Chapter Four

The Theory of Production

Inputs and Outputs

Inputs to production are called factors of production (classified into broad categories such as land, labour,
capital and raw materials). Capital goods are those inputs to production that are themselves produced
goods. Basically capital goods are machines of one sort or another. Money used to start up or maintain a
business is called financial capital and capital goods or physical capital used for produced factors of
production.

Describing Technological Constraints

Nature imposes technological constraints on firms, only certain combinations of inputs are feasible ways
to produce a given amount of output and the firm must limit itself to technologically feasible production
plans.

The set of all combinations of inputs and outputs that comprise a technologically feasible way to produce
is called a production set.

For example, one input (x) and one output (y) the production set may have the shape

Y = Output
Y = f (X )

production Set

X = Output

The production set shows the possible technological choices facing a firm. As long as the inputs to the firm
are costly it makes sense to limit ourselves to examining the maximum possible output for a production set
depicted. The function depicting the boundary set is known as the production function. It measures the
maximum possible output that you can get from a given amount of input.

In a two input case f (x1 x 2 ) a convenient way to depict productions is by use of isoquant. An isoquant is
the set of all possible combinations of inputs 1 and 2 that are just sufficient to produce a given amount of
output.

Isoquants are similar to indifference curves, but one difference is that isoquants are labelled with the
amount of output they can produce, not with a utility level. Thus the labelling of isoquants is fixed by the
technology and does not have the kind of arbitrary nature that the utility labelling has.

Examples of technology

(i) Fixed proportions

Eg. Producing holes, hence one man one shovel. Extra shovels are not worth anything. Thus
the total number of holes that you can produce will be the minimum of the number of men and
the number of shovels that you have.

f (x1 x2 ) = Minx1 , x2 

X2
Case of perfect complements

Isoquant

0 X1

(ii) Perfect substitutes

 Suppose now that we are producing homework and the inputs are red pencils and blue pencils.
The amount of homework produced depends only on the total number of pencils, the production
function is written as:

f (x1 x2 ) = x1 + x2

X2
Case of perfect substitutes

0 X1

Cobb-Douglas

A CD production function is given as:

f (x1 x2 ) = Ax1a x2b

Measures the scale of production – how much, output we would get if we used one unit of each input. The
parameters a and b measure how the amount of output responds to changes in the inputs.

Properties of technology

1. Technologies are monotonic – if you increase the amount of at least one of the inputs, it should be
possible to produce at least as much output as you were producing originally. This is sometimes
referred to as the property of free disposal: if the firm can costlessly dispose of any inputs, having
extra inputs around cant hurt it.
 2. Technology is convex – this means that if you have two ways to produce y units of output, (x1 x2 )

and ( z1 z 2 ) , then their weighted average will produce at least units of output. Two ways of
producing output is called production techniques.

X2

100a 2 • (100a1 + 100a2 )

• (25a1 + 75b1 ,25a1 + 75b2 )

100b2 •
(100b2 + 100b)1 Y = 100

100a1 100b1 X1

Convexity, if you can operate production activities independently then weighted averages of
production plans will also be feasible. Thus the isoquant will have a convex shape.

A production function : is a purely technical relation which connects factor inputs and
outputs, it describes the laws of production; - that is the transformation of factor inputs
into products (outputs) at any particular time period. The production function represents
the technology of a firm of an industry, or the economy as a whole. The production
function includes all the technically efficient methods of production,

A method of production is a combination of factor inputs required for the production of

one unit of output. Usually, a commodity may be produced by various methods of
production. For example, a unit of commodity x may be produced by the following
process;

Process P1 process P2 Provcess P3

Labour units 2 3 1
Capital units 3 2 4

Activities may be presented graphically by the length of lines from the origin to the point
determined by the labour and capital units. The three processes above may be presented

Method of production A is technically efficient relative to any other method B, if A uses

less of at least one factor and no more from the other factors as compared with B, e.g for
a commodity x can be produced by two methods

A B

Labour 2 1

Capital 3 4

Method B is technically inefficient as compared with A. The basic theory of production

concentrates only on efficient methods. Inefficient methods will not be used by rational
entrepreneurs.

If a process A uses less of some factors(s) and more of some others as compared with any
other process B, then A and B cannot be directly compared on the criterion of technical
efficiency. Check the following production function

A B

Labour 2 1

Capital 3 4
In this case both processes are considered as technically efficient and are included in the
production function (the technology). The choice of the particular method will entirely
depend on the individual price of the factors of production. Therefore, note that a
technically efficient method may not necessarily be a economically efficient method.

Note that the Kink isoquant are more realistic, production is considered discrete rather
than continuous array. However tradition economic theory has mostly adopted
continuous isoquants, because they are mathematically simpler to handle by the simple
rules of calculus.

The production function describes not only a single isoquant, but the whole array of
isoquants, each of which shows a different level of output. It shows how output varies as
the factor inputs change.

Production functions involve (and can provide measurements of) concepts which are
useful tools in all fields of economics. The main concepts are;-

i) The marginal productivity of the factors of production

ii) The marginal rate of substitution and elasticity of substitution

iii) Factor intensity

iv) The efficiency of production

v) Returns to scale

These concepts may be discussed as;-

The general mathematical form of the production function is

Y = f ( L, K , R, S , ,  )

Where Y=Output, L=Labour input, K= capital Output, R= raw materials, S= land

Input , R= returns to scale, γ= efficiency parameter

All variables are flows; that is, they are measured per unit of time, in its general form the
production function is a purely technological relationship between quantities of inputs
and quantities of output. Prices of factors of production do not enter into the production
function

Raw materials and land input are constant therefore the production function will be
described as X = f ( L, K , ,  ) this therefore can be presented graphically as
 x x

x = f ( L) − x = f (k ) −
K 3 , , L ,

L K

The slope of the Isoquant curve represents the marginal products of the factors of
production. The marginal product of the factors is defined as the change in output
resulting from a very small change of the factors, keeping all other factors constant.

Mathematically the marginal product of each factors is the partial derivative of the
production function with respect to this factor. Thus

X X
MPL = and MPK =
L K

Graphically the marginal product of labour is shown by the slope of the production
function

X = f 1 ( L) −
k , ,

And the marginal product of capital is shown by the slope of the production function;-

X = f 2 (K ) −
L , ,

In principle the marginal product of a factor may assume any value, positive, Zero, or
negative, however the basic production theory concentrates only on the efficient part of
the production function. Hence we say that the theory of production concentrates only
on the levels of employment of factors over which their marginal products are positive,
i.e

 ( MP ) L
MPL  0 But  0 for the case of Labour in the first equation and
L
  ( MP ) K
MPK  0 But  0 for the case of capital in the second equation
K

Formally the above can be presented as;-

X = f ( L, K , ,  )

X 
 0
L 
 Positive marginal products
X
 0
K 

2 X 
 0 
L2
 The slope of marginal product curves is negative
2 X
 0
K 2 

These implies that the traditional theory of production concentrates on the range of
isoquants over which their slope is negative and convex to the origin.

By construction the higher to the right an isoquant is, the higher the level of output it
depicts. By construction isoquants do not intersect one another, the locus of points of
isoquants where the marginal products of the factors are zero form the ridge lines. The
upper ridge line implies that the MP of capital is Zero. The lower ridge line implies that
the MP for labour is Zero. The production techniques are only (technically) efficient
inside the ridge lines. Outside the ridge lines the marginal products of factors are negative
and the methods of production are inefficient, since they require more quantities of both
factors for producing a given level of output. Such inefficient methods are not considered
by the theory of production since they imply irrational behavoiur of the firm. The
condition for positive but declining marginal products of the factors defines the range of
efficient product (the range of isoquants over which they are convex to the origin) K
Upper ridge line
The slope of the isoquant (−K / L) defines the degree of substitutability of the factors
of production

At point a and b the slope of the tangent is K / L .

Slope of the isoquant decreases (in absolute terms) as we move down wards along the
isoquant, showing the increasing difficulty in substituting K for L. The slope of the
isoquant is called the rate of technical substitution, or the marginal rate of substitution (MRS)
of the factors.
 K
− = MRS L, K
L

It can be proofed that the MRS is equal to the ratio of the marginal products of the factors

K X / L MPL
MRS L , K = − = =
L X / K MPK

Proof

The slope of a curve is the slope of the tangent at any point of the curve, the slope of the
tangent is defined by the total differential. In the case of the isoquant the total differential
is the total change in X resulting from a small change in both factors K and L. clearly if
we change K by K , the output X will change by the product K times the marginal
 X 
product of capital. (K )  Similarly, if we change labour by an infinitesimal amount
 K 
 X 
L , the resulting change in X is (L) 
 L 

Now along any isoquant the quantity X is constant, that the total change in X (the total
differential) must be equal to zero. Thus

 x   X 
dX = (K )  + (L) =0
 K   L 

Solving for K / L we obtain

K X / L MPL
− = =
L X / K MPK

Along the ridge lines the MRS=0. In particular along the upper ridge we have

X / K 0
MRS K , L = = =0
X / L X / L

and along the lower ridge

X / L 0
MRS L, K = = =0
X / K X / K
The elasticity of substitution

The marginal rate of substitution as a measure of the degree of substitutability of the

factors has a serious weakness;- that is;- it depends on the units of measurement of the
factors. A better measure of the ease of factor substitution is provided by the elasticity of
substitution. The elasticity of substitution is defined as the percentage change in the
capital labour, divided by the percentage change in the technical substitution

%inK / L
=
%inMRS

d ( K / L) /( K / L)
Or =
d ( MRS ) /( MRS )

The elasticity of substitution is purely independent of the units of measurement of K and

L, since both the numerator and the denominator are measured in the same units.

The factor intensity of any process is measured by the slope of the line through the origin
representing the particular process. Thus the factor intensity is the capital-labour ratio, in
the figure below process P1 is more capital intensive than process P2.

K1 K 2

L1 L2

The upper part of the isoquant includes more capital-intensive process. The lower part
of the isoquant includes more labour-intensive techniques.
Example 1

Let us illustrate the above concepts with a specific form of production function, namely
the Cobb-Douglas production function. This is the most popular in applied research,
because it is easier to handle mathematically.

The Cobb-Douglas function is of the form X = b0 .Lb1 .K b2

1. The Marginal products of factors

a) The MPL

X
MPL = = b1 .b0 .Lb1 −1 .K b2
L
= b1 (b0 Lb1 K b2 ) L−1
X
= b1 . = b1 ( APL )
L

Where APL is the average product of labour

Similarly

X
MPK = b2 . = b2 .( APK )
K

2. The marginal rate of substitution is

X
b1
X / L L = b1 . K
MRS L , K = =
X / K X b2 L
b2
K

3. The elasticity of substitution is

d ( K / L) /( K / L)
= =1
d ( MRS ) /( MRS )

Proof

Substitute MRS in the above equation and obtain

 d ( K / L) /( K / L)
=
 b K   b  K 
d  1 .  /  1  
 b2 L   b2  L 
 K  b 
d   1 
 L  b2 
= =1
 b1   K 
 d  
 b2   L 

Given that b1/b2 is constant and does not affect the derivative

4. Factor intensity. In a Cobb-Douglas function factor intensity is measured by the ratio

b1/b2. The higher this ratio the more labour intensive the technique. Similarly the
lower the ratio b1/b2 the more capital intensive is the technique.

5. The efficiency of production. The efficiency of production in the organization of

factors of production is measured by the coefficient b0. Intuitively it is clear that if two
firms have the same K, L, b1, and b2 and still produce different quantities of output,
the difference can be due to the superior organization and entrepreneurship of one of
the firms, which results in different efficiencies. The more efficient firm will have a
larger b0 than the less efficient one.

6. The returns to scale. This is a long run analysis concept. This concept will be
developed next

Laws of Production

The laws of production describe the technically possible ways of increasing the level of
production. We realize that output may increase in various ways, for example output
may be increased by using more of the variable factors while holding capital constant.
However the marginal product of the variable will decline eventually as more and more
of these quantities are combined with the other constant factors. The expansion of output
with one factor constant is described by the law of diminishing returns of the variable factor,
which is often referred to as the law of variable proportions.

a) Long-Run analysis of production;- Laws of Return to Scale.

In the long run expansion of output may be archived by varying all factors, in the long-
run all factors are variable. The laws of return to scale refer to the effects of scale
relationship.
In the long-run output may be increased by changing all factors by the same proportion,
or by different proportions. The returns to scale, refers to the change in output as all
factors change by the same proportion.

Suppose we start from an initial level of inputs and output

X 0 = f ( L, K )

And increase all the factors by the same proportion w. we will clearly obtain a new level
of output X*, higher than the original level X0

X * = f ( wL, wK )

If w can be factored out (that is, may be taken out of the brackets as a common factor),
then the new level of output X* can be expressed as a function of w (to any power v)
and the initial level of output

X * = w v f ( L, K ) Or X * = wv X 0

And the production function is called homogenous. If w cannot be factored out, the
production function is non-homogenous. Thus

A homogenous function is a function is such that if each of the inputs is multiplied by

w, then w can be completely factored out of the function. The power v and w is called
the degree of homogeneity of the function and is a measure of returns to scale;

If v=1 we have constant returns to scale. This production function is sometimes called
linear homogeneous.

If v<1 we have decreasing returns to scale.

If v>1 we have increasing returns to scale.

Returns to scale are measured mathematically by the coefficients of the production

function. For example, in a Cobb-Douglas function

X = b0 L K 

The returns to scale are measured by the sum (α + β) = v

Proof

Let L and K increase by w. the new level of output is

 X * = b0 ( wL)  ( wK ) 
= (b0 L K  ) w + 

Or X * = w +  X

Thus v = (α + β)

Production Lines
A production line shows the (physical) movement from one isoquant to another as we
change both factors or a single factor. A product curve is drawn independently of the
prices of factors of production. It does not imply any actual choice of expansion, which
is based on the prices of factors and is shown by the expansion path. The product line
describes the technically possible alternative paths of expanding output. What path will
actually be chosen by the firm will depend on the prices of factors.
The product curve passes through the original if all factors are variable. If only one
factor is variable ( the other being kept constant) the product line is a straight line
parallel to the axis of the variable factor. The K/L ration diminishes along the product
line.

Among all possible product lines of particular interest are the so-called Isoclines. An
Isoclines is the locus of points of different isoquants at which the MRS of a factor is
constant.

If the production is homogenous the isoclines are straight lines through the origin. Along
any one isoclines the K/L ratio is constant (as is the MRS of the factors). Of course the
K/L ratio (and the MRS) is different for different isoclines.
If the production function is non-homogenous the isoclines will not be straight lines, but
their shape will be twiddly. The K/L ratio changes along each isoclines (as well as on
different isoclines)

Equilibrium of the Firm; Choice of Optimal Combination of Factors of Production

Assumptions

a) The goal of the firm is profit maximization;- that is, the maximization of the
difference  = R − C

Where π is profits, R is revenue, C is costs,

b) The price of output is given Px

c) The price of factors : wage rate ( w) and the price of capital is (R)

A) Single Decision of the Firm

The problem facing the firm is that of constrained profit maximization, which may
take one of the following forms;

a) Maximize profits π, subject to a cost constraint. In this case total cost and prices
−
− − −
are iven (C , r , w, p) , and the problem may be stated as follows

−
max  = R − C
− −
 = Px X − C

Maximization of π is achieved in this case if X is maximized, since C and Px are

given constants by assumption.

b) Maximize profits π, for a given level of output. For example, a contractor wants
to build a bridge (X is given) with the maximum profit. In this case we have

max  = R − C
− −
 = Px X − C

Maximization of π is achieved in this case if cost C is minimized, given that X

and Px are given constraints by assumptions
Graphical presentation;

Given the isoquant and isocline curve

K K c/r

c/w

0 L 0 B L

Recall that the slope of the isoquant is given as

K MPL X / L
− = MRTS L , K = =
L MPK X / K

The isocost line is defined by the cost equation

C = (r )( K ) + ( w)( L) \

Where w= wage rate, and r= price of capital services

The isocost line is the locus of all combinations of factors the firm can purchase with a
given monetary cost outlay.

The slope of the isocost line is equal to the ratio of the prices of the factors of production;

w
Slope of isocost line =
r

Case 1: Maximization of output subject to cost constraint (financial constraint)

We assume; a given production function X = f ( L, K , ,  )

And given factor prices, w, r for labour and capital respectively

The firm is in equilibrium when it maximizes its output given its total cost outlay and the
prices of the factors, w and r.
The equilibrium is the point of tangency between isoclines and the highest possible
isoquant, in this case point a above equilibrium are desirable but not attainable due to the
cost constrain. This can be presented as follows;-

Ke e Iq3

Iq2

Iq1

0 Le B L

At the point of tangency (e) the slope of the isocost line (w/r) is equal to the slope of
isoquant (MPL/MPK). This is the first condition for equilibrium. The second condition is
that the isoquant be convex to the origin. That is to say

a) Slope of isoquant =slope of isocost

w MPL X / L
= = = MRTS L, K
r MPK X / K

b) The isoquant must be convex to the origin. If the isoquant is concave the point of
tangency of the isocost and the isoquant curves does not define an equilibrium
position.
Formal derivation of the equilibrium condition

A rational entrepreneur seeks to maximize his output, given his total cost outlay and the
prices of the factors, the problem is
−
Maximize X = f ( L, K ) Subject to C = wL + rK (cost constraint)

This problem of constraint maximization and the above conditions for equilibrium may
be obtained from its solutions

This maximization problem is solved by the Lagrangian Multipliers method;

Steps

i) Rewrite the constrain in the form

−
C − wL − rK = 0

ii) Multiply the constrain by a constant  which is the Lagrangian Multiplier

−
 (C − wL − rK ) = 0

iii) Form the composite function by subtracting the above equation from the
production function
−
 = X −  (C − wL − rK )

It can therefore be shown that maximization of the composite function implies

maximization of output.

The first order condition for maximization of a function is that its partial
derivative be equal to Zero. The partial derivatives of the above function with
respect to L, K and  are;-

 X
= +  (−W ) = 0
L L
 X
= +  (−r ) = 0
K K
 −
= C − wL − rK = 0

 solving the first two equations we obtain;-

X X / L MPL
= w or = =
L w w

X X / K MPK
= r or = =
K r r

It therefore follows that

X / L X / K
=
w r

X / L w MPL
Hence = =
X / K r MPK

The firm will be in equilibrium when it equates ratio of the marginal productivities of
factors to the ratio of their prices.

It can be shown that the second order conditions for equilibrium of the firm require that
the marginal product curves of the two factors have a negative slope.

The slope of the marginal product curve of labour is the second derivative of the
production function;

2 X
Slope of MPL curve =
L2

2 X
Similarly for capital Slope of MPK curve =
K 2

The second-order conditions are

2 X 2 X
 0 and 0
L2 K 2
2
 2 X   2 X   2 X 
And  2     
 L  K   LK 
2

These conditions are sufficient for establishing the convexity of the isoquants.
Case two: Minimization of cost for a given level of output

The condition for equilibrium are the same as the case of maximization of output in the
first case above.;- that there must be tangency between isoquant and the lowest possible
isocost curve, and the isoquant must be convex to the origin. However the problem in
this case is that the entrepreneur aims at cost minimization. Therefore in this case we have
a single isoquant which denotes the desired level of output and a set of isocost curves,
curve closer to the origin shows a lower total-cost outlay. The isocost lines are parallel
because they are drawn on the assumption of constant prices of factors: since w and r do
not change, all the isocost curves have the same slope w/r

The firm minimizes its costs by employing the combination of K and L determined by the
point of tangency of the isoquant with the lowest isocost line. As shown below

Ke

0 Le L
Mathematically

Maximize C = f ( X ) = wL + rK

−
Subject to X = f ( L, K )

Rewrite the constraint in the form

−
X − f ( L, K ) = 0

Pre-multiply the constraint by the Lagrangian multiplier 

−
{ X − f ( L, K )} = 0

Form the composite function

−
 = C − { X − f ( L, K )}

Or
−
 = (wL + rK ) − { X − f ( L, K )}

Take the partial derivatives of  with respect to L,K and  then equate to zero.

 f ( L.K ) X
= w− = 0 = w−
L l L
 f ( L, K ) X
= r − = 0 = r −
K K K
 −
= −{ X − f ( L, K )} = 0


Form the first two expressions we obtain;-

X
w=
L
X
r=
K

Solving these expressions we obtain

w X / L
= = MRTS L, K
r X / L
The second order condition concerning the convexity of the isoquant is the same as the
first case of maximization of Output, it is fulfilled by the assumption of negative slopes
of the marginal products of factors
2
2 X 2 X  2 X   2 X   2 X 
 0, 0 and  2     
L2 K 2  L  K   LK 
2

Formal derivation of cost curves from a product function.

Given the Cobb-Douglas production function

X = b0 L K 

And the cost equation

C = wL + rK

We want to derive the total cost function of output

C = f (X )

First solve the constraint maximization problem

Maximize X = b0 L K 

−
Subject to C = wL + rK (Cost constraint)

Steps

i) Rewrite the constraint

−
C − wL − rK = 0

ii) Pre-multiply by constant 

−
 (C − wL − rK ) = 0

iii) Form the composite function

−
 = X +  (C − wL − rK )
iv) the first condition for maximization is that the first derivative of the functions
with respect to L,K and  be equal to zero.

 X
=  − w = 0
L L
 X
=  − r = 0
K K
 −
= (C − wL − rK ) = 0


v) Therefore from the above first two equations

X X
 = w and  r
L K

vi) Dividing and solving for K we obtain

w 
K= . L
r 

vii) Substituting K in the production function we obtain

X = b0 L K 

w  
X = b0 L  . L
r  

w  
X = b0  .  L( +  )
r 

The term in brackets is the constant term of the function, it includes the three
coefficients of the production function, b0,α,β and the prices of factors of
production.

viii) Solving the above form of the production function for L, we obtain
 1

= L( +  )
w  
b0  . 
r 
OR
1 /( +  )
 
 
 1
.X  =L
  w   
 b0  .  
  r   

Or
 /( +  ) 1 /( +  )
 w  X 
L =    
 r   bo 

ix) Substituting the value of L in the expression

w 
K= . L
r 

We obtain

1 /( +  ) 1 /( +  )
 w  X 
K =   
 r   b0 

x) Substituting the two value of K and L in the cost function C = wL + rK we obtain

1 /( +  )
1    r   /( +  )  w 
 /( +  ) 
 1 /( +  )
C =   w  + r  . X
 b0    w   r  

xi) Rearranging the expression above we obtain

1 /( +  )

 1    

   
C =     +    


 
. w /( +  ) .r  ( +  ) . X 1 /( +  )
 0   
 b     


This is the cost function that is the cost expressed as a function of

i) Output X

ii) The production function coefficients, b0, α, β (recall that the sum (α+β) is the
measure of returns to scale.
 iii) The price of factors, w and r

If the prices of factors are given which is the usual assumption of the theory of
the firm, the cost depends only on output X, and therefore we can draw the
usual cost curves, which are express graphically the function

C = f (X )

Example

A firm in perfectly competitive market produces and sells two goods Q1 and Q2 priced
at KES 50 and 60 respectively. The firms total cost function is given as
TC = 3Q12 + 3Q1Q2 + 2Q2 2 + 10

Required

i. Find the total revenue function of the firm

ii. Find the profit function of the firm,
iii. Find the critical values of Q1 and Q2 for profit maximization
iv. By applying the second order condition, verify that the critical values
present the maximum profit