THE PRODUCTION FUNCTION

The Production Function

A function that defines the maximum amount of output that can be produced with a given set of inputs is called production function. Mathematically production function is expressed by: Q = f (K !" #hereas Q represents output and K and ! represent capital and labor respectively. $roduction %unction &able K ! Q ' ( ( )( ' )( *( + ,) -+ '+( +) * ')( +( ) +(( ', . +*( //////////////////////////////////////////////////////////////////////////////// The Discrete Production Function: &his involves distinct or lumpy patterns of input combination. Continuous Production Function: #here inputs can be varied. 0hort/run 1s !ong/2un 3ecisions Returns to Scale &he effect on output because of a proportional increase in all inputs. &his is a long/rum phenomenon.

Returns to Factor &he effect on output because of variation in only one input a short/run phenomenon of production function. Short-Run Production Function Analysis 4n the short/run it is assumed that production is only a function of labor. Q = f (K5 !" Measure ent o! Producti"ity &otal $roduct: whole output from a production system Average $roduct = Q6! Marginal $roduct MP#$ %&'%#
MP( $ %&'%)

*ra+hs &hree points A 7 and 8 on &otal product graph are important. $oint A is the inflection point of the &$ curve.&he M$ of ! increases till this point reaches then it declines. At point 7 A$ and M$ are e9ual and A$ is maximum. At point 8 the slope of the &$ is :ero and the curve is at maximum. 7eyond 8 M$ is negative and &$ is reduced.
The #a, o! Di inishin- Mar-inal +roduct o! #a.or in the short run #ith the increase in labor holding K constant M$ of labor declines. The Role o! the Mana-er in the Production Process The /o. o! the ana-er is0

1. &o use the available production function efficiently +. ;fficient use re9uires determining the right use of inputs. -. %or profit maximi:ation a manager should use inputs at levels at which the marginal benefit e9uals the marginal cost. *. &he marginal cost of labor in the short run is wage rate (w" the manager should continue to employ labor up to the point where

Mar-inal Product 2MP# and MP)3 !ro Production Function

Co..-Dou-las

&he marginal product function is the first derivative of the prod.f. with respect to the variable input. %or the general 8obb/3ouglas $rod. %. & $ A)4#5 the ar-inal +roduct are0 MP# $ d&'d# $5A)4#5-1 MP( $ d&'d( $ 4A)4-1#5

OPTIMA# EMP#O6MENT OF A FACTOR OF PRODUCTION &he additional units of the variable input should be hired until the M2$ (M$! 5M2" of the last unit employed is e9ual to the cost of the input. M2$! =w or $ M2$! = M2. M$! M2 = <&26<Q M$! = <Q6<! 0ubstituting (+" and (-" in ('" ('" (+" (-"

M2$! = <&26<Q. <Q6<! = <&26<! &he M2$! is the first derivate of the total revenue function with respect to that input. &hat is MRP# $ d2TR3'd# M2$! = w in the range of diminishing marginal product. 4f M2$!= # increase more usage of labor and if M2$! > # cut bac? wor?ers. In+ut De and0 M2$ curve is an input demand curve.

PRO7#EM A !ir +roduces out+ut that can .e sold at a +rice o! 819: The +roduction !unction is -i"en .y0 &$F2);#3 $ )1'< #1'< I! ) is !i=ed at 1 unit in the short-run; ho, uch la.or should the !ir e +loy to a=i i>e +ro!its i! the ,a-e rate is8<? Solution0 Set the MRP# $, and sol"e !or #: The +roduction !unction is Co.. Dou-las and MP# $.)a#.-1: a $ @; . $ @ and ) $1: Hence MP# $ 9:A#1'<-1

MRP# $ MP# B P $ 2 9:A#

1'<-1

3 2193 $ A#-1'<

Settin- this eCual to ,a-e rate ,e -et0 A#-1'< $< I! ,e sCuare .oth sides o! the eCuation; ,e -et <A'# $D # $ <A'D $ E:<A units:

#ON*-RUN PRODUCTION FUNCTION Production ,ith T,o Faria.le In+uts O+ti al Co .ination o! In+uts Production IsoCuants An iso9uant is a curve that represents a given output level produced efficiently by different combinations of inputs. Q '(( may be produced with the following combination of inputs. -------------------------------------------------------Co .ination ) # A 7 C D E G < 1 1 < G E

4nput 0ubstitution: 4f inputs are perfect complements to one another they can be substituted for one another. %or example more labor less capital or more capital and less labor can be used to produce a given level of output. Al-e.raic For s o! Production Functions and In+ut Su.stitutat.ility 1: #inear Production Function &hat assumes a perfect linear relationship between all inputs and output. Q= f (K !" = aK @b! %or example it ta?es wor?ers at a plant + hours to produce what a machine can ma?e in ' hour. 4n this case production function can be written as:

+K @ ! Mathematically it is stated that capital is always + times as productive as labor. 4f %(. *" = +(." @ '(*" = '. 7y using . units of K and * units of labor '. units of Q are produced. &he assumption is that there is perfect substitutability between K and !. 4n this case 4so9uant is a straight line. <: #eontie! Production Function &his is fixed proportions production function. &he underlying assumption is that inputs are used in a fixed proportions. &here is no substitutability between K and !. &he function is given by: Q = %(K !" = min(bK c!" Q =%(K !" = min()K -!" 4f K= '( and ! = +( then Q will be: Q =%('( +(" = min()('(" -(+(" = min()( .(" Aence '( units of K and +( units of labor can produce minimum )( units of output. 4so9uant curve is !/shaped.

G: Co..-Dou-las Production Function

A production function that assumes some degree of substitutability among inputs. &his production function is in between the two extremes of the linear production function and the !eontief production function. 8obb/3ouglas prod. %. is widely used in economics because it has properties representative of many production processes. Mathematically the function is given by: & $ A)4#5 8onsider a prod. %. of with parameters A = '(( B = (.) C= (.) that is: Q = '((K(.)!(.) Diven the above prod. %. if + units of labor and * units of capital are used maximum production is +E- units of output. 4f K = E and ! = + the output rate will be *((. $roduction rates can be obtained for various input/rate combinations applied to the production f. given above. 4t is observed that +*) units of output can be produced with any of the following input combinations0 -------------------------------------------------------Co .ination ) # A 7 C D E G < 1 1 < G E

&his implies that there is substitutability between factors of production. &he firm can use capital intensive or labor Fintensive techni9ue. &he manager can change the mix of K and ! in response to changes in relative prices of these inputs.

Marginal 2ate of &echnical 0ubstitution (M2&0" 4s the amount of input that must be substituted (given up" for another input to maintain the constant output. M2&0 = GK6G! slope of an iso9uant Hr M2&0 =IK6I! = M$!6M$K &he M2&0 usually diminishes with each additional unit of input and is termed is the: #a, o! di inishin- MRTS: #i its o! In+ut Su.stitution A firm will never combine resources in such a way that the marginal product of any input is negative which means decline in total output. 4f production iso9uant curve is positively sloped one of the inputs must have negative marginal product. 4nput combinations lying along a positively sloped portion of a production iso9uant are irrational. Hn a graph the lines on which M$ is negative are called rid-e

lines:

Isocost or 7ud-et #ines: 4socost lines represent the

combination of inputs that can be purchased at a given budget. 4t is expressed as : 8 = rK @ w! #here 8 is the total cost or amount of budget. # is the wage rate or price of labor r is the cost of capital. %or graphical purpose solving for K: rK = 8/ w! K = 86r / w6r! 86r the intercept on budget line w6r is the slope of the budget line 4f r=- and w=+ K='( and != ) #ith '(units of K and ) units of ! the total cost of production will be *(. K=*(6- /+6-! K= '-.-- /+6-! O+ti al In+ut Co .ination'Cost Mini i>ation #here w6r = M2&0 = M$!6M$K H2 #6r = M$!6M$K M$!6# = M$K6r

Hptimal input proportion rule states that the additional dollar spent on any input yields the same increase in output.

Draphically the optimal combination of the inputs is where the isocost line is tangent to the iso9uant curve. E=+ansion Path0 &his is the optimal combination of inputs as the scale of output expands. O+ti al E +loy ent and Pro!it Ma=i i>ation $rofit maximi:ation re9uires that a firm employs optimal input proportions and produces an optimal 9uantity of output : Cost minimi:ation and optimal input proportions are necessary but not sufficient conditions for profit maximi:ation. $rofit maximi:ation re9uires the employment of all inputs up to the point where M8 = M2 #6M$! = M2
And r'MP) $ MR Rearran-in- +roduces0 , $ MP# BMR $ MRP# r $ MP( BMR $ MRP( Cost ini i>ation reCuires e!!icient use o! in+uts and +ro!it e!!icient use o! resources and o+ti al le"el o! out+ut: a=i i>ation reCuires

Pro.le
QJ'. #hat is the efficient input combination for producing '((( units of output if w =* and r=+ if the production function is given as: ('" Q = K(.)!(.) &he optimal input combination re9uires: M$!6M$K = w6r M$!= (.) K(.)!(.)/' M$K = (.)K(.)/'!(.) M$!6M$K = (.) K(.)!(.)/' 6 (.)K(.)/'!(.)

%irst substitute the values in the production function: Q= Q = K(.)!(.)

RETURNS TO SCA#E

&he concept of returns to scale refers to changes in output when all inputs are varied proportionately. 4ncreasing returns to scale 8onstant returns to scale 3ecreasing returns to scale

Mar-inal Product 2MP# and MP)3 &he marginal product function is the first derivative of the prod.f. with respect to the variable input. %or the general 8obb/3ouglas $rod. %. & $ A)4#5 the ar-inal +roduct are0 MP# $ d&'d# $5A#)4#5-1 MP( $ d&'d( $ 4A)4-1#5 Mar-inal Product !or a #inear +roduction Function Q= f (K !" = aK @b! M$? = a M$! = b 7y ta?ing the partial derivative of the function with respect to input marginal product of each input is calculated.