CHAPTER 7 Production Economics  Production functions also can be expressed in the

 Managers are required to make resource allocation form of a schedule (or table), as illustrated in the
decisions about production operations, marketing, following ore-mining example.
financing, and personnel.  Production function A mathematical model,
 Although these decisions are interrelated, it is useful schedule (table), or graph that relates the maximum
to discuss each of them separately. feasible quantity of output that can be produced from
 Production decisions determine the types and given amounts of various inputs.
amounts of inputs—such as land, labor, raw and  Inputs A resource or factor of production, such as a
processed materials, factories, machinery, equipment, raw material, labor skill, or piece of equipment that is
and managerial talent—to be used in the production employed in a production process.
of a desired quantity of output.  Cobb-Douglas production function A particular
 The production manager’s objective is to minimize type of mathematical model, known as a multiplicative
cost for a given output or, in other circumstances, to exponential function, used to represent the
maximize output for a given input budget. relationship between the inputs and the output.
 First, we analyze the choice of a single variable input
Fixed and Variable Inputs
with fixed input prices.
 In deciding how to combine the various inputs (L and
 Later, we analyze the optimal multi-input combination
K) to produce the desired output, inputs are usually
and introduce the concept of returns to scale.
classified as being either fixed or variable.
 The economic theory of production consists of a
 A fixed input is defined as one required in the
conceptual framework to assist managers in deciding
production process but whose quantity employed in
how to combine most efficiently the various inputs
the process is constant over a given period of time
needed to produce the desired output (product or
regardless of the quantity of output produced.
service), given the existing technology.
 The costs of a fixed input must be incurred regardless
 This technology consists of available production
of whether the production process is operated at a
processes, equipment, labor and management skills,
as well as information-processing capabilities. high or a low rate of output.
 Production analysis is often applied by managers  A variable input is defined as one whose quantity
involved in assigning costs to the various feasible employed in the process changes, depending on the
output levels and in communicating with plant desired quantity of output to be produced.
engineers the operations plans of the company.  The short run corresponds to the period of time in
THE PRODUCTION FUNCTION which one (or more) of the inputs is fixed.
 The theory of production centers around the concept  To increase output, then, the firm must employ more
of a production function. of the variable input(s) with the given quantity of fixed
 A production function relates the maximum quantity input(s).
of output that can be produced from given amounts of  As the time period under consideration (the planning
various inputs for a given technology. horizon) is lengthened, however, more of the fixed
 It can be expressed in the form of a mathematical inputs become variable.
model, schedule (table), or graph.  Over a planning horizon of about six months, most
 A change in technology, such as the introduction of firms can acquire or build additional plant capacity
more automated equipment or the substitution of and order more manufacturing equipment.
skilled for unskilled workers, results in a new  In lengthening the planning horizon, a point is
production function. eventually reached where all inputs are variable.
 The production of most outputs (goods and services)  This period of time is called the long run.
requires the use of large numbers of inputs.  In the short run, because some of the inputs are fixed,
 Production processes often result in joint outputs. only a subset of the total possible input combinations
 Letting L and K represent the quantities of two inputs is available to the firm.
(labor L and capital K) used in producing a quantity Q  By contrast, in the long run, all possible input
of output, a production function can be represented in combinations are available.
the form of a mathematical model, such as  Short run The period of time in which one (or more)
Q = αLβ1Kβ2 of the resources employed in a production process is
fixed or incapable of being varied.
 where α, β1, and β2 are constants. This particular
 Long run The period of time in which all the
multiplicative exponential model is known as the
resources employed in a production process can be
Cobb-Douglas production function and is examined in
varied.
more detail later in the chapter.
PRODUCTION FUNCTIONS WITH ONE VARIABLE Increasing Returns with Network Effects
INPUT  The law of diminishing marginal returns is not a
Marginal and Average Product Functions mathematical theorem, but rather an empirical
 Once the total product function is given (in tabular, assertion that has been observed in almost every
graphic, or algebraic form), the marginal and average production process as the amount of the variable
product functions can be derived. input increases.
 The marginal product is defined as the incremental  A noteworthy exception occurs, however, with
change in total output ΔQ that can be produced by the network effects.
use of one more unit of the variable input ΔL, while K  The greater the installed base of a network product,
remains fixed. the larger the number of compatible network
 The marginal product is defined as connections and therefore the more possible value for
a new customer.
 A manufacturer’s product line costs usually now
for discrete and continuous changes, respectively. include marketing and distribution activities as well as
 The ratio ΔQ/ΔL represents the incremental product the labor and material direct costs of standard
rather than the marginal product. production and assembly.
 The average product is defined as the ratio of total  The reason is that, like service firms, many
output to the amount of the variable input used in manufacturers today compete on customer inquiry
producing the output. systems, change order responsiveness, delivery
 The average product of labor is reliability, and technological updates, not just on
delivery times and warranty repairs.
 Qualifying for and actually winning a customer order
often requires quality characteristics and support
 Marginal product. The incremental change in total
services beyond the physical unit of production.
output that can be obtained from the use of one more
 From 0 percent to 30 percent market share, the selling
unit of an input in the production process (while
efforts required to achieve each additional share point
holding constant all other inputs).
have a diminishing returns effect on the probability of
 Average product. The ratio of total output to the
adoption by the next potential user (note the reduced
amount of the variable input used in producing the
slope of the sales penetration curve).
output.
 Consequently, additional share points are increasingly
The Law of Diminishing Marginal Returns more and more expensive over this range.
 The tabular production function just discussed  But when the number of other users of a network-
illustrates the production law of diminishing marginal based device reaches a 30 to 40 percent share, the
returns. next 40 to 50 share points are cheaper and cheaper to
 Initially, the assignment of more workers to the crew promote.
operating the mining equipment allows greater labor  Beyond the 30 percent inflection point, each
specialization in the use of the equipment. additional share point of users leads to an increasing
 As a result, the marginal output of each worker added probability of adoption by another user—hence a
to the crew at first increases, and total output decrease in the marketing expense required to secure
increases at an increasing rate. another unit sale (note the increased slope of the
 A point is eventually reached, however, where the sales penetration curve in this middle range).
marginal increase in output for each worker added to  These network-based effects of compatibility with
the crew begins to decline. other users reflect increased value to the potential
 This decrease in output occurs because only a limited adopter.
number of ways exist to achieve greater labor  At times, additional marketing and distribution
specialization and because each additional worker activities can lead to increasing returns and declining
introduces crowding effects. marginal costs.
 With enough additional workers, the marginal product  Network effects. An exception to the law of
of labor may become zero or even negative. diminishing marginal returns that occurs when the
 Some work is just more difficult to accomplish when installed base of a network product makes the efforts
superfluous personnel are present. to acquire new customers increasingly more
productive.
Producing Information Services under Increasing  Hence, we see that the AP curve reaches a maximum
Returns at a point where the average and the marginal
 It is insightful to compare the production economics of products are equated.
old-economy companies that produce things to new-  Note also that the marginal product MP equals the
average product AP at L2, because the marginal
economy companies that produce information.
product MP is equal to the slope of the TP curve (MP =
 Things, when sold, the seller ceases to own. ∂Q/∂L), and at L2 the average product AP is also equal
Information, when sold, the seller can sell again (at to the slope of the TP curve.
least until information spillovers overwhelm the target
market). DETERMINING THE OPTIMAL USE OF THE VARIABLE
 Things must be replicated through expensive INPUT
manufacturing processes, whereas information is  With one of the inputs (K) fixed in the short run, the
replicable at almost zero incremental cost. producer must determine the optimal quantity of the
variable input (L) to employ in the production process.
 Things exist in one location. Information can exist
 Such a determination requires the introduction into
simultaneously in many locations.
the analysis of output prices and labor costs.
 The production and marketing of things are subject to  Therefore, the analysis begins by defining marginal
eventually diminishing returns. revenue product and marginal factor cost.
 The marketing (and maybe the production) of
information is subject to increasing returns. Marginal Revenue Product
 That is, the more people who use my information, the  Marginal revenue product (MRPL) is defined as the
more likely it is that another person will want to amount that an additional unit of the variable input
acquire it (for any given marketing cost), or, said adds to total revenue, or
another way, the cheaper it is to secure another sale.
 Things often involve economies of scale in production.
 Information is produced by small companies at  where ΔTR is the change in total revenue associated
comparably low costs. with the given change (ΔL) in the variable input, and
 Things focus a business on supply-side thinking and MRPL is equal to the marginal product of L (MPL)
the high costs of distribution. times the marginal revenue (MRQ) resulting from the
 Information products focus a business on demand- increase in output obtained:
side thinking and have almost no costs of distribution.
 By getting the next customer to adopt, one can set in
 Sometimes in practice this concept is referred to as
motion a “virtuous circle” of higher customer value,
the marginal value added—that is, the amount by
lower overhead costs, and lower prices and costs for
which potential sales revenue is increased as a result
the next customer.
of employing an additional unit of variable input to
The Relationship between Total, Marginal, and increase output.
Average Product  Marginal revenue product (MRP). The amount that an
 Figure 7.4 illustrates a production function total value additional unit of the variable production input adds
added or total product (TP) with a single variable input to total revenue. Also known as marginal value added.
to highlight the relationships among the TP, AP, and
MP concepts.
Marginal Factor Cost
 Marginal factor cost (MFCL) is defined as the amount
 In the first region labeled “Increasing returns,” the TP
that an additional unit of the variable input adds to
function is increasing at an increasing rate. total cost, or
 Because the marginal value added or marginal product
(MP) curve measures the slope of the TP curve (MP =
∂Q/∂L), the MP curve is increasing up to L1.  where ΔTC is the change in cost associated with the
 In the region labeled “Decreasing returns,” the TP given change (ΔL) in the variable input.
function is increasing at a decreasing rate, and the MP  Marginal factor cost (MFCL) The amount that an
curve is decreasing up to L3. additional unit of the variable input adds to total cost.
 In the region labeled “Negative returns,” the TP Optimal Input Level
function is decreasing, and the MP curve continues  Given the marginal revenue product and marginal
decreasing, becoming negative beyond L3. factor cost, we can compute the optimal amount of
 An inflection point occurs at L1. Next, if a line is drawn the variable input to use in the production process.
from the origin 0 to any point on the TP curve, the  For the short-run production decision, the optimal
slope of this line, Q/L, measures the average value level of the variable input occurs where
added or average product (AP). MRPL = MFCL
PRODUCTION FUNCTIONS WITH MULTIPLE DETERMINING THE OPTIMAL COMBINATION OF
VARIABLE INPUTS INPUTS
 Using the Deep Creek Mining Company example,  As shown in the previous section, a given level of
suppose now that both capital (measured by the output can be produced using any of a large number
maximum brake horsepower [bhp] rating of the of possible combinations of two inputs.
equipment) and labor (measured by the number of  The firm needs to determine which combination will
workers) are variable inputs to the ore-mining minimize the total costs for producing the desired
process. The firm can choose to operate the output.
production process using any of the capital-labor
combinations shown previously in Table 7.1. Isocost Lines
 The total cost of each possible input combination is a
Production Isoquants function of the market prices of these inputs.
 A production function with two variable inputs can be  Assuming that the inputs are supplied in perfectly
represented graphically by a set of two-dimensional elastic fashion in competitive markets, the per-unit
production isoquants. price of each input will be constant, regardless of the
 A production isoquant is either a geometric curve or amount of the input that is purchased.
an algebraic function representing all the various  Letting CL and CK be the per-unit prices of inputs L and
combinations of the two inputs that can be used in K, respectively, the total cost (C) of any given input
producing a given level of output. combination is C = CLL + CKK
 Although each isoquant indicates how quantities of  Once the isoquants and isocosts are specified, it is
the two inputs may be substituted for one another, possible to solve for the optimum combination of
these choices are normally limited for two reasons: inputs.
 First, some input combinations in Figure 7.5 employ  The production decision problem can be formulated in
an excessive quantity of one input. two different ways, depending on the manner in
 Second, input substitution choices are also limited by which the production objective or goal is stated. One
the technology of production, which often involves can solve for the combination of inputs that either
machinery that is not divisible.  1. Minimizes total cost subject to a given constraint on
 Production isoquant. An algebraic function or a output
geometric curve representing all the various  2. Maximizes output subject to a given total cost
combinations of two inputs that can be used in constraint
producing a given level of output.  Constrained cost minimization in Option 1 is the dual
problem to the constrained output maximization
The Marginal Rate of Technical Substitution
problem in Option 2.
 In addition to indicating the quantity of output that
can be produced with any of the various input Minimizing Cost Subject to an Output Constraint
combinations that lie on the isoquant curve, the  Consider first the problem in which the director of
isoquant also indicates the rate at which one input
operations desires to release to production a number
may be substituted for another input in producing the
given quantity of output. of orders for at least Q(2) units of output.
 The rate at which one input may be substituted for  As shown in Figure 7.9, this constraint requires that
another input in the production process, while total the solution be in the feasible region containing the
output remains constant, is known as the marginal input combinations that lie either on the Q(2)
rate of technical substitution (MRTS). isoquant or on isoquants that fall above and to the
 MRTS is given by the slope of the curve relating K to L right having larger output values (the shaded area).
—that is, the slope of the isoquant.
 The total cost of producing the required output is
 The slope of the AB segment of the isoquant in Figure
7.7 is equal to the ratio of AC to CB. Algebraically, AC = minimized by finding the input combinations within
K1 − K2 and CB = L1 − L2; therefore, the slope is equal this region that lie on the lowest cost isocost line.
to (K1 – K2) ÷ (L1 – L2).  Combination D on the C(2) isocost line satisfies this
 Because the slope is negative and one wishes to condition.
express the substitution rate as a positive quantity, a  Combinations E and F, which also lie on the Q(2)
negative sign is attached to the slope:
isoquant, yield higher total costs because they fall on
the C(3) isocost line.
 It can be shown that the MRTS is equal to the ratio of  Thus, the use of L1 units of input L and K1 units of
the marginal products of L and K by using the input K will yield a (constrained) minimum cost
definition of the marginal product (Equation 7.2). solution of C(2) dollars.
 This definition yields ΔL = ΔQ/MPL and ΔK = ΔQ/MPK.  At the optimal input combination, the slope of the
Substituting these expressions into Equation 7.8 (and given isoquant must equal the slope of the C(2) lowest
dropping the minus sign) yields isocost line.
 As in the previous section, the slope of an isoquant is
equal to dK/dL and
 MEASURING THE EFFICIENCY OF A PRODUCTION
PROCESS
 Mine 1 with production process M1 is said to be
allocatively inefficient because it has chosen the
wrong input mix; the mine has allocated its input
budget incorrectly.
 In addition to allocative inefficiency involving the
incorrect input mix, a production operation can exhibit
technical inefficiency.
 Benchmark plants often do substantially better, with
many processes meeting 98 percent and 99 percent of
their production goals.
 Overall production efficiency is defined as the product
of technical, scale, and allocative efficiency.
 must be satisfied in order for an input combination to  Allocative efficiency. A measure of how closely
production achieves the least-cost input mix or
be an optimal solution to the problem of minimizing
cost subject to an output constraint. process, given the desired level of output.
 Equation 7.15 indicates that the marginal product per  Technical efficiency. A measure of how closely
production achieves maximum potential output given
dollar input cost of one factor must be equal to the
marginal product per dollar input cost of the other the input mix or process.
factor.  Overall production efficiency. A measure of technical
and allocative efficiency.
 Note in Figure 7.10 that maximizing output subject to
a feasible region demarcated by the Q(2) cost RETURNS TO SCALE
constraint yields exactly the same (L1, K1) optimal
 An increase in the scale of production consists of a
input combination that satisfies the equimarginal
proportionate increase in all inputs simultaneously.
criterion.
 The proportionate increase in output that results from
A FIXED PROPORTIONS OPTIMAL PRODUCTION the given proportionate increase in all the inputs is
PROCESS defined as the physical returns to scale.
 The previous section analyzed the least-cost  Returns to scale. The proportionate increase in output
combination of divisible inputs in variable proportions that results from a given proportionate increase in all
production, where one input substituted continuously the inputs employed in the production process.
for another. Measuring Returns to Scale
 Linear programming techniques are available to  An increase in the scale of production can be
determine the least-cost process for fixed proportions represented graphically in a two dimensional isoquant
production. map, as is shown in Figure 7.12.
 Increasing the scale of production by a factor of λ = 2
Production Processes and Process Rays from the combination of 101 units of input L and 1001
 A production process can be defined as one in which units of input K to 20 units of input L and 200 units of
the inputs are combined in fixed proportion to obtain K results in an increase in the quantity of output from
Q(1) to Q(2).
the output.
 Three possible relationships that can exist between
 By this definition, a production process can be
the increase in inputs and the increase in outputs are
represented graphically as a ray through the origin as follows:
having a slope equal to the ratio of the number of  1. Increasing returns to scale: Output increases by
units of the respective resources required to produce more than λ; that is, Q(2) > λQ(1).
one unit of output  2. Decreasing returns to scale: Output increases by
 Operating multiple production processes like M1, M2, less than λ; that is, Q(2) < λQ(1).
and M3 can offer a firm flexibility in dealing with  3. Constant returns to scale: Output increases by
exactly λ; that is, Q(2) = λQ(1).
unusual orders, interruptions in the availability of
 Figure 7.12 illustrates three different production
resources, or binding resource constraints. functions that exhibit these three types of returns to
 However, not all fixed-proportions production scale. In Panel (a), showing increasing returns to scale,
processes are equally efficient. doubling input L from 10 to 20 units and input K from
 The firm will prefer to use one or two production 100 to 200 units yields more than double the amount
processes exclusively if they offer the advantage of of output (i.e., an increase from 100 to 250).
 In Panel (b), showing decreasing returns to scale, a
substantial cost savings.
similar doubling of two inputs, L and K, yields less than
double the amount of output
 Finally, in Panel (c), showing constant returns to scale,
a similar doubling of inputs L and K yields exactly
double the amount of output
Increasing and Decreasing Returns to Scale each index by expressing each yearly index value as a
 Many firm-level production functions are percentage of its overall trend value, and dropping the
assumption of constant returns to scale.
characterized by first increasing and then decreasing
 With these modifications, the estimated production
returns to scale.
function for the manufacturing sector was
 A number of industrial engineering arguments have Q = 0.84L.63 K.30 [7.19]
been presented to justify this inconsistency.  A 10 percent increase in labor input results in about a
 One major argument given for initially increasing 6 percent increase in output, and a 10 percent
returns is the opportunity for specialization in the use increase in capital input results in approximately a 3
of capital and labor. percent increase in output.
 Also, the resulting sum of the exponents of the labor
 Equipment that is more efficient in performing a
and capital variables is slightly less than 1, which
limited set of tasks can be substituted for lessefficient indicates the presence of decreasing returns to scale
all-purpose equipment. in the broadly defined manufacturing sector.
 Similarly, the efficiency of workers in performing a A Cross-Sectional Analysis of U.S. Manufacturing
small number of related tasks is greater than that of Industries
less highly skilled, but more versatile, workers.  Cross-sectional data have also been used to estimate
 Decreasing returns to scale thereafter often arises Cobb-Douglas production functions for 18 U.S.
from the increasingly complex problems of manufacturing industries.
 Using aggregate data on plants located within each
coordination and control faced by management as the
state, John Moroney estimated the following three-
scale of production is increased. variable model:
Q = αLβ1p Lβ2n Kβ3
The Cobb-Douglas Production Function
 where Q is the value added by the production plants,
 A somewhat simpler case is the Cobb-Douglas
Lp is production worker work hours, Ln is
production function that has returns to scale
nonproduction work years, and K is gross book values
determined by the sum of the parameters (β1 + β2) in
of depreciable and depletable assets.
the equation:
 The results for several of the industries are shown in
Q = αLβ1Kβ2
Table 7.4. The sum of the exponents (β1 + β2 + β3)
 If β1 + β2 is less than, equal to, or greater than 1, the
ranged from a low of 0.947 for petroleum to a high of
Cobb-Douglas production function will exhibit
1.109 for furniture.
decreasing, constant, or increasing returns,
 In 13 of the 18 industries studied, the statistical tests
respectively.
showed that the sum of the exponents was not
 The multiplicative exponential Cobb-Douglas function
significantly different from 1.0.
can be estimated as a linear regression relation by
 This evidence supports the hypothesis that most
taking the logarithm of Equation 7.16 to obtain
manufacturing industries exhibit constant returns to
log Q = log α + β1 log L + β2 log K [7.17]
scale.
 Thus, once the parameters of the Cobb-Douglas model
8Nonproduction workers are management and other staff
are estimated, the sum of the exponents of the labor personnel.
(β1) and capital (β2) variables can be used to test for 9“Book values” of assets are the historic values of these
the presence of increasing, constant, or decreasing assets as they appear on the balance sheet of the firm.
returns to scale. Book values may differ significantly from current
Empirical Studies of the Cobb-Douglas Production replacement values and hence may overstate or understate
Function in Manufacturing the actual amount of capital employed in the firm.
 In their original study, Cobb-Douglas fitted a
production function of the form in Equation 7.16 to SUMMARY
indices of production Q, labor L, and capital K over  A production function is a schedule, graph, or
time in the U.S. manufacturing sector. mathematical model relating the maximum quantity
 Q was an index of physical volume of manufacturing; L of output that can be produced from various
was an index of the average number of employed quantities of inputs.
wage earners only (i.e., salaried employees, officials,
 For a production function with one variable input, the
and working proprietors were excluded); and K was an
index of the value of plants, buildings, tools, and marginal product is defined as the incremental change
machinery reduced to dollars of constant purchasing in total output that can be produced by the use of one
power. more unit of the variable input in the production
 With the sum of the exponents restricted to one process.
(constant returns to scale), the following function was  For a production function with one variable input, the
obtained: average product is defined as the ratio of total output
Q = 1.01L.75K.25 [7.18]
to the amount of the variable input used in producing
 In later studies, Cobb-Douglas made several
modifications that altered their results somewhat. the output.
 These modifications included revisions in the output  The law of diminishing marginal returns states that,
and labor indices, removing the secular trend from with all other productive factors held constant, the
 use of increasing amounts of the variable factor in the
production process beyond some point will result in
diminishing marginal increases in total output.
 Increasing returns can arise with network effects
especially involving information economy goods and
industry standards.
 In the short run, with one of the productive factors
fixed, the optimal output level (and optimal level of
the variable input) occurs where marginal revenue
product equals marginal factor cost.
 Marginal revenue product is defined as the amount
that an additional unit of the variable input adds to
total revenue.
 Marginal factor cost is defined as the amount that an
additional unit of the variable input adds to total cost.
 A production isoquant is either a geometric curve or
algebraic function representing all the various
combinations of inputs that can be used in producing
a given level of output.
 The marginal rate of technical substitution is the rate
at which one input may be substituted for another
input in the production process, while total output
remains constant. It is equal to the ratio of the
marginal products of the two inputs.
 In the long run, with both inputs being variable,
minimizing cost subject to an output constraint (or
maximizing output subject to a cost constraint)
requires that the production process be operated at
the point where the marginal product per dollar input
cost of each factor is equal.
 The degree of technical efficiency of a production
process is the ratio of observed output to the
maximum potentially feasible output for that process,
given the same inputs.
 The degree of allocative efficiency of a production
process is the ratio of total cost for producing a given
output level with the least-cost process to the
observed total cost of producing that output
 Physical returns to scale is defined as the
proportionate increase in the output of a production
process that results from a given proportionate
increase in all the inputs.
 The Cobb-Douglas production function, which is used
extensively in empirical studies, is a multiplicative
exponential function in which output is a (nonlinear)
increasing function of each of the inputs, with the sum
of the exponential parameters indicating the returns
to scale.