Chapter 6 Production Theory & Analysis .

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

Introduction
In this chapter we turn our attention to the supply side of the ar!et" I #e hope to answer the question$ %&ow do producers deter ine price and output'(
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The Technology of Production

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Production +ategories of Inputs (factors of production)

Labor (L)$ Raw aterials$ +apital(,)

The process of co bining inputs or factors of production to achie*e an output"

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The Production Function

The production function indicates the relationship between the inputs and the resulting output gi*en the state of technology"
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Shows what is technically feasible when the fir

operates efficiently"

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The Production -unction. Q = F !"#$ Q = Output" ! = +apital$ # / Labor +obb01ouglas Production -unction.
Q = A! #

2arginal Product of Labor '

+hapter 3

Iso%uants
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Obser*ations. 4) -or any le*el of ,$ output increases with ore L" 5) -or any le*el of L$ output increases with ore ," 6) Various co binations of inputs produce the sa e output"

Iso%uants
Isoquants are cur*es showing the co binations of inputs that yield the sa e output"
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+hapter 3

Iso%uants
The isoquants e phasi7e how different input co binations can be used to produce the sa e output" I This infor ation allows the producer to respond efficiently to changes in the ar!ets for inputs"
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Iso%uants
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The Short Run Versus the Long Run Short0run. Long0run

9 ti e period when one or ore factors of production cannot be changed to change output" These inputs are called fi:ed inputs"
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9 ti e period when all inputs are *ariable"

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Production &ith 'ne (ariable Input

Production &ith 'ne (ariable Input

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Obser*ations. 4) #ith additional wor!ers$ output (Q) increases$ reaches a a:i u $ and then decreases" 5) The a*erage product of labor (AP)$ or output per wor!er$ increases and then decreases"
AP = 'utput Q = #abor Input #

6) The arginal product of labor (2P)$ or output of the additional wor!er$ increases rapidly initially and then decreases and beco es negati*e"
)P# = 'utput Q = #abor Input #

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Production &ith 'ne (ariable Input

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Production &ith 'ne (ariable Input

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Obser*ations.
#hen )C = =$ TP is at its a:i u #hen )P * AP" AP is increasing #hen )P + AP" AP is decreasing #hen )P = AP" AP is at its a:i u AP = slope of line fro origin to a point on TP$ points a" b" & c. )P = slope of a tangent to any point on the TP line

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The #a& of Di,inishing -eturns

9s the nu ber of units of a *ariable input increases$ a point will be reached at which resulting additions to output decreases (i"e" )P declines)" I #hen the labor input is s all$ )P increases due to speciali7ation" I #hen the labor input is large$ )P decreases due to inefficiencies"
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The #a& of Di,inishing -eturns

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Obser*ations.

+an be used for long0run decisions to e*aluate the trade0offs of different plant configurations ) 9ssu es the quality of the *ariable input is constant ) 1i inishing returns e:plains a declining )P$ not necessarily a negati*e one ) 1i inishing returns assu es a constant technology

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The .ffect of Technological I,pro/e,ent

Production &ith 'ne (ariable Input

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Labor Producti*ity and the Standard of Li*ing

Increasing producti*ity is the only way to raise the real standard of li*ing"

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Production &ith T&o (ariable Inputs

#e ha*e seen that there is a relationship between production and producti*ity" I @ow we will in*estigate alternati*e ways of producing by loo!ing at the shape of a series of isoquants"
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The 0hape of Iso%uants

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Production &ith T&o (ariable Inputs

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Reading the Isoquant 2odel 4) 9ssu e capital is 6 and labor increases fro 5) 9ssu e labor is 6 and labor increases fro

= to 4 to 5 to 6" = to 4 to 5 to 6"

@otice output increases at a decreasing rate (<<$ 5=$ 4<) illustrating di inishing returns fro labor in the short0run and long0run"
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fro

Output also increases at a decreasing rate (<<$ 5=$ 4<) due to di inishing returns capital"

Production &ith T&o (ariable Inputs

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Substituting 9 ong Inputs

2anagers want to deter ine what co bination if inputs to use" ) They ust deal with the trade0off between inputs" ) The slope of each isoquant gi*es the trade0off between two inputs while !eeping output constant" ) The arginal rate of technical substitution equals.
)-T0 = 1 +hange in capitalB+hange in labor input

)-T0 = !

(for a fi:ed le*el of Q )

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4=

)arginal -ate of Technical 0ubstitution

Production &ith T&o (ariable Inputs

4) 1i inishing )-T0 occurs because of di inishing returns and i plies isoquants are con*e:" 5) The change in output fro a change in labor equals.
)P#$ #$
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The change in output fro

a change in capital equals.

)P!$ !$

If output is constant and labor is increased$ then.

)P#$ #$ + )P!$ !$ =2 )P#$ )P!$ =1 !3 #$ = )-T0

4hen Inputs are Perfectly 0ubstitutable

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1 linear iso%uants
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Obser*ations 4) The 2RTS is constant at all points on the isoquant" 5) -or a gi*en output$ any co bination of inputs can be chosen (A" 5" or C$ to generate the sa e le*el of output (e"g" toll booths C usical instru ents)

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45

4) @o substitution is possible0each output requires a specific a ount of each input (e"g" labor and Dac!ha ers)" 5) To increase output requires ore labor and capital (i"e" o*ing fro A to 5 to C which is technically efficient)"

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.6a,ple7A Production Function for 4heat

-ar ers ust choose between a capital intensi*e or labor intensi*e technique of production"
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Obser*ations. 4) Operating at A" # = <== hours and ! = 4== achine hours" 5) Increase # to >3= and decrease ! to A= the 2RTS E 4.
)-T0 = 1 !

6) )-T0 E 4$ therefore the cost of labor ust be less than capital in order for the far er to substitute labor for capital" ;) If labor is e:pensi*e$ the far er would use ore capital (e"g" F"S")"
+hapter 3 4;

= (4= B 53=) = ="=;

Choosing Inputs
9ssu e two Inputs. Labor (#) C capital (!) C = &# 8 r! Isocost. 9 line showing all co binations of # C ! that can be purchased for the sa e cost" ! = C3r 1 &3r$# Slope of the isocost. 0 is the ratio of the wage rate to rental cost of capital" 0 this shows the rate at which capital can be substituted for labor with no change in cost" @ow$ the ne:t issue is how to output"
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ini i7e cost for a gi*en le*el of

#e will do so by co bining isocosts with isoquants 2RTS = 0 ! # = 2PL # 2P, = & r

Slope of isocost line = !

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The

ini u

cost co bination can then be written as.

2PL = 2P, & r

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-eturns to 0cale
2easuring the relationship between the scale (si7e) of a fir and output 4) Increasing returns to scale. output increases at a faster rate than inputs
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Larger output associated with lower cost (autos) One fir is ore efficient than any (electric utilities) The isoquants get closer together

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5)+onstant returns to scale. output increases at the sa e rate as inputs

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Si7e does not affect producti*ity 2ay ha*e a large nu ber of producers Isoquants equidistant apart

6)1ecreasing returns to scale. output increases at a slower rate than inputs

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1ecreasing efficiency with large si7e Reduction of entrepreneurial abilities Isoquants beco e farther apart

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Gcono ies and 1isecono ies of Scale

Gcono ies of Scale
Increase in output is greater than the increase in inputs"

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1isecono ies of Scale

Increase in output is less than the increase in inputs"

2easuring Gcono ies of Scale

.c =+ost Output Glasticity =H in cost fro a 4H increase in output

.c = (C B Q) B(C B Q ) = 2+B9+

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Therefore$ the following is true.

.C E 4. 2+ E 9+
9*erage cost indicate decreasing econo ies of scale

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.C / 4. 2+ / 9+
9*erage cost indicate constant econo ies of scale

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.C * 4. 2+ I 9+
9*erage cost indicate increasing disecono ies of scale

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.cono,ies of 0cope
Gcono ies of scope e:ist when the Doint output of a single fir is greater than the output that could be achie*ed by two different fir s each producing a single output" I #hat are the ad*antages of Doint production' 0 JVertical Integration in Oil Refinery Industry K I 9d*antages 4) Loth use capital and labor" 5) The fir s share anage ent resources" 6) Loth use the sa e labor s!ills and type of achinery" I Obser*ations
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There is no direct relationship between econo ies of scope and econo ies of scale"
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2ay e:perience econo ies of scope and disecono ies of scale 2ay ha*e econo ies of scale and not ha*e econo ies of scope

The degree of econo,ies of scope cost can be written.

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S+ =
) ) )

easures the sa*ings in

+(Q4) + C (Q 5) C (Q4$ Q 5) C (Q4$ Q 5)

+(M4) is the cost of producing M4 +(M5) is the cost of producing M5 +(M4M5) is the Doint cost of producing both products

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Interpretation.
If S+ I = 00 Gcono ies of scope If S+ E = 00 1isecono ies of scope

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5=