Economic Growth & Development Section/ Rita Hanna/ 2024

Economic Growth & Development

Production function

• The purpose of a firm is to turn inputs into outputs.

• An abstract model of production is the production function, a mathematical relationship
between inputs (amount of inputs used in production) and outputs (amounts of products).
• Q= f(K, L, M, ......)
• Letting Q represent the output of a particular good during a period
• K represent capital use
• L represent labor input
• M represent raw materials
• A assumption is often made that the firm uses two inputs, labor and capital. (Two-inputs
production function)
Q= f (K, L)
Short-run production function
• The firm is able to change just only one input like labor holding capital constant.
Q= f (𝐾, L)

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• Law of diminishing returns is applicable. (Diminishing Marginal Product)

o Marginal physical productivity, or the marginal product of an input: the additional
output that can be produced by adding one more unit of a particular input while holding
all other inputs constant.
o Marginal product of labor (MP): the extra output d obtained by employing one more
unit of labor while holding the level of capital equipment constant.
o Marginal product of capital (MPK): the extra output obtained by using one more
machine while holding the number of workers constant.
o

✓ Panel (a) shows the relationship between output and labor input, holding other inputs
constant.
✓ Panel (b) shows the marginal product of labor input, which is also the slope of the curve in
panel (a). Here, MP, diminishes as labor input increases. MPL reaches zero at L*.

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Long-run production function:

• The firm change both capital and labor together.
Q= f (K, L)
• An isoquant is a curve that shows the various combinations of inputs that will produce the
same (a particular) amount of output.
• An isoquant map is a contour map of a firm's production function. (All of the isoquants from
a production function are part of this isoquant map)
•

✓ the firm is assumed to use the production function, Q= f (K, L) to produce a single
good.
✓ The curve labeled q = 10 is an isoquant that shows various combinations of labor
and capital, such as points A and B, that produce exactly 10 units of output per
period.
✓ The isoquants labeled q = 20 and q = 30 represent two more of the infinite curves
that represent different levels of output.
✓ Isoquants record successively higher levels of output the farther away from the
origin they are in a northeasterly direction.
✓ The slope of these curves shows the rate at which L can be substituted for K while
keeping output constant. (− ∆𝐾⁄∆𝐿)
✓ The negative of this slope “the absolute value of the slope” is called the (marginal)
rate of technical substitution (RTS).
Rate of technical substitution (of labor for capital) = RTS (of L for K)
= - (slope of isoquant)
= - (− ∆𝐾⁄∆𝐿) = ∆𝐾⁄∆𝐿

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✓ The RTS is positive and it is diminishing for increasing inputs of labor. “Convex
curve”
✓ The slope of the isoquant may be derived formally with a mathematical approach
using, once again, the calculus of variations. Take the production function:
Q= f (K, L), since the isoquant is the line along which there is no difference in
output, then it is necessary to differentiate the production function (Q) totally and
set that total difference equal to zero. Hence:

Q= f (K, L)
𝜕𝑄 𝜕𝑄
𝑑𝐿 + 𝑑𝐾 = 0
𝜕𝐿 𝜕𝐾
𝜕𝑄 𝜕𝑄
𝑑𝐿 = − 𝑑𝐾
𝜕𝐿 𝜕𝐾
𝑀𝑃𝐿 × 𝑑𝐿 = − 𝑀𝑃𝐾 × 𝑑𝐾
𝑑𝐾 𝑀𝑃𝐿
− =
𝑑𝐿 𝑀𝑃𝐾
𝑀𝑃𝐿
𝑅𝑇𝑆 (𝑜𝑓 𝐿 𝑓𝑜𝑟 𝐾) =
𝑀𝑃𝐾

• Returns to Scale is applicable.

o A production function is said to exhibit constant returns to scale if a doubling of all inputs
results in a precise doubling of output. This situation is shown in Panel (a).
o If doubling all inputs yields less than a doubling of output, the production function is said
to exhibit decreasing returns to scale. This is shown in Panel (b).
o If doubling all inputs results in more than a doubling of output, the production function
exhibits increasing returns to scale. This is demonstrated in Panel (c).

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Costs

• Payment made by the firm when using inputs to produce any good.
• The two-input case, the firm uses only two inputs: labor and capital.
• Firms buy inputs in perfectly competitive markets.
• Economic profits and cost minimization
o Total costs: TC = WL + VK
𝐶 = 𝑊𝐿 + 𝑉𝐾
𝑉𝐾 = 𝐶 − 𝑊𝐿
𝐶 𝑊
𝐾= − 𝐿
𝑉 𝑉
𝑊
𝑆𝑙𝑜𝑝𝑒 = −
𝑉

o Assuming the firm produces only one output, total revenue equals the price of the product
(P) times its total output.
o Economic profit (𝝅): the difference between a firm’s total revenue and its total economic
cost.
𝜋 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠
= PQ – WL – VK
= P (f (K, L)) – WL – VK
Graphic presentation

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▪ The isoquant (q1) shows all the combinations of K and L that are needed to produce q1.
We wish to find the least costly point on this isoquant.
▪ Those combinations of K and L that keep total costs constant lie along a straight line with
slope w/v.
▪ Consequently, allenes of equal total cost can be shown, as a series of parallel straight
lines with slopes w/v. Three lines of equal total cost are shown: 𝑇𝐶1 < 𝑇𝐶2 < 𝑇𝐶3 .
▪ It is clear from the figure that the minimum total cost for producing (q1) is given by 𝑇𝐶1
(since it is closest to the origin) where the total cost curve is just tangent to the isoquant.
The cost-minimizing input combination is L*, K*.
▪ At the point of tangency, the rate at which the firm can technically substitute L for K
(RTS) equals the ratio of the inputs costs.
𝑊
𝑅𝑇𝑆 (𝐿 𝑓𝑜𝑟 𝐾) =
𝑉
𝑀𝑃𝐿 𝑤
=
𝑀𝑃𝐾 𝑉

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Changes in technology

• Technical progress is a shift in the production function that allows a given output level to be
produced using fewer inputs. (lower cost)
•

𝑲′𝝄
C
𝑲𝟏

𝑳′𝝄

o Isoquant 𝑞𝜊 summarized the initial state of technical knowledge.

o 𝐾𝜊 and 𝐿ο units of capital and labor respectively can produce this level of output.
o After a technology improvement, the same level of output can be produced with lower
level of L & lower level of K. (Pt “A”)
o The improvement in technology is represented by the shift of the isoquant to 𝑞′𝜊 .
Technical progress represents a real savings in inputs.
o Point (A) represent a neutral technological Progress.
o Point (B) represent a labor-saving technological Progress.
o Point (C) represent a capital-saving technological Progress.

o Technological progress can be represented by an upward shift in the production

function, a higher level of output can now be produced with the same level of labor.