5 Ed CH 06
5 Ed CH 06
5 Ed CH 06
The Theory and Estimation of Production The Production Function Short-Run Analysis of Total, Average, and Marginal Product Long-Run Production Function Estimation of Production Functions Importance of Production Functions in Managerial Decision Making
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Learning Objectives
Define production function and explain difference between short-run and long-run production function Explain law of diminishing returns and how it relates to the Three Stages of Production Define the Three Stages of Production and explain why a rational firm always tries to operate in Stage II
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Learning Objectives
Provide examples of types of inputs that might go into a production function for a manufacturing or service company Describe various forms of a production function that are used in statistical estimation of these functions Briefly describe the Cobb-Douglas function and cite a few statistical studies that used this particular functional form in their analysis
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Keat/Young
The Production Function For simplicity we will often consider a production function of two inputs: Q=f(X, Y) Q: output X: Labor Y: Capital
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Short-Run Analysis of Total, Average, and Marginal Product Marginal product (MP): change in output (or Total Product) resulting from a unit change in a variable input.
(Q MPX ! (X
Q X
Keat/Young
Keat/Young
Keat/Young
Short-Run Analysis of Total, Average, and Marginal Product The Three Stages of Production in the Short Run
Stage I: From zero units of the variable input to where AP is maximized (where MP=AP) Stage II: From the maximum AP to where MP=0 Stage III: From where MP=0 on
Keat/Young
Short-Run Analysis of Total, Average, and Marginal Product What level of input usage within Stage II is best for the firm? The answer depends upon how many units of output the firm can sell, the price of the product, and the monetary costs of employing the variable input.
Keat/Young
Marginal Revenue Product (MRP): change in the firms TRP resulting from a unit change in the number of inputs used.
MRP =
(TRP (X
= MP P
Managerial Economics, 5/e Keat/Young
Marginal Labor Cost (MLC): change in total labor cost resulting from a unit change in the number of variable inputs used. Because the wage rate is assumed to be constant regardless of the number of inputs used, MLC is the same as the wage rate (w).
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Keat/Young
Short-Run Analysis of Total, Average, and Marginal Product Multiple variable inputs
Consider the relationship between the ratio of the marginal product of one input and its cost to the ratio of the marginal product of the other input(s) and their cost.
MP MP2 MPk 1 ! ! w1 w2 wk
In the long run, a firm has enough time to change the amount of all its inputs.
Effectively, all inputs are variable.
The long run production process is described by the concept of returns to scale.
Keat/Young
The Long-Run Production Function If all inputs into the production process are doubled, three things can happen:
output can more than double
increasing returns to scale (IRTS)
The Long-Run Production Function Returns to scale can also be described using the following equation hQ = f(kX, kY) If h > k then IRTS If h = k then CRTS If h < k then DRTS
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
The Long-Run Production Function Graphically, the returns to scale concept can be illustrated using the following graphs.
Q IRTS Q CRTS Q DRTS
X,Y
2006 Prentice Hall Business Publishing
X,Y
Managerial Economics, 5/e Keat/Young
X,Y
Permits us to investigate MP for any factor while holding all others constant Elasticities of factors are equal to their exponents
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Importance of Production Functions in Managerial Decision Making Production levels do not depend on how much a company wants to produce, but on how much its customers want to buy. Capacity Planning: planning the amount of fixed inputs that will be used along with the variable inputs. Good capacity planning requires:
Accurate forecasts of demand Effective communication between the production and marketing functions
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young