Production

What Owners Want We focus on for-profit firms in the private sector in this course. We assume these firms’ owners are driven to maximize profit. Profit is the difference between revenue (R), what it earns from selling its product, and cost (C), what it pays for labor, materials, and other inputs. where R = pq. To maximize profits, a firm must produce as efficiently as possible, where efficient production means it cannot produce its current level of output with fewer inputs.

Production Function The Production Function measures the maximum possible output that the firm can produce from a given amount of inputs (such as labor, capital, land, raw materials, etc) by given technology..

Short-Run vs L0ng-Run A firm can more easily adjust its inputs in the long run than in the short run. The short run is a period of time so brief that at least one factor of production cannot be varied (the fixed input). The long run is a long enough period of time that all inputs can be varied.

Short Run Production: One Variable and One Fixed Input In the short run (SR), we assume that capital is a fixed input and labor is a variable input. SR Production Function: q is output, but also called total product; the short run production function is also called the total product of labor

Long Run Production: Two Variable Inputs In the long run (LR), we assume that both labor and capital are variable inputs. The freedom to vary both inputs provides firms with many choices of how to produce (labor-intensive vs. capital-intensive methods).

LR Production Isoquants A production isoquant graphically summarizes the efficient combinations of inputs (labor and capital) that will produce a specific level of output. (i.e. Contour Map of Production Function at the given quntity level)

LR Production Isoquants Properties of isoquants: The farther an isoquant is from the origin, the greater the level of output. Isoquants do not cross. Isoquants slope downward. The shape of isoquants (curvature) indicates how readily a firm can substitute between inputs in the production process.

LR Production Isoquants Types of isoquants: Perfect substitutes (e.g. q = Ax1 + Bx2)

LR Production Isoquants Types of isoquants: Fixed-proportions (e.g. q = min{ax1, bx2} )

LR Production Isoquants Types of isoquants: Cobb-Douglas (e.g. q =A x1a x2b )

Technical Rate of Substitution (TRS) Technical Rate of Substitution (TRS) of labor for capital is the rate at which K must be given up as L level is increased so as not to change the output level. OUTCOME: TRS is the negative slope of the isoquant curve.

Marginal Productivities (MP) The marginal product of an input is the change in output that results from a small change in an input holding the levels of other inputs constant.

TRS & Marginal Productivities A small change (dL, dK) in the inputs causes a change to the output level of (i.e. total differential of the production function): df = 0 since there is to be no change to the output level (on the same isoquant), so the changes dx1 and dx2 to the input levels must satisfy

TRS & Marginal Productivities By rearranging equation (A),

Returns to Scale Returns to scale helps us to understand how output will respond to the increases in all inputs together Suppose that all inputs are doubled, would the output double? There are three types of returns to scales: for t>1 Increasing Returns to Scale (IRS): Constant Returns to Scale (CRS): Decreasing Returns to Scale (DRS):

Varying Returns to Scale

Production Function & Utility Function Output from inputs Preference level from consumption Isoquant Curve Indifference Curve Technical Rate of Substitution (TRS) Marginal Rate of Substitution (MRS) Marginal Productivities Marginal Utilities