1. Chapter 6 Production

2. Chapter 6Slide 2 Topics to be Discussed The Technology of Production Isoquants Production with One Variable Input (Labor) Production with Two Variable Inputs Returns to Scale

3. Chapter 6Slide 3 Introduction Our focus is the supply side. The theory of the firm will address: How a firm makes cost-minimizing production decisions How cost varies with output Characteristics of market supply Issues of business regulation

4. Chapter 6Slide 4 The Technology of Production The Production Process Combining inputs i.e., factors of production to achieve an output Categories of Inputs (factors of production) Labor Materials Capital

5. Chapter 6Slide 5 The Technology of Production Production Function: Indicates the highest output that a firm can produce for every specified combination of inputs given the state of technology. Shows what is technically feasible when the firm operates efficiently (i.e., the case when each combination of inputs is used as efficiently as possible).

6. Chapter 6Slide 6 The Technology of Production The production function for two inputs: Q = F(K,L) Q = Output, K = Capital, L = Labor This is for a given technology.

7. Chapter 6Slide 7 The Short Run versus the Long Run 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.

8. Chapter 6Slide 8 AmountAmountTotalAverage Marginal of Labor (L)of Capital (K)Output (Q)ProductProduct Production with One Variable Input (Labor) 0100------ 110101010 210301520 310602030 410802020 510951915 6101081813 710112164 810112140 91010812-4 101010010-8

9. Chapter 6Slide 9 Observations: 1) With additional workers, output (Q) increases, reaches a maximum, and then decreases. Production with One Variable Input (Labor)

10. Chapter 6Slide 10 Observations: 2) The average product of labor (AP), or output per worker, increases and thendecreases. Production with One Variable Input (Labor)

11. Chapter 6Slide 11 Observations: 3) The marginal product of labor (MP), or output of the additional worker, increases rapidly initially and then decreases and becomes negative.. Production with One Variable Input (Labor)

12. Chapter 6Slide 12 Total Product A: slope of tangent = MP (20) B: slope of OB = AP (20) C: slope of OC= MP & AP Labor per Month Output per Month 60 112 023456789101 A B C D Production with One Variable Input (Labor)

13. Chapter 6Slide 13 Average Product Production with One Variable Input (Labor) 8 10 20 Outpu t per Month 02345679101 Labor per Month 30 E Marginal Product Observations: Left of E: MP > AP & AP is increasing Right of E: MP < AP & AP is decreasing E: MP = AP & AP is at its maximum

14. Chapter 6Slide 14 Observations: When MP = 0, TP is at its maximum When MP > AP, AP is increasing When MP < AP, AP is decreasing When MP = AP, AP is at its maximum Production with One Variable Input (Labor)

15. Labor per Month Output per Month 60 112 023456789101 A B C D 8 20 E 0234567 9 10 1 30 Output per Month Labor per Month AP = slope of line from origin to a point on TP, lines b, & c. MP = slope of a tangent to any point on the TP line, lines a & c.

16. Chapter 6Slide 16 As the use of an input increases in equal increments, a point will be reached at which the resulting additions to output decreases (i.e. MP declines). When the labor input is small, MP increases due to specialization. When the labor input is large, MP decreases due to inefficiencies. Production with One Variable Input (Labor) The Law of Diminishing Marginal Returns

17. Q L Q=F(K,L) Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns MP AP Increasing, Diminishing and Negative Marginal Returns

18. Chapter 6Slide 18 The Effect of Technological Improvement Labor per time period Output per time period 50 100 023456789101 A O1O1 C O3O3 O2O2 B Labor productivity can increase if there are improvements in technology, even though any given production process exhibits diminishing returns to labor.

19. Chapter 6Slide 19 Consumption can increase only if productivity increases. Determinants of Productivity  Stock of capital  Technological change Labor Productivity

20. Chapter 6Slide 20 Labor Productivity in Developed Countries _ÖDEV 1960-19734.754.048.302.892.36 1974-19862.101.852.501.690.71 1987-19971.482.001.941.021.09 United FranceGermanyJapanKingdomStates Annual Rate of Growth of Labor Productivity (%) $54,507$55,644$46,048$42,630$60,915 Output per Employed Person (1997)

21. Chapter 6Slide 21 1) U.S. productivity is growing at a slower rate than other countries. 2)Productivity growth in developed countries has been decreasing. Trends in Productivity

22. Chapter 6Slide 22 1) Growth in the stock of capital is the primary determinant of the growth in productivity. 2) Rate of capital accumulation in the U.S. was slower than other developed countries because the others were rebuilding after WWII. 3) Depletion of natural resources 4) Environment regulations Explanations for Productivity Growth Slowdown

23. Chapter 6Slide 23 Production with Two Variable Inputs There is a relationship between production and productivity. Long-run production K& L are variable. Isoquants analyze and compare the different combinations of K & L and output

24. Chapter 6Slide 24 Isoquants Curves showing all possible combinations of inputs that yield the same output Assumptions Food producer has two inputs  Labor (L) & Capital (K)  (use Table 6.4)

25. Chapter 6Slide 25 Production Function for Food 12040556575 24060758590 3557590100105 46585100110115 57590105115120 Capital Input12345 Labor Input

26. Chapter 6Slide 26 Isoquants Observations: 1) For any level of K, output increases with more L. 2)For any level of L, output increases with more K. 3)Various combinations of inputs produce the same output.

27. Chapter 6Slide 27 Production with Two Variable Inputs (L,K) Labor per month 1 2 3 4 12345 5 Q 1 = 55 The isoquants are derived from the production function for output of of 55, 75, and 90. A D B Q 2 = 75 Q 3 = 90 C E Capital per month The Isoquant Map

28. Chapter 6Slide 28 Isoquants The isoquants emphasize how different input combinations can be used to produce the same output. This information allows the producer to respond efficiently to changes (e.g., relative price changes) in the markets for inputs. Input Flexibility

29. Chapter 6Slide 29 Reading the Isoquant Model 1)Assume capital is 3 and labor increases from 0 to 1 to 2 to 3.  Notice output increases at a decreasing rate (55, 20, 15) illustrating diminishing returns from labor in the short-run and long-run. Production with Two Variable Inputs Diminishing Marginal Rate of Substitution

30. Chapter 6Slide 30 Reading the Isoquant Model 2)Assume labor is 3 and capital increases from 0 to 1 to 2 to 3.  Output also increases at a decreasing rate (55, 20, 15) due to diminishing returns from capital. Diminishing Marginal Rate of Substitution Production with Two Variable Inputs

31. Chapter 6Slide 31 The Shape of Isoquants Labor per month 1 2 3 4 12345 5 In the long run both labor and capital are variable and both experience diminishing returns. Q 1 = 55 Q 2 = 75 Q 3 = 90 Capital per month A D B C E

32. Chapter 6Slide 32 Substituting Among Inputs Managers want to determine what combination of inputs to use. They must deal with the trade-off between inputs. Production with Two Variable Inputs

33. Chapter 6Slide 33 Substituting Among Inputs The slope of each isoquant gives the trade- off between two inputs while keeping output constant. When we ignore the (-) sign, then the slope is called “the marginal rate of technical substitution (MRTS)” Production with Two Variable Inputs

34. Chapter 6Slide 34 Substituting Among Inputs The marginal rate of technical substitution (of L for K) equals: Production with Two Variable Inputs

35. Chapter 6Slide 35 Marginal Rate of Technical Substitution Labor per month 1 2 3 4 12345 5 Capital per month Isoquants are downward sloping and convex like indifference curves. 1 1 1 1 2 1 2/3 1/3 Q 1 =55 Q 2 =75 Q 3 =90

36. Chapter 6Slide 36 Observations: 1)Increasing labor in one unit increments from 1 to 5 results in a decreasing MRTS from 1 to 1/3. 2) Diminishing MRTS occurs because of diminishing returns and implies isoquants are convex. Production with Two Variable Inputs

37. Chapter 6Slide 37 Observations: 3)MRTS and Marginal Productivity (+ output per unit of +input) are quite related  The change in output from a change in labor equals:  The change in output from a change in capital equals: Production with Two Variable Inputs

38. Chapter 6Slide 38 Observations: 3)MRTS and Marginal Productivity  If output is constant and labor is increased, then: Production with Two Variable Inputs

39. Chapter 6Slide 39 Observations when inputs are perfectly substitutable: 1)The MRTS is constant at all points on the isoquant. 2) For a given output, any combination of inputs can be chosen (A, B, or C) to generate the same level of output (e.g. musical instruments) Production with Two Variable Inputs Perfect Substitutes

40. Chapter 6Slide 40 2 Cases: 1) Isoquants When Inputs are Perfectly Substitutable Labor per month Capital per month Q1Q1 Q2Q2 Q3Q3 A B C

41. Chapter 6Slide 41 Observations when inputs must be in a fixed- proportion: 1)No substitution is possible. Each output requires a specific amount of each input (e.g. labor and jackhammers). 2) To increase output requires more labor and capital (i.e. moving from A to B to C which is technically efficient). Fixed-Proportions Production Function 2 Cases: 2) Isoquants when inputs are Perfect complements

42. Chapter 6Slide 42 Fixed-Proportions Production Function Labor per month Capital per month L1L1 K1K1 Q1Q1 Q2Q2 Q3Q3 A B C

43. Chapter 6Slide 43 A Production Function for Wheat Farmers must choose between a capital intensive or labor intensive technique of production.

44. Chapter 6Slide 44 Isoquant Describing the Production of Wheat Labor (hours per year) Capital (machine hour per year) 2505007601000 40 80 120 100 90 Output = 13,800 bushels per year A B Point A is more capital-intensive, and B is more labor-intensive.

45. Chapter 6Slide 45 Observations: 1)Operating at A:  L = 500 hours and K = 100 machine hours. 2)Operating at B  Increase L to 760 and decrease K to 90 the MRTS < 1: Isoquant Describing the Production of Wheat

46. Chapter 6Slide 46 Observations: 3)MRTS < 1, therefore the cost of labor must be less than capital in order for the farmer substitute labor for capital. 4)If labor is expensive, the farmer would use more capital (e.g. U.S.). 5) If labor is inexpensive, the farmer would use more labor (e.g. India). Isoquant Describing the Production of Wheat

47. Chapter 6Slide 47 Returns to Scale Measuring the relationship between the scale (size) of a firm and output 1)Increasing returns to scale: output more than doubles when all inputs are doubled  Larger output associated with lower cost (autos)  One firm is more efficient than many (utilities: electricity or telephone) (from a public policy perspective)  The isoquants get closer together

48. Chapter 6Slide 48 Returns to Scale Labor (hours) Capital (machine hours) 10 20 30 Increasing Returns: The isoquants move closer together 510 2 4 0 A

49. Chapter 6Slide 49 Returns to Scale Measuring the relationship between the scale (size) of a firm and output 2)Constant returns to scale: output doubles when all inputs are doubled  Size does not affect productivity (travel agency)  May have a large number of producers  Isoquants are equidistant apart

50. Chapter 6Slide 50 Returns to Scale Labor (hours) Capital (machine hours) Constant Returns: Isoquants are equally spaced 10 20 30 15510 2 4 0 A 6

51. Chapter 6Slide 51 Returns to Scale Measuring the relationship between the scale (size) of a firm and output 3)Decreasing returns to scale: output less than doubles when all inputs are doubled  Decreasing efficiency with large size  Reduction of entrepreneurial abilities  Isoquants become farther apart

52. Chapter 6Slide 52 Returns to Scale Labor (hours) Capital (machine hours) Decreasing Returns: Isoquants get further apart 10 20 510 2 4 0 A

53. Chapter 6Slide 53

54. Chapter 6Slide 54

55. Chapter 6Slide 55 Summary A production function describes the maximum output a firm can produce for each specified combination of inputs. An isoquant is a curve that shows all combinations of inputs that yield a given level of output.

56. Chapter 6Slide 56 Summary Average product of labor measures the productivity of the average worker, whereas marginal product of labor measures the productivity of the last worker added.

57. Chapter 6Slide 57 Summary The law of diminishing returns explains that the marginal product of an input eventually diminishes as its quantity is increased.

58. Chapter 6Slide 58 Summary Isoquants always slope downward because the marginal product of all inputs is positive. The standard of living that a country can attain for its citizens is closely related to its level of productivity.

59. Chapter 6Slide 59 Summary In long-run analysis, we tend to focus on the firm’s choice of its scale or size of operation.

60. End of Chapter 6 Production