Production Function

Production is the transformation of inputs into outputs. Inputs are the factors of
production -- land, labor, and capital -- plus raw materials and business services.

The transformation of inputs into outputs is determined by the technology in use.

Limited quantities of inputs will yield only limited quantities of outputs. The
relationship between the quantities of inputs and the maximum quantities of
outputs produced is called the "production function."

But how do these outputs change when the input quantities vary? Let's take a look
at an example of a production function.

In general, we would allow for varying amounts of land, labor and capital.
However, in this example, labor will be the only input, for the sake of simplicity.

A Production Function Example

Here's a Javascript example of a production function, with labor as
the input variable. Play around with it a little to get the idea. (You
have to have Netscape 2.0 or later or another browser that
recognizes Javascript to do this; otherwise, go on to the next
page). Type a number into the "land" cell and the output
produced will be shown in the "output" cell. If you don't see the
change right away, click "Update."

Program Example 1
Click here to see the result:

Labor Output

In this chapter, to keep things simple, we will stick mostly to

examples in which labor is the only input variable. As we will see
later on, that makes sense as an approximation in the short run.
But, for those who like a more mathematical approach, here's a
footnote with an example in which land, labor, and capital are
all variable.

Marginal Productivity
Productivity, by definition, is a ratio of output to labor input. In most statistical
discussions of productivity, we refer to the average productivity of labor:

Average labor productivity is an important concept, especially in macroeconomics.

In microeconomics, however, we will focus more on the marginal productivity. We
can think of the

marginal productivity of labor as

the additional output as a result of adding one unit of labor, with all other
inputs held steady and ceteris paribus.
In algebraic terms, an equally correct definition is:

Let's have a numerical example to illustrate the application of the theory. Suppose
that:

• When 300 labor-days per week are employed the firm produces 2505
units of output per week.
• When 400 labor-days per week are employed the firm produces 3120 units
of output per week.
• It follows that the change in labor input, ﾐ Labor, is 100.
• It also follows that the change in output, ﾐ Output, is 615.
• Applying the formula above, we approximate the marginal productivity of
labor by the quotient 615/100 = 6.15.
• We can interpret this result as follows: over the range of 300 to 400 man-
days of labor per week, each additional worker adds approximately 6.15
units to output.

Of course, if we had more information, we could get a closer approximation. For

example, if we had the outputs for 310, 320, ... 390 man-days of labor, we could
see how MP varies within the range 300-400. But we can be sure that the values
will be in the neighborhood of 6.15.

Now let's think a little further about the Law of Diminishing Returns.
 The Law of Diminishing Marginal
Productivity
In his discussions of the Law of Diminishing Returns, Malthus did not distinguish
between average and marginal productivity. However, in modern economics, we
think of diminishing returns primarily in terms of marginal, not average,
productivity. Thus, we would state the law this way:
Law of Diminishing Returns (Modern Statement):
When the technology of production and some of the inputs are held constant
and the quantity of a variable input increases continually, the marginal
productivity of the variable input will eventually decline.
The inputs that are held steady are called the "fixed inputs." In these pages we are
treating land and capital as fixed inputs. The inputs that are allowed to vary are
called the "variable inputs." In these pages we are treating labor as the variable
input.

Another way to express the law of diminishing returns, is that, as the variable input
increases, the output also increases, but at a decreasing rate. The marginal
productivity of labor is the rate of increase in output as the labor input increases.
To say that output increases at a decreasing rate when the variable input increases
is another way to say that the marginal productivity declines

Marginal Productivity Example

Let's extend the numerical example in the page before last and see how marginal
productivity varies over a wide range of labor inputs. Here is a hypothetical
example of production with the inputs of land and labor held steady and varying
quantities of labor, and the output and average and marginal productivities.

Table 1
Average
Labor Output Marginal
Productivity
Productivity
0 0 0
9.45
100 945 9.45
8.35
200 1780 8.90
7.25
 300 2505 8.35
6.15
400 3120 7.80
5.05
500 3625 7.25
3.95
600 4020 6.70
2.85
700 4305 6.15
1.75
800 4480 5.60
0.65
900 4545 5.05
-0.45
1000 4500 4.50

Output Diagram
Here is a picture of the relationship between the variable input
and the output in the numerical example in the previous table.
Notice how the slope gets flatter: as the variable input increases,
output increases at a decreasing rate. This is a visualization
of the Law of Diminishing Marginal Productivity.

Figure 1. Production with Diminishing Returns

Average and Marginal Productivity

Diagram
We have put some stress on the difference between average and
marginal productivity. Both are important, but for a model of
short-run profit-maximizing supply, marginal productivity is the
more important. and the two are quite different.

Here are the average and marginal productivities for the same numerical example
in the page before last. Notice how both average and marginal productivity
decrease as the labor input increases. But the marginal productivity declines faster
than the average productivity, pulling the average productivity down after it. The
downward slope of the marginal productivity line expresses the Law of
Diminishing Returns, and the downward slope of the average productivity is also a
result of the law.

Figure 2: Average and Marginal Productivity

Average and Marginal Productivity 2

The relationship between average and marginal productivity in the diagram is
important in itself, and we will see similar relationships in future chapters. So let's
look at it a little more closely. Average and marginal productivity will not always
have the same slope. In general,

• whenever average productivity is greater than marginal productivity,

average productivity will slope downward.
• whenever average productivity is less than marginal productivity, average
productivity will slope upward.

The diagram does not show any values where average productivity is less, but a
more complicated example might, and then we would see the second part of the
relationship visualized.
To understand the relationship, think of it this way: as we add labor input, one unit
after another, we add a bit more to output at each step. When the addition is greater
than the average, it pulls the average up toward it. When the addition is less than
the average, it pulls the average down toward it.

Application: Efficient Allocation of

Resources

Diminishing returns plays an important part in the efficient allocation of resources.

For efficiency, of course, we want to give more resources to the use in which they
are more productive. But, as we give more resources to a particular use, we will
observe diminishing returns -- that use will become less productive. That may
sound frustrating, but in fact it leads to a very important principle we can apply to
the problem of efficient allocation of resources. We'll explore this in the next few
pages and we will see the same principle again and again in the other
microeconomics chapters in this book.

Allocation of Labor Between Two Fields

The concept of marginal productivity is central to economists'
understanding of efficient allocation of resources. For an
illustrative example, consider a farmer who has two fields to
plant. He can grow a crop of corn (let's say) on each of them, but
has a limited amount of labor to allocate between them. Let us
say that the farmer can spend 1000 hours of labor, total, on the
two fields. If he spends one more hour of labor on the north field,
that means he has one hour less to spend on the south field.

Here are the production functions for the two fields.

Table 2

Labor Input and Output on Two

Fields
North Field South Field

labor output labor output

0 0 0 0
 100 9500 100 12107

200 18000 200 23429

300 25500 300 33964

400 32000 400 43714

500 37500 500 52679

600 42000 600 60857

700 45500 700 68250

800 48000 800 74858

900 49500 900 80679

1000 50000 1000 85715

Production Functions for the Two Fields

We can visualize the production functions for the two fields.
Figure 1, below, shows the production function for the relatively
fertile south field with a vertically dashed purple curve, and the
less fertile north field with a solid green curve. As we see, the
south field can always produce more, with the same amount of
labor, as the north field can.
 Figure 3. Production Functions for Two Fields

The Problem of Allocation

The farmer's "allocation problem" is: How much labor to commit to the north field,
and how much to the south field? One "common sense" approach might be to
abandon the infertile north field and allocate the whole 1000 hours of labor to the
south field. But a little arithmetic shows that this won't work. Here is a table that
shows the correlated quantities of labor on the two fields, and the total output of
corn from both fields taken together.

Table 3

Allocation of Labor
and Total Output
on Two Fields
total
Labor
Labor on output
on
South in
North
Field bushels
Field
of corn

0 1000 85000

100 900 89600

200 800 92400

300 700 93400

400 600 92600

500 500 90000

600 400 85600

700 300 79400

800 200 71400

900 100 61600

1000 0 50000
We see that the farmer gets his largest output by allocating most, but not all, of his
labor to the south field. Because of the principle of diminishing returns, however,
he shouldn't put all his resources into the one field, but divide the labor resource
(unevenly!) between the two.

But how much should go to the north plot, and how much to the south plot?

Visualizing The Problem of Allocation

We can visualize the efficient allocation of resources with a graph like this one.
The labor used on the infertile north field is measured on the horizontal axis and
the total output from both fields in shown on the vertical axis. (We are assuming,
of course, that all labor not used on the North field is used on the South field). The
dark green curve shows how total output changes as we shift labor from the north
field to the south field. Thus, the top of the curve is the interesting spot -- that's
where we get the most output. In this example, that's the efficient allocation of
resources between the two fields.

Figure 4: Maximum Production

It's easy to see that we should put some labor to work on the
north field -- but not too much. The vertical orange line shows
that the maximum output -- the top of the dark green curve --
comes when about 300 labor days are allocated to the north field
and the rest, 700 labor days, to the south field. And that's exactly
right.

It's pretty easy to see where the maximum is in this simple example. But in a more
realistic example, in which there could be many more than just two dimensions, it's
harder to visualize. We need a rule that we can apply in more complex, realistic
examples, a rule that will tell us if we have or don't have an efficient allocation of
resources.
That's where the economist's "marginal approach" comes in. The objective is to get
to the top of the hill. You could call "the marginal approach" the "bug's-eye view."
Think of yourself as a bug climbing up that production hill in the picture. How will
you know when you are at the top?

Marginal Productivity and Allocation

If you were a bug, you couldn't see much. Perhaps you couldn't see to the top of
the hill. But you would be able to tell if you were going up, or down, or neither. So
you would just keep going as long as you were going up, and stop when you were
neither going up nor down. That's the way a bug gets to the top of a hill.

If you were a farmer with two fields, it's a little more complicated, but the same
principles apply: take it step by step. However much you may be producing, ask
yourself "What would happen if I were to take one worker away from the North
Field and put her to work on the South Field? How much less will the North Field
produce? The answer to that question is the marginal productivity of labor on the
North Field. How much more will the South Field produce? The answer to that
question is the marginal productivity of labor on the South Field. So the move of
labor from the North Field will increase production if the marginal productivity on
the North Field is less than the marginal productivity on the South Field. Like the
bug, you want to keep moving in that direction as long as production keeps getting
greater, that is, as long as the marginal productivity on the North Field is less than
the marginal productivity on the South Field. And you stop when further
movement won't get you any higher on the hill, that is, when the marginal
productivities are equal on the two fields.

So now, let's visualize the marginal productivities for these two fields. But this
time we will do it a slightly different way. We will measure the labor used on the
infertile north field from left to right on the horizontal axis. Then, what's left is
what's available for the north field, so we will measure the labor used on the south
field from left to right -- from 1000 hours down to zero. The marginal product on
the north field is shown with the green line, and the marginal product on the south
field with the vertical-dashed purple line. (Remember, the marginal productivity on
the south field decreases as the labor input on the south field gets bigger, so the
marginal productivity on that field increases as labor used on the field gets smaller,
as it does here). Here it is:
 Figure 5: Marginal Productivity and Efficient Allocation

Marginal Productivity
Figure 6 shows the most efficient allocation of resources in this case. It is to
allocate 300 hours of labor to the north field, and 700 hours to the south field, as
shown by the vertical red-orange line. For maximum output, labor is allocated so
that the marginal productivity of labor on the north field is equal to the marginal
productivity of labor on the south field.

Figure 6: Efficient Allocation

To see why this works, think it through in reverse: what happens if the allocation
of labor is not 300 to the north field and 700 to the south field? For example,
suppose 200 hours are allocated to the south field and 800 to the north field. This
puts us to the left of the orange line -- and we read off the diagram that the
marginal productivity of labor on the north field is 80 bushels of corn, while the
marginal productivity on the south field is about 62. Remembering the definition of
marginal productivity, that means: if the farmer spends one additional hour on the
north field, he will gain 80 bushels, while spending one less on the south field will
cost him 62 bushels, leaving a net gain of 18 bushels. What has happened is that
spending 800 hours of labor on the south field has pushed the "diminishing
returns" on that field so far that it is less productive at the margin than the north
field. and that will be true anywhere to the left of the orange line, since, in that
range, the marginal productivity on the north field is always greater than the
marginal productivity on the south field.

Now let's see what happens if the allocation is to the right of the most efficient one
-- for example, suppose the farmer were to allocate 600 hours to the north field and
400 to the south field. Looking at the diagram, we see that the marginal
productivity on the north field is 40 while the marginal productivity on the south
field is 90. Thus, moving an hour of labor from the north field to the south field
will yield a gain of 90-40=fifty bushels of corn. And the farmer will continue to
gain as he moves toward the efficient allocation from the right, because, in that
range, the marginal product on the south field is always bigger than the marginal
product on the north field.

We have seen that the farmer can gain by reallocating his labor from either side
toward the efficient output. Once he has 300 hours of labor on the north field and
700 on the south, the farmer cannot increase his output any further. That is why we
think of it as the "efficient" allocation of resources.