Intermediate Microeconomic

Theory

Production Functions
 OUTLINE
• PRODUCTION FUNCTION
• MARGINAL AND AVERAGE PRODUCT
• RELATIONSHIP BETWEEN 𝐴𝑃𝐿 AND 𝑀𝑃𝐿
• ISOQUANTS
• MARGINAL RATE OF TECHNICAL SUBSTITUTION
• SPECIAL TYPES OF PRODUCTION FUNCTIONS
• RETURNS TO SCALE
• TECHNOLOGICAL PROGRESS
• APPENDIX A. MRT AS THE RATIO OF MARGINAL PRODUCTS
• APPENDIX B. ELASTICITY OF SUBSTITUTION

2
PRODUCTION FUNCTION

3
 PRODUCTION FUNCTION

• INPUTS ARE FACTORS OF PRODUCTION, SUCH AS LABOR, CAPITAL, LAND, AND

ANY OTHER ELEMENT THAT THE FIRM CAN TRANSFORM INTO UNITS OF OUTPUT.

• THE PRODUCTION FUNCTION REPRESENTS HOW A CERTAIN AMOUNT OF INPUTS

IS TRANSFORMED INTO AN AMOUNT OF OUTPUT 𝑞.

• EXAMPLE:

𝑞 = 𝑓(𝐿, 𝐾)
THIS PRODUCTION FUNCTION DESCRIBES HOW SPECIFIC AMOUNTS OF LABOR 𝐿 AND
CAPITAL 𝐾 ARE TRANSFORMED INTO AN AMOUNT OF OUTPUT 𝑞 .

Intermediate Microeconomic Theory 4

 PRODUCTION FUNCTION
• EXAMPLE 7.1: EXAMPLES OF PRODUCTION FUNCTIONS.
• THE COBB-DOUGLAS FUNCTION IS
𝑞 = 𝐴𝐾 𝛼 𝐿𝛽 ,
WHERE 𝐴 IS A POSITIVE PARAMETER, AND 𝛼, 𝛽 ∈ (0,1).
1
• CONSIDER 𝐴 = 3, 𝛼 = 𝛽 = , 𝐾 = 4 MACHINES AND 𝐿 = 9
2
WORKERS.
• THE MAXIMUM OUTPUT THE FIRM CAN GENERATE IS
𝑞 = 3 × 41/2 × 91/2 = 18 UNITS.

5
 PRODUCTION FUNCTION

• EXAMPLE 7.1 (CONTINUED):

• IF INSTEAD THE FIRM PRODUCES ONLY 14 UNITS, IT IS NOT
EFFICIENTLY MANAGING ITS AVAILABLE INPUTS.
• THE FIRM’S EFFICIENCY IS
14
= 0.77.
18

• ALTERNATIVELY, THE FIRM HAS AN INEFFICIENCY LEVEL OF

1 − 0.77 = 0.33.

6
 PRODUCTION FUNCTION
• EXAMPLE 7.1 (CONTINUED):
• OTHER TYPES OF PRODUCTION FUNCTIONS ARE:
(1) 𝑞 = 𝑎𝐾 + 𝑏𝐿, WHERE 𝑎, 𝑏 ARE POSITIVE PARAMETERS,
AND 𝐾, 𝐿 ENTER LINEARLY.
(2) 𝑞 = 𝐴𝑚𝑖𝑛 𝑎𝐾, 𝑏𝐿 , WHERE 𝐴, 𝑎, 𝑏 ARE POSITIVE
PARAMETERS, AND 𝐾 AND 𝐿 MUST BE USED IN A
CERTAIN PROPORTION.
(3) 𝑞 = 𝐴𝐾 𝛼 + 𝑏𝐿, WHERE 𝐴, 𝑎, 𝑏 ARE POSITIVE
PARAMETERS, AND ONE INPUT (IN THIS CASE 𝐿) ENTERS
LINEARLY AND THE OTHER INPUT ENTERS NONLINEARLY.

7
MARGINAL AND AVERAGE PRODUCT

8
 AVERAGE PRODUCT

• THE AVERAGE PRODUCT IS THE TOTAL UNITS OF OUTPUT PER UNIT OF INPUT.
𝑞
• THE AVERAGE PRODUCT OF LABOR IS 𝐴𝑃𝐿 = .
𝐿
𝑞
• THE AVERAGE PRODUCT OF CAPITAL IS 𝐴𝑃𝐾 = .
𝐾

• EXAMPLE:
• IF A FIRM PRODUCES 𝑞 = 100 UNITS OF OUTPUT, AND HIRE 𝐿 = 4 WORKERS, ITS
AVERAGE PRODUCT PER WORKER IS
100
𝐴𝑃𝐿 = = 25 UNITS.
4

• EVERY WORKER PRODUCES ON AVERAGE 25 UNITS (“LABOR PRODUCTIVITY”).

9
 AVERAGE PRODUCT

• WHEN LABOR PRODUCTIVITY IN A COUNTRY GROWS, THE

𝑞
RATIO 𝐴𝑃𝐿 = MUST GO UP.
𝐿
• REASONS:
1. TOTAL OUTPUT INCREASES WHILE NUMBER OF EMPLOYED
WORKERS REMAINS CONSTANT.
2. TOTAL OUTPUT REMAINS UNAFFECTED, BUT WORKERS ARE
FIRED AFTER FIRMS AUTOMATE THE PRODUCTION PROCESS.
3. TOTAL OUTPUT INCREASES AND MORE WORKERS ARE HIRED,
BUT THE FORMER

10
 AVERAGE PRODUCT

• CONSIDER PRODUCTION FUNCTION 𝑞 = 100 𝐿:

q
• At 𝐴,
• 𝐿𝐴 = 4.
• 𝑞𝐴 = 200. 400
B
200
• 𝐴𝑃𝐿𝐴 = = 50 units.
4
• At 𝐵, A
200
• 𝐿𝐵 = 16.
• 𝑞𝐵 = 400.
400
• 𝐴𝑃𝐿𝐵 = = 25 units. L
16 4 16
Figure 7.1
11
 AVERAGE PRODUCT
• EXAMPLE 7.2 (CONTINUED):
• CONSIDER PRODUCTION FUNCTION 𝑞 = 5𝐿1/2 + 3𝐿 − 6.
• THE AVERAGE PRODUCT OF LABOR IS
𝑞 5𝐿1/2 + 3𝐿 − 6
𝐴𝑃𝐿 = =
𝐿 𝐿
1/2−1
6
= 5𝐿 +3−
𝐿
5 6
= 1/2 + 3 − .
𝐿 𝐿
𝜕𝐴𝑃𝐿
• AS L INCREASES, 𝐴𝑃𝐿 INCREASES IF ≥ 0,
𝜕𝐿

5 6
− 3 + 2 ≥ 0,
𝐿
2𝐿2
12
 AVERAGE PRODUCT
• EXAMPLE 7.2 (CONTINUED):

6 5
− 2 ≥ 3/2 ,
𝐿 2𝐿
3/2−2
5 12 1
𝐿 ≥ ⟹ ≥ 𝐿2
12 5
2
12 2
≥ 𝐿1/2
5
144
𝐿≤ ≅ 5.76 WORKERS
25
• 𝐴𝑃𝐿 INCREASES (DECREASES) IN 𝐿 FOR ALL 𝐿 ≤ 5.76 (𝐿 > 5.76).
• 𝐴𝑃𝐿 REACHES IT MAXIMUM WHEN 𝐿 = 5.76 WORKERS.
13
 MARGINAL PRODUCT

• THE MARGINAL PRODUCT IS THE RATE AT WHICH TOTAL OUTPUT

INCREASES AS THE FIRM USES AN ADDITIONAL UNIT OF EITHER INPUT.
Δ𝑞
• THE MARGINAL PRODUCT OF LABOR IS 𝑀𝑃𝐿 = WHEN LABOR IS
Δ𝐿
𝜕𝑞
DISCRETE OR 𝜕𝐿 WHEN IT IS CONTINUOUS.
Δ𝑞
• THE MARGINAL PRODUCT OF CAPITAL IS 𝑀𝑃𝐾 = Δ𝐾 WHEN CAPITAL
𝜕𝑞
IS DISCRETE OR 𝜕𝐾 WHEN IT IS CONTINUOUS.

• GRAPHICALLY, THE MARGINAL PRODUCT OF AN INPUT CAN BE

INTERPRETED AS AS THE SLOPE OF THE FUNCTION WHEN WE
MARGINALLY INCREASE THE AMOUNT OF THAT INPUT.

14
 MARGINAL PRODUCT
• CONSIDER PRODUCTION FUNCTION 𝑞 = 100 𝐿.

(a) 𝑀𝑃𝐿 as the slope of the (b) 𝑀𝑃𝐿 directly

q production function MPL

50 50
At 𝐴, 𝑀𝑃𝐿𝐴 = = = 50 units.
41/2 2
B 40
400 50 50
At 𝐵, 𝑀𝑃𝐿𝐵 = = = 12.5 units.
30 161/2 4
A
25
A 20
200 B
12.5
10

L L
4 16 4 5 10 15 16 20

Figure 7.2
𝑀𝑃𝐿 is diminishing.
15
 MARGINAL PRODUCT
• EXAMPLE 7.3: FINDING MARGINAL PRODUCT.
• CONSIDER THE SAME PRODUCTION FUNCTION 𝑞 = 5𝐿1/2 + 3𝐿 −
6.
• THE MARGINAL PRODUCT OF LABOR IS
𝜕𝑞 1 1/2−1 5
𝑀𝑃𝐿 = =5 𝐿 + 3 = 1/2 + 3.
𝜕𝐿 2 2𝐿
• AS L INCREASES, 𝑀𝑃𝐿 DECREASES BECAUSE
𝜕𝑀𝑃𝐿 5
=− 3 < 0, WHERE 𝐿 > 0.
𝜕𝐿
4𝐿2

• ADDITIONAL WORKERS BRING MORE PRODUCTION TO THE

FIRM, BUT A DECREASING RATE.

16
 RELATIONSHIP BETWEEN APL AND MPL

Intermediate Microeconomic Theory 17

RELATIONSHIP BETWEEN APL AND MPL
• THE 𝐴𝑃𝐿 AND 𝑀𝑃𝐿 EXHIBIT INTERESTING RELATIONSHIPS:
1. WHEN THE 𝐴𝑃𝐿 CURVE IS INCREASING, 𝑀𝑃𝐿 LIES ABOVE 𝐴𝑃𝐿 ;
2. WHEN THE 𝐴𝑃𝐿 CURVE IS DECREASING, 𝑀𝑃𝐿 LIES BELOW 𝐴𝑃𝐿 ;
3. WHEN THE 𝐴𝑃𝐿 CURVE IS INCREASING, 𝑀𝑃𝐿 CURVE CROSSES 𝐴𝑃𝐿 .

• EXAMPLE: CONSIDER GRADES IN A CLASS.

• YOU TAKE A MIDTERM EXAM. A FEW DAYS LATER, THE INSTRUCTOR INFORMS
HOW YOUR AVERAGE GRADE IN THE CLASS IS AFFECTED BY THE MIDTERM:
• THE MIDTERM INCREASES YOUR AVERAGE IF THE MIDTERM GRADE IS HIGHER THAN
YOUR PREVIOUS AVERAGE (𝑀𝑃 > 𝐴𝑃); OR
• THE MIDTERM DECREASES YOUR AVERAGE IF THE MIDTERM GRADE IS LOWER THAN
YOUR PREVIOUS AVERAGE (𝑀𝑃 < 𝐴𝑃); OR
• THE MIDTERM DOES NOT AFFECT YOUR AVERAGE IF THE MIDTERM GRADE
COINCIDES WITH YOUR PREVIOUS AVERAGE (𝑀𝑃 = 𝐴𝑃).

18
RELATIONSHIP BETWEEN APL AND MPL
• THE 𝑀𝑃𝐿 CURVE CROSSES THE 𝐴𝑃𝐿 AT THE MAXIMUM POINT (THE
PEAK) OF THE 𝐴𝑃𝐿 CURVE.
• CONSIDER PRODUCTION FUNCTION 𝑞 = 𝑓(𝐿).
𝑞 𝑓(𝐿)
• THE AVERAGE PRODUCT PER WORKER IS 𝐴𝑃𝐿 = 𝐿 = 𝐿
.
• TO FIND THE NUMBER OF WORKERS, 𝐿, AT WHICH 𝐴𝑃𝐿 REACHES ITS
MAXIMUM,
𝜕𝐴𝑃𝐿 𝑓 ′ 𝐿 𝐿 − 1𝑓(𝐿)
= = 0,
𝜕𝐿 𝐿2
WHERE WE HAVE USED THE QUOTIENT RULE.

• AS 𝑓 ′ 𝐿 IS THE MARGINAL PRODUCT OF LABOR, 𝑀𝑃𝐿 = 𝜕𝐿 ,

𝜕𝑞

𝑀𝑃𝐿 𝐿 − 1𝑓(𝐿) 𝑀𝑃𝐿 𝑓 𝐿

= − 2 = 0.
𝐿2 𝐿 𝐿
19
 RELATIONSHIP BETWEEN APL AND MPL
• MULTIPLYING BOTH SIDES BY L,
𝑀𝑃𝐿 𝑓 𝐿 𝑓 𝐿
𝐿 − 𝐿 2 = 0 ⟹ 𝑀𝑃𝐿 − = 0.
𝐿 𝐿 𝐿
𝑓 𝐿
• NOTE THAT 𝐿
= 𝐴𝑃𝐿 , THEN
𝑀𝑃𝐿 = 𝐴𝑃𝐿 .

• THIS EQUATION TELLS THAT, AT THE MAXIMUM OF THE 𝐴𝑃𝐿

CURVE, THE 𝑀𝑃𝐿 CURVE CROSSES THE 𝐴𝑃𝐿 CURVE.

Intermediate Microeconomic Theory 20

RELATIONSHIP BETWEEN APL AND MPL
MPL
APL

MPL
A

APL

L
Figure 7.3

• WHEN THE 𝐴𝑃𝐿 CURVE IS INCREASING, 𝑀𝑃𝐿 LIES ABOVE 𝐴𝑃𝐿 ;

• WHEN THE 𝐴𝑃𝐿 CURVE IS DECREASING, 𝑀𝑃𝐿 LIES BELOW 𝐴𝑃𝐿 ;
• WHEN THE 𝐴𝑃𝐿 CURVE IS INCREASING, 𝑀𝑃𝐿 CURVE CROSSES 𝐴𝑃𝐿 .
21
RELATIONSHIP BETWEEN APL AND MPL
• EXAMPLE 7.4: RELATIONSHIP BETWEEN 𝐴𝑃𝐿 AND 𝑀𝑃𝐿 .
• CONSIDER THE PRODUCTION FUNCTION IN EXAMPLES 7.2 AND
7.3,
𝑞 = 5𝐿1/2 + 3𝐿 − 6.

• FROM EXAMPLE 7.2,

5 6
𝐴𝑃𝐿 = 1/2 + 3 − ,
𝐿 𝐿
144
WHICH REACHES ITS MAXIMUM AT 𝐿 = ≅ 5.76, WHERE ITS
25
HEIGHT BECOMES,
5 6
𝐴𝑃𝐿 = +3− ≅ 4.04.
5.76 1/2 5.6
22
RELATIONSHIP BETWEEN APL AND MPL
• EXAMPLE 7.4 (CONTINUED):
• IF WE EVALUATE THE 𝑀𝑃𝐿 CURVE FROM EXAMPLE 7.3

5
𝑀𝑃𝐿 = 1/2 + 3
2𝐿
AT THE SAME 𝐿 = 5.76, THE HEIGHT OF THE 𝑀𝑃𝐿 CURVE IS

5
𝑀𝑃𝐿 = + 3 ≅ 4.04,
2 5.76 1/2

CONFIRMING THAT THE 𝑀𝑃𝐿 CROSSES THE 𝐴𝑃𝐿 AT ITS

MAXIMUM POINT.

23
 ISOQUANTS

Intermediate Microeconomic Theory 24

 ISOQUANTS

• THE ISOQUANT CURVE REPRESENTS COMBINATIONS OF

LABOR AND CAPITAL THAT YIELD THE SAME AMOUNT OF
OUTPUT. K

q = 100
• At 𝐴, the firm uses an input
q = 200
combination intense in capital. A3

• At 𝐵, it uses a labor-intense
input combination, producing the
A
same 𝑞 = 100 than at 𝐴.
C
• At 𝐶, the firm reaches a higher
A1 A2
output, 𝑞 = 200. B L
Figure 7.4
25
 ISOQUANTS

• THE ISOQUANT CURVE REPRESENTS COMBINATIONS OF

LABOR AND CAPITAL THAT YIELD THE SAME AMOUNT OF
OUTPUT. K

q = 100
• The shaded areas are q = 200
unprofitable for the firm. A3

• It would not choose 𝐴2 or 𝐴3

because it can reach the same A
output with less inputs at 𝐴1 .
C

A1 A2
B L
Figure 7.4
Intermediate Microeconomic Theory 26
 ISOQUANTS
• EXAMPLE 7.5: FINDING ISOQUANT CURVES FOR A COBB-
DOUGLAS PRODUCTION FUNCTION.
• CONSIDER A COBB-DOUGLAS PRODUCTION FUNCTION 𝑞 =
5𝐿1/2 𝐾 1/2 .
• TO FIND THE ISOQUANT CORRESPONDING TO 𝑞 = 100 UNITS:
• INSERT THIS OUTPUT LEVEL INTO THE PRODUCTION FUNCTION,
100 = 5𝐿1/2 𝐾1/2 ,
20 = 𝐿1/2 𝐾1/2 .

• SOLVE FOR CAPITAL 𝐾,

2
202 = 𝐿1/2 𝐾1/2 ,
400
400 = 𝐿𝐾 ⟹𝐾= .
𝐿

27
 ISOQUANTS

• EXAMPLE 7.5 (CONTINUED):

400
• GRAPHICALLY, THE ISOQUANT 𝐾 =
𝐿
• IS A CURVE APPROACHING THE VERTICAL AXIS WHEN 𝐿 IS
CLOSE TO ZERO (BUT IT NEVER CROSSES THIS AXIS);
• AND THAT APPROACHES THE HORIZONTAL AXIS WHEN 𝐿
IS LARGER (WITHOUT EVER CROSSING).

Intermediate Microeconomic Theory 28

 MARGINAL RATE OF
TECHNICAL SUBSTITUTION

Intermediate Microeconomic Theory 29

 MARGINAL RATE OF TECHNICAL
SUBSTITUTION

• THE SLOPE OF THE ISOQUANT ANSWERS THE QUESTION:

HOW MANY UNITS OF CAPITAL MUST THE FIRM GIVE UP TO
MAINTAIN ITS OUTPUT LEVEL UNAFFECTED AFTER HIRING AN
EXTRA WORKER?

• MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS). AFTER

INCREASING THE QUANTITY OF LABOR BY 1 UNIT, THE MRST
MEASURES THE AMOUNT BY WHICH CAPITAL MUST BE
REDUCED SO THAT OUTPUT REMAINS CONSTANT.
30
MARGINAL RATE OF TECHNICAL
SUBSTITUTION
K

K = 80 A
Large
decrease
in K
B
Small K = 60
decrease C
K = 50
in K q = 100 units

4 5 6 L
1 more 1 more
worker worker
Figure 7.5 31
 MARGINAL RATE OF TECHNICAL
SUBSTITUTION

• INTUITIVELY,
• WHEN CAPITAL IS ABUNDANT, THE FIRM IS WILLING TO
GIVE UP MANY UNITS OF CAPITAL TO HIRE ONE MORE
WORKER.

• WHEN CAPITAL BECOMES MORE SCARCE, THE FIRM IS LESS

WILLING TO REPLACE IT WITH WORKERS.

Intermediate Microeconomic Theory 32

MARGINAL RATE OF TECHNICAL SUBSTITUTION
• EXAMPLE 7.6: FINDING THE MRTS OF A COBB-DOUGLAS
PRODUCTION FUNCTION.
• CONSIDER A FIRM WITH 𝑞 = 8𝐿1/2 𝐾1/2 .
1
• 𝑀𝑃𝐿 = 8 𝐿1/2−1 𝐾 1/2 = 4𝐿−1/2 𝐾1/2 .
2
1
• 𝑀𝑃𝐾 = 8 𝐿1/2 𝐾 1/2−1 = 4𝐿1/2 𝐾 −1/2.
2
• HENCE, THE MRTS IS
𝑀𝑃𝐿 4𝐿−1/2 𝐾 1/2 𝐾
𝑀𝑅𝑇𝑆 = = 1/2 −1/2 = ,
𝑀𝑃𝐾 4𝐿 𝐾 𝐿
WHICH IS DECREASING IN 𝐿.
• GRAPHICALLY, THE SLOPE OF THE ISOQUANT (MRTS) FALLS
AS WE MOVE RIGHTWARD TOWARD MORE UNITS OF 𝐿.
THAT IS, THE ISOQUANT IS BOWED IN FORM THE ORIGIN.
33
MARGINAL RATE OF TECHNICAL SUBSTITUTION
• EXAMPLE 7.7: FINDING THE MRTS OF A LINEAR PRODUCTION
FUNCTION.
• CONSIDER A FIRM WITH 𝑞 = 𝑎𝐿 + 𝑏𝐾, WHERE 𝑎, 𝑏 > 0.
• 𝑀𝑃𝐿 = 𝑎 AND 𝑀𝑃𝐾 = 𝑏.
• HENCE, THE MRTS IS
𝑀𝑃𝐿 𝑎
𝑀𝑅𝑇𝑆 = = ,
𝑀𝑃𝐾 𝑏
WHICH IS NOT A FUNCTION OF 𝐿 OR 𝐾. IT IS JUST A CONSTANT.
6
• IF 𝑎 = 6 AND 𝑏 = 3 , 𝑀𝑅𝑇𝑆 = = 2 . THE SLOPE OF THE
3
ISOQUANT WOULD BE −2 IN ALL ITS POINTS.
• GRAPHICALLY, THE ISOQUANT WOULD BE A STRAIGHT LINE.
34
 SPECIAL TYPES OF
PRODUCTION FUNCTIONS

Intermediate Microeconomic Theory 35

 LINEAR PRODUCTION FUNCTION
• THE LINEAR PRODUCTION FUNCTION TAKES THE FORM
𝑞 = 𝑎𝐿 + 𝑏𝐾, WHERE 𝑎, 𝑏 ARE POSITIVE PARAMETERS.
• SOLVING FOR 𝐾, THE ISOQUANT OF THIS PRODUCTION FUNCTION IS
A STRAIGHT LINE
𝑞 𝑎
𝐾 = − 𝐿,
𝑏 𝑏
𝑞 𝑎
WHERE 𝑏 IS THE VERTICAL INTERCEPT AND 𝑏 DENOTES ITS NEGATIVE SLOPE.

• THE SLOPE (MRTS) IS CONSTANT ALONG ALL POINTS OF THE

𝑎
ISOQUANT BECAUSE IS NOT A FUNCTION OF 𝐿 OR 𝐾.
𝑏
• THE FIRM CAN SUBSTITUTE UNITS OF CAPITAL AND LABOR AT THE
SAME RATE REGARDLESS OF THE NUMBER OF INPUT THAT IT EMPLOYS.

36
 LINEAR PRODUCTION FUNCTION
K

q
b

a
b

q
L
Figure 7.6 a

• LINEAR PRODUCTION FUNCTIONS CAN REPRESENT FIRMS CAPABLE OF

SUBSTITUTING BETWEEN INPUTS, SUCH AS TWO TYPES OF OILS OR COMPUTERS.
37
 FIXED-PROPORTIONS
PRODUCTION FUNCTION

• THE FIRM CANNOT SUBSTITUTE BETWEEN INPUTS AND STILL MAINTAIN

THE SAME OUTPUT LEVEL.
• INSTEAD, THE FIRM MUST USE INPUTS IN A FIXED PROPORTION.
• THIS PRODUCTION FUNCTION TAKES THE FORM

𝑞 = 𝐴𝑚𝑖𝑛{𝑎𝐿, 𝑏𝐾}, WHERE 𝐴, 𝑎, 𝑏 ARE POSITIVE.

• EXAMPLE: 𝑞 = MIN 2𝐿, 3𝐾 .
• AN INCREASE IN ONE INPUT WITHOUT A PROPORTIONAL INCREASE IN
THE OTHER INPUT WILL NOT RESULT IN AN INCREASE IN PRODUCTION.

38
 FIXED-PROPORTIONS
PRODUCTION FUNCTION

K= a L
b

q
Ab aL = bK

q
Aa L
Figure 7.7
Intermediate Microeconomic Theory 39
 FIXED-PROPORTIONS
PRODUCTION FUNCTION
• DEPENDING ON THE AMOUNTS OF 𝐿 AND 𝐾, THE FIRM
FACES EITHER OF THE FOLLOWING CASES:

1. If 𝐦𝐢𝐧 𝒂𝑳, 𝒃𝑲 = 𝒂𝑳 (when 𝑎𝐿 < 𝑏𝐾), K

𝑞 = 𝐴𝑎𝐿.
𝑞 K= a L
Solving for 𝐿, 𝐿 = ,
which is a vertical b
𝐴𝑎
line.
In this example, 𝑞 = min 2𝐿, 3𝐾 , if the
firm produces 𝑞 = 100, the vertical
segment of the isoquant happens when q
2 Ab aL = bK
2𝐿 < 3𝐾 ⟹ 3 𝐿 < 𝐾,
where the vertical line lies at q
L
𝑞 100 Aa
𝐿= 𝐴𝑎
= 2
workers. Figure 7.7

40
 FIXED-PROPORTIONS
PRODUCTION FUNCTION

• DEPENDING ON THE AMOUNTS OF 𝐿 AND 𝐾, THE FIRM

FACES EITHER OF THE FOLLOWING CASES:
2. If 𝐦𝐢𝐧 𝒂𝑳, 𝒃𝑲 = 𝒃𝑲 (when 𝑎𝐿 > 𝑏𝐾),
K
𝑞 = 𝐴𝑏𝐾.
𝑞
Solving for 𝐾, 𝐾 = , which is a K= a L
𝐴𝑏 b
horizontal line.
In this example, 𝑞 = min 2𝐿, 3𝐾 , if the
firm produces 𝑞 = 100, the horizontal
segment of the isoquant occurs when
2 q
2𝐿 > 3𝐾 ⟹ 𝐿 > 𝐾, Ab aL = bK
3
where the horizontal line lies at
q
𝑞 100 L
𝐾= = units of capital. Aa
𝐴𝑏 3
Figure 7.7

41
 FIXED-PROPORTIONS
PRODUCTION FUNCTION

• DEPENDING ON THE AMOUNTS OF 𝐿 AND 𝐾, THE FIRM

FACES EITHER OF THE FOLLOWING CASES:
K
3. If 𝐦𝐢𝐧 𝒂𝑳, 𝒃𝑲 is either 𝒂𝑳 or 𝒃𝑲
(when 𝑎𝐿 = 𝑏𝐾), 𝑞 = 𝐴𝑎𝐿 = 𝐴𝑏𝐾. K= a L
b
This occurs at the kink of the isoquant.
𝑎
Solving for 𝐾, yields a kink at 𝐾 = 𝑏 𝐿.
In this example, 𝑞 = min 2𝐿, 3𝐾 , the
kink happens at q
Ab aL = bK
2
𝐾 = 𝐿.
3
q
Graphically, the kinks of all isoquants Aa L
are crossed by a ray from the origin Figure 7.7
2
with slope 3.
42
 FIXED-PROPORTIONS
PRODUCTION FUNCTION

• THE MRTS IS NOT WELL DEFINED BECAUSE WE CAN FIND INFINITELY MANY
SLOPES FOR THE ISOQUANT AT ITS KINK.

• WE CAN NONETHELESS SAY THE SLOPE OF THE ISOQUANT IS INFINITE IN ITS

VERTICAL SEGMENT, AND ZERO IN ITS HORIZONTAL SEGMENT.

• THIS TYPE OF PRODUCTION FUNCTION IS COMMON IN FIRMS THAT CANNOT

EASILY SUBSTITUTE ACROSS INPUTS WITHOUT ALTERING TOTAL OUTPUT.

• EXAMPLES:
• FIRMS IN THE CHEMICAL INDUSTRY.
• FIRMS WITH A HIGHLY AUTOMATED PRODUCTION PROCESS.

Intermediate Microeconomic Theory 43

 COBB-DOUGLAS
PRODUCTION FUNCTION
• THE COBB-DOUGLAS PRODUCTION FUNCTION TAKES THE FORM
𝑞 = 𝐴𝐿𝛼 𝐾𝛽 WHERE 𝐴, 𝛼, 𝛽 ARE POSITIVE.

• EXAMPLE: IF 𝐴 = 1 AND 𝛼 = 𝛽 = 1/2,

𝑞 = 𝐿1/2 𝐾 1/2 .
WE FIND THE ISOQUANT
2
𝑞2 = 1/2
𝐿 𝐾 1/2 ,
𝑞 2 = 𝐿𝐾,
𝑞2
𝐾= .
𝐿

44
 COBB-DOUGLAS
PRODUCTION FUNCTION
THE SLOPE OF THE ISOQUANT (MRTS) BECOMES
𝑀𝑃𝐿
𝑀𝑅𝑇𝑆 =
𝑀𝑃𝐾
1/2𝐿−1/2 𝐾1/2
=
1/2𝐿1/2 𝐾 −1/2
𝐾 1/2+1/2
= 1/2+1/2
𝐿
𝐾
= .
𝐿

45
 CONSTANT ELASTICITY OF
SUBSTITUTION
PRODUCTION FUNCTION
• THE CONSTANT ELASTICITY OF SUBSTITUTION (CES)
PRODUCTION FUNCTION TAKES THE FORM
𝜎
𝜎−1 𝜎−1 𝜎−1
𝑞= 𝑎𝐿 𝜎 + 𝑏𝐾 𝜎 ,
WHERE 𝜎 REPRESENTS THE ELASTICITY OF SUBSTITUTION.
• WHEN 𝜎 → ∞, CES COINCIDES WITH THE LINEAR
PRODUCTION FUNCTION, WHERE THE FIRM CAN SUBSTITUTE
INPUTS.
• WHEN 𝜎 = 0, CES CONVERGES TO THE FIXED-PROPORTION
PRODUCTION FUNCTION.
• WHEN 𝜎 = 1, CES COINCIDES WITH THE COBB-DOUGLAS
PRODUCTION FUNCTION.
46
 RETURNS TO SCALE

Intermediate Microeconomic Theory 47

 RETURNS TO SCALE

• RETURNS TO SCALE. CONSIDER THAT ALL INPUTS ARE

INCREASED BY A COMMON FACTOR, 𝜆 > 1. HENCE, 𝐿 IS
INCREASED TO 𝜆𝐿, AND 𝐾 IS INCREASED TO 𝜆𝐾. IF THE FIRM
INCREASES AS FOLLOWS:
• 𝜆𝑎 > 𝜆 (WHEN 𝑎 > 1), THE FIRM EXHIBITS INCREASING RETURNS TO
SCALE.

• 𝜆𝑎 < 𝜆 (WHEN 𝑎 < 1), THE FIRM EXHIBITS DECREASING RETURNS TO

SCALE.
• 𝜆𝑎 = 𝜆 (WHEN 𝑎 = 1), THE FIRM EXHIBITS CONSTANT RETURNS TO SCALE.

Intermediate Microeconomic Theory 48

 RETURNS TO SCALE

• CONSIDER A FIRM DOUBLING THE UNITS OF ALL INPUTS

(𝜆 = 2):
• IF OUTPUT INCREASES MORE THAN PROPORTIONALLY (MORE THAN
DOUBLE), WE HAVE INCREASING RETURNS TO SCALE.
• IF OUTPUT INCREASES LESS THAN PROPORTIONALLY (IT FALLS SHORT
FROM DOUBLING), WE HAVE DECREASING RETURNS TO SCALE.
• IF OUTPUT INCREASES PROPORTIONALLY (EXACTLY DOUBLING), WE HAVE
CONSTANT RETURNS TO SCALE.

Intermediate Microeconomic Theory 49

 RETURNS TO SCALE

• EXAMPLE 7.8: TESTING FOR RETURNS TO SCALE.

• CONSIDER A COBB-DOUGLAS PRODUCTION FUNCTION
𝑞 = 𝐴𝐿𝛼 𝐾𝛽 .
• IF WE INCREASE ALL INPUTS BY 𝜆, (𝜆𝐿 AND 𝜆𝐾), TOTAL OUTPUT IS
NOW
𝐴(𝜆𝐿)𝛼 (𝜆𝐾)𝛽 = 𝐴𝜆𝛼 𝐿𝛼 𝜆𝛽 𝐾𝛽 ,
𝜆𝛼+𝛽 𝐴𝐿𝛼 𝐾𝛽 = 𝜆𝛼+𝛽 𝑞.
𝑞

• OUTPUT INCREASED BY 𝜆𝛼+𝛽 , GIVING RISE TO 3 POSSIBLE CASES:

• IF 𝛼 + 𝛽 > 1, INCREASING RETURNS TO SCALE.
• IF 𝛼 + 𝛽 < 1, DECREASING RETURNS TO SCALE.
• IF IF 𝛼 + 𝛽 = 1, CONSTANT RETURNS TO SCALE.
50
 RETURNS TO SCALE
• EXAMPLE 7.8 (CONTINUED):
• CONSIDER A LINEAR PRODUCTION FUNCTION
𝑞 = 𝑎𝐿 + 𝑏𝐾.

• IF WE INCREASE ALL INPUTS BY 𝜆, TOTAL OUTPUT BECOMES

𝑎 𝜆𝐿 + 𝑏 𝜆𝐾 = 𝜆 𝑎𝐿 + 𝑏𝐾 = 𝜆𝑞.
𝑞

• OUTPUT INCREASED PROPORTIONALLY TO INPUTS. THE

FIRM’S PRODUCTION PROCESS EXHIBITS CONSTANT
RETURNS TO SCALE.
51
 RETURNS TO SCALE
• EXAMPLE 7.8 (CONTINUED):
• CONSIDER A FIXED-PROPORTIONS PRODUCTION FUNCTION
𝑞 = 𝐴𝑚𝑖𝑛{𝑎𝐿, 𝑏𝐾}.

• IF WE INCREASE ALL INPUTS BY 𝜆, TOTAL OUTPUT BECOMES

𝐴𝑚𝑖𝑛{𝑎𝜆𝐿, 𝑏𝜆𝐾} = 𝜆𝐴𝑚𝑖𝑛{𝑎𝐿, 𝑏𝐾} = 𝜆𝑞.
𝑞

• OUTPUT RESPONDS PROPORTIONALLY TO A GIVEN

INCREASE IN INPUTS. THE FIRM’S PRODUCTION PROCESS
EXHIBITS CONSTANT RETURNS TO SCALE.
52
 TECHNOLOGICAL PROGRESS

Intermediate Microeconomic Theory 53

 TECHNOLOGICAL PROGRESS
• FIRMS OFTEN BENEFIT FROM TECHNOLOGICAL ADVANCES THAT ALLOW
THEM TO PRODUCE MORE OUTPUT USING THE SAME AMOUNT OF INPUTS.

• MATHEMATICALLY, FOR A GIVEN PAIR OF INPUTS 𝐿 AND 𝐾,

• THE FIRM CAN PRODUCE 𝑞1 UNITS OF OUTPUT BEFORE THE
TECHNOLOGICAL PROGRESS,
• BUT IT CAN PRODUCE 𝑞2 AFTERWARD (WHERE 𝑞2 > 𝑞1 ).

• EXAMPLE: IF THE FIRM’S PRODUCTION FUNCTION IS 𝑞 = 𝐴1 𝐿𝛼 𝐾𝛽 BEFORE

TECHNOLOGICAL PROGRESS, AFTERWARD IT COULD BE
• 𝑞 = 𝐴2 𝐿𝛼 𝐾𝛽 ;
• 𝑞 = 𝐴1 𝐿𝛼+𝛾 𝐾𝛽 (WHERE 𝛾 > 0); OR
• 𝑞 = 𝐴1 𝐿𝛼 𝐾𝛽+𝛾 (WHERE 𝛾 > 0).

54
 TECHNOLOGICAL PROGRESS
• EXAMPLE 7.9: TESTING FOR TECHNOLOGICAL PROGRESS.
• CONSIDER A FIRM WHICH PRODUCTION FUNCTION CHANGES
FROM
𝑞 = 𝐿𝛼 𝐾𝛽 TO 𝑞 = 𝐿2𝛼 𝐾𝛽 .
• THE FIRM BENEFITS FROM TECHNOLOGICAL PROGRESS BECAUSE
𝐿𝛼 𝐾𝛽 < 𝐿2𝛼 𝐾𝛽 ,
𝐿 < 𝐿2 ,
• THIS CONDITION HOLDS TRUE FOR ANY NUMBER OF WORKERS
𝐿 > 1.

55
 TYPES OF TECHNOLOGICAL PROGRESS

• TECHNOLOGICAL PROGRESS CAN BE OF THREE TYPES:

• LABOR ENHANCING.

• CAPITAL ENHANCING.
• NEUTRAL.

56
 LABOR-ENHANCING TECH PROGRESS

• TECHNOLOGICAL PROGRESS IS LABOR ENHANCING IF IT

INCREASES THE MARGINAL PRODUCT OF LABOR MORE
THAN THAT OF CAPITAL,

∆𝑀𝑃𝐿 > ∆𝑀𝑃𝐾 .

• EXAMPLE:
• IF HIGHER EDUCATION ALLOWS WORKERS TO BE MORE PRODUCTIVE
WHILE CAPITAL DOES NOT INCREASE ITS MARGINAL PRODUCT AS
QUICKLY.

Intermediate Microeconomic Theory 57

 LABOR-ENHANCING TECH PROGRESS

• AS A RESULT,
𝑀𝑃𝐿
𝑀𝑅𝑇𝑆 = INCREASES.
𝑀𝑃𝐾

• GRAPHICALLY, THE FIRM’S ISOQUANT BECOMES STEEPER

AFTER THE TECHNOLOGICAL PROGRESS.
• THE FIRM IS WILLING TO GIVE UP MORE UNITS OF CAPITAL
TO HIRE ONE MORE WORKER.
• ALSO KNOWN AS “CAPITAL SAVING.”

Intermediate Microeconomic Theory 58

CAPITAL-ENHANCING TECH PROGRESS
• CAPITAL-ENHANCING TECHNOLOGICAL PROGRESS MEANS
THAT CAPITAL INCREASES ITS MARGINAL PRODUCT FASTER
THAN LABOR DOES,
∆𝑀𝑃𝐿 < ∆𝑀𝑃𝐾 .
• EXAMPLE: IF NEW SOFTWARE MAKES EACH UNIT OF CAPITAL
MORE PRODUCTIVE WHILE LABOR DOES NOT INCREASE ITS
MARGINAL PRODUCT AS MUCH.
𝑀𝑃𝐿
• AS A RESULT, 𝑀𝑅𝑇𝑆 = DECREASES.
𝑀𝑃𝐾
• GRAPHICALLY, THE FIRM’S ISOQUANT BECOMES FLATTER
AFTER THE TECHNOLOGICAL PROGRESS.
• THE FIRM IS WILLING TO GIVE UP FEWER UNITS OF THE MORE
PRODUCTIVE CAPITAL TO HIRE ONE MORE WORKER.
• ALSO KNOWN AS “LABOR SAVING.”
59
 NEUTRAL TECH PROGRESS
• TECHNOLOGICAL PROGRESS IS REGARDED AS NEUTRAL IF
THE MARGINAL PRODUCT OF LABOR AND CAPITAL
INCREASE AT THE SAME AMOUNT,
∆𝑀𝑃𝐿 = ∆𝑀𝑃𝐾 .
𝑀𝑃𝐿
• AS A RESULT, 𝑀𝑅𝑇𝑆 = IS UNAFFECTED.
𝑀𝑃𝐾

• GRAPHICALLY, THE FIRM’S ISOQUANT DOES NOT CHANGE

ITS SLOPE AFTER THE TECHNOLOGICAL PROGRESS.
• THE FIRM IS WILLING TO GIVE UP AS MANY UNITS OF CAPITAL TO
HIRE ONE MORE WORKER.

60
 TECHNOLOGICAL PROGRESS
• EXAMPLE 7.10: IDENTIFYING THE TYPE OF TECHNOLOGICAL PROGRESS.
• CONSIDER THE FIRM IN EXAMPLE 7.9.
• BEFORE TECHNOLOGICAL CHANGE,
𝛼𝐾
𝑀𝑅𝑇𝑆𝑃𝑟𝑒 = ,
𝛽𝐿
WHILE AFTERWARD IT BECOMES
2𝛼 𝐾
𝑀𝑅𝑇𝑆𝑃𝑜𝑠𝑡 = .
𝛽 𝐿
• COMPARING THEM,
𝑀𝑅𝑇𝑆𝑃𝑟𝑒 < 𝑀𝑅𝑇𝑆𝑃𝑜𝑠𝑡 ,

INDICATING THAT THE TECHNOLOGICAL PROGRESS IS LABOR

ENHANCING.
61
 APPENDIX A.
MRTS AS THE RATIO OF MARGINAL
PRODUCTS

Intermediate Microeconomic Theory 62

 MRTS AS RATIO OF MARGINAL
PRODUCTS 𝑀𝑃𝐿
• WE SHOW THAT THE SLOPE OF THE ISOQUANT IS MEASURED BY .
𝑀𝑃𝐾
• CONSIDER A FIRM WITH PRODUCTION FUNCTION 𝑞 = 𝑓(𝐿, 𝐾).
• TO EVALUATE THE SLOPE OF THE ISOQUANT, WE SIMULTANEOUSLY
INCREASE LABOR (E.G., BY 1 UNIT) AND DECREASE CAPITAL.

• HENCE, WE TOTALLY DIFFERENTIATE THE PRODUCTION FUNCTION

WITH RESPECT TO 𝐿 AND 𝐾
𝜕𝑓(𝐿, 𝐾) 𝜕𝑓(𝐿, 𝐾)
𝑑𝑞 = 𝑑𝐿 + 𝑑𝐾,
𝜕𝐿 𝜕𝐾
𝑀𝑃𝐿 𝑀𝑃𝐾

𝑑𝑞 = 𝑀𝑃𝐿 𝑑𝐿 + 𝑀𝑃𝐾 𝑑𝐾.

Intermediate Microeconomic Theory 63
 MRTS AS RATIO OF MARGINAL
PRODUCTS
• BECAUSE WE ARE MOVING ALONG DIFFERENT POINTS OF THE FIRM’S
ISOQUANT, THE OUTPUT LEVEL IS THE SAME, ENTAILING 𝑑𝑞 = 0. THEN,
𝑑𝑞 = 𝑀𝑃𝐿 𝑑𝐿 + 𝑀𝑃𝐾 𝑑𝐾,
0 = 𝑀𝑃𝐿 𝑑𝐿 + 𝑀𝑃𝐾 𝑑𝐾,
𝑀𝑃𝐾 𝑑𝐾 = −𝑀𝑃𝐿 𝑑𝐿.

• BECAUSE WE ARE INTERESTED IN THE SLOPE OF THE ISOQUANT, WE

𝑑𝐾
SOLVE FOR − , WHICH REFLECTS THE RATE AT WHICH THE FIRM
𝑑𝐿
NEEDS TO DECREASE 𝐾 IF 𝐿 INCREASES BY 1 UNIT,

𝑑𝐾 𝑀𝑃𝐿
− = .
Intermediate Microeconomic Theory 𝑑𝐿 𝑀𝑃𝐾 64

Slope of Ratio of marginal

isoquant products (MRTS)
 APPENDIX B.
ELASTICITY OF SUBSTITUTION

Intermediate Microeconomic Theory 65

 ELASTICITY OF SUBSTITUTION
• THE ELASTICITY OF SUBSTITUTION IS A COMMON MEASURE OF HOW
EASY IT IS FOR A FIRM TO SUBSTITUTE LABOR FOR CAPITAL,

𝐾𝐾
− 𝐿𝐿
𝐵 𝐴
𝐾 𝐾
%Δ 𝐿 𝐿 𝐴
𝜎= = .
%∆𝑀𝑅𝑇𝑆 𝑀𝑅𝑇𝑆𝐵 − 𝑀𝑅𝑇𝑆𝐴
𝑀𝑅𝑇𝑆𝐴

• THE ELASTICITY OF SUBSTITUTION TELLS US THAT, IF THE MRTS

𝐾
INCREASES BY 1%, THE CAPITAL LABOR RATIO THAT THE FIRM USES, ,
𝐿
INCREASES BY 𝜎%.

66
 ELASTICITY OF SUBSTITUTION
• FINDING MRTS AT TWO POINTS TO OBTAIN 𝜎.

K 𝐾𝐴 20 𝐾𝐵 8
At 𝐴: = = 5, At 𝐵: = 10 = 0.8,
𝐿𝐴 4 𝐿𝐵
𝑀𝑅𝑇𝑆𝐴 = 6. 𝑀𝑅𝑇𝑆𝐵 = 2.
KA = 20 A

𝐾 𝐾
−
𝐿 𝐵 𝐿 𝐴
𝐾 0.8 − 5
B 𝐿 𝐴 5 −0.84
KB = 8 𝜎= = = = 1.26.
𝑀𝑅𝑇𝑆𝐵 − 𝑀𝑅𝑇𝑆𝐴 2−6 2
−
𝑀𝑅𝑇𝑆𝐴 6 3
LA = 4 LB = 10 L
Figure 7.8

If the MRTS decreases by 2/3 (about 66%), 𝐾/𝐿 decreases more than
proportionally, by 84%. 67
 ELASTICITY OF SUBSTITUTION
• LINEAR PRODUCTION FUNCTION.
• IF THE FIRM HAS A LINEAR PRODUCTION FUNCTION, 𝑞 =
𝑎𝐿 + 𝑏𝐾, ITS ISOQUANTS ARE STRAIGHT LINES.
𝑎
• 𝑀𝑅𝑇𝑆 = IS CONSTANT ALONG ALL THE POINTS OF THE
𝑏
ISOQUANT.
𝐾 𝐾
−
𝐿 𝐵 𝐿 𝐴
𝐾
𝐿 𝐴
𝜎= = +∞.
0
• REGARDLESS OF % CHANGE IN THE 𝐾/𝐿 RATIO, THE
ELASTICITY OF SUBSTITUTION IS INFINITE.
• THE FIRM CAN SUBSTITUTE LABOR FOR CAPITAL VERY EASILY WITHOUT
ALTERING ITS OUTPUT.
68