Managerial Economics

Chapter 5

Production

Table of Contents

• 5.1 Production Functions

• 5.2 Short-Run Production

• 5.3 Long-Run Production

• 5.4 Returns to Scale

• 5.5 Productivity and Technology Change

Introduction

• Managerial Problem

– Labor productivity during recessions

– How much will the output produced per worker rise or fall with each additional layoff?

• Solution Approach

– First, a firm must decide how to produce. Second, if a firm wants to expand its output, it
must decide how to do that in both the short run and the long run. Third, given its ability
to change its output level, a firm must determine how large to grow.

• Empirical Methods

– A production function summarizes how a firm converts inputs into outputs using one
available technology, and helps to decide how to produce.

– Increasing output in the short-run can be done only by increasing variable inputs, but in
the long-run there is more flexibility.

– The size of a firm depends on returns to scale and its growth will be determined by
increments in productivity that comes from technological change.

5.1 Production Functions

• Production Process

– A firm uses a technology or production process to transform inputs or factors of

• Inputs
 – Capital (K) - land, buildings, equipment

– Labor (L) – skilled and less-skilled workers

– Materials (M) – natural resources, raw materials, and processed products

• Output

– It could be a service, such as an automobile tune-up by a mechanic, or a physical product,

• Production Function

– Maximum quantity of output that can be produced with different combinations of inputs,
given current knowledge about technology and organization

– A production function shows only efficient production processes because it gives the
maximum output.

• q = f(L, K)

– Production function for a firm that uses only labor and capital

– q units of output (such as wrapped candy bars) are produced using L units of labor
services (such as hours of work by assembly-line workers) and K units of capital (such as
the number of conveyor belts)

• Time and Variability of Inputs

– Short run: a period of time so brief that at least one factor of production cannot be varied.
Inputs in the short run are fixed or variable inputs.

– Long run: period of time that all relevant inputs can be varied. Inputs in the long run are
all variable.

– 5.2 Short-Run Production

– Relationship between output and labor when a firm’s capital is fixed

– In Table 5.1, capital is fixed to eight fully equipped workbenches. As the number of
workers increases, so does output: 1 worker assembles 5 computers in a day, 2 workers
assemble 18, 3 workers assemble 36, and so forth.

• The Average Product of Labor: APL = q/L

– The ratio of output to the amount of labor used to produce that output
 – Table 5.1 shows that 9 workers can assemble 108 computers a day, so the average
product of labor for 9 workers is 12 (= 108/9) computers a day.

– Ten workers can assemble 110 computers in a day, so the average product of labor for 10
workers is 11 (= 110/10) computers.

– Thus, increasing the labor force from 9 to 10 workers lowers the average product per
worker

– Relationship between output and labor when a firm’s capital is fixed

– In Table 5.1, capital is fixed to eight fully equipped workbenches. As the number of
workers increases, so does output: 1 worker assembles 5 computers in a day, 2 workers
assemble 18, 3 workers assemble 36, and so forth.

• The Average Product of Labor: APL = q/L

– The ratio of output to the amount of labor used to produce that output

– Table 5.1 shows that 9 workers can assemble 108 computers a day, so the average
product of labor for 9 workers is 12 (= 108/9) computers a day.

– Ten workers can assemble 110 computers in a day, so the average product of labor for 10
workers is 11 (= 110/10) computers.

– Thus, increasing the labor force from 9 to 10 workers lowers the average product per
worker

• The Marginal Product of Labor: MPL = ∆q/∆L

– Change in total output resulting from using an extra unit of labor, holding other factors
(capital) constant

– Table 5.1 shows if the number of workers increases from 1 to 2, ∆L = 1, output rises by
∆q = 13 = 18 – 5, so the marginal product of labor is 13.

– When the change in labor is very small (infinitesimal) we use the calculus definition of
the marginal product of labor: the partial derivative of the production function with
respect to labor [MPL = ∂q/∂L = ∂f(L,K)/∂L]

• Graphing the Product Curves

– Figure 5.1 shows how output (total product), the average product of labor, and the
marginal product of labor vary with the number of workers.

• Product Curve Characteristics

– In panel a, output rises with labor until it reaches its maximum of 110 computers at 11
workers, point C.
 – In panel b, the average product of labor first rises and then falls as labor increases. Also,
the marginal product of labor first rises and then falls as labor increases.

– Average product may rise because of division of labor and specialization. Workers
become more productive as we add more workers. Marginal product of labor goes up,
and consequently average product goes up.

– Average product falls as the number of workers exceeds 6. Workers might have to wait to
use equipment or get in each other’s way because capital is constant. Because marginal
product of labor goes down, average product goes down too.

• Figure 5.1 Production Relationships with Variable Labor

• Relationships among Product Curves

– The three curves are geometrically related.

• Average Product of Labor and Marginal Product of Labor

– If the marginal product curve is above that average product curve, the average product
must rise with extra labor

– If marginal product is below the average product then the average product must fall with
extra labor
 – Consequently, the average product curve reaches its peak, where the marginal product
and average product are equal (where the curves cross)

• Deriving APL and MPL using the Total Production Function

– The average product of labor for L workers equals the slope of a straight line from the
origin to a point on the total product of labor curve for L workers in panel a.

– The slope of the total product curve at a given point equals the marginal product of labor.
That is, the marginal product of labor equals the slope of a straight line that is tangent to
the total output curve at a given point.

• The Law of Diminishing Marginal Returns

– If a firm keeps increasing an input, holding all other inputs and technology constant, the
corresponding increases in output will eventually become smaller (diminish).

– This law comes from realizing most observed production functions have this property.

– This law determines the shape of the marginal product of labor curves: if only one input
is increased, the marginal product of that input will diminish eventually.

5.3 Long-Run Production

– In the long run, labor and capital are variable. The firm can substitute one input for
another while continuing to produce the same level of output.

– An isoquant shows the efficient combinations of labor and capital that can produce the
same (iso) level of output (quantity). Points a, b, c and d show the same level of output, q
= 24, in Figure 5.2

• Properties of Isoquants

– The farther an isoquant is from the origin, the greater the level of output

– Isoquants do not cross

– Isoquants slope downward

• Substituting Inputs: MRTS=ΔK/ΔL

– The slope of an isoquant shows the ability of a firm to replace one input with another
while holding output constant.

– This slope is the marginal rate of technical substitution (MRTS): how many units of
capital the firm can replace with an extra unit of labor while holding output constant.

• Diminishing MRTS (absolute value)

– The more labor and less capital the firm has, the harder it is to replace remaining capital
with labor and the flatter the isoquant becomes.

– In Figure 5.4, the firm replaces 6 units of capital per 1 worker to remain on the same
isoquant (a to b), so MRTS= -6. If it hires another worker (b to c), the firm replaces 3
units of capital, MRTS = -3.

• Figure 5.4 How the Marginal Rate of Technical Substitution Varies Along an Isoquant

• Substitutability of Inputs and Marginal Products

– The marginal rate of technical substitution is equal to the ratio of marginal products

– -MPL/MPK = ΔK/ΔL = MRTS

– A, α, and β are all positive constants

– The marginal product of labor is MPL = αq/L = αAPL and α = MPL/APL

– The marginal product of capital is MPK = βq/K = βAPK, and β = MPK/APK

– MRTS = -αK/βL

5.4 Returns to Scale

• Constant Returns to Scale (CRS): f(2L, 2K) = 2f(L,K) = 2q

– A technology exhibits constant returns to scale if doubling inputs exactly doubles the
output. The firm builds an identical second plant and uses the same amount of labor and
equipment as in the first plant.

• Increasing Returns to Scale (IRS): f(2L, 2K) > 2f(L,K) = 2q

– A technology exhibits increasing returns to scale if doubling inputs more than doubles the
output. Instead of building two small plants, the firm decides to build a single larger plant
with greater specialization of labor and capital.

• Decreasing Returns to Scale (DRS): f(2L, 2K) < 2f(L,K) = 2q

– A technology exhibits decreasing returns to scale if doubling inputs less than doubles
output. An owner may be able to manage one plant well but may have trouble organizing,
coordinating, and integrating activities in two plants.

• Varying Returns to Scale

– Many production functions have increasing returns to scale for small amounts of output,
constant returns for moderate amounts of output, and decreasing returns for large
amounts of output.

• Graphical Analysis

– Figure 5.5, a to b: When a firm is small, increasing labor and capital allows for gains
from cooperation between workers and greater specialization of workers and equipment,
so there are increasing returns to scale

– Figure 5.5, b to c: As the firm grows, returns to scale are eventually exhausted. There are
no more returns to specialization, so the production process has constant returns to scale.

– Figure 5.5, c to d: If the firm continues to grow, the owner starts having difficulty
managing everyone, so the firm suffers from decreasing returns to scale.

• Figure 5.5 Varying Scale Economies

• Relative Productivity

– Firms are not necessarily equally productive

– A firm may be more productive than others if: a manager knows a better way to organize
production; it’s the only firm with access to a new invention; union-mandated work
rules, government regulations, or other institutional restrictions affect only competitors.

– Firms are equally productive in competitive markets, not in oligopoly markets

• Innovation

– An advance in knowledge that allows more output to be produced with the same level of
inputs is called technological progress.

– Technological progress is neutral if more output is produced using the same ratio of
inputs. It is nonneutral if it is capital saving or labor saving.

– Organizational changes may also alter the production function and increase the amount of
output produced by a given amount of inputs. In the early 1900s, Henry Ford
revolutionized mass production of automobiles through interchangeable parts and the
assembly line.

Managerial Solution

• Managerial Problem

– Labor productivity during recessions

– How much will the output produced per worker rise or fall with each additional layoff?

• Solution
– Layoffs have the positive effect of freeing up machines to be used by remaining workers.
However, if layoffs force the remaining workers to perform a wide variety of tasks, the
firm will lose the benefits from specialization.

– Holding capital constant, a change in the number of workers affects a firm’s average
product of labor. Labor productivity could rise or fall.

– For some production functions layoffs always raise labor productivity because the APL
curve is everywhere downward sloping, for instance the Cobb-Douglass production
function.

Table 5.1 Total Product, Marginal Product, and Average Product of Labor with
Fixed Capital

Table 5.2 Output Produced with Two Variable Inputs

Figure 5.3 Substitutability of Inputs