants look like if all inputs were nearly perfect substitutes in a
production process? What if the three was near zero substitutability between inputs?

The isoquants of a production function for which the inputs are perfect substitutes are straight
lines, so the MRTS is constant, equal to the slope of the lines .

6-12 in one production period a firm producing an output rate of 1000 using 50 units of capital
and 40 units of labor .in a later period output was 1500 units the capital input was 60 units and
the labor was 45 units .The base period input prices are r =5 and w=10.Determine total factor
productivity in each period and the percentage of change in that productivity between two
periods.

Q
P=
rK +wL

1000
P1 = =1.54
50× 5+40 ×10

1500
P2 = =2
60× 5+45 × 10

P1 2
= (
P 2 1.54 )
−1 ×100=29.87 %
7-1 use the following data to compute total variable cost,total fixed cost ,average total
cost,average carriable cost average fixed vost marginal cost for each output rate shown.also use
the following information to determine equations for each of the total and per unit cost functions

7-4 Based on a consulting economist’s report, the total cost function for Advanced
Electronics, Inc. is:
TC =200+5Q - 0.04Q2 +0.001Q3
MC =5-0.08Q +0.003 Q2
a) determine the level of FC and equations for average TC ,average variable cost and
average fixed cost
here FC =200
VC =5Q -0.04Q2 +0.001Q3

TC 200+5 q−0.04 Q 2 +0.001Q 3 200 2

ATC = = = +5−0.04 Q+ 0.001Q
Q Q Q

VC 5 Q−0.04 Q 2 +0.001 Q 3 2
AVC = = =5−0.04 Q+ 0.001Q
Q Q
FC 200
AFC = =
Q Q
b)determine the rate of output that results in minimum average variable cost.
AVC =5 -0.04Q +0.001Q2
following the rule of optimization that is the slope =0 we get
d ( AVC )
=−0.04+0.002 Q
dQ
Or Q = 20
c) if fixed cost increases to rs 500 what output rate will result in minimum average variable
cost.
Because a change in fixed cost does not affect the average variable cost, the minimum point on
that function is unchanged
7-2 Raipur motors has one fixed input.the long term lease on its factory building for which the
rent is rs5000 per production period.use the data shown here to determine average cost average
variable cost and marginal cost for each output rate shown .also write equations for total cost
total variable cost and marginal cost