Lecture 5 – Technology of Production

The production function

In the production process, firms turn inputs into outputs (products and services). Inputs are
called factors of production and include anything that the firm must use as a part of the
production process (labour, land and capital).
The relationship between the inputs and the resulting outputs is described by a production
function. The production function indicates the highest output Q that the firm is able to
produce with every combination of inputs. For simplicity we assume that there are only two
inputs: labour (L) and capital (C). We can then write the production function as:

Q = f (C,L)

This equation relates the quantity of output to the quantities of the two inputs, capital and
labour. The production function allows inputs to be combined in various proportions, so
that output can be produced in many ways. This could mean using more capital and less
labour or vice versa.
The above equation refers to a given technology. If technology becomes more advanced
and the production function changes, the firm can obtain more output for a given
amount of inputs.

Isoquants

Let’s analyse the production technology assuming that the firm uses two inputs and can vary
both of them. This can be presented graphically using isoquants. The isoquant is a curve
showing all the possible combinations of inputs that yield the same output. Figure 1
shows three isoquants. The lowest isoquant Q1 shows all combinations of labour and capital
that give the level of production labelled by Q1. If we move down along the curve, form point
a to b in Figure 1, this means that we substitute capital for labour. Isoquant Q2 lies above and
to the right of Q1 because obtaining the higher level of output requires more labour and
capital. The next curve Q3 presents the combinations of inputs that yield the highest output.

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When several isoquants are combined together in a single graph, as in Figure 1, we call the
graph an isoquant map. Each isoquant corresponds to a different level of output and the level
of output increases when we move up and to the right in the graph.

Figure1. Isoquants – production with two variable inputs

Short run and long run

The isoquants in Figure 1 show how capital and labour can be substituted for each other to
produce the same amount of output. In practice, this substitution can take time. If the firm is
going to increase the quantity of capital, usually the new factory has to be built and the new
capital equipment to be purchased. These activities can take a long time to complete. As a
result, if we are looking at production decisions over a short period of time, such as a month
or two, the firm will not be able to increase capital much. Therefore it is important to
distinguish between the short and the long run. The short run refers to a period of time in
which one or more factors of production cannot be changed. In other words, in the short
run there is at least one factor that can not be varied. Such a factor is called a fixed input. In
the long run, all inputs are variable. There is no specific period of time, such as one year,
that separates the short run from the long run. This mainly depends on the industry. For

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example, the long run can lasts a few days in the case of clothing industry and a few years in
the case of petrochemical or automobile industry.

Production with one variable input (the short run)

When deciding how much of a particular input to buy, the firm should compare the benefits
with the costs. Sometimes it is useful to compare the marginal benefits and costs, sometimes
the average benefits and costs.
Let’s begin with considering the case in which capital is fixed but labour is variable. In
this case, the only way the firm can produce more output is increasing its labour input. The
contribution that labour makes to the production process can be described by the average
product of labour or marginal product of labour. The average product of labour is the
output per unit of labour input. It is calculated by dividing the total output Q by the total
input of labour L. It measures the productivity of the firm’s workforce in terms of how
much output each worker produces on average. In our example average product initially
increases, but fall when the labour input becomes greater than six.
The last column in Table 1 presents marginal product of labour. This is the additional
output produced with the use of the extra unit of labour. It can be written as ∆Q/∆L. At the
beginning it increases with the amount of labour, then reaches the maximum value and
becomes to fall.

Table 1. Production with one variable input

Average Marginal
Amount of Labour Total Output
product product
Np. Pc
Pc /Np. ΔPc /ΔNp
0 0 - -
1 5 5 5
2 12 6 7
3 21 7 9
4 32 8 11
5 40 8 8
6 42 7 2
7 42 6 0
8 40 5 -2

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Figure 2 presents graphically the information contained in Table 1. Figure 2a shows that as
labour increases output also increases until it reaches the maximum output of 42 and then
starts to fall. Figure 2b shows the average and marginal product curves. Note that the
marginal product is positive as long as output is increasing, but becomes negative when
output is decreasing. The marginal product curve crosses the horizontal axis at the point of
maximum total product.

Figure 2. Total output, average product and marginal product

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The average product and marginal product curves are closely related. When the marginal
product is greater than the average product, the average product is increasing.
Similarly, when the marginal product is less than the average product, the average
product is decreasing.

The law of diminishing marginal returns

The diminishing marginal product of labour refers to most production processes. The law of
diminishing marginal returns states that as the use of labour increases with equal
portions (by one unit), a point will be reached at which the additions to output will
diminish. Why? Let’s imagine the automobile production line. A low number of workers will
not be able to operate the production line at all. The higher number of workers will be able to
operate the line, but not very efficiently. Adding a few more workers might allow the
production line to be operated much more efficiently, so the marginal product of those
workers would be very high. However, this efficiency may diminish when more workers is
employed, as they will probably get in each other’s way and therefore will reduce output (the
marginal product will be negative). So, when there are too many workers, some of them
become ineffective and the marginal product of labour falls or even becomes negative.

Production with two variable inputs (the long run)

In the long run both capital and labour inputs are variable. The firm can now produce its
output in different ways, combining various amounts of both inputs. We will use isoquants to
analyze and compare different ways of producing. The slope of each isoquant shows how the
quantity of one input can be traded off against the quantity of the other, while output is held
constant. We call the slope the marginal rate of technical substitution (MRTS). It is the
amount by which the input of capital is decreased when one extra unit of labour is used,
so that output remains constant. This is analogous to the marginal rate of substitution in the
consumer theory.

MRTS = change in capital input/change in labour input = ∆C/∆L

where ∆C and ∆L are small changes in capital and labour along the isoquant. Remember that
the change in capital is negative if we assume the increase in labour holding output constant.

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We assume that MRTS is diminishing. Diminishing MRTS tells us that the productivity of
any input is limited. This is the case for most technologies. As more and more labour is added
to the production process in place of capital, the productivity of labour falls. Similarly, when
more capital is added in place of labour, the productivity of capital falls. Production needs a
balanced mix of both inputs.
MRTS is closely related to marginal products of labour (MPL) and capital (MPC). Let’s
assume adding some labour and reducing the amount of capital so as to keep output constant.
The additional output resulting from the increased labour input is equal to the additional
output per unit of additional labour (the marginal product of labour) times the number of units
of additional labour.

Additional output from increased use of labour = MPL · ∆L

Similarly, the decrease in output resulting from the reduction in capital is as follows:

Additional output from decreased use of capital = - (MPC · ∆C)

Because we are keeping output constant moving along the isoquant, the total change in output
must be zero:

MPL · ∆L + (-MPC · ∆C) = 0 (1)

Now we can rearrange this equation so that

∆C/∆L = MPL / MPC (2)

But because ∆C/∆L is MRTS, it follows that

MRTS = MPL / MPC (3)

Equation 3 tells us that the marginal rate of technical substitution between two inputs is
equal to the ratio of the marginal physical products of the inputs.

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Returns to scale

Our analysis has shown what happens when the firm substitutes one input for another keeping
the output constant. However, in the long run, the firm must also consider the best way to
increase output. One way to do so is to change the scale of operation by increasing all of
the inputs to production in a given proportion. Returns to scale is the rate at which output
increases as inputs are increased proportionately. Three different cases may be distinguished:
increasing, constant and decreasing returns to scale.

• Increasing returns to scale – when inputs double, output more than doubles. This may
happen because larger scale of operations allows managers and workers to specialize
in their tasks and to use more sophisticated equipment. If there are increasing returns,
then this is economically advantageous to have one large firm producing at lower costs
rather than to have many smaller firms producing at higher costs. Because this large
firm can control the price of its product, it may need to be regulated. For example,
increasing returns in electricity provision is a main reason why there exist large power
companies.
• Constant returns to scale – output doubles when input double. In this case, the size of
the firm’s operations does not affect the productivity of the production factors.
• Decreasing returns to scale – output less than doubles when inputs double. This may
apply to some firms with large scale of operations. Difficulties with organising and
running the large firm may lead to lower productivity of both labour and capital.
In Figure 3a the firms has constant returns to scale. When 1 unit of both labour and capital are
used, the output of 100 units is produced. When both inputs double, output also doubles and
so on. In Figure 3b there are increasing returns to scale. Now the isoquants become closer to
one another when we move away from the origin. As we triple inputs (from 1 to 3), the
production more than triples. Finally, Figure 3c presents decreasing returns to scale. The
isoquants become increasingly distant from one another. This means that output increases in
smaller proportion than inputs do.

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Figure 3. Returns to scale