Econ 2021 – Microeconomics-I

Chapter three
Theory of Production
Bekele M.
 Contents
1. Production function
 The Short run Production Function
 The Long run Production Function
2. Laws of production
 The law of variable proportions
 Laws of returns to scale
3. Choice of optimal combination of factors of production
 THEORY OF PRODUCTION
Production Function
 A production function shows the technical relationship between
factor inputs and output.
 It describes the amount of output expected from different
combination of input usage.
 It can be expressed in tabular or graphic form or by a
mathematical formula.
Factors of production
 A method of production (process, activity) is a combination of
factor inputs required for the production of one unit of output.
Usually a commodity may be produced by various methods of
production.
 THEORY OF PRODUCTION
For example,
 A unit of commodity x may be produced by the following
processes:
Process P1 Process P2 Process P3
Labour units 2 3 1
Capital units 3 2 4
 Factors of production could be fixed or variable. The difference
between fixed and variable factors relates to the time horizon
involved.
 In economics, there are two main horizons;
The short run & The long run production function.
 THEORY OF PRODUCTION
The Short run Production Function
 The short run is a relatively short period of time in which the
quantity of some factors of production such as equipment and
buildings cannot be varied. Such factors are called fixed factors.
 Factors of production whose quantity can be varied in the short
run are called variable factors.
 The long run, on the other hand, is a relatively long period which
allows the variation of all factors of production including plants
and equipment.
 In this section, we will focus on a production process in which
there are only two factors of production; labour and capital,
where capital is the fixed factor and labour is the variable factor.
 THEORY OF PRODUCTION

As more and more units of a Output
variable factor (L) are combined
with fixed factors (in our case K), Production
we may initially obtain function
increasingly larger additions to
output, but we eventually obtain
Labor
smaller increments in output Short Run Production function
This economic phenomenon is referred to as the principle of
diminishing returns (also called the law of variable proportions)
The bar on K indicates that capital is constant and variation in
output depends on variation in labour L
THEORY OF PRODUCTION
 THEORY OF PRODUCTION
Average and Marginal Product Curves
 Given the production function which transforms a set of inputs
into output, the technical relationship between inputs and output
could further be analysed by deriving marginal and average
product curves.
 The behaviour of total product curve (schedule) has an interesting
implication to the marginal cost and average cost curves
(schedules).
 Total product (TP) is the total amount that is produced during a
given period of time.
 If the inputs of all but one factor are held constant, total product will change
as the quantity of the variable factor used changes.
 THEORY OF PRODUCTION
 Suppose capital is fixed at 5 units. By applying varying quantity of
labour, the firm can produce different levels of output
Qty of capital Qty of Labor Total product Average Marginal
(K) (L) (TP) product (AP) product (MP)
5 0 0 - -

5 1 15 15.0 15
5 2 34 17.0 19
5 3 48 16.0 14
5 4 60 15.0 12
5 5 62 12.4 2
5 6 60 10 -2
Table 3.1: Total Product, Average Product and Marginal Product
 THEORY OF PRODUCTION

 THEORY OF PRODUCTION
 The level of output at which AP reaches maximum is called
the point of diminishing average productivity. Up to that
point, average productivity is increasing; beyond that point,
average productivity is decreasing.
 Marginal Product (MP) – is the change in total product
resulting from the use of one unit more of a variable factor.
 As the first unit of labour is an employed, total product
increase by 15 units. This increase in TP is the marginal
product of the first unit of labour.
 The second unit of labour adds 19 more units of output to TP;
therefore, its MP is 19 units.
 THEORY OF PRODUCTION
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 THEORY OF PRODUCTION
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 THEORY OF PRODUCTION
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6
 THEORY OF PRODUCTION

 THEORY OF PRODUCTION
Relationship between MP and AP: Graphic approach
 To clearly understand this relationship between AP and MP
consider, for example, a class of 10 students.
 Suppose the average height of the students is 170 cm. If now
we bring in a tall student with a height of 192 cm, the average
height of the class will increase to 172 cm.
 This happens simply because the height of the new student
(which we may call the marginal height) is greater than
average height of the class.
 On the contrary, if we bring in a short student with height just
159 cm, the average height of the class will fall to 169 cm,
because the height of the new student (marginal height) is less
than the average height of the class.
 THEORY OF PRODUCTION
Output The Relationship between AP and MP
 For employment level between 0 and L1
Maximum AP
TP units, TP increases at an increasing rate
(slope of the TP becomes steeper and
steeper), this means that MP and AP are
also increasing.
 At L1, MP reaches its maximum. Between
Labor
L1 and L2 units of labour, TP increases at
L1 L2 L3 a decreasing rate and MP declines, but is
Output
Point of diminishing MP above AP. As a result, AP increases.
 At L2, AP reaches maximum and is cut by
Point of diminishing AP MP. Between L2 and L3, TP still increases
at a decreasing rate, but MP is below AP.
This pulls the AP down and AP falls.
 At L3, MP is zero and TP reaches
Labor maximum. Beyond L3, MP is negative,
therefore, TP declines.
L1 L2 L3 MP
 THEORY OF PRODUCTION
The Relationship between MP and AP: Algebraic Approach
 Suppose the production function is given by .Q  cL  bL2  aL3
 The marginal product and average product functions are, then
defined as
dQ
MP   c  2bL  3aL2
dL
Q
AP    c  bL  aL 2

L
 The maximum point of MP occurs where its slope is zero.
2b  6 aL  0 b
L 
3a
 THEORY OF PRODUCTION
 The maximum point of AP, on the other hand, occurs where its
slope is zero.
b
b2aL0 L
2a
b b
 Since ,  the maximum point of MP lies to the left of
3a 2 a
the maximum point of AP.
 Let’s now try to show that MP cuts AP at its maximum point. If
this is true, the point of intersection of MP and AP must
coincide with the maximum point of AP.
 THEORY OF PRODUCTION
 At the point of intersection .MP  AP This means:
c  2bL3aL2  c bL aL2
3aL2  aL2  bL  2bL  0
2 aL 2
 bL  0
L ( 2 aL  b )  0
L  0 or 2aL  b
b
L  0 or L 
2a
 With the production function defined as , Q f (L)K however, we are
interested with positive level of labour employment. Therefore
b
L  The result verifies that MP cuts AP at its maximum point.
2a
 THEORY OF PRODUCTION
Example
2
 Consider the production function Q  8 L2  L3 The MP and AP
3
functions were found to be
2 2
MP  16 L  2 L or
2
AP  8 L  L
3
 In the previous example, it was found that the maximum point of
AP occurs at L = 6. At the point of intersection of AP and MP
2 2
8L  L  16 L  2 L 2
3
2 4 2
2 L  L2  16 L  8 L  0
2 L  8L  0
3 3
4 L 0 or L  6
L( L  8)  0
3
 THEORY OF PRODUCTION
 Since output varies with variation in L, we are interested with
positive level of labour employment.
 Therefore, MP crosses AP at L = 6.
 For employment level less than L = 6, MP is greater than AP,
therefore AP will rise. Consider for example L = 5.
MP  16 (5)  2 (5) 2 MP  30
2 2
AP8(5)  (5)  23.33
3
 For employment level greater than L = 6, MP is less than AP,
therefore AP will fall. For example consider L = 7.
MP  16 (7 )  2(7 ) 2 MP  14 AP  8 ( 7 )  2 ( 7 ) 2  23 . 33
3
 THEORY OF PRODUCTION
The Stages of Production
 We may split the whole production functions into three
segments (or stages).
 Stage I represents a range over which output grows at an increasing
rate causing the MP to rise, therefore, there is no rationale for a firm
to stop its employment over this range because an additional unit of
labour produces more than the previous units.
 Stage I I Starts where AP of labour inputs begins to decline. Out put
still continues to increase but at a decreasing rate and in fact reach
maximum.
 Stage III is one on which output decreases, implying that
employment of additional units reduces output, i.e. MP is negative.
 THEORY OF PRODUCTION
The Stages of Production  The basic theory of production
usually concentrates on the range
of output over which the MP of a
variable factor (labour) decreases,
but is positive; i.e.,
 the range of diminishing (but non-
negative) productivity of the
factor. See Stage II.
 Formally, the efficient stage of
production is defined by the
condition:
MP of labour
Q
MPL  0 should be positive
L
 MP L  2Q & slope o f MP is
  0 negative
L L2
 THEORY OF PRODUCTION
The Long run Production Function
The Production Function
 Suppose that a production process involves just two factors
labour (L) and capital (K).
 Production function is an equation, table, or graph showing the
amount of output of a product that a firm can produce per
period of time for each set of inputs.
 Both inputs and outputs are measured in physical rather than
in monetary units.
 Technology is assumed to remain constant during the period of
the analysis. Technology summarizes the feasible means
(knowhow) of converting raw inputs, in to an output.
 THEORY OF PRODUCTION
An isoquant
 An isoquant is the locus of all technically efficient methods (all
combinations of factors of production) for producing a given
level of output;
 i.e. it shows the different combinations of L and K that can be
used to produce a given level of output.
 The production isoquant may assume various shapes
depending on the degree of substitutability of factors.
 THEORY OF PRODUCTION
 Linear Isoquant- assumes perfect substitutability of factors of
production: a given commodity may be produced using only
capital, or only labour, or by an infinite combination of K and L.
 This isoquant implicitly assumes that factors are perfectly
divisible (See the figure below).
K  The assumption of perfect
divisibility is, however, unrealistic.
Most factors of production are not
perfectly divisible.
Isoquant
 Tractor cannot be, for example,
considered divisible. There is no
L such thing as 0.5 unit of tractor, 0.21
Linear Isoquant unit of tractor, etc.
 THEORY OF PRODUCTION
 Input-output Isoquant- assumes strict complementarily
(zero substitutability) between factors of production.
 There is only one efficient method of production for any
given level of output, which is defined at the corner of the L-
shaped isoquant.
 Though, operation anywhere on the vertical as well as the
horizontal segments is possible, it involves larger quantity
of one of the factors and not less of the other. This implies,
therefore, irrational behaviour.
 THEORY OF PRODUCTION
K  Along the vertical segment of the
input-output isoquant (Figure 4.8
above), a firm uses more and more
Isoquant of capital but not less of labour to
produce the same level of output.
 Along the horizontal segment, on
the other hand, the firm uses more
L and more units of labour but not
Input-Output Isoquant less of capital.

 It is not rational, therefore, for a firm to operate along the

vertical or horizontal segments of the L-shaped isoquant.
 THEORY OF PRODUCTION
K  Kinked Isoquant- assumes
limited substitutability between
K1 factors of production L and K.
K2  There are a few processes for
K3 Isoquant producing any one commodity.
Substitutability of factors is
L1 L2 L3 L possible only at the kinks.
Kinked Isoquant

 This isoquant assumes that factors are not perfectly

divisible. Among the four widely known types of isoquants
this one is the most realistic. In the real world, factors
substitute each other only to a limited extent.
 THEORY OF PRODUCTION
K  Factor combinations (L1, K1)
and (L2, K2) yield the same level
K1 of output since both are located
K2 on the same isoquant. This
K3 Isoquant implies the effect of fall in capital
from K1 to K2 could be offset by
L1 L2 L3 L rise in labour from L1 to L2.
Kinked Isoquant

 Substitution between these two points is, however,

impossible. This point is in harmony with the fact that some
factors are not perfectly divisible. Continuous substitution
of inputs requires that the factors involved be perfectly
divisible.
 THEORY OF PRODUCTION
K  Smooth, Convex Isoquant – assumes
continuous substitutability of K and L
only over a certain range, beyond which
factors cannot substitute each other.
Isoquant  The isoquant appears as a smooth curve
convex to the origin. Substitution of one
factor by the other is possible only on
Smooth, Convex Isoquant L the convex segment of the isoquant.
 The smooth, convex isoquant is a limiting case of the kinked isoquant
with infinite number of kinks.
 Traditional theory of production mostly adopted the continuous
isoquants because; they are mathematically simple to handle by
simple rules of calculus.
 THEORY OF PRODUCTION
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
THEORY OF PRODUCTION
 Production isoquants show
the various combinations of
inputs necessary for the firm
to produce a given output.
 A set of isoquants, or
isoquant map, describes the
firm's production function.
 Output increases as one
moves from isoquant Q1 (55
units per year) to isoquant
Q2 (75 units per year) and to
isoquant Q3 (90 units per
year).
 THEORY OF PRODUCTION
Characteristics of Isoquants
 Given a set of isoquants, the higher to the right an isoquant,
the higher the level of output it represents.
 Conversely, the lower an isoquant the lower the level of output it
represents. This is because higher isoquants are associated with
higher quantity of factors while lower isoquants are associated with
lower quantity of factors.
 Isoquants do not intersect each other. The point at which
two isoquants cross each other implies two different levels
of output, which is not possible.
THEORY OF PRODUCTION
 THEORY OF PRODUCTION
 Iisoquants Iq1 and Iq2 cross each
other at point R.
 Points P, R and Q are located on the
same isoquant, therefore, represent
the same level of output.
 Similarly points S, R and T are located
on the same isoquant, therefore
represent the same level of output.
 Point S is, however, located to the
right of point P; and must represent a
higher level of output.
By rule of transitivity, since S represents higher level of output than P
and the same level of output as R, therefore, R must represent higher
level of output than P. Yet, this is not true.
 THEORY OF PRODUCTION
Laws of Production
 The laws of production describe the technically possible
ways of increasing the level of production. Output may
increase in various ways.
 Output can be increased by changing all factors of
production. Clearly this is possible only in the long run.
Thus the laws of returns to scale refer to the long-run
analysis of production.
 In the short run output may be increased by using more of
the variable factor(s), while capital (and possibly other
factors as well) are kept constant.
 THEORY OF PRODUCTION
 The marginal product of the variable factor(s) will decline
eventually as more and more quantities of this factor are
combined with the other constant factors.
 The expansion of output with one factor (at least) constant
is described by the law of (eventually) diminishing returns
of the variable factor, which is often referred to as the law
of variable proportions.
 We will first examine the long-run laws of returns of scale.
Laws of Returns to Scale: Long-Run Analysis of Production
 In the long run expansion of output may be achieved by
varying all factors. In the long run all factors are variable.
 THEORY OF PRODUCTION
 The laws of returns to scale refer to the effects of scale
relationships.
 In the long run output may be increased by changing all
factors by the same proportion, or by different proportions.
 Traditional theory of production concentrates on the first
case, that is, the study of output as all inputs change by the
same proportion.
 The term 'returns to scale' refers to the changes in output
as all factors change by the same proportion.‘
 Suppose we start from an initial level of inputs and output
X 0 = f (L, K)
 THEORY OF PRODUCTION
 And we increase all the factors by the same proportion k.
We will clearly obtain a new level of output X*, higher than
the original level X 0 ,
X* = f (kL, kK)
 If X* increases by the same proportion k as the inputs, we
say that there are constant returns to scale.
 If X* increases less than proportionally with the increase in
the factors, we have decreasing returns to scale.
 If X* increases more than proportionally with the increase
in the factors, we have increasing returns to scale.
 THEORY OF PRODUCTION
Returns to scale and homogeneity of the production function
 Suppose we increase both factors of the function
X0 = f (L, K)
 by the same proportion k, and we observe the resulting new
level of output X*
X* = f (kL, kK)
 If k can be factored out (that is, may be taken out of the brackets
as a common factor), then the new level of output X* can be
expressed as a function of k (to any power v) and the initial
level of output
X* = kv f (L, K) or X*= kvX0
And the production function is called homogeneous
 THEORY OF PRODUCTION
 If k cannot be factored out, the production function is non-
homogeneous. Thus:
 A homogeneous function is a function such that if each of the
inputs is multiplied by k, then k can be completely factored out of
the function.
 The power v of k is called the degree of homogeneity of the
function and is a measure of the returns to scale:
 If v = 1 we have constant returns to scale. This production
function is sometimes called linear homogeneous.
 If v < 1 we have decreasing returns to scale.
 If v > 1 we have increasing returns to scale.
 THEORY OF PRODUCTION
 Returns to scale are measured mathematically by the
coefficients of the production function.
 For example, in a Cobb-Douglas function
X = b0 Lb1Kb2
 The returns to scale are measured by the sum (b1 + b2) = v.
 THEORY OF PRODUCTION
Graphical presentation of the returns to scale for a
homogeneous production function
 The returns to scale may be shown graphically by the
distance (on an isocline) between successive 'multiple-level-
of-output' isoquants,
 that is, isoquants that show levels of output which are multiples of
some base level of output, e.g., X, 2X, 3X, etc.
 THEORY OF PRODUCTION
Constant returns to scale.
 Along any isocline the
distance between successive
multiple isoquants is
constant. Doubling the factor
inputs achieves double the
level of the initial output;
trebling inputs achieves
treble output, and so on
 THEORY OF PRODUCTION
Decreasing returns to scale.
 The distance between
consecutive multiple-
isoquants increases. By
doubling the inputs, output
increases by less than twice
its original level. In figure
3.19 the point a', defined by
2K and 2L, lies on an
isoquant below the one
showing2X.
 THEORY OF PRODUCTION
Increasing returns to scale.
 The distance between
consecutive multiple
isoquants decreases.
 By doubling the inputs,
output is more than
doubled.
 In figure 3.20 doubling K
and L leads to point b'
which lies on an isoquant
above the one denoting 2X.
 THEORY OF PRODUCTION
The Law of Variable Proportions: Short-run Analysis of
Production
 We said above that if one factor is variable while the other(s)
is kept constant, the product line will be a straight line
parallel to the axis of the variable factor
 In general if one of the factors of production (usually capital
K) is fixed, the marginal product of the variable factor
(labour) will diminish after a certain range of production.
 We said that the traditional theory of production
concentrates on the ranges of output over which the
marginal products of the factors are positive but diminishing.
 THEORY OF PRODUCTION
 The ranges of increasing returns (to a factor) and the range
of negative productivity are not equilibrium ranges of output.
 If the production function is homogeneous with constant or
decreasing returns to scale everywhere on the production surface, the
productivity of the variable factor will necessarily be diminishing.
 If, however, the production function exhibits increasing returns to
scale, the diminishing returns arising from the decreasing marginal
product of the variable factor (labour) may be offset, if the returns to
scale are considerable.
 This, however, is rare. In general the productivity of a single-variable
factor (ceteris paribus) is diminishing.
 Let us examine the law of variable proportions or the law of
diminishing productivity (returns) in some detail.
 THEORY OF PRODUCTION
 If the production function is
homogeneous with constant returns to
scale everywhere, the returns to a
single-variable factor will be
diminishing.
 This is implied by the negative slope
and the convexity of the isoquants.
With constant returns to scale
everywhere on the production surface,

doubling both factors (2K, 2L) leads to a doubling of output. In figure 3.22
point b on the isocline OA lies on the isoquant 2X. However, if we keep K
constant (at the level K) and we double only the amount of L, we reach point
c, which clearly lies on a lower isoquant than 2X
 THEORY OF PRODUCTION

 In figure 3.23 we see that with 2L and

2K output reaches the level d which is
on a lower isoquant than 2X.
 If we double only labour while keeping
capital constant, output reaches the
level c, which lies on a still lower
isoquant.
 THEORY OF PRODUCTION
 If the production function
shows increasing returns to
scale, the returns to the
single- variable factor L will in
general be diminishing (figure
3.24), unless the positive
returns to scale are so strong
as to offset the diminishing
marginal productivity of the
single- variable factor.
 Figure 3.25 shows the rare
case of strong returns to scale
which offset the diminishing
productivity of L.
 THEORY OF PRODUCTION
Equilibrium of the Firm: Choice of Optimal Combination of
Factors of Production
 it is assumed that the firm can choose the optimal
combination of factors, that it can employ any amount of any
factor in order to maximise its profits.
 This assumption is valid if the firm is new, or if the firm is in the long-
run. However, an existing firm may be coerced, due to pressure of
demand, to expand its output in the short-run, when at least one
factor, usually capital, is constant.
 we make the following assumptions:
I. The goal of the firm is profit maximisation-that is, the
maximisation of the difference II = R - C where
 THEORY OF PRODUCTION
II. The price of output is given, P".
III. The prices of factors are given:
 w is the given wage rate
 r' is the given price of capital services (rental price of machinery).
Single Decision of the Firm
 The problem facing the firm is that of a constrained profit
maximisation, which may take one of the following forms:
 (a) Maximise profit II, subject to a cost constraint. In this case
total cost and prices are given ( C, w, r, P "), and the problem
may be stated as follows
Max ii=R-C II= P"X- C
 THEORY OF PRODUCTION
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 THEORY OF PRODUCTION
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