Production Theory and Analysis

Production

Production refers to the transformation of inputs or

resources into outputs of goods and services

Creation of utility

Characteristics of goods & services to be

classified as Production are:

Created by human labor and capital

Satisfy human wants directly or indirectly

Are comparatively scarce and have economic

value

Have a definite monetary price/cost

Factors of Production

INPUTS

Land

Labor

Capital

Immobile
Passive
Heterogen
eous

Active
Mobile
Variable
productivity

Structures
Equipment
Cap.goods
Money

Enterprise
Innovative function
Risk
Decision making

INPUTS

CAPITAL

LABOR

Workers

Entrepreneur

Land &
Structures
Machinery
plant &
equipment

Natural
Resources

Factors of Production

Inputs
Fixed Inputs
Variable Inputs

Short Run- At least one input is fixed

Long Run - All inputs are variable

The length of long run depends on industry.

Level & Scale of Production

Level of production can be altered changing the

proportion of variable inputs
Output = Fixed inputs + Variable inputs

Scale of production can be altered by changing the

supply of all the inputs only in the long run
Output = Total inputs(variable inputs)

Concept of Product

Total Product - total volume of goods produced

during a specific period of time

Average Product - the per unit product of a

variable factor

Marginal Product - the rate at which total

product increases / addition to total product
resulting from a unit increase in the quantity of the
variable factor

Production Function With Two Inputs

K
6
5
4
3
2
1

Q = f(L, K)
10
12
12
10
7
3
1

24
28
28
23
18
8
2

31
36
36
33
28
12
3

36
40
40
36
30
14
4

40
42
40
36
30
14
5

39
40
36
33
28
12
6 L

Input & output are measured in physical units

Assumption- Technology is constant the during analysis period
- All units of L & K are homogenous

Production Function with Two Inputs

Discrete Production Surface

Production Function with Two Inputs

Continuous Production Surface

Production Function with

One Variable Input
Total Product

TP = Q = f(L)

Marginal Product

TP
MPL =
L

Average Product

TP
APL =
L

Production or
Q/Q
=
E
Output Elasticity L L/L

Q/ L = MPL
APL
Q/L

Production Function with

One Variable Input
Total, Marginal, and Average Product of Labor, and Output Elasticity

L
0
1
2
3
4
5
6

Q
0
3
8
12
14
14
12

MPL
3
5
4
2
0
-2

APL
3
4
4
3.5
2.8
2

EL
1
1.25
1
0.57
0
-1

Production Function with

One Variable Input
Total, Marginal, and Average Product of Labor, and Output Elasticity

L
0
1
2
3
4
5
6

Q
0
3
8
12
14
14
12

MPL
3
5
4
2
0
-2

APL
3
4
4
3.5
2.8
2

EL
1
1.25
1
0.57
0
-1

Production Function
with One Variable Input

Production Function with One Variable Input

Total 16
Product

14

12

TP

10

8
6

4
2

Marginal
& Average
Product

Labor

6
5

D
E

AP

1
0
-1
-2
-3

MP

Labor

The Law of Diminishing Returns &

Stages of Production
Total 16
Product

14

12

TP

10

4
2

Marginal
& Average
Product

Stage I of Labor

Stage II of Labor
B

Labor

Stage III of Labor

E

AP

1
0
-1
-2
-3

MP

Labor

Optimal Use of the Variable Input

Marginal Revenue
Product of Labor
Marginal Resource
Cost of Labor

MRPL = (MPL)(MR)
TC
MRCL =
L

Optimal Use of Labor MRPL = MRCL

Optimal Use of the Variable Input

L
2.50
3.00
3.50
4.00
4.50

MPL
4
3
2
1
0

MR = P
$10
10
10
10
10

Assumption : Firm hires additional units of labor at constant

wage rate = $20

Optimal Use of the Variable Input

L
2.50
3.00
3.50
4.00
4.50

MPL
4
3
2
1
0

MR = P
$10
10
10
10
10

MRPL
$40
30
20
10
0

MRCL
$20
20
20
20
20

Assumption : Firm hires additional units of labor at constant

wage rate

Use of Labor is Optimal When L = 3.50

Optimal Use of the Variable Input

$
40

30

20

MRCL = w = $20
10

dL = MRPL
0

2.5

3.0

3.5

4.0

4.5

Units of Labor Used

Exercise

The marginal product of labor equation for a firm

is given by: MPL = 10(K/L)0.5
Currently the firm is using 49 units of capital and
100 units of labor. Capital usage is fixed, but labor
can be varied. If the price of labor is $20 per unit
and the firms' output sells for $4, is the firm
producing efficiently in the short run? If not,
explain and determine the optimal rate of labor
input.

MRPL = MRCL = w

28 20 Not efficient

L = 196

Production With Two Variable Inputs

Isoquants show combinations of two inputs
that can produce the same level of output.
K
6
5
4
3
2
1

10
12
12
10
7
3
1

24
28
28
23
18
8
2

31
36
36
33
28
12
3

36
40
40
36
30
14
4

40
42
40
36
30
14
5

39
40
Q
36
33
28
12
6 L

Isoquants

Economic Region of Production

Firms will only use combinations of two inputs that are in
the economic region of production.

Marginal Rate of Technical Substitution

Absolute value of the slope of isoquant is called the MRTS

MRTS = -(-2.5/1) = 2.5

Marginal Rate of Technical Substitution

Q = f(L,K)
dQ=Q/ L *dL + Q/ K *dK= 0

dK= (-) Q/ L
dL
Q/ K
Q/ L = MPL and Q/ K = MPK
dK = - MPL = MRTS
dL
MPK
(L) MPL = -(K) MPK

Production With Two Variable Inputs

Perfect Substitutes

Perfect Complements
2K
1L

Capital

Capital

6
4

6
B
4

-1K
2L

A
8

10

12

Labor

Labor

Optimal Combination of Inputs

Isocost lines represent all combinations of
two inputs that a firm can purchase with
the same total cost.
C wL rK

C Total Cost
w Wage Rate of Labor ( L)

C w
K L
r r

r Cost of Capital ( K )

Isocost Lines
Capital
10

AB

C = $100, w = r = $10

slope = -w/r = -1

vertical intercept = 10
1K

1L

2
B

10

Labor

Isocost Lines
Capital

14

Isocost Lines

10
8 A

AB

C = $100, w = r = $10

AB

C = $140, w = r = $10

AB

C = $80, w = r = $10

AB*

C = $100, w = $5, r = $10

4
B
0

10 12 14 16

B*
20

Labor

Optimal Combination of Inputs for

Minimizing costs or Maximizing output
Isocost Lines
AB

C = $100, w = r = $10

AB

C = $140, w = r = $10

AB

C = $80, w = r = $10

MRTS = w/r

Product lines
A product line shows the movement
from one isoquant to another as we
change both factors or a single factor.
The product line describes the
technically possible alternative paths of
expanding output and what path
actually be chosen by the firm will
depend on the prices of factors.

The product curve passes through the origin if

all factors are variable. If only one factor is
variable (the other being kept constant) the
product line is a straight line parallel to the
axis of variable factor. The K/L ratio
diminishes along the product line.

Optimal input combinations:

Slope of isoquant = Slope of isocost line
(absolute)Slope of isoquant = (absolute) Slope of isocost line
MRTS =

w
r

Since MRTS = MPL/ MPK

MPL = w
MPK
r

MPL = MPK
w
r

If MPL = 5, MPK =4, and w = r

MPL > MPK
w
r

Profit Maximization
MRP(input) = MRC(input)
with constant input prices
MRP(input) = input price
To maximize Profits:
MRPL = w = (MPL)(MR)
MRPK = r = (MPK)(MR)

MPL = w
MPK r

MPL = MPK
w
r

Optimal Combination of Inputs

Effect of a Change in Input Prices

Returns to Scale
Production Function Q = f(L, K)
Q = f(hL, hK)
If = h, constant returns to scale.
If > h, increasing returns to scale.
If < h, decreasing returns to scale.

Returns to Scale
Constant
Returns to
Scale

Increasing
Returns to
Scale

Decreasing
Returns to
Scale

Empirical Production Functions

Cobb-Douglas Production Function
Q = AKaLb
If a + b = 1, constant returns to scale.
If a + b > 1, increasing returns to scale.

If a + b <1, decreasing returns to scale.

Q=ALa Kb

Where Q= Manufacturing output

L= quantity of labour employed
K= quantity of capital employed
A, a, b are constant or parameter of funcions.
1. the sum of exponents of factors i.e. a+b measures returns to
scale. If

If a + b = 1, constant returns to scale.

If a + b > 1, increasing returns to scale.
If a + b <1, decreasing returns to scale.

2. Average and marginal product of factors

depend upon the ratios in which factors are
combined for the production of a
commodity.
APL=Q/L=ALaKb/L=A(K/L)b
Thus ,average product of labour depends on
the ratios of the factor(K/L) and does not
depend upon the absolute quantities of the
factor used.

Cobb Douglas Production Function

and Output Elasticities of Factors
The exponents of labour and capital in
cobb-douglas production function measure
output elasticities of labour and capital.
Output elasticity of a factor refers to the
relative or percentage change in output
caused by a given percentage change in a
variable factor, other factors and inputs
remaining constant.

Elasticity of Technical Substitution (between

factors) =
Proportionate change in factor proportions
K/L
Proportionate change in MRTS between
labour and capital

Exercise
Do the following production functions have constant,
increasing or decreasing returns of scale? ( K, L, M
are inputs)

a.
b.
c.
d.
e.

Q = 0.5X + 2Y + 40Z
Q = 3L + 10K + 500
Q = K0.3 L0.5
Q = 4A2 + 6B2 + 8AB
Q = 10L 0.5 K 0.6

A. constant returns to scale.

B. constant returns to scale.
C. Decreasing returns to scale
D. increasing returns to scale.
E. increasing returns to scale

Exercise

a.
b.

Medical Testing Labs, Inc., provides routine testing services

for blood banks in the Los Angeles area. Tests are supervised
by skilled technicians using equipment produced by two
leading competitors in the medical equipment industry.
Records for the current year show an average of 27 tests per
hour being performed on the Testlogic-1 and 48 tests per
hour on a new machine, the Accutest-3. The Testlogic-1 is
leased for $18,000 per month, and the Accutest-3 is leased at
$32,000 per month. On average, each machine is operated 25
eight-hour days per month.
Does Medical Testing Lab usage reflect an optimal mix of
testing equipment?
If tests are conducted at a price of $6 each while labor and all
other costs are fixed, should the company lease more
machines?

a)
(27*25*8)/ 18000 = (48*25*8) / 32000 = 0.3
In both instances, the last dollar spent on each machine
increased output by the same 0.3 units, indicating an
optimal mix of testing machines.

b) For each machine hour, the relevant question is

Testlogic-1
27 (25 8) $6 > $18,000 or $32,400 > $18,000.
Accutest-3
48 (25 8) $6 > $32,000 or $57,600 > $32,000.
In both cases, each machine returns more than its
marginal cost (price) of employment, and expansion
would be profitable.

Exercise
The marginal product of labor for international
trading is given by the equation
MPL = 10K0.5/L0.5
Currently the firm is using 100 units of capital and
121 units of labor. The capital stock is constant but
the labor can be varied. If the price of labor is 10/and price of output is Rs. 2/- per unit, is the firm
operating efficiently in the short run? If not,
determine the optimal rate of labor input.

Answer: not optimally, L = 400

The production function is : Q = 20K0.5L0.5

With marginal product functions
MPK = 10L0.5/K0.5
MPL = 10K0.5/L0.5
If the price of capital is Rs. 5/- and price of labor is Rs.
4/- per unit, determine the expansion path for the firm.
The firm currently is producing 200 units of output per
period using input rates of L = 4 and K =25. is this an
efficient input combination? Why or why not? If not,
determine the efficient input combination for producing
an output rate of 200.
If the price of labor increases from Rs 4 to Rs 8 per unit,
determine the efficient input combination for an output
rate of 200. What is the capital labor ratio now?

Answer: K= 0.8L,
L= 11.18 and K= 8.94,
L = 7.905 and K = 12.65

Suppose the price of one unit of labor is $10

and price of one unit of capital is $2.50.

Use this information to determine the isocost

equations corresponding to a total cost of $200 and
$500.
Plot these two isocost lines on a graph
If the price of labor falls from $10 per unit to $8 per
unit, determine the new $500 isocost line and plot it
on the same diagram used in part (b)

Answer: K = 200 4L and K = 80- 4L, K =

200 3.2L

4. Given the production function Q = 30K0.7L0.5

and input prices r = 20 and w = 30.
Determine an equation for the expansion path
What is the efficient input combination for an
output rate of Q = 200? For 500?
Answer: K = 2.1L, for 200: L = 3.15 and K = 6.62,
for 500: L = 6.765 and K = 14.207

The revenue dept. of a state govt. employs certified public

accountants (CPAs) to audit corporate tax returns and
book keepers to audit individual returns. CPAs are paid
$31200 per yr, while the annual salary of a bookkeeper is
$18200. Given the current staff of CPAs and bookkeepers,
a study made by the depts economist shows that adding
one year of a CPAs time to audit corporate returns results
in an additional tax collection of $52000. In contrast, an
additional bookkeeper adds $41600 per year in additional
tax revenue.

If the depts objective is to maximize tax revenue collected, is

the present mix of CPAs and bookkeepers optimal? Explain
If the present mix of CPAs and bookkeepers is not optimal,
explain what re-allocation should be made. That is, should the
department hire more CPAs and fewer bookkeepers or vice
versa.

Answer: CPAs 1.67 and bookkeepers 2.29