Chapter ? Single Input Model earning O1 After learning this chapter you will understand : Single Input Single Output Model. Production Function. v Average Physical Product, v Marginal Physical Product. Diminishing Marginal productivity. Profit Maximization with Output as Choice Variable. Supply Curve for a Competitive Firm. Profit Maximization with Input as Choice Variable. Relation Between Total, Average & Marginal Products. Profit Maximization with Multiple Inputs. For Full Course Video Lectures of ALL Subjects of Eco (Hons), B Com (H), BBE, MA Economics, UGC Net Economies, Indian Economic Service (IES) Register yourself at www.primeacademy.in Dheeraj Suri Classes Prime Academy 9899192027Prime Academy, www.primeacademy.in Bas. Concepts 1. Production : Production is the transformation of inputs such as raw materials, labour, capital ete. into outputs that can be consumed. Production can take place in various sectors, including agriculture, manufacturing, and services. 2. Single Input Single Output Model : A single-input, single-output (SISO) model is a type of system or model in which there is only one input variable and one output variable. In this model, we assume that the firm wants to maximize its profit. And our firm faces two constraints : technical constraints and market constraints. Technical constraint means that the firm must work with an existing body of scientific and technical knowledge and the restrictions imposed by the nature. Such restrictions are embodied in the idea of the production function. Market constraints are the constraints on the prices and quantities of the inputs the firm uses, and on the prices and quantities of the output the firm sells. a, Production Function : A production function is a mathematical description of how the firm can transform inputs into outputs, given the technological constrain A production function is a mathematical expression to the relationship between the quantities of inputs employed and the quantities of output produced. Production function gives the relationship by which production of a commodity depends on the factors of production. It expresses the technological relationship between inputs and output of a product. Though production depends on various factors like land, labour, capital ete. So, in general, we can represent the production function for a firm as : Y= fle 2, 5 Yn) Where y is the maximum quantity of output, x), x2, ...., % are the quantities of various inputs, and f stands for functional relationship between inputs and output. However, in Single input single output model, we assume that output quantity is y and the input quantity is x. The technological constraints on the firm are represented by its production function y = f(x). It shows the maximum output y which can be obtained if the firm uses x units of inputs. 4. Assumptions about the Production Function : The following assumptions are made about the production function (i) Monotonicity : By monotonicity we mean that as input quantity x increases the output quantity y will also increase. Mathematically, the first order derivative of the production function is positive, f(x) > 0. This is very plausible assumption because if by increasing the number of workers the output of the firm falls then it will never increase the number of workers, rather it will increase the number of workers only if its output increases with increase in number of workers. Micro Economics 2 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in (i) Curvature : The second assumption about the production function is about its curvature. We have two alternative versions of this assumption : a simple version and a more realistic version. In the simple version it is assumed that the production function is concave, as shown in the adjoining figure. Concavity fox) says that, whereas increases in x lead to increases in y, the increases gets smaller and smaller as x gets bigger and bigger. Mathematically, whereas the first derivative of the production function f'(x) is positive the second derivative f'(%) is negative. This is described as the assumption of diminishing returns. + In the more realistic version, it is assumed that the production function is convex when x is small and it becomes concave for larger fe) values of x. Mathematically f'(x) is positive for all values of x but f(x) is positive for small values of x, for some value of x it becomes zero and as x increases further it becomes negative. This is described as increasing returns when the firm is small followed by diminishing returns when the firm is large. The firm becomes more and more efficient as it grows from size zero, in the sense that, if x is the number of workers, the incremental output of an additional worker gets greater and greater, until the firm reaches maximal efficiency, in the sense that the incremental output of an additional worker is maximized. 5. Market Constraints : We assume that firms operates in perfectly competitive markets, where the price of input w and the price of output p is given. 6. Profit : Profit is the difference between revenue and cost. It is represented by the symbol 7. Revenue is the money that comes into the firm from the sale of its output. Here revenue is p.y(2). Cost is the money that goes out of the firm because of its purchase of its input. Here cost is w.x. Micro Economics 3 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in The firm wants to select the input quantity x, and/or the output quantity y, that will maximize profit : R=py—wx We can substitute y(x) for y in the above equation so that we get profit as a function of x, such that R(x) = p.y(x) — wx Alternatively, we can consider inverse of the production function x = f~?(y). We can use this function to substitute for x in the expression for profit, so that we get profit as a function of y, such that mQ) = p-y—w. f-") = Gp) If the firm is to produce and sell y, it must buy or hire x =f~1(y). The function f-1(y) shows what's called the firm’s conditional input demand or conditional factor demand. The adjoining figure shows this factor demand function for the real world case of a production function that is convex at first, and then turns concave. This figure shows the conditional input demand which is the inverse o the production function and this figure is obtained by flipping the axes of the production function of real world case. foutput) 7. Cost : Gost is the money that goes out of the Cas firm because of its purchase of its input. Here cost is w.x or wf~1(y) we can write it as cost function such that C(y) = wf~1(y). The adjoining figure shows a graph of the q total cost function, or the total cost curve. The total cost curve is simply a translation ts 2 of the conditional input demand curve in this simple single input model. Average Cost : Average cost is the cost per unit of output. Mathematically, AC(y) = Tatalost = £09 yy (ouput) Output y In this graph, Average cost is the slope of a ray starting from origin and intersecting the total cost curve. For instance a ray /,, starting from origin and intersecting the total cost curve at point P. The output corresponding to point P is y° which is the horizontal component of point P. So, the slope of line fi is the average cost at point P. As we decrease the output from y" the Tine /; becomes steeper which means average cost increases and as we increase the output from y° the line J; becomes flatter which means average cost falls, the average cost is Micro Economics 14 By Dheeraj Suri, 9899-192027 cy)= wh)Prime Academy, www.primeacademy.in minimum when a ray from origin is tangent to the total cost curve, in the given figure corresponding to output y* the ray is tangent at point Q, so the average cost is minimum at output y*. On increasing output from y* the intersecting ray from origin becomes steeper and average cost rises. Marginal Cost : The additional cost of producing an extra unit of output is called its marginal cost. Mathematically, MC(y) = C"(y) = 22. In the above graph, line [ is tangent to the curve at point P, the horizontal component of point P is output y°, therefore, the marginal cost corresponding to output y" is slope of line b. Relation Between AC and MC : > Both MC and AC are obtained from TC. Cost Mc Both MC and AC have ‘U? shape for (6) ac the real world case. When AC is falling MC stays below AC. When AC is minimum, we have MC = AC. As in the graph AC is minimum at output’ y* and corresponding to output y* we have AC = MC. . a” — > When AC is rising MC stays above AC. v vv 8. Profit Maximization with Output as the Choice Variable : We know that profit as a function of output y can be expressed as, ny) =p: ral We can consider w. f(y) as C(y) so we write the profit function as my) =p.y- Cy) We start by observing that because the firm can choose = 0, the y it chooses must produce non negative profits, ie, ny) =p.y—CO) =0 => py2zCQ) => p2co)/y > p2ac Which in turn implies, p > min AC. This means that if the market price p for the output does not cover the firm’s minimum average cost of producing its output, the firm will not produce anything. Now, if p is high enough to cover minimum average cost, the level of output is decided by the first and second order conditions. Micro Economics 75 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in The First Order Condition The first order condition for maximum profit says that the derivative of x(y) should be zero, i.e., daly) _ 0 => dipy-CO)) 0 ay oe > p-“=0 => p-MCQ)=0 => p=MCGQ) This gives the crucial basic rule for profit maximization for a competitive firm : price equals marginal cost. Of course, this does not guarantee maximum profit because to assure maximum profit we must.check the second order condition as well. The Second Order Condition The second order condition for profit maximization is ae <0 => s@=MCO) <9 ty’ dy = ~aMCO eg = sco 5 9 ay a This means MC is rising. Thus at a profit maximizing point we marginal cost is rising. So we can summ: For a profit maximizing competitive firm : (i) Ifpis less than minimum average cost, the firm will produce nothing. (ii) If the firm is producing something, it will choose an output Ievel at which p =MC()), and at which marginal cost is rising (or at least not falling). ave, price equals marginal cost, and as under : The adjoining figure shows U shaped average cost and marginal cost curves for real world case. Let’s consider a price p such that p is more than the minimum average cost. Masia profit Now, for maximum profit the cs ON first order condition is p = MC. a — This condition is satisfied at two points, point 1 and point 2. But the second order condition, MC Lt ylostpa) is rising is only satisfied at point y 2. Thus point 2 is the point of maximum profit. 9. Supply Curve for a Competitive Firm : We know that, for a profit maximizing competitive firm : w than minimum average cost, the firm will produce nothing, i.e., s zero. Micro Economics 1.6 By :D eray Suri, 9899-192027Prime Academy, www.primeacademy.in (i) If p = min ACQ), then the firm is producing something, it will choose an output level at which p = MCQ), and at which marginal cost is rising (or at least not falling). The level of supply is this case is corresponding to p = MCQ). Thus, as shown in the adjoining figure, when p < min AC(y) the supply of the firm is zero and the supply curve is on the vertical axis. When p 2 min ACQ) the supply curve will coincide with that part of the MCG) that lies above the AC() curve. (output) Exercise 1 Theory Questions QI. Prove that the marginal cost is equal to average cost at the output level for which average cost is minimum. Basic Concepts 1. Marginal Product of an Input : The marginal product of an input is the additional output that can be produced by employing one more unit of that input while holding all other inputs constant. Marginal product translates into additional output per extra unit of input. Mathematically, if the production function is y = flx), where x represents the units of input used then the marginal product of input x is MP(x) = “222 = "(x), Average Product of an Input : The average product represents the amount of output per unit of input. Mathematically, AP(x) = ~~ 3. Diminishing Marginal Productivity : If you take a look at the total, average, and marginal product from the following table. In all three cases, labor productivity reaches a maximum and then begins to decline. Why the decline? The adage, "Too many cooks in the kitchen spoils the broth”, hints at the answer. Initially, each additional employee hired increases total product at an increasing rate (marginal product is increasing). In this stage (1-3 employees), dividing tasks up and working as a team significantly increases output. After the third employee is hired, additional employees continue to increase total product, but at a decreasing rate (marginal product begins to decline). Beyond six employees, total output actually Micro Economics 7 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in falls (marginal product becomes negative). In this stage, your workshop is overcrowded and capital is spread too thinly across your employees. Idle workers get in the way and actually detract from the work of others, reducing total output. This eventual decline in output is an extreme example of the law of diminishing marginal returns, which helps explain the shapes of the total, average, and marginal _product curves. Quantity of | Total Output | Average Product | Marginal Product Input 0 0 - 7 1 4 4 4 2 14 7 10 3 30 10 16 4 40 10 10 5 48 9.6 6 6 50 83 2 7 48 69 2 8 42 53 6 The law of diminishing marginal returns : All else constant (e.g., technology and at least one fixed resource) given successive increments of variable resources eventually result in declining marginal products. The existence of at least one fixed resource means that this law is a short run concept. The law of diminishing marginal returns is unavoidable when at least one resource is fixed, and is without exception. Were it not for diminishing returns, enough food might be grown in a flower pot to feed the world. Mathematically, the assumption of diminishing marginal physical productivity is an assumption about the second-order partial derivatives of the production function : amr(e) _ #7) — 9 ax ax? 4. Geometric Relationships between Total, Average, and Marginal Product Curves : The shapes of the average and marginal product curves and how they are related are tightly linked to the shape of the total product curve. This should come as no surprise - average and marginal products are calculated from total product data, Micro Economics 78 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in 5 sO S 8 4 2 30 g e 2 10 ° 12 3 4 5 67 8 9 WW Quantity of Labor - ° a3 5S 23 25 28 § 2 of aD — 53 @ te a Quantity of Labor Graphically, the average physical product of labor equals the slope of a ray from the origin to a given point on the total product curve. The average physical product of labor reaches a maximum when a ray from the origin is just tangent to the total product curve. The marginal physical product of labor graphically corresponds to the slope at particular points on a total product curve. When a ray from the origin (average product) is just tangent (marginal product) to the total product curve, MP(x) = AP(a), i.e., at maximum point of AP(x) we have MP(x) = AP(a). From the above Table and its graphical presentation, we can establish the following relationship between TP, MP(x), and AP(x) curves. “If MP(x) > 0, TP will be rising as x increases. The TP curve begins at the origin, increases at an increasing rate over the range 0 to 3, and then Micro Economics 79 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in increases at a decreasing rate. The MP(x) reaches a maximum at 3, which corresponds to an inflection point on the TP curve. At the inflection point, the TP curve changes from increasing at an increasing rate to increasing at a decreasing rate. If MP(x) = 0, TP will be constant as x increases. The TP is constant between workers 6 and 7. ¢ If MP(x) < 0, TP will be declining as x increases. The TP declines beyond 7. Also, the TP curve reaches a maximum when MP(x) = 0 and then starts declining when MP(x) < 0. “> MP(a) intersects AP(x) (MP(x) = AP(x)) at the maximum point on the AP(x) curve. This occurs at labour input rate 3.5. Also, observe that whenever MP(x) > AP(a), the AP(x) is rising (upto number of workers 3.5). When MP(x) < AP(x) (from number of workers 3.5), the AP(x) is falling. ‘Therefore, the intersection must occur at the maximum point of AP(x). It is important to understand why. The key is that AP(x) increases as long as the MP(x) is greater than AP(x) And AP(x) decreases as long as MP(x) is less than AP(x). Since AP(x) is positively or negatively sloped depending on whether MP(x) is above or below AP(a), it follows that MP(x) = AP(x) at the highest point on the AP(x) curve. Even mathematically we can prove that at TEC) — 0 we have MP(x) = APC) maximum point of AP(x), i.e., when Exercise 2 Theory Questions QI. If the average product is rising, marginal product is also rising. Do you agree? Q2. You are an employer seeking to fill an additional position on an assembly line in order to increase output. If you observe that the average product of workers is just beginning to decline, should you hire any more workers? Explain. What does this situation imply about the marginal product of your last worker hired? [Eco. (H) III Sem. 2013] Q3. Show the relation between average product of labour and marginal product of labour. Q4. If Diminishing marginal returns set in from the very start what do the total product, average product and marginal product curves of the variable input look in this case? [Eco. (H) 1995] (Hint : AP, MP always falling, TP concave] Basic Concepts 1. Value of Marginal Product : Marginal product and average product of an input are measured in terms of units of output. To convert the measure into dollars, we simply multiply by the output price p. The product of marginal product of an input with output price gives value of marginal product (VMP) such that, VMP(x) = p.MP(x) Micro Economics 7.10 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Similarly, the multiplication of price of output and average product of an input gives the value of average product of input (VAP), such that VAP(x) = p-AP(x) 2. Profit Maximization with Input as the Choice Variable : The production function with input as the choice variable takes the form : M(x) = pfx) — wx Atx=0 we will have y = 0, this means that the firm always have the option to get zero profits by using zero input. So, it will never accept a negative profit. Which means, n(x) 20 > pfx)-wx20 > pfl)2we > pfx)/x2w > VAPG)2w This leads to a condition that must hold if the firm is to use any input max VAP(x) > w Also, the first order condition for maximum profit is pMP()=w = or VMP(x)= and the second order condition for maximum profit is d?m(x) _ dVMP(x) ae au <0 dx? dx 3. Multiple Outputs : Suppose that the firm produces two different outputs yy and ys using one input x. In this case we use inverse production function x=f"Ovy2) This production function simply means that if the firm is going to produce y; units of output | and y» units of output 2 then it needs to hire x units of input. Assumptions : The following assumptions are made for this production function: (i) | We assume monotonicity, this means if firm wants to increase production of ‘one output keeping the other output as fixed it needs to increase the level of ar ces.) > Oand 2 se) >0 (ii) It is assumed that the ir inverse ‘production function i is convex, which means to produce average of outputs less than average of inputs is required. This is because, perhaps the firm can profitably rearrange the units of inputs going to each output Gii) If the units of input are zero then the output is also zero. input. Mathematically, 4. Profit Maximization with Multiple Outputs : With respect to the firm’s market constraints, we continue to assume that the firm is competitive in all markets in which it operates. That is it acts as a price taker in output market as well as in the input market. Let p; and p» be the output prices and w be the input price. The firm wants to maximize the profit, given by : Tp V2) = Pri + P2V2 — WE. V2) Subject to the constraint 1(y,, y2) > 0 ‘The first order conditions for maximum profit are : Micro Economics 71 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in na) = =p- wi Gate) — Oand on Fy) — Ixy PA Gyn = Which means that for maximum profit Pi =MC, and p; =MC; Thus to maximize profit, the firm will produce an amount of each output that equates price and marginal cost. Exercise 3 QI. A competitive firm’s production function is y = 10 + x1/3. The price of input x is wel, Find the inverse production function. (ii) Find firm’s cost function in terms of output. (ii) Find the marginal and average cost functions. (iv) Show that the marginal cost is minimum at y = 10. (v) Show that average cost and marginal cost are equal at output for which average cost is minimum. (vi) Find the firm’s supply curve y(p). 1) x =(y- 10), Cy) = (y- 10), (ili) MC(y) = 3(y - 10), AC(y) = (y-10)3/y, (wi), y(p) = 10 + & For Full Course Video Lectures of ALL Subjects of Eco (Hons), B Com (H), BBE, MA Economics, UGC Net Economics, Indian Economic Service (IES) Register yourself at www.primeacademy.in Dheeraj Suri Classes Prime Academy 9899192027 Micro Economics 7.12 By Dheeraj Suri, 9899-192027