Unit 2.
Production
F&D: Chapter 7
Outcomes
Define and illustrate an isoquant.
Explain and illustrate the characteristics of an isoquant.
Explain the difference between an isoquant and an
indifference curve.
Define and calculate the marginal rate of technical
substitution (MRTS)
Discuss the characteristics of the MRTS.
Discuss and illustrate the variables that influence the shape
of the isoquant and MRTS.
Define returns to scale.
Illustrate and explain the difference between increasing,
decreasing and constant returns to scale. In addition, refer to
the reasons and consequences of each of the different types
of returns to scale.
Distinguish between the law of diminishing returns,
economies of scale and decreasing returns to scale.
1. The Production Function
Production function: shows the
amount of output that can be produced
with different amounts of inputs
– i.e. how much output(Q), we can get after
employing specific quantities of Capital(K) and
Labour(L).
i.e Output is
Mathematically, a function
of K and L
Q = F (K, L)
K = Capital
L = Labour
Production Function (cont.)
Long run: the shortest period of time
required to alter the amounts of ALL inputs
used in a production process.
Short run: the longest period of time during
which at least one of the inputs used in a
production process cannot be varied.
Variable input: an input that can be varied
in the short run.
Fixed input: an input that cannot vary in the
short run.
2. Production In The Long Run
Isoquant: all the combinations of 2
inputs that can be used to produce the
same level of total output.
– i.e. combinations of inputs that yield the
same level of output ( Analogous to
indifference curves)
Slope of the isoquant is the Marginal
rate of technical substitution (MRTS):
the rate at which one input can be
exchanged for another without alterng the
total level of output.
Figure 7.10: Isoquant curves
Higher levels
of isoquant
gives higher
levels of
output
• From before we defined an isoquant as a set of inputs that yields the same
level of output. For example from the diagram each combination/ pair of
inputs L and K on the curve labelled Q=16, yields 16 units of output.
• MRTS at point A= the absolute value of the slope of the isoquant, i.e.
3. Characteristics of isoquants
Isoquant which lies further from the origin
(north-east direction) is preferred – higher
output level, for example: Point D is preferred to
◦Point D > Point C > Point A point C and Point C is
preferred to point A
An isoquant is downward sloping and
convex to the origin due to decreasing
MRTS
◦ For example from the previous diagram as one moves from
point A to point B along the same isoquant the MRTS of L
for K decreases. i.e. as more units of labour are being used
and certain units of K are given up, the marginal product of
L in relation to K will decline.
4. Marginal Rate of Technical
Substitution (MRTS)
MRTS: the rate at which one input is substituted or
another, while the output level is held constant.
◦ MRTS (in absolute value) decreases with a movement along
the isoquant curve
To keep output constant – as more of the one input sacrificed, more
of the other input must be added to compensate for the one unit
reduction of the first input (due to decreasing MP).
Thus =
i.e. MRTS at point A is equal to the ratio of the marginal product
of L to marginal product of K.
Fig 7.13: MRTS
Recall: MRTS is the rate at which one input can be exchanged for
another without altering total output. i.e. MRTS at point A is
equal to the absolute
value of the slope of
the isoquant
5. Different forms of isoquants
Different shapes of isoquants
reflects different MRTS
Fig. 7.14
Perfect input substitute
MRTS = 1
Perfect compliments
Inputs used in fixed combinations
MRTS = 0 or ∞
Figure 7.14: Isoquant for Perfect
Substitutes and Perfect Complements
Shell Computer
Caltex
• Diag. (a) cars and petrol are combined in the production process to produce
trips. E.g. Shell and Caltex garages are regarded as perfect substitutes-
whether you fill up 10 litres of petrol at Shell or Caltex you will drive the
same distance (output).
• Diag. (b)Perfect complements- Inputs are most effective when combined in
fixed proportions. E.g. Having more than one typist per computer is
pointless.
6. Returns to scale
Large vs. small plant = which one is the most
efficient?
The relationship between scale and efficiency
= returns to scale.
Returns to scale: What will happen with output
if all inputs are increased with the same
proportion?
The term returns to scale is a long term
concept since ALL inputs are varied/ changed.
Returns to scale (cont.)
Increasing returns to scale
◦Proportion in inputs lead to a greater (or
more than) proportional in output
double inputs → more than double output
◦Cause: greater possibility for specialization in
larger firms
◦Effect:
smaller number of firms supply most of the
market
Large plant an advantage.
Returns to scale (cont.)
Decreasing returns Constant returns
to scale
◦ Proportional in inputs to scale
lead to a smaller in ◦Proportion in inputs
output
Double inputs → less than result in exactly the
double output same proportional
in output
◦Cause: Double inputs =
organization and
communication problems – double output
firms become too big
Shortage of management /
entrepreneurial sources ◦Effect:
Large plant can be an
◦Effect: advantage or a
Usually no large firms – plenty disadvantage.
small firms supply the market.
Large plant a disadvantage.
Fig 7.15:Returns to scale
• The diagram illustrates different types of returns to scale. In the beginning
doubling of inputs led to more than double in output ( Increasing returns to
scale). In the middle- constant returns to scale- doubling of inputs led to
doubling of output. At the end- decreasing returns to scale- doubling of
inputs led to less than double in output.
7. Important production
concepts
Economies of scale: over the long term, the average
total cost per product decreases as the scale of
production increases.
Returnsto scale: what happens to output if all inputs
change/vary with x-percent.
Diminishing returns : short term concept – refers to
the decline in marginal product of a variable input
when other inputs are held constant.
Economies of scope: Decline in average costs as a
result of the production of 2 or more different
products
Activity
Refer to Class Activity
Refer to Additional Activities for Unit 2.1
