Production Analysis

Dr. Mukta Mukherjee

Reading
 5.1.6. S_N_Chapter06
 5.1.7. S_N_Chapter07_Appendix
 5.2.5. P_R_Chapter06

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Production
 The theory of the firm describes how a firm makes cost-minimizing production decisions and
how the firm’s resulting cost varies with its output.

 Production Decisions of a Firm

◦ The production decisions of firms are analogous to the purchasing decisions of consumers, and can
likewise be understood in three steps:
 Production Technology
 Cost Constraints
 Input Choices

 Factors of production
◦ Inputs into the production process (e.g., labor, capital, and materials)

 Production function
◦ Function showing the highest output that a firm can produce for every specified combination of inputs

◦ Production functions describe what is technically feasible when the firm operates efficiently

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Short-run versus Long-run
 Short run
◦ Period of time in which quantities of one or more production
factors cannot be changed

 Fixed input
◦ Production factor that cannot be varied

 Long run
◦ Amount of time needed to make all production inputs variable

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 PRODUCTION WITH ONE VARIABLE
INPUT (LABOR)
Production with One Variable Input Average product
Amount Amount Total Average Marginal Output per unit of a particular input
of Labor of Capital Output Product Product
(L) (K) (q) (q/L) (∆q/∆L)
0 10 0 — —
1 10 10 10 10
2 10 30 15 20 Marginal product
3 10 60 20 30 Additional output produced as an input is
increased by one unit
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 4
10 10 100 10 8
PRODUCTION WITH ONE VARIABLE
INPUT (LABOR)
Production with One Variable
Input
The total product curve in (a) shows
the output produced for different
amounts of labor input.

The average and marginal products in

(b) can be obtained (using the data in
Table 6.1) from the total product curve.

At point A in (a), the marginal product

is 20 because the tangent to the total
product curve has a slope of 20.

At point B in (a) the average product of

labor is 20, which is the slope of the
line from the origin to B.
The average product of labor at point
C in (a) is given by the slope of the line
0C.
PRODUCTION WITH ONE VARIABLE
INPUT (LABOR)
Production with One Variable Input
(continued)

To the left of point E in (b), the

marginal product is above the average
product and the average is increasing;
to the right of E, the marginal product
is below the average product and the
average is decreasing.

As a result, E represents the point at

which the average and marginal
products are equal, when the average
product reaches its maximum.

At D, when total output is maximized,

the slope of the tangent to the total
product curve is 0, as is the marginal
product.

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3 Stages of Production

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PRODUCTION WITH ONE VARIABLE
INPUT (LABOR)
● law of diminishing marginal returns Principle that as the use
of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.

The Effect of Technological

Improvement
Labor productivity (output
per unit of labor) can
increase if there are
improvements in
technology, even though
any given production
process exhibits diminishing
returns to labor.
As we move from point A on
curve O1 to B on curve O2 to
C on curve O3 over time,
labor productivity increases.

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Optimal Use of the Variable Input
 Marginal Revenue Product of Labor (MRPL)
◦ The additional revenue generated by the use an additional
unit of labor is called Marginal Revenue Product of Labor

 Marginal Resource Cost of Labor

◦ The additional cost of hiring an additional unit of labor is
called Marginal Resource Cost of Labor

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Optimal Use of the Variable Input
Marginal Revenue
MRPL = (MPL)(MR)
Product of Labor

Marginal Resource TC

MRCL =
Cost of Labor L

Optimal Use of Labor MRPL = MRCL

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Optimal Use of the Variable Input
Optimal Use of the Variable Input
PRODUCTION WITH TWO VARIABLE
INPUTS TABLE 6.4 Production with Two Variable Inputs
LABOR INPUT
Capital Input 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

Isoquant
Curve showing all possible
combinations of inputs that yield
the same output.

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PRODUCTION WITH TWO VARIABLE
INPUTS
● isoquant map Graph combining a number of
isoquants, used to describe a production function.

Production with Two Variable Inputs

A set of isoquants, or isoquant

map, describes the firm’s
production function.

Output increases as we move

from isoquant q1 (at which 55
units per year are produced at
points such as A and D), to
isoquant q2 (75 units per year at
points such as B) and
to isoquant q3 (90 units per year
at points such as C and E).

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PRODUCTION WITH TWO VARIABLE
INPUTS
 Diminishing Marginal Returns

Holding the amount of capital

fixed at a particular level—say
3, we can see that each
additional unit of labor
generates less and less
additional output.

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 PRODUCTION WITH TWO VARIABLE
INPUTS
Marginal rate of technical substitution (MRTS)
Amount by which the quantity of one input can be reduced when one
extra unit of another input is used, so that output remains constant.
MRTS = − Change in capital
Marginal Rate of Technical input/change in labor input
Substitution = − ΔK/ΔL (for a fixed level of q)
Like indifference curves, isoquants
are downward sloping and convex.
The slope of the isoquant at any
point measures the marginal rate of
technical substitution—the ability of
the firm to replace capital with labor
while maintaining the same level of
output.

On isoquant q2, the MRTS falls from

2 to 1 to 2/3 to 1/3.

(MP ) / (MP )  (K / L) MRTS

L K

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PRODUCTION WITH TWO VARIABLE
INPUTS
 Production Functions – Special Case – Perfect Substitutes

Isoquants When Inputs Are

Perfect Substitutes

When the isoquants are

straight lines, the MRTS is
constant. Thus the rate at
which capital and labor can be
substituted for each other is
the same no matter what level
of inputs is being used.

Points A, B, and C represent

three different capital-labor
combinations that generate
the same output q3.

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PRODUCTION WITH TWO VARIABLE
INPUTS
 Production Functions – Special Case – Perfect Complements
Fixed-proportions production function
Production function with L-shaped isoquants, so that only one combination of labor
and capital can be used to produce each level of output.

Fixed-Proportions Production
Function

When the isoquants are L-

shaped, only one combination
of labor and capital can be used
to produce a given output (as at
point A on isoquant q1, point B
on isoquant q2, and point C on
isoquant q3). Adding more labor
alone does not increase output,
nor does adding more capital
alone.

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RETURNS TO SCALE

Returns to scale Rate at which output increases as inputs are

increased proportionately.

Increasing returns to scale Situation in which output more

than doubles when all inputs are doubled.

Constant returns to scale Situation in which output doubles

when all inputs are doubled.

Decreasing returns to scale Situation in which output less

than doubles when all inputs are doubled.

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RETURNS TO SCALE
Returns to Scale

When a firm’s production process exhibits However, when there are increasing
constant returns to scale as shown by a returns to scale as shown in (b), the
movement along line 0A in part (a), the isoquants move closer together as
isoquants are equally spaced as output inputs are increased along the line.
increases proportionally.