The Production Function

Introduction
The firm is the most important agent in the
economy that makes decisions about the
production of the specific goods or services in
which it specializes.
The firms’ options are affected by the market
structure in which they operate.
They also have to make supply decisions in the
light of their costs of production.
The Production Decision of a Firm

Production Technology: Produce a level of

output using different combinations of inputs.

Cost Constraints: Firms may take into account

the prices of labor, capital, and other inputs.

 Input Choices: Given the technology and input

prices, the firm must choose how much of each
input to use in producing its output.
 Inputs
 Firm needs inputs in order to increase production.

 Types of Inputs: Variable Inputs and Fixed Inputs.

 Variable Inputs: Quantity of inputs varies with output produced.

 FixedInputs: Quantity of inputs do not vary with output

produced in the short-run.
 Short Run variations in Inputs
 The short run is a period of time over which some inputs
cannot be varied.

 Fixed inputs cannot vary in the short run.

Some Industries may acquire machinery in few Weeks.

 Long Run variations in Inputs
 The long run is a period of time over which all the inputs can
be varied.

 Fixed inputs also vary in the long run.

Companies set up new manufacturing plants for production.

 Production Function: Automobile
Industry
Production Function shows the maximum output of a
commodity that a firm can produce per period of time with
each set of inputs.
 Production Function: Automobile
Industry
Quantity produced = f(F1, F2, F3, F4, F5,…)
Labor
Plant and Machinery (e.g. Cobots/Robots)
Raw materials: Steel, Plastics, Aluminum, Rubber.
Components
Electricity

Production Function is the technological relation between quantity

of inputs and quantity of outputs that a firm produces.

 Technology is assumed to remain constant during the period of

analysis.
The production function relates physical quantities of
inputs to the quantity of output.

A production function is a functional specification that

provides the most efficient combination of input with
which a chosen target level of output can be produced.

It is specific to each industry and technology.

 Inputs and outputs are flows.

Production functions change when the technical

process of production change leading to an entirely
different set of input combinations related in an entirely
different manner.

 Production function describe what is technically

feasible when the firm operates efficiently.
A production function is an equation, table or
graph showing the maximum output of a
commodity that a firm can produce per period of
time with each set of inputs. Technology is
assumed to remain constant during the period of
analysis

Q=f(L,K)

The Production Function

 Labor and Capital can be substituted for each other in production.

 Input prices determine which combination of L and K is cheaper.

 The output that the firm will want to produce is the one that
maximizes its profits.

The Production Function

What can production functions tell us?
1. Marginal product
Change in output per unit change in input (evaluated at a given
point, holding other inputs constant)

2. Average product
Average output per unit of input
Marginal product of a factor is the amount of additional
output it produces with a unit increase in the amount of
that factor, other things held constant.

Thus, marginal product of labour (MPL) is

MPL =  TP /  L = (TP1 – TP0)/(L1 – L0)

TP is total product.

Marginal Product
Average product of a factor is the amount of
output produced by per unit of the factor
employed.

Thus, average product of labour (APL) is

APL = TP/L

Average Product
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

Calculate Average Product and Total Product

Labor Output or Total Product
(number of workers)
0 0
1 15
2 40
3 69
4 96
5 120
6 138
7 147
8 152
9 153
10 150
11 143
12 133
Q: How many people can work in this Kitchen?
BIG KITCHEN
 Calculate Average Product and Total Product
Amount of Amount of Total AP MP
Labor (L) K Output
0 10 0 - -
1 10 15 15 15
2 10 40 20 25
3 10 69 23 29
4 10 96 24 27
5 10 120 24 24
6 10 138 23 18
7 10 147 21 9
8 10 152 19 5
9 10 153 17 1
10 10 150 15 -3
11 10 143 13 -7
12 10 133 11.08 -10
PRODUCTION WITH ONE VARIABLE INPUT
(LABOR)
Law of Diminishing Marginal Returns
Stage I: both MPL and APL are
increasing and MPL reaches it
maximum

Stage II: MPL falling and APL

rising, APL reaches its maximum

Stage III: both MPL and APL are

falling and MPL becomes zero

Stage II and III are the stages

of Law of Diminishing Returns
 Law of Diminishing Marginal Returns
It is assumed that all labor inputs are of
equal quality.

The law of diminishing marginal returns

results from limitations on the use of all other
fixed inputs,not from quality of labor.

The law describes a declining marginal

product but not necessarily a negative one.
Relation between AP and MP
Let Q is a Quantity and x is Labor, then AP=Q/x, and
MP=dQ/dx
The law of diminishing return states that as we
use more and more units of the variable input
with a given amount of the fixed input, after a
point we get diminishing returns from the
variable input.
That is, as the firm uses more and more units of
the variable input with the same amount of the
fixed input, each additional unit of the variable
input has less and less of the fixed input to work
with and, after a point, the marginal product of
the variable input declines.
 The range from the origin to the point where the AP is maximum
is Stage I of Production for Labor.
 Stage II of production of labor extends from the point where AP is
maximum to the point where MP is zero.
 The range over which MP is negative is Stage III of production for
Labor.
 The rational producer will not operate in Stage III , even if labor
was free as MP is negative. This means that a greater output or
TP could be produced by using less labor.
 Similarly, stage I for Labor corresponds to Stage III of capital.
 The rational producer will operate in Stage II where the MP of
both factors is positive, but declining. The precise point within
Stage II at which the rational producer operates will depend on
the prices of inputs and output.
Q: How much labor should the firm use
in order to maximize profits?
 Optimal Use of the
Variable Input
Marginal Revenue MRPL = (MPL)(MR)
Product of Labor
Marginal Resource TC
MRCL =
Cost of Labor L

Optimal Use of Labor MRPL = MRCL

The firm should employ an additional unit of labor as long as the extra
revenue from the sale of output exceeds the extra cost of hiring the
unit of labor. Thus, a firm should continue to hire labor as long as
MRPL > MRCL and until MRPL = MRCL
 Few Questions

• How a firm can choose a combination of inputs that

generate same inputs?
An isoquant is a curve on which every
point satisfies the production function and
thus, all combination of L and K on an
isoquant are technically efficient
combination with which the given level of
output can be produced.
Each isoquant corresponds to a different
level of output.

Production Function with Two

Variable Inputs (long Run)–
Production Isoquant
 Isoquants
 Graphical representation of production function
 A curve drawn through the technically feasible
combinations of inputs to produce a target level of
output

 Marginal rate of technical substitution is the

substitution of one input for another. MRTS = -
change in K/change in labor
 Properties of Isoquants
 They are downward sloping – That is as you employ
more and more of the input on the X axis, you
necessarily employ less of the input on the Y axis in
order to maintain the same level of output. Employing
more of both inputs would lead to a higher isoquant.

 They are convex to the origin – This happens as the

power to substitute diminishes, called as the marginal
physical product as we employ more and more of a
factor. However, in case of perfect substitutes the
isoquant is a downward sloping straight line with a
constant slope, while for perfect complements the
isoquant is a L shaped curve.
Properties of Isoquants
 They do not intersect each other

Application of Isoquants
 Isoquants enable the decision maker to
conceptualize the trade-offs involved in
substitution between inputs. Managers consider
the costs and benefits of substituting one input
for another and select that one where the net
benefits are maximised.
 Isoquant model helps the decision maker to figure
out the increase /decrease in output with a
change in input.
 Input Flexibility
Important for Managers to understand the nature of this
flexibility.

Replacement of
waiters with Robot
waiters in
restaurants.
Diminishing Marginal Returns
Production with Two Variable Inputs

Marginal Rate of Technical Substitution

MRTS = -K/L = MPL/MPK

Within, the economically relevant range, isoquants are
negatively sloped and convex to the origin.
The reason is that as the firm moves down an isoquant and uses
more labor and less capital, the MP of labor declines and the
MP of capital increases (since the firm is in Stage II for both
labor and capital). With the MPL and the MPK rising as we
move down along an isoquant, the MPL/MPK
= MRTS will fall (thus, the isoquant is convex to the origin)
 Production Analysis with Calculus

• Constrained Output Maximization

• Constrained Cost Minimization

Question: Given: Q=100K0.5 L0.5 , C*=$1000, w=$30,

and r=$40. Determine the amount of labor and capital
that firm should use in order to maximize. What is the
level of output?
Example: A Production Function for Wheat
 Optimal Combination of Inputs

Isocost lines represent all combinations of two inputs

that a firm can purchase with the same total cost.

C wL  rK C Total Cost

w Wage Rate of Labor ( L )
C w
K  L r Cost of Capital ( K )
r r
Returns to Scale
 The rate at which output increases to a proportionate
change in all inputs is known as the degree of returns to
scale. Increasing output given constraints of technology
means moving from one isoquant to another.
 Increasing Returns to Scale - When output increases by a
proportion greater than the proportionate increase in all
inputs. Specialization and division of labor assists in being
in this stage. Thus the decline in long run average costs
must occur, as output is increasing more than in
proportion to inputs as the scale of firm’s production
expands.
 Decreasing returns to scale – Output increases by a
proportion less than that of the increase in inputs.
 Constant returns to scale – Output increases by the same
proportion as the increase in inputs.
Returns to scale measures the relationship between change in
output with equi-proportionate change in both the inputs,
capital and labour, given the state of technology.
It is a long run concept
Suppose, both inputs are doubled. Then, returns to scale is
expressed as

 Q  f ( 2 L, 2 K )
where  > 2, or  2 may hold.

Returns to Scale
 Types of Returns to Scale
 Increasing Returns to Scale (IRS) - Increase in output
is more than proportional to the increase in inputs.  >
2.

Constant Returns to Scale (CRS) - Increase in output

is equi-proportionate to the increase in inputs.  = 2.

DecreasingReturns to Scale (DRS) - Increase in

output is less than proportionate to the
increase in inputs.  < 2.
 Problems 1-3
 Mini Cases- 3
 Problem 4

The relationship between output per hour (Q) and the

number of workers (L) and machines (K) used per hour is
Q=10(LK)0.5

The wage of a worker is $80 per hour, and the price of a

machine is $20 per hour. If the company produces 800 units
of output per hour, how many workers and machines should
managers use?
 Problem 5
The production function for the personal computers of company
A is given by
q = 10K0.5L0.5
where q is the number of computers produced per day, K is hours
of machine time, and L is hours of labors input. Another,
company B is using the production function
q = 10K0.6L0.4
a.If both companies use the same amounts of capital and labor,
which will generate more output?
b. Assume that capital is limited to 9 machine hours, but labor is
unlimited in supply. In which company is the marginal product
of labor greater? Explain.
 Problem 6

The marginal product of labor in the

production of computer chips is 50 chips
per hour. The marginal rate of technical
substitution of hours of labor for hours of
machine capital is ¼. What is the marginal
product of capital.
 Problem 7
Suppose a chair manufacturer is producing in the
short run. The manufacturer has observed the
following levels of production corresponding to
different numbers of workers:
Number of Workers Number of Chairs
1 10
2 18
3 24
4 28
5 30
6 28
7 25

Compute Average Product and Marginal Product for each level of

worker.
 Problem 8
Fill in the gaps in the table below:

Quantity of Total MP AP
Variable Output
Input
0 0 - -
1 225
2 300
3 300
4 1140
5 225
6 225