Lecture one

By Phyllis Mumia Machio

Production function

In the production process, firms turn inputs into output. Inputs are also called the factors of
production. The relationship between the inputs used in the production process and the output is
described using a production function. Formally a production function is defined as a function
showing the highest (maximum) output that a firm can produce for every specified combination
of inputs. The production function can be written as,

(1) Q  F (L) Where Q is output and L is labor

Quantity of output

Total product

Units of labor

Equation 1 applies to a given technology. As technology becomes more advanced and the
production function changes, a firm can obtain more output for a given set of inputs.

In this case we have only 1 input, labor. The concept of production function applies also when
we have more than one input. Suppose we not only have labor but also capital. In this case we
depict production relations using isoquants. An isoquant is a set of all possible combinations of

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the two inputs just sufficient to produce a given amount of output. The labeling of isoquants is
fixed by the technology.

Capital per month

Q3=100

Q2=80

1 Q1=60

1 2 3 Labor per month

Q1=60 shows all combinations of labor and capital that together yield 60 units of output. When a
number of isoquants are combined in a single graph, we call the graph an isoquat map. The level
of output increases as we move up to the right in the figure. Isoquants show the flexibility firms
have when making production decisions. They usually obtain a particular output by substituting
one input for another.

Marginal product

Suppose we want to increase input 1 (labor) by 1 unit while keeping the other input (capital)
constant what happens to output? This gives us the marginal product of labor and is given by

Q Q( L  L, K )  Q( L, K )

L L

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Marginal product of labor is the additional output produced as the labor input is increased by 1
unit while capital held constant. Marginal product at any point is given by the slope of the total
product at that point. Marginal product of capital is defined in a similar way.

Consider the following production function,

Q  AK  L

Marginal product of labor is given by,

Q Q
 AK  1 L  AK  L 1
K L

Example

Q Q
Q  AK 0.5 L0.5  0.5 AK 0.5 L0.5  0.5 AK 0.5 L0.5
K L

When 100 units of labor and 10 units of capital are used and A is equal to 1, the marginal
product of labor is 1.6 and the marginal product of capital is 0.16. Increasing labor by 1 unit
while keeping capital constant increases output produced by 1.6 units. Increasing capital by 1
unit while keeping labor constant increase output produced by 0.6 units.

As the use of an input increases with other inputs fixed, a point will eventually be reached at
which the resulting additions to output decrease. This is referred to as the law of diminishing
marginal returns. When labor input is still small, extra labor adds considerably to output since
workers devote themselves to specialized tasks. Eventually the law of diminishing marginal
returns applies. This may be because when there are too many workers some workers become
ineffective and the marginal product of labor falls.

Amount of Labor (L) Amount of Capital Total Output (Q) Marginal product(Change
(K) in Q/Change in L

0 10 0 -

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1 10 10 10

2 10 30 20

3 10 60 30

4 10 80 20

5 10 95 15

6 10 108 13

Marginal rate of technical substitution

By how much should we reduce one input if we want to increase another input 1 unit but keep
output constant? This is just the slope of the isoquant. It measures the rate at which the firm will
substitute one input for another in order to keep output constant. This is called the marginal rate
K
of technical substitution. MRTS=-Change in capital input/change in labor input=-
L

Consider adding some labor and reducing amount of capital sufficient to keep output constant.
The additional output resulting from the increased labor input is equal to the additional output
per unit of labor (marginal product of labor) times the number of units of additional labor.
Additional output from increased use of labor = MPL (L)

Similarly the decrease in output resulting from the reduction in capital is the loss of output per
unit of reduction in capital (marginal product of capital) times the number of units of capital
reduction. Reduction in output from decreased use of capital = MPK (K )

Since the total output is constant, the change in output is zero. Thus,

MPL (L)  MPK (K )  0

Re-arranging this gives

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 MPL K
(2)  ( )  MRTS
MPK L

This equation tells us that the marginal rate of technical substitution between two inputs is equal
to the ratio of the marginal products of the inputs.

Diminishing MRTS

As more and more labor replaces capital labor becomes less productive and capital becomes
more productive and so we need less capital to keep output constant and so the isoquant becomes
flatter. This is referred to as diminishing MRTS. This is because as we initially replace capital
with labor, we replace low productivity units of capital. But as substitution continues we now
starting replacing even the very productive units of capital. Thus the isoquats are convex. This
means productivity of one input is limited and so production needs a balanced mix of both
inputs.

Returns to scale

It is the rate at which output increases as inputs are increased proportionally. If we use twice as
much of each input, how much output will we get? If 1 tailor working with 1 machine to
produces 3 clothings per day how much clothing will be produced if there are two tailors and two
machines? There are three different cases,

i) Increasing returns to scale

This occurs when output more than doubles when inputs are doubled. This may arise because the
larger scale of operation allows workers and managers to specialize in their tasks. The
automobile assembly industry is a famous example of increasing returns to scale. If there are
increasing returns to scale then it’s advantageous to have one large firm producing than many
small one due to cost reasons. But since such firms control price, they need to be regulated.

Mathematically this is given as,

Q(tK , tL)  tQ( K , L)

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ii) Constant returns to scale

This occurs when output doubles when inputs are doubled. This means that two times as much of
each input gives two times as much output. In this case the size of the firm does not affect the
productivity of its factors. Mathematically this is given as,

Q(tK , tL)  tQ( K , L) . A Cobb – Douglas production function shows constant returns to scale if
    1,

iii) Decreasing returns to scale

This occurs when output less than doubles when inputs are doubled. This applies to firms with
large scale of operations. We get less than twice as much output from having twice as much of
each input. Difficulties in running a large scale operation may lead to decreased productivity of
both labor and capital. It is likely to be associated with the problem of coordinating tasks and
maintaining a useful line of communication between management and workers. Mathematically
it is given as,

Q(tK , tL)  tQ( K , L) . A cob - Douglas production function is said to have decreasing returns
to scale if     1,

Returns to scale need not be uniform at all possible levels of output. For example at lower levels
of output the firm could have increasing returns to scale but constant and eventually decreasing
returns to scale at higher levels of output. Returns to scale vary considerably across firms and
industries. The greater the returns to scale, the larger the firms in an industry are likely to be.

Consider the following production function; check whether it exhibits CRTS, IRTS or DRTS.
Where K=20, L=100 and t=2

Q  10 K  20 L
Q  10 K  20 L
 (10 *10)  (20 *100)
 (2 *10 *10)  (2 * 20 *100)
 2 * (100  2000) Q  K 0.4 L0.3
 200  4000
 2 * 2100
 4200
4200

Types of production functions

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 1. Linear production functions

This is a production function that assumes a perfect linear relationship between inputs & total
output. The production function in this case is given as,

Q  K  L Where Q, K , L are as defined before and  ,  are parameters

For linear production function the isoquants are straight lines as shown below because the two
inputs in this case are perfect substitutes. The marginal products for linear production functions
are given as follows,

Q
  MPK
K

Q
  MPL
L


The MRTS is constant and is equal to . This production function also exhibits constant

returns to scale.

Q  10K  20L

In this case the MPL is 20 and MPK is 10. Increasing capital by 1 unit cases output to increase
by 10 units. The MRTS is 2.

Capital

Labor

2. Cobb-Douglas production function

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 It is a production function that assumes some degree of substitutability between inputs but
not perfect substitutability. The general form is given as,

Q  K  L

The marginal products are given as,

Q Q
 AK  1 L  AK  L 1
K L

AK  L 1 K
The MRTS equals to 
AK  1 L L

Capital

Labor

The MRTS declines as we move down along the isoquant. The Cobb – Douglas production
function has constant returns to scale if     1, increasing returns to scale if     1, and
decreasing returns to scale if     1 .

3. Leontief production function

This is a production function that assumes that inputs are used in fixed proportions. There is no
substitutability in the factors. Capital and labor are perfect compliments i.e. they go together. The
production function is of the form,

Q( K , L)  Min(K , L)

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Leontief production function assumes constant returns to scale and no substitution and so the
MRTS is either zero, infinity or undefined depending on the relative magnitudes of K and L.

MRTS =infinity if K<L, MRTS =0 if K>L and MRTS=undefined if K=L

Suppose a company has this Leontief production function

Q  min(50K ,100L)

We can list a few combinations that will produce 1000 units of output

K=20 L=10 Min{50(20),100(100)}=1000

K=20 L=100 Min {50(20),100(100)}=1000

K=50 L=10 Min{50(150),100(10)}=1000

K=100 L=10 Min{50(100),100(10)}=1000

100

50

20 Q=1000

10 50 100 L

When K>L (Vertical axis, K=50, L=10)

MRTSLK=MPL/MPK=infinity/0=infinity

When L>K (Horizontal axis, i.e. K=20, L=50)

MRTSLK=MPL/MPK=0/infinity=0

When K=L (at the corner)

MRTSLK=MPL/MPK=infinity/infinity=undefined
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 4. Constant elasticity of substitution production function

The general form is given as,

1
 
Q  [K  L ] 

The CEC contains several other well known production functions as special cases depending on
the value of the parameter  . When  equals 1, the CES production function yields a linear
production function, when  approaches zero, then CES production function yields and CD
production function and when  equals to negative infinity, the CEC yields a Leontief
production function.

MRTS for CES=MPL/MPK

1
1 1
 
MPK  [K  L ] 
K  1

1
1 1
 
MPL  [K  L ] 
L 1

1
1 1
[K   L ]  L 1
 L 1
MRTS  
1  
1
1 K  1
[K  L ] 
K  1


Elasticity of substitution

Elasticity of substitution measures the curvature of the isoquant and thus the substitutability
between inputs. It measures is how easy it is to substitute 1 input for another. When it is easy to
substitute 1 input for another the isoquant is flat and the elasticity of substitution is large. It is
denoted by  and given by,

 ( K / L)
 K/L
MRTS
MRTS

We can re-write this as follows,

MRTS d ( K / L)

( K / L) dMRTS

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We can express this in log form as follows,

1 1
Since d ln y  dy and d ln x  dx
y x

d ln y dy x

d ln x dx y

d ln( K / L)
In this case therefore  
d ln( MRTS )

Elasticity of substitution for CD production function,

K K 
MRTS  ,  MRTS
L L 

K 
Ln( )  ln  ln MRTS
L 

d ln( K / L)
 =1
d ln( MRTS )

For the CES production function,

L 1 L  1
MRTS   1
( )
K K


1
K
 ( MRTS ) 1 
L 

K 1  1
ln   MRTS
L 1   1 

d ln( K / L) 1
 
d ln( MRTS ) 1  

For linear, the elasticity of substitution is infinite, for CD it is 1 and for Leontief it is undefined.

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