The Production Function

The production function shows the relationship

between quantity of inputs used to make a good and
the quantity of output of that good.
Q=f(ln, lb, k)
Q=Quantity of output;
ln=land;
lb=labor;
k=capital.
The Firm’s Objective
The firm makes many decisions to achieve its main
objective: profit maximization.
All decisions can be placed in two time frames:
 The short run
 The long run
 The Short run
Short run is a time period at which at least one factor is fixed.

The Long Run

The long run is a time frame in which the quantities of all resources
—including the plant size—can be varied.
Production in the short run
For a two-input production process, the total product of labor (TP L) is
defined as the maximum rate of output forthcoming from combining varying
rates of labor input with a fixed capital input. Denoting the fixed capital input
as k, the total product of labor function is

TPL=f(K,L)

Similarly, the total product of capital function is written as -

TPK=f(K,L)
 Marginal Product of Labor & Capital (MPL, MPK)
Two other product relations are relevant. First, marginal
product (MP) is defined as the change in output per one-unit
change in the variable input. Thus, the marginal product of
labor is–
MPL=dQ/dL
And the marginal product of capital is-

MPK=dQ/dK
 Average Product of Labor & capital (APL, APk)
Second, average product (AP) is total product per unit of the
variable input and is found by dividing the rate of output by
the rate of the variable input. The average product of labor
function is –
APL=TPL/L

And the equation for the average product of capital is-

APK=TPK/K
 The law of diminishing marginal returns
When increasing amounts of a variable factor are
used with a given amount of a fixed factor, there will
come a point when each extra unit of the variable
factor will produce less extra output than the previous
unit.
Total Product Marginal Product The second worker
Curve shows a Curve shows how the hired produces 6
marginal product units of output and
total product total product
curve relates to the
curve shows how total product curve. becomes 10 units.
total product The first worker
changes with the hired produces 4 The third worker
quantity of labor units of output. hired produces 3
units of output
employed.
and total product
becomes 13
units.
And so on.
To make a graph of the The law of diminishing returns
marginal product of labor, states that:
we can stack the bars in As a firm uses more of a variable
the previous graph side by input with a given quantity of
side. fixed inputs, the marginal
product of the variable input
The marginal product eventually diminishes.
of labor curve passes
through the mid-points
of these bars.

 Increasing marginal
returns initially
 Diminishing
marginal returns
eventually
Average Product Curve shows
its relationship with the
marginal product curve.

When marginal product

exceeds average product,
average product increases.

When marginal product is

below average product,
average product decreases.

When marginal product equals

average product, average
product is at its maximum.
 Three stages of production
Until N1 employment of labor marginal

product is higher than average product

Thus average product rises, which is the

basic feature of stage I. Marginal product,

however, rises until N then falls but stays

above average product. At N1 employ-

-ment of labor average product is

maximum where it is equal to marginal

product. Stage I ends at this point. Beyond

N1 employment of labor average produc-

-tivity falls due to low marginal productivity.

Stage II continues up to N2 labor. If labor

employment exceeds N2 marginal produc-

-tivity goes to negative which is the

 Decision to hire the number of labor:
Stage II is termed as the reasonable stage of production because of
consistency between capital and labor. Production decision in first stage
would be economically unjustifiable as there will have a lot of unutilized
capital equipment due to the unavailability of required amount of labor.
Stage III, where the amount of labor is so excessive relative to capital,
signifies the polar opposite of stage I. In this stage the incoming labor
force does not find enough capital equipment to work with, rather they
hamper production environment which eventually reduces production.
Stage II, on the other hand, is the stage where available capital equipment
are properly operated by required number of labor, therefore, yields
expected output.
Note that the law of variable proportion is also named as the law of
diminishing marginal product because in stage II, where production takes
place, marginal product diminishes.
Wheat production per year from a particular farm
a. Calculate APP & Number of TPP APP MPP
workers
MPP.
b. Draw the total
product curve, 0 0
average product 1 3
curve and 2 10
marginal product
3 24
curve
4 36
5 40
6 42
7 42
8 40
Optimal Employment of a Factor of Production
Formally stated, the basic principle is that additional units of the variable output should
be hired until the marginal revenue product (MRP) of the last unit employed is equal to
the cost of the input. The MRP is defined as marginal revenue times marginal
product and represents the value of the extra unit of labor. Thus labor is hired until
MRPL equals the wage rate (w).
MRPL=w
Similarly, if the labor input was fixed and the capital stock could be varied, capital would
be employed until the marginal revenue product of capital equaled the price of capital
(r), that is,
MRPK=r
 Example-1: The Optimal Labor Input Rate
The production function for Global Electronics is
Q=2K0.5L0.5
With marginal product functions for labor and capital given by-
MPL=dQ/dL
and MPK=dQ/dK

Assume that the capital stock if fixed at nine units (i.e. K=9). If the price of output (P) is 6 tk per unit and
the wage rate (w) is 2 tk per unit, determine the optimal or profit-maximizing rate of labor to be hired.
What labor rate is optimal if the wage rate increased to 3 tk per unit?
Example-2

• Use the production function -

Q=2K0.5L0.6
a. If the rate of capital input is fixed at three and if output
sells for TK5 per unit, the wage rate is TK28 per unit,
how much labor should be employed.
b. If the rate of labor input is fixed at 5 and the price of
output is TK5 per unit, the price of capital is TK 40 per
unit, how much units of capital should be employed.
Production in the long-run: Production with Two Variable Inputs

If both capital and labor inputs are variable, a different set of analytical
techniques must be applied to determine optimal input rates. The
approaches are –i. maximizing production for a given cost on labor and
capital;
ii. Minimize the cost on labor and capital inputs necessary to produce
a specified rate of output.

A standard managerial economics technique using the concept of

production isoquants and production isocosts is used to determine
efficient input rate combination for given production rates.
 Isoquant
Isoquant shows different combinations of capital (k) and labor (L) that
generate equal amount of output. Isoquant are downward sloping,
convex to the origin, do not intersect each other and higher isoquant
represents higher output.
Table 1: An Isoquant Schedule
Combination Units of Units of Output of
s of Labor Labor Capital Cloth
and Capital (L) (K) (meters)
A 5 9 100
B 10 6 100
C 15 4 100
D 20 3 100
An iso-product curve is the graphic
representation of an iso-product schedule.

Thus, an isoquant is a curve showing all combinations of labor and capital that can be used to produce a given
quantity of output.
Isoquant Map
An isoquant map is a set of isoquants that shows the maximum attainable output from
any given combination inputs.
 Isocost
Iso quant shows how factors combine to produce different levels of output,
but how do we choose the level of output? This will involve taking costs into
account.
For example, assuming that PK is $20000 per unit and PL is $10000 per
worker that would cost the firm $300000.
Definition
A line showing all the combinations of two factors that cost the same to
employ.
Isocost equation

Isocost curve and slope

 The optimum combination of factors:
1. The least-cost combination of factors to produce a given level of output
2. Highest output for a given cost of production

The condition is –
The slope of the isoquant equals MRS, which equals MPL/MPK; and the slope of the isocost equals PL/PK.
1. The least-cost combination of factors to produce a given level of
output
2. Highest output for a given cost of production
The scale of production
If a firm were to double all of its inputs-something it could do in the long
run-would it double its output? Or will output more than double or less than
double? We can distinguish three possible situations.

1. Constant returns to scale. This is where a given percentage increase in

inputs will lead to the same percentage increase in output.
2. Increasing returns to scale. This is where a given percentage increase
in inputs will lead to a larger percentage increase in output.
3. Decreasing returns to scale. This is where a given percentage increase
in inputs will lead to a smaller percentage increase in output.