MICROECONOMICS

Chapter 6 – Production

1
 Topics to be Discussed
• The Technology of Production
• Production with One Variable Input (Labor)
• Production with Two Variable Inputs
• Isoquants
• Returns to Scale

2
 Introduction
• Our study of consumer behavior was
broken down into 3 components:
– Describing consumer preferences
– Consumers face budget constraints
– Consumers choose to maximize utility
• Production decisions of a firm can also be
broken down into 3 components:
– Production technology
– Cost constraints
– Input and output choices – cost minimization
and profit maximization
3
 Production Decisions of a Firm
1. Production Technology
– Describes how inputs can be transformed
into outputs
• Inputs: land, labor, capital and raw materials
• Outputs: cars, desks, books, etc.
– Firms can produce different amounts of
outputs using different combinations of
inputs

4
 Production Decisions of a Firm
2. Cost Constraints
– Firms must consider costs of production and
how these costs change:
• as level of output changes
• for different combinations of inputs – labor,
capital and other inputs – as determined by their
prices

5
 Production Decisions of a Firm
3. Input and Output Choices for Cost
Minimization and Profit Maximization
– Given prices of different inputs, the firm may
choose different combinations of inputs to
minimize cost of producing a given level of
output
• E.g., if labor is cheap, firm may choose to
produce with more labor and less capital
– The firm chooses the level of output to
maximize its profits; chooses combinations
of inputs to minimize costs
6
 The Technology of Production
• Production Function:
– We can represent the firm’s production
technology in the form of a production
function
– The production function indicates the
highest output (q) that a firm can produce
for every specified combination of inputs
– Shows what is technically feasible when the
firm operates efficiently
– For simplicity, we will consider only labor (L)
and capital (K) 7
 The Technology of Production
• The production function for two inputs:
q = F(K,L)
– Output (q) is a function of capital (K) and labor
(L)
– The production function is defined for a given
technology
• If technology changes (advances), more output
can be produced for a given level of inputs
– The production function is defined for a given
time period
• K, L and other inputs are defined as flows over a
given time period (e.g., for pizza restaurant, K =
use of two brick ovens with capacity x for one year)8
 The Technology of Production
• Short Run versus Long Run
– It takes time for a firm to adjust production
from one set of inputs to another
– Firms must consider not only what inputs can
be varied but over what period of time that
can occur
– We must distinguish between long run and
short run

9
 The Technology of Production
• Short Run
– Period of time in which quantities of one or
more production factors cannot be changed
– These inputs are called fixed inputs
• Long Run
– Amount of time needed to make all
production inputs variable
• Short run and long run are not time
specific
– They depend on the production technology of
the firm
10
 Production: One Variable Input
• We will begin looking at the short run
when only one input can be varied
• We assume capital is fixed and labor is
variable
– Output can only be increased by increasing
labor
– Must know how output changes as the
amount of labor is changed (Table 6.1)

11
Table 6.1

12
 Production: One Variable Input
• Observations:
1. When labor is zero, output is zero as well
2. With additional workers, output (q) increases
up to 8 units of labor
3. Beyond this point, output declines
• Increasing labor can make better use of existing
capital initially
• After a point, more labor is not useful and can be
counterproductive

13
Production: One Variable Input
Two important concepts in understanding
production:
• Average Product
• Marginal Product

14
 Production: One Variable Input
• Average product (of Labor ) - Output per
unit of a particular input (e.g., output per
unit of labor)
• Measures the productivity of a firm’s labor
in terms of how much, on average, each
worker can produce
Output q
APL  
Labor Input L
15
 Production: One Variable Input
• Marginal Product of Labor – additional
output produced when labor increases by
one unit
• Change in output divided by the change in
labor

Output q
MPL  
Labor Input L
16
Production: One Variable Input
Compute for average and marginal products of
labor in Table 6.1

17
Table 6.2

18
 Production: One Variable Input
• We can graph data in Table 6.1 to show
how output varies with changes in labor
• Three types of product curves:
– Total Product (or total output) curve – always
positive or zero
– Average Product curve – always positive or
zero (except at L = 0 where AP is not defined)
– Marginal Product curve
• positive as long as total output is increasing;
• becomes negative when total output starts to
decrease
• At L = 0, MP is not defined 19
Production: One Variable Input
Output At point D, output is
per
maximized.
Month D
112

C Total Product

60
B

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

20
Production: One Variable Input
Output • Left of E: MP > AP & AP is increasing
per • Right of E: MP < AP & AP is decreasing
Worker • At E: MP = AP & AP is at its maximum
• At 8 units, MP is zero and output is at max
30
Marginal Product

E Average Product
20

10

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

21
 Marginal and Average Product
• When marginal product is greater than the
average product, the average product is
increasing
• When marginal product is less than the average
product, the average product is decreasing
• Marginal product crosses average product at its
maximum
• When marginal product is zero, total product
(output) is at its maximum

22
 Product Curves
• We can show a geometric relationship
between the total product and the average
and marginal product curves
– Slope of line from origin to any point on the
total product curve is the average product
– At point B, AP = 60/3 = 20 which is the same
as the slope of the line from the origin to point
B on the total product curve

23
 Product Curves
AP is slope of line from
q origin to point on TP
q/L curve
112
TP
30
C

60 20
B
AP
10
MP
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor Labor
24
 Product Curves
• Geometric relationship between total
product and marginal product
– The marginal product is the slope of the line
tangent to any corresponding point on the
total product curve
– For 2 units of labor, MP is slope of total
product curve at point A.
MP=Δq/ΔL=20/1=20

25
 Product Curves
MP is slope of line tangent to
corresponding point on TP
q q curve
112

TP 30

20
60
AP
30 10
A MP
10
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor Labor

26
Product Curves

27
 Law of Diminishing Marginal
Returns
• From the previous example, we can see
that as we increase labor the additional
output produced (MP) increases initially
then eventually declines (at Labor > 3)
• Law of Diminishing Marginal Returns:
As the use of an input increases with other
inputs fixed, the resulting additions to
output will eventually decrease (i.e., MP
will eventually decrease although it may
increase initially) 28
 Law of Diminishing Marginal
Returns
• When the use of labor input is small and
capital is fixed, output increases
considerably as labor increases since
workers can begin to specialize and MP of
labor increases
• When the use of labor input is large, some
workers become less efficient and MP of
labor decreases
• Typically applies only for the short run
when other input is fixed
– Assumes the quality of the variable input is
constant 29
 Law of Diminishing Marginal
Returns
• Do not confuse declining MP with
negative MP
– Additional output (MP) can be
declining but still positive (i.e., total
output is still increasing)
– Negative MP means total output is
decreasing

30
 Law of Diminishing Marginal
Returns
• Do not confuse declining MP with
declining AP
– MP may be declining while AP is still
increasing (MP will still be greater
than AP)
– …but eventually, MP will cross AP at
its maximum and AP will start to
decline

31
 The Effect of Technological
Improvement
• Improvements in technology will cause
upward shifts in the total product curve
– With improved technology, more output can
be produced with same inputs
• Law of diminishing marginal returns may
not hold with changing technology
– …even though the specific production
process exhibits diminishing returns to
labor
• The law assumes a constant technology
32
The Effect of Technological
Improvement
Moving from A to B to
Output
C C, marginal product
increases over time as
technology improves
100 O3
B

A
O2
50

O1

Labor per
time period
0 1 2 3 4 5 6 7 8 9 10
33
 Example – Malthus and the Food
Crisis
• Malthus predicted mass hunger and starvation
as diminishing returns limited agricultural output
and the population continued to grow
• Why did Malthus’ prediction fail (on a worldwide
scale)?
– Did not take into account changes in technology
– Although he was right about diminishing marginal
returns to labor
• Severe hunger still exists in some areas, in part
because labor productivity is low in agriculture
– also because of low incomes and difficulty of
redistributing food or population from high to low
production areas 34
 Ex. 2 – Labor Productivity
• Microeconomics helps explain the
concept of labor productivity in
macroeconomics
– Measured as the average product of labor
for an entire industry or the economy as a
whole
– Can provide useful comparisons across
time and across industries
q
Average Productivity 
L
35
 Ex. 2 – Labor Productivity (contd)
• Link between labor productivity and
standard of living
– Differences in standards of living across
countries are closely linked to differences in
labor productivity
– Factors permitting growth of productivity as
size of labor force increases
1. Growth in stock of capital – total amount of
capital available for production
2. Technological change – development of new
technologies that allow factors of production to be
used more productively
36
Production: Two Variable Inputs
• Firm can produce output by combining
different amounts of labor and capital
• In the long run, capital and labor are both
variable
• We can look at the output we can achieve
with different combinations of capital and
labor – Table 6.3

37
Table 6.3. Output achieved with
different K-L combinations

• Example – 75 units of output can be produced using

different combinations of capital and labor

38
Production: Two Variable Inputs
• The information can be represented
graphically using isoquants
– Curves showing all possible combinations of
inputs that yield the same output
– Curve 1 shows all possible combinations of
labor and capital that will produce 55 units of
output
– Curves are smooth to indicate possibility of
using fractional inputs
• An isoquant map shows a number of
isoquants in a single graph, describing a
production function 39
 Isoquant Map
With K fixed at 3 units, output
can be increased from 55 to 75
Capital 5 to 90 units by increasing L from
per year 1 (pt. A) to 2 (pt. B) to 3 (pt. C)
units
4

55 units of output can be

3 produced with 3K & 1L
A B C (pt. A) OR 1K & 3L (pt. D)

2
q3 = 90
D q2 = 75
1
q1 = 55
1 2 3 4 5 Labor per year
40
Production: Two Variable Inputs
Diminishing Returns to Labor with Isoquants
• Holding capital constant at 3 and
increasing labor from 0 to 1 to 2 to 3
– Output increases at a decreasing rate (0, 55,
75, 90) illustrating diminishing marginal
returns from labor (55, 20, 15)
– Would hold true in the short run and the long
run if capital is held constant

41
Production: Two Variable Inputs
Diminishing Returns to Capital with Isoquants
• Holding labor constant at 3 and increasing
capital from 0 to 1 to 2 to 3
– Output increases at a decreasing rate (0, 55,
75, 90) due to diminishing returns from capital
(55, 20, 15)
– Would hold true in the short run and the long
run if labor is held constant

42
 Diminishing Returns
Capital 5 Increasing labor
per year holding capital
constant (A, B, C)
4 OR
Increasing capital
holding labor constant
3 (E, D, C)
A B C
D
2
q3 = 90

1 E q2 = 75
q1 = 55
1 2 3 4 5 Labor per year
43
Production: Two Variable Inputs
• Substituting Among Inputs
– Firms have flexibility to substitute one input
for another to produce a given level of output
(e.g., more computers, less clerical labor)
– There is a trade-off between inputs, allowing
firms to use more of one input and less of
another for the same level of output
– Firms must decide what combination of inputs
to use

44
Production: Two Variable Inputs
• Substituting among Inputs
– Slope of the isoquant shows how one
input can be substituted for the other while
keeping the level of output the same
– The negative of the slope is the 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

45
 Marginal Rate of
Technical Substitution
Capital
5
per month Negative of Slope measures MRTS;
MRTS = -(-2/1) = 2 when labor
2 increases from 1 to 2 and output is
4 fixed at 75

1
3

2
Q3 =90

1 Q2 =75
Q1 =55
1 2 3 4 5 Labor per month
46
Production: Two Variable Inputs
• The marginal rate of technical substitution
equals:

Change in Capital Input

MRTS  
Change in Labor Input
MRTS   K (for a fixed level of q )
L

47
Production: Two Variable Inputs
• We assume there is diminishing MRTS
• As labor increases to replace capital
– Labor becomes relatively less productive
– Capital becomes relatively more productive
– Need less capital to replace one unit of labor
to keep output constant
– Isoquant becomes flatter
• In the next Figure, increasing labor in one
unit increments from 1 to 5 results in a
decreasing MRTS from 2 to 1/3 48
 Marginal Rate of
Technical Substitution
Capital
5
per month
MRTS decreases with movement
2 down the isoquant
4

1
3
1
1
2
2/3 1
Q3 =90
1/3 Q2 =75
1 1
Q1 =55
1 2 3 4 5 Labor per month
49
MRTS and Marginal Products
• We can show a relationship between
MRTS and marginal product of each
input
• If we increase labor and decrease
capital to keep output constant, the
increase in output due to increased
labor must just offset the decrease in
output due to decreased capital

50
 MRTS and Marginal Products
• Recall that:

q L
MPL 
L
• Similarly:
q K
MPK 
K
51
 MRTS and Marginal Products
• Therefore:
– The increase in output due to the increased
labor equals

qL  ( MPL )(L)

– The decrease in output due to the decreased
capital equals

qK  ( MPK )(K )

52
 MRTS and Marginal Products
• If we are holding output constant, the
net effect of increasing labor and
decreasing capital must be zero
• Using changes in output from capital and
labor we can see

(MPL )( L)  (MPK )( K)  0

53
 MRTS and Marginal Products
• Rearranging the equation, we can see the
relationship between MRTS and the MPs
(MPL )( L)  (MPK )( K)  0
(MPL )(L)  - (MPK )( K)
(MPL ) K
  MRTS
( MPK ) L
54
 Isoquants: Special Cases
Two extreme cases show the possible range
of input substitution in production
1. Perfect substitutes
– MRTS is constant at all points on isoquant
– Same output can be produced with a lot of
capital or a lot of labor or a balanced mix

55
 Perfect Substitutes
Capital
per A
Same output can be
month reached with mostly
capital or mostly labor
(A or C) or with equal
amount of both (B)
B

C
Q1 Q2 Q3
Labor
per month
56
 Isoquants: Special Cases
2. Perfect Complements
– Fixed proportions production function
– There is no substitution available between
inputs
– The output can be made with only a specific
proportion of capital and labor
– Cannot increase output unless increase both
capital and labor in that specific proportion

57
 Fixed-Proportions
Production Function
Capital
per Same output can
month only be produced
with one set of
inputs.

Q3
C
Q2
B

K1 Q1
A

Labor
per month
L1 58
 Example – A Production
Function for Wheat
• Farmers can produce crops with different
combinations of capital and labor
– Crops in developed countries are typically
grown with capital-intensive technology
– Crops in developing countries grown with
labor-intensive technology
• Can show the different options for crop
production with isoquants

59
 Isoquant Describing the
Production of Wheat
Point A is more
Capital capital-intensive, and
B is more labor-intensive.
120
A
100 B
90
80 Output = 13,800 bushels
per year

40

Labor
250 500 760 1000
60
 Example – A Production
Function for Wheat
• Manager of a farm can use the isoquant to
decide what combination of labor and
capital will minimize cost of crop
production
– A: 500 hours of labor, 100 units of capital
– B: decreases units of capital by 10 (to 90), but
must increase hours of labor by 260 (to 760)
hours
• Should the manager change input mix
from A to B?
61
 Example – A Production
Function for Wheat
• Must increase L by 260 and decrease K by
10 to maintain output level => the MRTS =
0.04
MRTS  - K  (10 / 260)  0.04
L
 If price of labor equals price of running a machine,
more capital should be used
 Unless labor is much less expensive than capital,
production should be capital intensive
 If one hour of labor costs much less than one hour
of a machine, labor-intensive farming may be used
(as in developing countries) 62
 Returns to Scale
• So far we have discussed the tradeoff
between inputs to keep production the
same
• How does a firm decide, in the long run,
the best way to increase output?
– Simplest way is to change the scale of
production by increasing all inputs in
proportion
– If inputs double, output will most likely
increase, but by how much?
63
 Returns to Scale
• Returns to scale - rate at which output
increases as inputs are increased
proportionately
– Increasing returns to scale
– Constant returns to scale
– Decreasing returns to scale

64
 Returns to Scale
• Increasing returns to scale: output more
than doubles when all inputs are doubled
(e.g., specialization of workers and
managers becomes possible; more
extensive use of sophisticated, large-scale
equipment)
– Larger output associated with lower average
cost (e.g., cars; “heavy” industries)
– One firm is more efficient than many (e.g.,
utilities)
65
 Returns to Scale
• Constant returns to scale: output
doubles when all inputs are doubled
– Size does not affect productivity (e.g., many
small-to-medium scale businesses/services
like travel agency, call center, private security
services, etc.)
– May have a large number of producers
because size does not matter

66
 Returns to Scale
• Decreasing returns to scale: output less
than doubles when all inputs are doubled
– Decreasing efficiency with large size
– Reduction of entrepreneurial / managerial /
coordination abilities

67
 Returns to Scale
• Returns to scale are not necessarily
fixed for one firm across all levels of
output
– A firm may have increasing returns to
scale at lower levels of output
– Constant and eventually decreasing
returns at higher levels of output

68
 Returns to Scale
• Returns to scale are not necessarily
fixed within one industry.
– They may change over time or across
firms as the scale of operations changes.
– Example: US carpet industry (see P&R,
pp. 217-218)
• Constant returns to scale for relatively small
plants
• Increasing returns to scale for larger plants
(using more advanced, high-tech equipment)

69
 Assignment for Next Class
Prepare to discuss the following questions
and exercises from P&R, chapter 6:
• Questions 5, 7, 11, 12, 13a, 13b
• Exercises 1-5, 10

70