Technology and Production

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Production Technologies
Firms produce products or services,
outputs they can sell profitably
A firm’s production technology
summarizes all its production methods
for producing its output
A production method is efficient if there
is no other way for the firm to produce
more output using the same amounts of
inputs

7-2
 The Technology of Production
Mathematically, describe efficient production
frontier with a production function
Output=F(Inputs)
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 true for a given
technology
If technology increases, more output can be produced
for a given level of inputs
 Production Possibilities Set

A production possibilities set contains all

combinations of inputs and outputs that are
possible given the firm’s technology
Output on vertical axis, input on horizontal axis
A firm’s efficient production frontier shows
the input-output combinations from all of its
efficient production methods

7-4
 Short and Long-Run Production

An input is fixed if it cannot be adjusted over

any given time period; it is variable if it can be
Short run: a period of time over which one or
more inputs is fixed
Long run: a period over time over which all
inputs are variable
Length of long run depends on the production
process being considered
Auto manufacturer may need years to build a new
production facility but software firm may need only a
month or two to rent and move into a new space

7-5
 Short run and long run
Suppose that output can be produced
with the help of capital and labor inputs
In the short run, one input cannot be
changed, e.g. capital. This is therefore a
fixed input
Output can be changed only by applying
more or less labor to a fixed amount of
capital
Labor is the variable input
 Long run

In the long run, all inputs are variable

Both capital and labor inputs can be
varied
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
Production: One Variable Input

We can relate the total amount of output

produced to the amount of labor use
We will then get a total product curve
 Example:
Q = 10K0.5L0.5
Suppose that K = 25 in the short run
Then Q = 50L0.5
Production Possibility Set for
Garden Benches

Q  F L   2 L3  10 L2  25 L
7-10
 Average and Marginal Products
Average product of labor is the amount of
output that is produced per worker:
Q F L 
APL  
L L
Marginal product of labor measures how
much extra output is produced when the firm
changes the amount of labor it uses by just a
little bit:
Q F L   F L  L 
MPL  
L L 7-11
 Production with One
Variable Input (Labor)
TABLE 6.1 PRODUCTION WITH ONE VARIABLE INPUT
AMOUNT OF AMOUNT OF TOTAL AVERAGE MARGINAL PRODUCT
LABOR (L) CAPITAL (K) OUTPUT (q) PRODUCT (q/L) (q/L)
0 10 0 — —

1 10 10 10 10

2 10 30 15 20

3 10 60 20 30

4 10 80 20 20

5 10 95 19 15

6 10 108 18 13

7 10 112 16 4

8 10 112 14 0

9 10 108 12 4

10 10 100 10 8
 AP and MP Curves

When labor is finely divisible, AP and MP

are graphed as curves
For any point on a short run production
function:
AP is the slope of the straight line
connecting the point to the origin
MP equals the slope of the line tangent to
the production function at that point

7-13
Marginal Product of Labor

7-14
 Diminishing Marginal Returns

Law of diminishing Table 7.3: Marginal Product of

marginal returns: Producing Garden Benches

eventually the Number of

Benches
Produced MPL
Workers
marginal product for Per Week
0 0 --
an input decreases 1 33 33
as its use increases, 2 74 41
holding all other 3 111 37

inputs fixed 4 132 21

7-15
Relationship Between AP and MP

Compare MP to AP to see whether AP rises or

falls as more of an input is added
MPL shows how much output the marginal
worker adds
If he is more productive than average, he brings the
average up
If he is less productive than average, he drives the
average down
Relationship between a firm’s AP and MP:
When the MP of an input is (larger/smaller/the
same as) the AP, the marginal units
(raise/lower/do not affect) the AP
7-16
 Average and Marginal Product
Curves
AP curve slopes
upward when it is
below MP
AP slopes downward
when it is above MP
AP is flat where the
two curve cross

7-17
The Slopes of the Product Curve

PRODUCTION WITH
ONE VARIABLE INPUT
To the left of point E in (b), the
marginal product is above the average
product and the average is increasing;
to the right of E, the marginal product
is below the average product and the
average is decreasing.
As a result, E represents the point at
which the average and marginal
products are equal, when the average
product reaches its maximum.
At D, when total output is maximized,
the slope of the tangent to the total 20
product curve is 0, as is the marginal
product.
 Production with Two Variable Inputs

Most production processes use many variable

inputs: labor, capital, materials, and land
Capital inputs include assets such as physical
plant, machinery, and vehicles
Consider a firm that uses two inputs in the long
run:
Labor (L) and capital (K)
Each of these inputs is homogeneous
Firm’s production function is Q = F(L,K)

7-19
 Production with Two Variable Inputs

When a firm has more than one variable

input it can produce a given amount of
output with many different combinations
of inputs
E.g., by substituting K for L
Productive Inputs Principle: Increasing
the amounts of at least one input strictly
increases the amount of output the firm
can produce
7-20
 Isoquants

An isoquant identifies all input

combinations that efficiently produce a
given level of output
Note the close parallel to indifference curves
Can think of isoquants as contour lines for
the “hill” created by the production function
Firm’s family of isoquants consists of
the isoquants for all of its possible output
levels
7-21
Isoquant Example

7-22
 Properties of Isoquants

Isoquants are thin

Do not slope upward
The boundary between input
combinations that produce more and less
than a given amount of output
Isoquants from the same technology do
not cross
Higher-level isoquants lie farther from the
origin
7-23
Properties of Isoquants

7-24
Properties of Isoquants

7-25
 Substitution Between Inputs
 Rate at which one input can be substituted for another
is an important factor for managers in choosing best
mix of inputs
 Shape of isoquant captures information about input
substitution
 Points on an isoquant have same output but different input mix
 Rate of substitution for labor with capital is equal to negative
the slope
 Marginal Rate of Technical Substitution for input X
with input Y: the rate at which a firm must replace
units of X with units of Y to keep output unchanged
starting at a given input combination

7-26
MRTS

7-27
 MRTS and Marginal Product

Recall the relationship between MRS and

marginal utility
Parallel relationship exists between MRTS
and marginal product

MPL
MRTS LK 
MPK

7-28
 Declining MRTS

Assume declining
MRTS
Here MRTS declines
as we move along
the isoquant,
increasing input X
and decreasing input
Y

7-29
Extreme Production Technologies

Two inputs are perfect substitutes if their

functions are identical
Firm is able to exchange one for another at a fixed
rate
Each isoquant is a straight line, constant MRTS
Two inputs are perfect complements when
They must be used in fixed proportions
Isoquants are L-shaped

7-30
Perfect Substitutes

7-31
Fixed Proportions

7-32
 Cobb-Douglas Production
Function
Common production function in economic
analysis
Introduced by mathematician Charles Cobb
and economist (U.S. Senator) Paul Douglas
General form:
Q  F L, K   AL K
a b

Where A, a, and b are parameters that take

specific values for a given firm

7-33
 Cobb-Douglas Production Function

Q  F L, K   AL Ka b

A shows firm’s general productivity level

a and b affect relative productivities of labor
and capital
MPL  aALa 1 K b
MPK  bALa K b 1
Substitution between inputs:
 a  K 
MRTS LK    
 b  L 
7-34
Cobb-Douglas Production
Function

7-35
 Returns to Scale
In the long run, all inputs are variable

What happens if all inputs are changed in the

same proportion?

Proportional change in What happens when all

Types of Returns to Scale
ALL inputs yields… inputs are doubled?

Same proportional change in

Constant Output doubles
output
Greater than proportional Output more than
Increasing
change in output doubles
Less than proportional
Decreasing Output less than doubles
change in output

7-36
Returns to Scale

7-37
 Reasons for returns to scale

Increasing returns to scale:

- Specialisation
- Physical laws
Decreasing returns to scale:
- If simple replication is possible, we
should never see DRS
- Therefore some fixed input (managerial
capacity is needed to explain DRS
 Cobb-Douglas Production Function

Q  F L, K   AL K
a b

A(mL)a(mK)b = Ama+bLaKb

So whether we have IRS, CRS or DRS

depends on a+b

7-39