PAN African e-Network Project

Diploma in Business Management

Managerial Economics
Session - 3

Ms. Tavishi

PRODUCTION

The Production Function

Inputs
Land, labour, capital, and so forth

Outputs
(cars, polio vaccine,
home-cooked meals,
TV broadcasts, and so forth)

The Production Function

Long run: the shortest period of time required
to alter the amounts of all inputs used in a
production process.
Short run: the longest period of time during
which at least one of the inputs used in a
production process cannot be varied.
Variable input: an input that can be varied in
the short run.
Fixed input: an input that cannot vary in the
short run.

Short-run Production
Funtion
Three properties:
1.It passes through the origin.
2.Initially the addition of variable inputs
augments output at an increasing rate.
3.Beyond some point additional units of
the variable input give rise to smaller
and smaller increments in output.

Figure 7.3: A Specific Short-Run Production Function

Figure 7.4: Another Short-Run Production Function

Short-run Production
Function
Law of diminishing returns: if
other inputs are fixed, the increase in
output (marginal product) from an
increase in the variable input must
eventually decline.

Figure 7.5: The Effect of Technological Progress in

Food Production

Q2010

Q1810

L1810

L2010

Short-run Production
Function
Total product curve: a curve showing
the amount of output as a function of the
amount of variable input.
Marginal product: change in total
product due to a 1-unit change in the
variable input.
Average product: total output divided by
the quantity of the variable input.

Figure 7.6: The Marginal Product

of a Variable Input

Figure 7.7: Total, Marginal, and

Average Product Curves

Relationship between Total, Marginal

and Average Product Curves

When the marginal product curve lies

above the average product curve, the
average product curve must be rising.
When the marginal product curve lies
below the average product curve, the
average product curve must be falling.
The two curves intersect at the maximum
value of the average product curve.

The Practical Significance Of The

Average -Marginal Distinction
Suppose you own a fishing fleet consisting of a
given number of boats, and can send your boats
in whatever numbers you wish to either of two
ends of an extremely wide lake, east or west.
Under your current allocation of boats, the ones
fishing at the east end return daily with 100
kilograms of fish each, while those in the west
return daily with 120 kilograms each. The fish
populations at each end of the lake are
completely independent, and your current yields
can be sustained indefinitely.
Should you alter your current allocation of
boats?

Production Function

Qt=(inputst)
Qt=output rate
inputt=input rate
where is technology?

Firms try to be on the surface of

the PF.
Inside the function implies there is
waste, or technological
inefficiency.

Kt

Production Function
Q=(Kt,Lt)

Qt

Lt

Difference between LR and

SR
LR is time period where all inputs can
be varied.
Labor, land, capital, entrepreneurial
effort, etc.

SR is time period when at least some

inputs are fixed.
Usually think of capital (i.e., plant size)
as the fixed input, and labor as the
variable input.

LR production function as many SR

production functions.
Long Run: Q = f (K,L)
Suppose there are two different
sized plants, K1 and K2.

One Short Run:

Q = f ( K1,L) i.e., K fixed at K1

A second Short Run:

Q = f ( K2,L) i.e., K fixed at K2

Show this graphically

Two Separate SR Production

Functions
Q
Q = f( K2, L )
Q = f( K1, L )

K2 > K1

What Happens when

Technology Changes?
This shifts the entire production
function, both in the SR and in
the LR.

Technology Changes
Q
TP after computer
TP before computer

SR Production Function in More

Detail Q =(K ,L )

Express this in two

dimensions, L and Q, since K is
fixed.
Define Marginal Product of
Labor.
Slope is MPL=dQ/dL
Identify three ranges
I: MPL >0 and rising

fixed

II

III

II: MPL >0 and falling

III: MPL<0 and falling

Where Diminishing Returns

Sets In

As you add more and more

variable inputs to fixed inputs,
eventually marginal
productivity begins to fall.
As you move into zone II,
diminishing returns sets in!
Why does this occur?

II

Why Diminishing Returns

Sets In

Since plant size (i.e., capital) is

fixed, labor has to start
competing for the fixed capital.
Even though Q still increases
with L for a while, the change in
Q is smaller.

II

Define APL and MPL

Average Product = Q / L
output per unit of labor.
frequently reported in press.

Marginal Product =dQ/dL

output attributable to last unit of labor used.
what economists think of.

Average Productivity
Graphically
Take ray from origin to the
Q

SR production function.
Derive slope of that ray
Q=Q1

Q=f(KFIXED,L)

L=L1

Thus,
Q/L =Q1 /L1
Q1

Q
L
L

L1

Average Productivity
Graphically
Q

APL rises until L2

Beyond L2 , the APL begins to

fall.
That is, the average
productivity rises, reaches a
peak, and then declines

Q=f(KFIXED,L)
Q2

Q/L

L2

APL
L2

Average & Marginal

Productivity
There is a relationship between the productivity
of the average worker, and the productivity of
the marginal worker.
Think of a batting average.
Think of your marginal productivity in the most recent
game.
Think of average productivity from beginning of year.
When MP > AP, then AP is RISING
When MP < AP, then AP is FALLING
When MP = AP, then AP is at its MAX

Average Productivity
Graphically
Q

MPL rises until L1

Beyond L1 , the MPL begins

to fall.
Look at AP
i. Until L2, MPL >APL and thus

APL rises.
ii. At L2, MPL=APL and thus APL
peaks.
iii. Beyond L2, MPL<APL and thus
APL falls.

L1

L2

Q/L

MPL
L1

L2

APL

Intuitive explanation

Anytime you add a marginal unit to an average unit, it either

pulls the average up, keeps it the same, or pulls it down.
When MP > AP, then AP is rising since it pulls it the average up.
When MP < AP, then AP is falling since it pulls the average down.
When MP = AP, then AP stays the same.

Think of softball batting average example.

LR Production Function
Qt
Kt
Isoquants
(i.e.,constant
quantity)

Lt

Define Isoquant
Different combinations of Kt
and Lt which generate the
same level of output, Qt.

Isoquants & LR Production Functions

ISOQUANT MAP

Qt = Q(Kt, Lt)
Output rate increases as you move to
higher isoquants.
Slope represents ability to tradeoff
inputs while holding output constant.

Marginal Rate of Technical Substitution.

Closeness represents steepness of

production hill.

Q3

Q2
Q1

Slope of Isoquant

Slope is typically not constant.

Tradeoff between K and L
depends on level of each.

Can derive slope by totally

differentiating the LR
production function.
Marginal rate of technical
substitution is MPL/MPK

Kt

Q
Lt

Extreme Cases

No Substitutability

Perfect Substitutability
Q2

Q2

Q1

Q1
L
Inputs used in fixed
proportions!

L
Tradeoff is constant

Substitutability
Low Substitutability
K

High Substitutability
Q1

Q1
L
Slope of Isoquant
changes a lot

L
Slope of Isoquant
changes very little

Isoquants and Returns to Scale

Returns to scale are cost

savings associated with a
firm getting larger.

Increasing Returns to Scale

K

Q=40
Q=30
Q=20
Q=10
L

Production hill is rising quickly.

Lines on the contour map get
closer with equal increments
in Q.

Decreasing Returns to Scale

K

Q=40

Q=30
Q=20
Q=10
L

Production hill is rising

slowly.
Lines on the contour map
get further apart with equal
increments in Q.

How Can You Tell if a PF has IRS,

DRS, or CRS?
It is possible that it has all three,
along various ranges of production.
However, you can also look at a
special kind of function, called a
homogeneous function.
Degree of homogeneity is an indicator
returns to scale.

Homogeneous Functions of Degree

A function is homogeneous of degree k

if multiplying all inputs by , increases the dependent variable by
Q = f ( K, L)
So, Q = f(K, L) is homogenous of degree k.

Cobb-Douglas Production Functions are homogeneous of degree

Cobb-Douglas Production Functions

Q=AK

is a Cobb-Douglas Production

Function
Degree of Homogeneity is derived by increasing all the
inputs by

= A ( K) ( L)
Q = A K L
Q = A K L

Cobb-Douglas Production Functions

This is a Constant Elasticity Function

Elasticity of substitution = 1

Coefficients are elasticities

is the capital elasticity of output, E K
is the labor elasticity of output, E L

If Ek or L <1 then that input is subject to Diminishing Returns.

C-D PF can be IRS, DRS or CRS
if + 1, then CRS
if + < 1, then DRS
if + > 1, then IRS

Technical Change in LR

Technical change causes isoquants to shift inward

Less inputs for given output

May cause slope to change along ray from origin

Labor saving
Capital saving

May not change slope

Neutral implies parallel shift

Technical change

Labor Saving

Capital Saving

Lets now turn to the Cost

Side
What is Goal of Firm?

Define Isocost Line

Put K on vertical axis, and L on

horizontal axis.
Assume input prices for labor (i.e.,
K
w) and capital (i.e., r) are fixed.
Slope=-w/r
Define: TC=w*L + r*K
TC/r
Solve for K:
Isocost Line
r*K= TC-w*L
K=(TC/r) - (w/r)*L

TC constant along Isocost

line.
K

TC1/r

L
TC1/w

in TC parallel shifts
Isocost
K
TC2/r

TC2 > TC1

TC1/r

L
TC1/w

TC2/w

Change in input price rotates

Isocost
K

w2 < w 1
TC/r

L
TC/w 1

TC/w 2

Optimal Input Levels in LR

Suppose Optimal Output level

is determined (Q1).

Suppose w and r fixed.

What is least costly way to
produce Q1?

Q1
L

Optimal Input Levels in LR

Suppose Optimal Output level is

determined (Q1).

Suppose w and r fixed.

What is least costly way to
produce Q1?

Find closest isocost

origin!

line to

Optimal point is point of allocative

efficiency.

K1
Q1

L1

Cost Minimizing Condition

Slopes of Isoquant and Isocost are equal

Slope of Isoquant=MRTS=- MPL/ MPK
Slope of Isocost=input price ratio=-w/r
At tangency, - MPL/ MPK = -w/r

Rearranging gives: MPL/w= MPK /r

In words:
Additional output from last $ spent on L = additional output from last
$ spent on K.

The LR Expansion Path

Costs increase when output

increases in LR!
Look at increase from Q1 to
Q2.

Both Labor and Capital adjust.

Connecting these points gives
the expansion path.

expansion path

K2
K1

Q2
Q1
L

L1 L2

We can show that LR adjustment along the

expansion path is less costly than SR adjustment
holding K fixed!

Start at an original LR equilibrium

(i.e., at Q1).

K1
Q1
L

L1

LR Adjustment

LR adjustment:
K increases (K1 to K2)

L increases (L1 to L2)

TC increases from black to blue
isocost.

K2
K1

Q2
Q1
L

L1 L2

SR Adjustment

SR adjustment.
K constant at K1.

L increases (L1 to L3)

TC increases from black to white
isocost.

K1

Q2
Q1
L

L1

L3

LR Adjustment less Costly

White Isocost (i.e., SR) is further

from the origin than the Blue
Isocost (LR).
Thus, the more flexible LR is less
costly than the less flexible SR.

K2
K1

Q2
Q1
L

L1 L2 L3

Impact of Input Price

Change

Start at equilibrium.
Recall slope of isocost=K/L=
-w/r

Suppose w
and optimal Q
stays same (i.e., Q1)

Rotate budget line out, and

then shift back inward!

Q1

K1

L1

Decrease in wage leads to

substitution

Firms substitute away from

capital (K1 to K2).

Firms substitute toward labor (L1

to L2)

Pure substitution effect: a to b

Maps out demand for labor curve

K1

K2

Q1

L1

L2

Derivation of Labor Demand from

Substitution Effect

Wage falls

w1
a

K1

w2

K2

Q1

L1

L2

DL1
L

L1

L2

There is also a scale effect

Scale effect is increase in

output that results from lower
costs
Scale effect: b-c

Q1

Q2

K1

c
b

L1

Scale Effect Shifts Demand

Wage falls

w1
K1

w2

K2

Q1

L1

L2 L3

DL1
L

L1

L2 L3

DL2

Recall the Isocost Line

TC=w*L + r*K

Thus, TC=TVC+TFC
Lets relate the cost relationships to the
production relationships.
Recall the Law of Diminishing Returns.

Law of Diminishing Marginal

Returns

As you add more and more variable

inputs (L) to your fixed inputs (K),
marginal additions to output
eventually fall (i.e., MPL= Q/L falls)
What does this say about the shape
of cost curves?

Marginal Productivity (MPL) and

Marginal Cost (MC)
Look at how TC changes when
output changes.
Assume w and r are fixed.
Since TC=w*L+r*K
then TC = w*L + r*K
How does K change in SR?

Changes in TC in SR must come from

changes in Labor.
TC = w* L
Divide through by change in Q (ie. Q)
TC/Q = w* (L/Q)
TC/Q = Marginal Cost = MC
What is MPL?
MPL=(Q/L)
Thus: TC/Q = w* 1/(Q/L)
This gives: MC=w/MPL

MC=w/MPL
Look at where Diminishing Returns sets in.
MC

MPL

MPL
L1

MC=w/MPL
Substitute L1 into SR Production Function
Q1=f(KFIXED,L1)
MC

MPL

MC

MPL
L1

L
Q1

Alternatively: TC and TP
Substitute L1 into SR Production Function
Q1=f(KFIXED,L1)
TC

TC

MPL
L1

L
Q1

Relationship between APL and

AVC
TC=TVC + TFC
TC = w*L + r*K
Divide equation by Q to get average
cost formula.
TC/Q = w*L/Q + r*K/Q
ATC = AVC + AFC
Thus, AVC=w*L/Q

AVC and APL

AVC=w*L/Q
Rearranging: AVC=w/(Q/L)
Since Q/L=APL
AVC=w/APL
Diagram is similar.

AVC=w/APL
Substitute L2 into SR Production Function
Q2=f(KFIXED,L2)
APL

AVC
AVC

APL
L2

L
Q2

Put SR Cost Curves

Together

Average Cost Curves

ATC
$

AVC

AFC
Q

Short Run Average Costs and

Marginal Cost
$
ATC
MC

AVC

Cost Curve Shifters

(Variable Cost Increases)

A change in the wage shifts

the AVC and MC curves.
Thus, the ATC curve also shifts
upward.

MC
$

ATC
AVC
ATC
AVC

MC
Q

Cost Curve Shifters

(Fixed Cost Increases)

An increase in price of capital

increases fixed costs, but not
variable costs.
Thus, AVC and MC are fixed,
but ATC increases.

$
MC

ATC
ATC
AVC

Costs in the LR
Why did SR cost curves have the
shape they did?
Why do LR cost curves have the
shape they do?

LR Total Costs Graphically

TC
Cost

CRS
DRS
IRS

Why are there Economies of Scale?

Specialization in use of inputs.

Less than proportionate materials use as plant
size increase.
Some technologies are not feasible at small
scales.

Why do Diseconomies of Scale

Set In?
Eventually, large scale operations become more
costly to operate (i.e., they use more resources)
due to problems of coordination and control.
e.g., red tape in the bureaucracy.
Graphical Representation

Economies and Diseconomies

of Scale
Assume Q increases 10 units for
each isoquant

IRS
L

Economies and Diseconomies of

Scale
Assume Q increases 10 units for
each isoquant

DRS

IRS
L

Economies and Diseconomies

of Scale
Assume Q increases 10 units for
each isoquant

DRS

DRS

IRS
LRAC curve

CRS

CRS

IRS
L
QMES

LRMC and LRAC Curves

LRAC and LRMC

$

LRMC

LRAC

LRMC is TC/Q (i.e., change

in TC from a change in Q)
when all inputs are variable
inputs.
When LRMC is above LRAC, it
pulls the average up, and
vice-versa.

Relating SR to LR curves

Relationship between SR ATC and

LRAC curves.

$
ATC1

LRAC

Q
Q1

At Q1, the SR plant size which

gives ATC1 is least costly.

Relationship between SR ATC and

LRAC curves.

$
ATC1

LRAC

Q
Q1

At Q1, the SR plant size which

gives ATC1 is least costly.

SR ATC is tangent to LRAC at

one point.

Relationship between SR ATC and

LRAC curves.
$
ATC1

LRAC

At Q1, the SR plant size which

gives ATC1 is least costly.

SR ATC is tangent to LRAC at

one point.
Tangency is not at minimum
point of ATC1.

Q
Q1

Adjustments in SR are still more

costly than LR
$
ATC1

LRAC

atc1
lrac1

Q
Q2

At Q2, the SR plant size which

gives ATC1 is no longer least
costly.

Adjustments in SR are still more

costly than LR

ATC1

LRAC

atc1

lrac1

Q
Q2

At Q2, the SR plant size which

gives ATC1 is no longer least
costly.
Optimal move would be to
larger plant size!

LRAC is lower envelope of family

of SRATC curves
$
ATC1

ATC2

ATC3
LRAC

Q
Q1

Q2=QMES

Q3

SRMC and LRMC

$

LRMC
SRMC1

SRMC3
SRMC2

LRAC

SRATC3

SRATC1
SRATC2

q1

q2

q3

Thank you
For Queries mail at
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