Production Function

Chapter 6
Production Function
Inputs Process Output

Land
Product or
Labor service
generated
Capital
– value added
 Basic Concepts of Production Theory

 Production function
 Maximum amount of output that can be produced
from any specified set of inputs, given existing
technology
 Technical efficiency
 Achieved when maximum amount of output is
produced with a given combination of inputs
 Economic efficiency
 Achieved when firm is producing a given output at
the lowest possible total cost
Basic Concepts of Production Theory
 Inputs
 variable or
 Fixed
 Variable input
 An input for which the level of usage may be changed quite
readily
 Fixed input
 level of usage cannot readily be changed
 must be paid even if no output is produced
 Quasi-fixed input
 An input employed in a fixed amount for any positive level of
output that need not be paid if output is zero
 Basic Concepts of Production Theory

 Short run
 At least one input is fixed
 All changes in output achieved by changing usage of
variable inputs
 Long run
 All inputs are variable
 Output changed by varying usage of all inputs
Short Run Production
 In the short run, capital is fixed
 Only changes in the variable labor input can change the
level of output
 Short run production function

Q  f ( L,K )  f ( L )
Production with one variable input

TPL = f(K̅,L )

Total product of labor (TPL) is defined as maximum rate

of out put forthcoming from combining varying rates of
labor input with a fixed capital input.
Similarly,
TPK = f(K, ̅L
Marginal Product of Labor
MPL = ΔQ/ ΔL
Production with one variable input
(contd.)
 Marginal Product of Capital
 MPk = ΔQ/ ΔK
 Using Cobb-Douglas:
 Q =AKαLβ
 MPL = dQ/dL = βAKαLβ-1
 MPK = dQ/dK= αAKα-1Lβ
 Average Product of Labor
 APL =TPL/L
 Average Product of Labor
 APK =TPK/K
Average & Marginal Products
 Average product of labor
 AP = Q/L
 Marginal product of labor
 MP = Q/L
 When AP is rising, MP is greater than AP
 When AP is falling, MP is less than AP
 When AP reaches it maximum, AP = MP
 Law of diminishing marginal product
 As usage of a variable input increases, a point is reached
beyond which its marginal product decreases
Total, Average, & Marginal Products of Labor, K = 2
Number of Total product (Q) Average product Marginal product
workers (L) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4
Total, Average & Marginal Products, K = 2
Total, Average & Marginal Product Curves
Q2

Q1 Total
product
Panel A
Q0

L0 L1 L2

Panel B

Average product

L0 L1 L2
Marginal product
Explaining TP, AP and MP
• Marginal product is the change in output associated
with a one-unit
change in the variable input (i.e., MPL= ΔQ/ΔL) or the
first derivative
of the production function with respect to the variable
input (MPL= dQ/dL),
• Average product is the rate of output produced per
unit of the variable input employed (APL= Q/L),
• The law of diminishing marginal returns states that
when increasing rates of a variable input are combined
with a fixed rate of anotherinput, a point will be
reached where marginal product will decline.
Explaining Marginal Revenue
Product
• Marginal revenue product (MRP) is found by
multiplying the marginal product function by
marginal revenue ( i.e., MRP = MR.MP),
• The marginal revenue product function for a
productive factor is the demand curve for that factor,
• Additional units of productive factor should be hired
until the value of the marginal product of the input is
equal to the prices of that input.
Cobb Douglas Production Function
There are various types of production functions, one is Cobb-
Douglas production function:
Q =AKαLβ
or, log Q = log A + α log K + β log L

Combination K L
A 6 1
B 3 2
C 2 3
D 1 6
Three important relationships can be found

1. Substitutability between Factors: There are a variety of ways

to produce a particular rate of output (example: to produce a fixed
units, any combination can be used). Therefore, the question of
labor or capital-intensive production arises.

2. Return to Scale: If input rates are doubled, the output rate

also doubles. [example: 200 = 1K + 4L, if 2K + 8L the Q would be =
400]. The relationship between output change and proportionate
changes in both inputs is referred to Return to Scale.

3. Returns to Factor: When output changes because one input

changes while the other remains constant, the changes in the
output rates are referred to as Return to Factor. [example: 200 = 1K +
4L → 1K + 8L = 250
Stages of Production

Q Increasing Diminishing Negative

Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
Isoquant
 The combinations of inputs (K, L) that yield the
producer the same level of output.
 The shape of an isoquant reflects the ease with
which a producer can substitute among inputs
while maintaining the same level of output.

L
Linear Isoquants
 Capital and labor are
perfect substitutes
K
Increasing
Output

Q1 Q2 Q3
L
 Leontief Isoquants
Q3
 Capital and labor are K
Q2
perfect complements Q1 Increasing
 Capital and labor are Output

used in fixed-
proportions
Cobb-Douglas Isoquants
 Inputs are not K
Q3
perfectly Increasing
Q2
substitutable Output
Q1
 Diminishing
marginal rate of
technical substitution
 Most production
processes have
isoquants of this
shape L
OPTIMAL EMPLOYMENT OF A
FACTOR OF PRODUCTION
The marginal revenue product (MRP) of the last unit employed
is equal to the cost of input
Data Set
Marginal Revenue Product is the
labor demand function for the firm
Example of Optimum Utilization
 Determine the optimal or profit maximizing rate of
labor to be hired, given that
 Capital (K) = 9 unit,
 Price (P) = Tk. 6 per unit, and
 Wage rate (w) = Tk. 2 per unit
 The production function is a Cobb-Douglus type
Q = 2K0.5 L0.5
Answer
 First determine,
 MPL = dQ/dL = 2(1/2) K0.5 L0.5 - 1 = K0.5 /L 0.5

Or,

And MPk = dQ/dK = 2(1/2) K0.5 – 1 L0.5 = L0.5 /K 0.5

Or,
Answer (contd)
 MRPL =MR.MPL
Since P = MR
MRPL =P. MPL =

= 6.( 9 /  L) = 18/  L
We know MRPL =w,
Therefore 18/  L = 2 or, L = 81 Ans.

(Page 196)
Costs Theory and Analysis
 Short run – Diminishing marginal returns results
from adding successive quantities of variable factors to
a fixed factor
 Long run – Increases in capacity can lead to
increasing, decreasing or constant returns to scale
Short Run Production Costs
 Total variable cost (TVC)
 Total amount paid for variable inputs
 Increases as output increases
 Total fixed cost (TFC)
 Total amount paid for fixed inputs
 Does not vary with output
 Total cost (TC)
 TC = TVC + TFC
Short-Run Total Cost Schedules

Output (Q) Total fixed cost Total variable cost Total Cost Taka
(TFC) taka (TVC) Taka TC=TFC+TVC)
0 6,000 0 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000
Total Cost Curves
 Average Costs

• Average variable cost ( AVC )

TVC
AVC 
Q
• Average fixed cost ( AFC )
TFC
AFC 
Q
• Average total cost ( ATC )
TC
ATC   AVC  AFC
Q
Short Run Marginal Cost
 Short run marginal cost (SMC) measures rate of
change in total cost (TC) as output varies

TC TVC
SMC  
Q Q
Average & Marginal Cost Schedules

Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/Q) (AVC=TVC/Q) (ATC=TC/Q= (SMC=TC/Q)
AFC+AVC)
0 -- -- -- --
100 60 40 100 40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120
Average & Marginal Cost Curves
Short Run Average & Marginal Cost Curves
 Short Run Cost Curve Relations
 AFC decreases continuously as output increases
 Equal to vertical distance between ATC & AVC
 AVC is U-shaped
 Equals SMC at AVC’s minimum
 ATC is U-shaped
 Equals SMC at ATC’s minimum
 Short Run Cost Curve Relations
 SMC is U-shaped
 Intersects AVC & ATC at their minimum points

 Lies below AVC & ATC when AVC & ATC are
falling
 Lies above AVC & ATC when AVC & ATC are
rising
 Relations Between Short-Run Costs &
Production
 In the case of a single variable input, short-run costs
are related to the production function by two
relations

w w
AVC  and SMC 
A
MP MP

Where w is the price of the variable input

Short-Run Production & Cost Relations
 Relations Between Short-Run Costs &
Production
 When marginal product (average product)
is increasing, marginal cost (average cost) is
decreasing
 When marginal product (average product)
is decreasing, marginal cost (average
variable cost) is increasing
 When marginal product = average product
at maximum AP, marginal cost = average
variable cost at minimum AVC
 Isocost
 The combinations of K
inputs that cost the
producer the same
amount of money
 For given input prices, C0 C1
L
isocosts farther from the
K
origin are associated with New Isocost Line
higher costs. for a decrease in the
wage (price of
 Changes in input prices labor).

change the slope of the

isocost line L
Cost Minimization
 Marginal product per dollar spent should be equal for
all inputs:

MPL MPK

w r
 Expressed differently

w
MRTS KL 
r
Cost Minimization
K

Point of Cost
Slope of Isocost Minimization
=
Slope of
Isoquant

L
The Firm’s Expansion Path
 An Expansion curve is formally defined as the set
of combinations of capital and labor that meet the
efficiency condition MPL/w = MPK/r, where w and r
are wage rate and interest rate respectively.
 The firm can determine the cost-minimizing
combinations of K and L for every level of output
 If input costs remain constant for all amounts of K
and L the firm may demand, we can trace the locus
of cost-minimizing choices
 called the firm’s expansion path

45
The Firm’s Expansion Path
The expansion path is the locus of cost-minimizing
tangencies
K per period The curve shows
how inputs increase
E
as output increases

q1

q0

q00
L per period
46
Equation for Expansion Path
 Production Function
Q = 100K0.5L0.5
The marginal product functions are
MPL =50

MPK = 50

Efficiency Condition is MPL/ MPK = w/r

Solving for K
K = (w/r).L
The production function re-written as
Q = 100((w/r)L)0.5 L0.5
Or Q = 100L(w/r)0.5
Example
 Determine the efficient input combination for
producing 1000 units of output if w = 4, r = 2.
 Answer: 1000 = 100L(4/2)0.5
 Or L = 7.07
 K = (4/2) 7.07 = 14.14
 The input combination ( K=14.14 and L = 7.07) is the
most efficient way to produce 1000 units of output.
The Firm’s Expansion Path
 The expansion path does not have to be a straight
line
 the use of some inputs may increase faster than others
as output expands
 depends on the shape of the isoquants
 The expansion path does not have to be upward
sloping
 if the use of an input falls as output expands, that
input is an inferior input

49
Revenue
 Total revenue – the total amount received
from selling a given output
 TR = P x Q
 Average Revenue – the average amount
received from selling each unit
 AR = TR / Q
 Marginal revenue – the amount received from
selling one extra unit
of output
 MR = TRn – TR n-1 units
Profit
 Profit = TR – TC
 The reward for enterprise
 Profits help in the process of directing resources to
alternative uses in free markets
 Relating price to costs helps a firm to assess
profitability in production
Profit
 Normal Profit – the minimum amount
required to keep a firm in its current line of
production
 Abnormal or Supernormal profit – profit
made over and above normal profit
 Abnormal profit may exist in situations where firms
have market power
 Abnormal profits may indicate the existence of
welfare losses
 Could be taxed away without altering resource
allocation
Profit
 Sub-normal Profit – profit below normal profit
 Firms may not exit the market even if sub-normal profits
made if they are able to cover variable costs
 Cost of exit may be high
 Sub-normal profit may be temporary (or perceived as
such!)
Profit
 Assumption that firms aim to maximise profit
 May not always hold true –
there are other objectives
 Profit maximising output would be where MC = MR
 Profit
Cost/Revenue
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100 101 102 103 104 Output

Example
 A micro-entrepreneur produces caps and hats for
women. The output-cost data of the business is
reproduced below:
Output Total a. Estimate the total cost function and then use
Cost that equation to determine the average and
50 870 marginal cost functions. Assume a cost
function.
100 920 b. Determine the output rate that will minimize
150 990 average cost and the per-unit cost at that rate of
200 1240 output.
c. The current market price of caps and hats per
250 1440 unit is Tk. 9.00 and is expected to remain at
300 1940 that level for the foreseeable future. Should the
350 2330 firm continue its production?
Getting an Idea about the form of
the equation
Output-Cost
2500

2000

1500

1000

500

0
50 100 150 200 250 300 350
Estimate of Example
 First we assume the cost function as
TC = c0+c1Q + c2Q2 +c3Q3
 Results
TC= 954.29 -2.46Q +0.02Q2 -.0002Q3
(5.9) (-0.75) (1.04) (-0.07)
R2 = 0.99 F = 197.78
 Comments: t-statistics are not acceptable though R2 and F are good.
 Second, we assume the cost function as
TC = c0+c1Q + c2Q2
Results
 TC = 944.29 -2.24Q + 0.02Q2
t Stat (12.51) (-2.58) (8.45)
R2 = 0.99 F = 394.86
 Comments: t-statistics are acceptable and R2 and F are good.
Answer to Question (a)
 a. The t-statistics, shown in the parenthesis of
the second estimation, indicate that the
coefficient of each of the independent variables
are significantly different from zero. The value
of the co-efficient of determination means that
99 percent of the variation in total cost is
explained by changes in the rate of output.
Answer (a) contd.
Answer (b)
 The output rate that results in minimum per-unit cost
is found by taking the first derivative of the average
cost function, setting it equal to zero, and solving for
Q.
Answer (b) contd.
Sign mistake
Answer (c)
 Because the lowest possible cost is Tk. 6.45 per unit,
which is above the market price of Tk. 9.00, the
production should be continued.
Assignment
Output Total Cost
25 700
100 920
150 990
200 1240
280 1440
360 1940
460 2330
600 3500