Production Economics

Chapter 7
Managers must decide not only what to produce for the market, but also how to produce it in the most efficient or least cost manner. Economics offers widely accepted tools for judging whether the production choices are least cost. A production function relates the most that can be produced from a given set of inputs.
Production functions allow measures of the marginal product of each input.
2008 Thomson * South-Western Slide 1

The Production Function

A Production Function is the maximum quantity from any amounts of inputs If L is labor and K is capital, one popular functional form is known as the Cobb-Douglas Production Function

Q = a K b1 L b2

is a Cobb-Douglas Production Function The number of inputs is often larger than just K & L. But economists simplify by suggesting some, like materials or labor, is variable, whereas plant and equipment is fairly fixed in the short run.

Slide 2

The Short Run Production Function

Short Run Production Functions: Max output, from a n y set of inputs Q = f ( X1, X2, X3, X4, X5 ... )
FIXED IN SR
_

VARIABLE IN SR
_

Q = f ( K, L) for two input case, where K is Fixed

A Production Function is has only one variable input, labor, is easily analyzed. The one variable input is labor, L.
Slide 3

 Average Product = Q / L
output per labor

Marginal Product =Q / L = dQ / dL
output attributable to last unit of labor applied

Similar to profit functions, the Peak of MP occurs before the Peak of average product When MP = AP, were at the peak of the AP curve
Slide 4

Short Run Production Function Numerical Example

Marginal Product
L
0 1 2 3 4 5

Q
0 20 46 70 92 110

MP
--20 26 24 22 18

AP --20 23 23.33 23 22
1 2 3

Average Product

Labor Elasticity is greater then one, for labor use up through L = 3 units

5
Slide 5

 When MP > AP, then AP is RISING

IF YOUR MARGINAL GRADE IN THIS CLASS IS HIGHER THAN YOUR GRADE POINT AVERAGE, THEN YOUR G.P.A. IS RISING

When MP < AP, then AP is FALLING

IF YOUR MARGINAL BATTING AVERAGE IS LESS THAN THAT OF THE NEW YORK YANKEES, YOUR ADDITION TO THE TEAM WOULD LOWER THE YANKEES TEAM BATTING AVERAGE

When MP = AP, then AP is at its MAX

IF THE NEW HIRE IS JUST AS EFFICIENT AS THE AVERAGE EMPLOYEE, THEN AVERAGE PRODUCTIVITY DOESNT CHANGE

Slide 6

Law of Diminishing Returns

INCREASES IN ONE FACTOR OF PRODUCTION, HOLDING ONE OR OTHER FACTORS FIXED, AFTER SOME POINT, MARGINAL PRODUCT DIMINISHES.
MP

A SHORT RUN LAW

point of diminishing returns Variable input

Slide 7

Three stages of production

Total Output Stage 1: average product rising. Stage 1 Stage 2: average product declining (but marginal product positive). Stage 3: marginal product is negative, or total product is declining. Stage 2

Stage 3

Figure 7.4 on Page 269

Slide 8

Optimal Use of the Variable Input

HIRE, IF GET MORE MRP L MP L P Q = W REVENUE THAN COST wage HIRE if TR/L > TC/L HIRE if the marginal revenue product > W MFC W marginal factor cost: MRPL MRP L > MFC L MPL AT OPTIMUM, L MRP L = W MFC optimal labor
Slide 9

MRP L is the Demand for Labor

If Labor is MORE productive, demand for labor increases If Labor is LESS productive, demand for labor decreases
Suppose an EARTHQUAKE destroys capital

MP L declines with less capital, wages and labor are HURT

SL
W DL D L

L L
Slide 10

Long Run Production Functions

All inputs are variable
greatest output from any set of inputs

Q = f( K, L ) is two input example

MP of capital and MP of labor are the derivatives of the production function
MPL = Q /L = Q /L

MP of labor declines as more labor is applied. Also the MP of capital declines as more capital is applied.
Slide 11

Isoquants & LR Production Functions

In the LONG RUN, ALL factors are variable Q = f ( K, L ) ISOQUANTS -- locus of input combinations which produces the same output (A & B or on the same isoquant) SLOPE of ISOQUANT is ratio of Marginal Products, called the MRTS, the marginal rate of technical substitution

ISOQUANT MAP

B A

Q3

Q2
Q1

L
Slide 12

Optimal Combination of Inputs

The objective is to minimize cost for a given output ISOCOST lines are the
combination of inputs for a given cost, C0 Equimarginal Criterion: Produce where

MPL/CL = MPK/CK

where marginal products per dollar are equal Figure 7.15 on page 276 at D, slope of isocost = slope of isoquant

C0 = CLL + CKK K = C0/CK - (CL/CK)L Optimal where:

MPL/MPK = CL/CK Rearranged, this becomes the equimarginal criterion

C(1)

Q(1)
Slide 13

Use of the Equimarginal Criterion

Q: Is the following firm EFFICIENT? A dollar spent on labor produces 3, and a dollar spent on capital produces 2. Suppose that: USE RELATIVELY MP L = 30 MORE LABOR! MPK = 50 If spend $1 less in capital, W = 10 (cost of labor) output falls 2 units, but rises 3 units when spent on labor R = 25 (cost of Shift to more labor until the capital) equimarginal condition Labor: 30/10 = 3 holds. Capital: 50/25 = 2 That is peak efficiency. A: No!
Slide 14

Production Functions with Fixed Proportions

If a firm has five computers and just one person, typically only one computer is used at a time. You really need five people to work on the five computers. The isoquants for processes with fixed proportions are L-shaped. Small changes in the prices of input may lead to no change in the process. M is the process ray of one worker and one machine

people
5 4 M

3
2 1
1 2 3 4 5 6 7 8 9

computers
Slide 15

Allocative & Technical Efficiency

Allocative Efficiency asks if the firm using the least cost combination of input Technical Efficiency asks if the firm is maximizing potential output from a given set of inputs
When a firm produces at point T rather than point D on a lower isoquant, they firm is not producing as much as is technically possible.

It satisfies: MPL/CL = MPK/CK

D T Q(1) Q(0)
Slide 16

 If multiplying all inputs by (lambda) increases the dependent variable by,the firm has constant returns to scale (CRS).
Q = f ( K, L) So, f(K, L) = Q is Constant Returns to Scale Also, if 10% more all inputs leads to 10% more output the firm is constant returns to scale.

Returns to Scale

Cobb-Douglas Production Functions are constant returns if a + b=1

Slide 17

Cobb-Douglas Production Functions

Q = A Ka Lb is a Cobb-Douglas Production Function
IMPLIES:

Can be CRS, DRS, or IRS

if a + b= 1, then constant returns to scale if a + b< 1, then decreasing returns to scale if a + b> 1, then increasing returns to scale Suppose: Q = 1.4 K .35 L .70 Is this production function constant returns to scale? No, it is Increasing Returns to Scale, because
1.05 > 1.
Slide 18

Interpreting the Exponents of the Cobb-Douglas Production Functions

The exponents a and b are elasticities

ais the capital elasticity of output

The a is [% change in Q / % change in K]

b is the labor elasticity of output

The bis a [% change in Q / % change in L]
These elasticities can be written as EK and E L Most firms have some slight increasing returns to scale.
Slide 19

Problem
Again Suppose:

Q = 1.4 K .35 L .70

1. What is the production elasticity of capital? 2. What is the production elasticity of labor? 3. What happens to Q, if L increases 5% and capital is cut 10%?

Answers: 1. .35; 2. .70; 3. %Q = EL %L+ EK %K = .7(+5%) + .35(-10%) = 3.5% -3.5% = 0%. Note that this may reduce
costs without reducing output.
Slide 20