Production

Production

The Production Decisions of a Firm

The production decisions of firms are analogous to the

purchasing decisions of consumers, and can likewise be
understood in three steps:
1. Production Technology
2. Cost Constraints
3. Input Choices
 THE TECHNOLOGY OF PRODUCTION

● factors of production Inputs into the production

process (e.g., labor, capital, and materials).

• The Production Function

q F (K , L)
● production function Function showing the highest
output that a firm can produce for every specified
combination of inputs.
Remember the following:

Inputs and outputs are flows.

Production functions describe what is technically feasible

when the firm operates efficiently.
 THE TECHNOLOGY OF PRODUCTION

• The Short Run versus the Long Run

● short run Period of time in which quantities of one or

more production factors cannot be changed.

● fixed input Production factor that cannot be varied.

● long run Amount of time needed to make all

production inputs variable.
 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

Production with One Variable Input

Amount Amount Total Average Marginal
of Labor (L) of Capital (K) Output (q) Product (q/L) Product
0 10 0 — ∆L)
(∆q/—
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 4
10 10 100 10 8
 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

• Average and Marginal Products

● average product Output per unit of a particular input.

● marginal product Additional output produced as an input is

increased by one unit.

Average product of labor = Output/labor input = q/L

Marginal product of labor = Change in output/change in labor input
= Δq/ΔL
 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

• The Slopes of the Product Curve

Production with One Variable Input

(continued)
To the left of point E in (b), the
marginal product is above the
average product and the average is
increasing; to the right of E, the
marginal product is below the
average product and the average is
decreasing.
As a result, E represents the point
at which the average and marginal
products are equal, when the
average product reaches its
maximum.
At D, when total output is
maximized, the slope of the tangent
to the total product curve is 0, as is
the marginal product.
 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

• The Law of Diminishing Marginal Returns

● law of diminishing marginal returns Principle that as the use
of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.

The Effect of Technological

Improvement
Labor productivity (output
per unit of labor) can
increase if there are
improvements in
technology, even though
any given production
process exhibits diminishing
returns to labor.
As we move from point A on
curve O1 to B on curve O2 to
C on curve O3 over time,
labor productivity increases.
 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

The law of diminishing marginal returns was central to the thinking

of political economist Thomas Malthus (1766–1834).
Malthus believed that the world’s limited amount of land would not be able
to supply enough food as the population grew. He predicted that as both
the marginal and average productivity of labor fell and there were more
mouths to feed, mass hunger and starvation would result.
Fortunately,
Malthus was wrong TABLE 6.2 Index of World Food
(although he was right Production per Capita
about the diminishing Year Index
marginal returns to
1948-1952 100
labor).
1960 115
1970 123
1980 128
1990 138
2000 150
2005 156
Cereal Yields and the World
Price of Food

Cereal yields have increased. The average world price of food increased
temporarily in the early 1970s but has declined since.
 PRODUCTION WITH TWO VARIABLE INPUTS

• Isoquants
● isoquant map Graph combining a number of
isoquants, used to describe a production function.

Production with Two Variable Inputs

A set of isoquants, or isoquant

map, describes the firm’s
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D),
to isoquant q2 (75 units per year
at points such as B) and
to isoquant q3 (90 units per year
at points such as C and E).
 PRODUCTION WITH TWO VARIABLE INPUTS
• Substitution Among Inputs
● marginal rate of technical substitution (MRTS) Amount by
which the quantity of one input can be reduced when one extra
unit of another input is used, so that output remains constant.
MRTS = − Change in capital input/change in labor input
Marginal Rate of Technical = − ΔK/ΔL (for a fixed level of q)
Substitution

Like indifference curves,

isoquants are downward sloping
and convex. The slope of the
isoquant at any point measures
the marginal rate of technical
substitution—the ability of the
firm to replace capital with labor
while maintaining the same level
of output.
On isoquant q2, the MRTS falls
from 2 to 1 to 2/3 to 1/3.

(MP ) / (MP )  (K / L) MRTS (6.2)

L K
 PRODUCTION WITH TWO VARIABLE INPUTS
• Production Functions—Two Special Cases

Isoquants When Inputs Are

Perfect Substitutes

When the isoquants are

straight lines, the MRTS is
constant. Thus the rate at
which capital and labor can
be substituted for each
other is the same no matter
what level of inputs is
being used.
Points A, B, and C
represent three different
capital-labor combinations
that generate the same
output q3.
 PRODUCTION WITH TWO VARIABLE INPUTS
• Production Functions—Two Special Cases
● fixed-proportions production function Production function
with L-shaped isoquants, so that only one combination of labor
and capital can be used to produce each level of output.
The fixed-proportions production function describes
situations in which methods of production are limited.

Fixed-Proportions
Production Function
When the isoquants are L-
shaped, only one
combination of labor and
capital can be used to
produce a given output (as at
point A on isoquant q1, point
B on isoquant q2, and point C
on isoquant q3). Adding more
labor alone does not
increase output, nor does
adding more capital alone.
 RETURNS TO SCALE

● returns to scale Rate at which output increases as

inputs are increased proportionately.

● increasing returns to scale Situation in which output

more than doubles when all inputs are doubled.

● constant returns to scale Situation in which output

doubles when all inputs are doubled.

● decreasing returns to scale Situation in which output

less than doubles when all inputs are doubled.
 RETURNS TO SCALE
• Describing Returns to Scale

Returns to Scale

When a firm’s production process exhibits However, when there are increasing
constant returns to scale as shown by a returns to scale as shown in (b), the
movement along line 0A in part (a), the isoquants move closer together as
isoquants are equally spaced as output inputs are increased along the line.
increases proportionally.