1. Chapter 6
Production

2. Introduction
Our study of consumer behavior was broken down into 3 steps
Describing consumer preferences
Consumers face budget constraints
Consumers choose to maximize utility
Production decisions of a firm are similar to consumer decisions
Can also be broken down into three steps
Chapter 6 3

3. Production Decisions of a Firm
Production Technology
Describe how inputs can be transformed into outputs
Inputs: land, labor, capital & raw materials
Outputs: cars, desks, books, etc.
Firms can produce different amounts of outputs using different combinations of inputs
Chapter 6 4

4. Production Decisions of a Firm
Cost Constraints
Firms must consider prices of labor, capital and other inputs
As consumers must consider budget constraints, firms must be concerned about costs of production
Chapter 6

5. Production Decisions of a Firm
Input Choices
Given input prices and production technology, the firm must choose how much of each input to use in producing output
Given prices of different inputs, the firm may choose different combinations of inputs to minimize costs
Chapter 6

6. Q: Decision Making of Owner-Manager
Suppose you are running a small business.
What is your objective?
What are you supposed to decide?
What is profit?
How can you make your profit max?
Chapter 6
Chapter 8 6

7. The Technology of Production
Production Function:
Indicates the highest output (q) that a firm can produce for every specified combination of inputs.
For simplicity, we will consider only labor (L) and capital (K)
Chapter 6 5

8. 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)
If technology increases, more output can be produced for a given level of inputs
Q: Why is raw material not included?
Chapter 6 6

9. 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
Chapter 6 16

10. 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
Chapter 6

11. Production: One Variable Input
We assume capital is fixed and labor is variable
Output can only be increased by increasing labor
How does output change as the amount of labor is changed?
Chapter 6

12. Production: One Variable Input
Chapter 6 17

13. Production: One Variable Input
Observations:
When labor is zero, output is zero as well
With additional workers, output (q) increases up to 8 units of labor.
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
Chapter 6 18

14. Production: One Variable Input
Average product of Labor - Output per unit of labor
Measures the productivity of a firm’s labor in terms of how much, on average, each worker can produce
Chapter 6

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
Chapter 6 20

16. Production: One Variable Input
Chapter 6

17. Production: One Variable Input
Output
per
Month 60
112 A B C D
Total Product
At point D, output is maximized. 1 2 3 4 5 6 7 8 9 10
Labor per Month
Chapter 6 23

18. Production: One Variable Input
Output
per
Worker
Left of E: MP > AP & AP is increasing
Right of E: MP < AP & AP is decreasing
At E: MP = AP & AP is at its maximum
At 8 units, MP is zero and output is at max 30 E
Marginal Product 20
Average Product 10 8 2 3 4 5 6 7 9 10 1
Labor per Month
Chapter 6 27

19. Marginal & 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
When marginal product is zero, total product (output) is at its maximum
Marginal product crosses average product at its maximum
Chapter 6 28

20. Product Curves
AP is slope of line from origin to point on TP curve q
q/L
112 C 30 60 B 20 10
Labor 2 3 4 5 6 7 8 9 10 1 8 2 3 4 5 6 7 9 10 1
Labor
Chapter 6

21. Product Curves
MP is slope of line tangent to corresponding point on TP curve q 60
112 30 10 30 q D 15 A
Labor 2 3 4 5 6 7 8 9 10 1 1 2 3 4 5 6 7 8 9 10
Labor
Chapter 6

22. Law of Diminishing (Marginal) Returns
When the labor input is small and capital is fixed, output increases considerably since workers can begin to specialize and MP of labor increases
When the labor input is large, some workers become less efficient and MP of labor decreases
Chapter 6 32

23. Production: Two Variable Inputs
In the long run, capital and labor are both variable.
We can look at the output that can be achieved with different combinations of capital and labor.
Chapter 6 53

24. Production: Two Variable Inputs
Chapter 6

25. Production: Two Variable Inputs
The information can be represented graphically using isoquants
Curves showing all possible combinations of inputs that yield the same output
Curves are smooth to allow for use of fractional inputs
Curve 1 shows all possible combinations of labor and capital that will produce 55 units of output
Chapter 6

26. Ex: 55 units of output can be produced with
Isoquant Map
q3 = 90 E 1 2 3 4 5
Capital
per year
Ex: 55 units of output can be produced with
3K & 1L (pt. A) OR
1K & 3L (pt. D)
q2 = 75
q1 = 55 A B C D
Labor per year 1 2 3 4 5
Chapter 6 14

27. Production: Two Variable Inputs
Holding capital at 3 and increasing labor from 0 to 1 to 2 to 3.
Output increases at a decreasing rate (0, 55, 20, 15) illustrating diminishing marginal returns from labor in the short-run and long-run.
Chapter 6 55

28. Production: Two Variable Inputs
Holding labor constant at 3 increasing capital from 0 to 1 to 2 to 3.
Output increases at a decreasing rate (0, 55, 20, 15) due to diminishing returns from capital in short-run and long-run.
Chapter 6 56

29. Diminishing Returns q3 = 90 1 2 3 4 5 Capital per year q2 = 75 q1 = 55
Increasing labor holding capital constant (A, B, C) OR
Increasing capital holding labor constant (E, D, C
q2 = 75
q1 = 55 D E A B C
Labor per year 1 2 3 4 5
Chapter 6 14

30. Production: Two Variable Inputs
Substituting Among Inputs
Slope of the isoquant shows how one input can be substituted for the other and keep the level of output the same.
Positive slope is the marginal rate of technical substitution (MRTS)
Chapter 6 58

31. Production: Two Variable Inputs
The Marginal Rate of Technical Substitution equals:
Chapter 6 59

32. Marginal Rate of Technical Substitution
Q1 =55
Q2 =75
Q3 =90
Capital
per year 5 1 2
2/3
1/3
Slope measures MRTS
MRTS decreases as move down the indifference curve 4 3 2 1 1 2 3 4 5
Labor per month
Chapter 6 60

33. MRTS and Marginal Products
If we increase labor and decrease capital to keep output constant, we can see how much the increase in output is due to the increased labor
Amount of labor increased times the marginal productivity of labor
Chapter 6 62

34. MRTS and Marginal Products
Similarly, the decrease in output from the decrease in capital can be calculated
Decrease in output from reduction of capital times the marginal produce of capital
Chapter 6 62

35. 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
Chapter 6 63

36. MRTS and Marginal Products
Rearranging equation, we can see the relationship between MRTS and MPs
Chapter 6

37. Isoquants: Special Cases
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
Chapter 6

38. Perfect Substitutes Q1 Q2 Q3 A B C Capital per month Labor per month
Same output can be reached with mostly capital or mostly labor (A or C) or with equal amount of both (B)
Labor
per month
Chapter 6 64

39. Isoquants: Special Cases
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
Chapter 6 65

40. Fixed-Proportions Production Function
Capital
per
month Q1 A Q2 Q3 B C
Same output can only be produced with one set of inputs. L1 K1
Labor
per month
Chapter 6 66

41. 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
Chapter 6

42. Increasing Returns to Scale
Capital
(machine
hours) 2 4
The isoquants move closer together A 30 20 10
Labor (hours) 5 10
Chapter 6 75

43. Constant Returns: Isoquants are equally spaced
Returns to Scale 30
Capital
(machine
hours) 2 4 6 A 20
Constant Returns: Isoquants are equally spaced 10
Labor (hours) 15 5 10
Chapter 6 75

44. Returns to Scale A Decreasing Returns: Isoquants get further apart 4
Capital
(machine
hours) A 15
Decreasing Returns:
Isoquants get further
apart 12 10 4 10 5 2
Labor (hours)
Chapter 6 75