Department of Business Administration

Spring 2019

Production Theory and Estimation

By
Prof. M. Harun-Ar-Rashid
 The Production Function

• Production refers to the transformation of inputs

or resources into outputs of goods and services. In
other words, production refers to all of the
activities involved in the production of goods and
services, from borrowing to set up or expand
production facilities, to hiring workers, purchasing
raw materials, running quality control, cost
accounting, and so on, rather than referring merely
to the physical transformation of inputs into
outputs of goods and services.

2
 How firms combine the inputs?
• Production function is the relationship
between the quantities of inputs used and the
maximum quantity of output that can be
produced, given current knowledge about
technology and organization
What are the categories of inputs?
• Capital (K) - long-lived inputs.
– land, buildings (factories, stores), and equipment
(machines, trucks)

• Labor (L) - human services

– managers, skilled workers (architects, economists,
engineers, plumbers), and less-skilled workers (custodians,
construction laborers, assembly-line workers)

• Materials (M) - raw goods (oil, water, wheat) and

processed products (aluminum, plastic, paper, steel)
 Production Function

Production
Inputs Function Output
(K, L) Q
Q = f(K, L)

• Formally,
Q = f(K, L)

– where Q units of output are produced using L units of

labor services and K units of capital (the number of
conveyor belts).
 For example
• A computer company hires workers to use
machinery, parts, and raw materials in factories to
produce personal computers.
• The output of a firm can either be a final
commodity or an intermediate product such as
computer and semiconductor respectively.
• The output can also be a service rather than a good
such as education, medicine, banking etc.

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 The Organization of Production

• Inputs
– Labor, Capital, Land
• Fixed Inputs
• Variable Inputs
• Short Run
– At least one input is fixed
• Long Run
– All inputs are variable

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 The Organization of Production

• Inputs: are the sources used in the production

of goods and services and can be broadly
classified into labour, capital, land, natural
resources, and entrepreneurial talent.
• Fixed input: are those that cannot be readily
changed during the time period under
consideration such as a firm’s plant and
specialized equipment.

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 The Organization of Production

• Variables Inputs: are those can be varied

easily and on very short notice such as
raw materials and unskilled labour.
• The time period during which at least one
input is fixed called the short-run and if
all inputs are variable, we are in the long-
run.

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 The Production Function

• A production function is an equation, tables, or

graph showing the maximum output of a
commodity that a firm can produce per period
of time with each set of inputs.
• Both inputs and outputs are measured in
physical rather than in monetary units. Here
technology is assumed to remain constant
during the period of the analysis.

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 The Production Function

• The general equation of the production

function of a firm using labour (L) and capital
(K) to produce a good or service (Q) or
shows the maximum amount of output (Q)
that can be produced within a given time
period with each combination of (L) and (K).
This can be defined as follows:

Q = f (K L)

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Production Function With Two Inputs

Q = f(K, L)
K Q  The table shows
6 10 24 31 36 40 39 that by using 1
5 12 28 36 40 42 40 unit of labour
4 12 28 36 40 40 36 (1L) and 1 unit
3 10 23 33 36 36 33 of capital (1K),
2 7 18 28 30 30 28
the firm would
1 3 8 12 14 14 12
1 2 3 4 5 6 L
produce 3 units
of output (3Q).

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Production Function With One Variable Input

 When discussing production in the short

run, three definitions are important:
 Total product
 Marginal product
 Average product

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Production Function With One Variable Input

Total Product TP = Q = f(L)

Marginal Product TP

MPL =
L

Average Product TP
APL =
L
Production or MPL
Output Elasticity EL =
APL
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 Total Product

 Total product (TP) is another name for output

in the short run.

TP = Q = f (L)

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 Marginal Product
 The marginal product (MP) of a variable input is
the change in output (or TP) resulting from a one
unit change in the input.
 MP tells us how output changes as we change the
level of the input by one unit.
 Consider the two input production function Q=
f(K,L) in which input L is variable and input K is
fixed at some level.
 The marginal product of input L is defined as
holding input K constant.
TP
MPL =
L
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 Average Product

 The average product (AP) of an input is the

total product divided by the level of the
input.
 AP tells us, on average, how many units of
output are produced per unit of input used.
 The average product of input L is defined
as holding input K constant.

TP
APL =
L
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 Production Function With One Variable Input-Example

Total, Marginal, and Average Product of Labor, and Output Elasticity

L Q MPL APL EL
0 0 - - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1

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Production Function With One Variable Input

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 The Law of Diminishing Returns

• As additional units of a variable input are

combined with a fixed input, after a point
the additional output (marginal product)
starts to diminish. This is the principle
that after a point, the marginal product of
a variable input declines.

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The Law of Diminishing Returns

Increasing
Returns
MP Diminishing Returns Begins

X
MP

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The Three Stages of Production

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 The Three Stages of Production

 Stage I: The range of increasing average

product of the variable input.
 From zero units of the variable input to
where AP is maximized
 Stage II: The range from the point of
maximum AP of the variable i/p to the point at
which the MP of i/p is zero.
 From the maximum AP to where MP = 0
 Stage III: The range of negative marginal
product of the variable input.
 From where MP=0 and MP is negative.
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The Three Stages of Production

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 The Three Stages of Production

• In the short run, rational firms should only

be operating in Stage II.
• Why Stage II?
• Why not Stage I and III?
• In Stage III- MPLis negative
• In Stage I- MPK is negative
• In Stage II- MPL and MPK are both
positive but decline
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 The Three Stages of Production-Example

Labor Total Average Marginal

Unit Product Product Product
(L) (Q or TP) (AP) (MP)
0 0
1 10,000 10,000 10,000
2 25,000 12,500 15,000
3 45,000 15,000 20,000
4 60,000 15,000 15,000
5 70,000 14,000 10,000
Stage 6 75,000 12,500 5,000
II 7 78,000 11,143 3,000
8 80,000 10,000 2,000
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The Three Stages of Production-Example

 What level of input usage within

Stage II is best for the firm? Is
there a precise point.

 The answer depends upon how many

units of output the firm can sell, the
price of the product, and the monetary
costs of employing the variable input.

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 Optimal Use of the Variable Input

 How much labor or the variable input

should the firm use in order to maximize
profit.
 The firm should employ an additional unit
of labor as long as the extra revenue
genereted until the extra revenue equals the
extra cost.
 Where MRP=MLC.

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 Optimal Use of the Variable Input

Marginal Revenue
MRPL = (MPL)(MR)
Product of Labor

Marginal Resource TC

Cost of Labor MRCL =
L

Optimal Use of Labor MRPL = MRCL

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 Optimal Use of the Variable Input-Example

Use of Labor is Optimal When L = 3.50

L MPL MR = P MRPL MRCL

2.50 4 $10 $40 $20
3.00 3 10 30 20
3.50 2 10 20 20
4.00 1 10 10 20
4.50 0 10 0 20

MRPL=MRxMPL--------MRC=W

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Optimal Use of the Variable Input

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 Production With Two Variable Inputs

-In the long run, all inputs are variable.

Isoquants show combinations of two inputs that can produce the
same level of output.
-In other words, Production isoquant shows the various
combination of two inputs that the firm can use to produce a
specific level of output.
-Firms will only use combinations of two inputs that are in the
economic region of production, which is defined by the portion
of each isoquant that is negatively sloped.
-A higher isoquant refers to a larger output, while a lower
isoquant refers to a smaller output.
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 Equal Product Curve or Isoquant
An equal product curve is the locus of different
combination of two inputs that can produce a given
level of output.
 Buget Line or Iso-Cost Line
A budget line in production analysis shows the
different combination of two inputs that a firm owner
can buy with a given amount of money and given
prices of two inputs.
 Properties of Equal Product or Isoquant Curve

1. Equal Product Curve is downward sloping.

2. Equal Product curve is convex to the origin.
3. Equal Product curve do not intersect nor to
be tangent to one another.
4. Upper Equal Product curve represent
higher level of Production than the lower
one.
Production With Two Variable Inputs

Isoquants K Q
6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36
3 10 23 33 36 36 33
2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6 L

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 Production Isoquant

Economic region of production: Negatively sloped

portions of the isoquants within the ridge lines
represents the relevant economic region of production.
Ridge lines: The lines that separate the relevant (i.e.,
negatively sloped) from the irrelevant ( or positively
sloped) portions of the isoquant.
This refers to stage II where the MPLand MPK are both
positive but declining and producers never want to
operate outside this region.
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Production With Two Variable Inputs

Economic Region
of Production

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 Production With Two Variable Inputs

Substitution among inputs

Marginal Rate of Technical Substitution: The absolute

value of the slope of the isoquant. It equals the ratio
the marginal products of the two inputs. Slope of
isoquant indicates the quantity of one input that can be
traded for another input, while keeping output
constant.

MRTS = −K/L = MPL/MPK

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 Marginal Rate of Technical Substitution

• Marginal Rate of Technical Substitution

(MRTS) - the number of extra units of one input
needed to replace one unit of another input that
enables a firm to keep the amount of output it
produces constant

change in capital K
MRTS  
change in labor L
Slope of Isoquant!

6-40
 Substitutability of Inputs and Marginal Products.

• Along an isoquant output doesn’t change (dQ = 0), or:

Extra units of Extra units of
labor capital

(MPL x ΔL) + (MPK x ΔK) = 0.

Increase in q per Increase in q per extra
extra unit of labor unit of capital
– or
MPK  K  0  MPL  L
MPL
K    L
MPK
K MPL
   MRTS  slope of isoquant
L MPK
 MRTS and Marginal Product
• Recall the relationship between MRCS and
marginal utility
• Parallel relationship exists between MRTS and
marginal product
MPL
MRTS LK 
MPK
• The more productive labor is relative to capital,
the more capital we must add to make up for any
reduction in labor; the larger the MRTS

7-42
Production With Two Variable Inputs

MRTS = -(-2.5/1) = 2.5

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 Production With Two Variable Inputs

Perfect Substitutes Perfect Complements

When an isoquant is straight line or MRTS is constant, inputs are
perfect substitutes whilst an isoquant is right angled, inputs are perfect
complements.
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 Optimal Combination of Inputs

To determine the optimal combination of labor and capital,

we also need an isocost line.
Isocost lines represent all combinations of two inputs that a
firm can purchase with the same total cost.

C  wL  rK C  Total Cost
Vertical intercept
of isocost w  Wage Rate of Labor ( L)
C w
K  L r  Cost of Capital ( K )
r r
Slope of isocost
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An Example: Cobb-Douglas Production
Function

1 1
Q  f ( K , L)  10 K L
2 2

1
1 1
Q 1 1 K 2
MPL   10 K   L
2 2
 5 
L 2 L
1
1 1
Q 1 1 L 2
MPK   10   K 2
L  5 
2
K 2 K
1
MPL 5  K / L  K 2
MRTS   1

MPK 5 L / K 2 L
 
 An Example: Cobb-Douglas Production
Function
1 1 1
Q 10 K L 2
K2 2
APL    10  
L L  L
1
Q  L 2
APK   10  
K K
1
MPL 5 K / L 2 1
 EQ ;L   1

APL 10  K / L  2 2
1
MPK 5 L / K 2 1
EQ ;K   1

APK 10  L / K  2 2
 Cobb-Douglas production function
In general, Q  f ( K , L)  10 K  L
Q Q
MPL   10 K  L  10 K L   L      APL
  1   1

L L
Q Q
MPK   10 K  1L    APK
K K
MPL  Q / L  K
MRTS   
MPK  Q / K  L
MPL  Q / L
EQ; L   
APL Q/L
EQ; K   and R   
Optimal Combination of Inputs

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 Example: Isocost Lines
 AB
 AB*
Total Cost = c = $100
w = r =$10 C = $100,
c/r = $100/$10 = $10k (vertical intercept) w = $5,
-w/r = -$10/$10 = -1(slope) r = $10
 A’B’ c/r = $100/$10 =$10k
Total Cost = c = $140 -w/r = -$10/$5 = -1/2
w = r = $10
c/r = $140/$10 = $14k -w/r = -$10/$10
= -1
MRTS = w/r;
 A’’B’’
Total Cost = c = $80 since MRTS = MPL/ MPK,
w=r=$10 condition for optimal combination
c/r = $80/$10 = $8k of inputs as MPL/ MPK= w/r
-w/r = -$10/$10 = -1
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 Equal Product curve
1. Efficient production requires that the isoquant function be tangent
to the iso-cost function. At those point, the marginal product per
dollar of input cost is equal for both inputs. That is
MPL MPK

w r

2. If the condition for efficient production is not met, there is some

way to substitute one input for other that will result in an
increase in production at no change in total cost.
3. Profit maximization requires that inputs be hired until MRPK = r
and MRPL = w. The conditions also imply that MPL/w = MPK/r

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Expansion Path

MPL PL w
 
Expansion path: joinning
MPK PK r points of tangency of
MPL MPK
or  isoquants and isocost of
w r
optimal input combination.
The optimal input
combination required to
minimize the cost of
producing a given level of
maximum output that the
firm can produce at the
tangency of an isoquant
and an isocost.
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 Optimal Combination of Inputs
If the price of an input declines, the firm will
substitute the cheaper input for another inputs in
production in order to reach a new optimal input
combination.

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 Optimal Employment of Two
Inputs
Marginal Rvenue
 Returns to Scale
A production function is said to be homogenous if when
each input factor is multiplied by a positive real constant
µ, the constant can be completely factored out. If the
exponent of the factor is 1(one), the function is
homogenous of degree 1(one). Mathematically, a
function Q = f(K,L) is homogenous of degree n if for all
positive real values of µ, if f(µK, µL) = µn f(K,L)
Z = x2+xy+y2 is homogenous of degree 2 because
f(µx, µy)=(µx)2+(µx, µy) +(µy)2 = µ2( x2+xy+y2 )

55
 Returns to scale
There are three types returns to scale:
(i) constant returns to scale
(ii) increasing returns to scale
(iii) decreasing returns to scale

Constant return to Scale

A production function exhibits constant returns to scale if

when all inputs are increased by a given proportion µ, output
increases by the same proportion. Thus, if the quantities of
labour and capital used per unit of time are both increased by
10%, output increases by 10% also; if labour and capital are
doubled , output doubles.
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 Returns to scale
Increasing returns To Scale:
If the out increase by a portion greater than µ, there are
increasing returns to scale; Thus, if the quantities of labour and
capital used per unit of time are both increased by 10%, output
increases by more than 10% also; if labour and capital are
doubled , output more than doubles.
Decreasing returns to scale;
If the out increase by a portion less (smaller) than µ, there are
decreasing returns to scale;
Thus, if the quantities of labour and capital used per unit of time
are both increased by 10%, output increases by less than 10%
also; if labour and capital are doubled , output less than doubles.
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 Returns to Scale

What happens when

Types of Returns to Proportional change in
all inputs are
Scale ALL inputs yields…
doubled?
Same proportional
Constant Output doubles
change in output
Greater than proportional Output more than
Increasing
change in output doubles
Less than proportional Output less than
Decreasing
change in output doubles

7-58
Figure 7.17: Returns to Scale

7-59
 Returns to Scale
• Constant returns to scale (CRS) - property of
a production function whereby when all inputs
are increased by a certain percentage, output
increases by that same percentage.

f(2L, 2K) = 21f(L, K).

 Returns to Scale (contd.).
• Increasing returns to scale (IRS) -
property of a production function whereby
output rises more than in proportion to an
equal increase in all inputs

f(2L, 2K) = 21.5f(L, K).

 Returns to Scale (cont).
• Decreasing returns to scale (DRS) -
property of a production function whereby
output increases less than in proportion to
an equal percentage increase in all inputs

f(2L, 2K) = 20.8f(L, K).

 Returns to Scale
How does output vary with the scale of production?
Returns to scale describes what happens to total output
as all of the inputs are changed by the same proportion.
Production Function Q = f(L, K)
Q = f(hL, hK)
If  = h, then f has constant returns to scale.
If  > h, then f has increasing returns to scale.
If  < h, the f has decreasing returns to scale.
63
 The Cobb-Douglas Production Function

• It one is the most popular estimated

functions.

Q = ALK
 Cobb-Douglas Production
Function
Q  F  L, K   AL K 
• A shows firm’s general productivity level
• a and b affect relative productivities of labor and
capital
MPL  AL 1 K 
MPK  AL K  1
• Substitution between inputs:
   K 
MRTS LK    
   L 
7-65
 Returns to Scale

Constant Returns Increasing Decreasing

to Scale Returns to Scale Returns to Scale

66
 Empirical Production Functions
Several Useful Properties :
1. The Marginal Product of capital and the Marginal
Product of labor depend on both the quantity of
capital and the quantity of labor used in
production, as is often the case in the real world.
2. Exponent of capital (K) α and exponent of
labor(L) β , represents the output elasticity of labor
and capital and the sum of these exponents gives
the returns on scale.
α + β = 1 Constant return to scale
α + β > 1 Increasing return to scale
α + β <1 Decreasing return to scale
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Empirical Production Functions