Lecture - 4: Production
Abdul Quadir
XLRI
September 10, 2020
Readings
Chapters 6 of the Textbook
Production
I Production: The process by which inputs are combined,
transformed, and turned into outputs
I Firm: An organization that comes into being when a person
or a group of people decides to produce a good or service to
meet a perceived demand
I Most firms exist to make a profit
I To maximize profits, all firms make the following decisions to
achieve this:
1. How much output to supply?
2. Which production technology to use?
3. How much of each input to demand?
I A profit-maximizing firm chooses the technology that
minimizes its costs for a given level of output
Production Process
I Production process transform inputs into outputs
I Production technology: The quantitative relationship
between inputs and outputs
I Labor-intensive technology Technology that relies heavily
on human labor instead of capital
I Capital-intensive technology Technology that relies heavily
on capital instead of human labor
Production Function
I The technology available for converting capital and labour
into output is summarized in the production function
I The production function is an engineering relation that
defines the maximum amount of output that can be produced
with a given set of inputs
I In other words, production function is a numerical or
mathematical expression of a relationship between inputs and
outputs
I It shows units of total product as a function of units of inputs
I Mathematically,
Q = f (K , L)
Production Set
I The production function in equation Q = f (K , L) tells us the
maximum output a firm could get from a given combination
of labor and capital
I Consider a production function with input only, Q = f (L)
I We can invert the production function and can write
L = f (Q)
I This is known as labor requirements function
√
I For instance, if Q = L, then L = Q 2
Technical Efficiency
Q
Technical efficient
Q = f (L)
B
A D
Technical inefficient
L
Production Function with Single Input
increasing
marginal returns
decreasing diminishing
marginal total
returns returns
L∗ L∗∗ L
Total Product
L Q
0 0
1 76
2 248
3 492
4 784
5 1100
6 1416
7 1708
8 1952
9 2124
10 2200
11 2156
Productivity
I The measurement of productivity are very important for
managerial decisions
I Three important measures of productivity:
1. Total product (TP): maximum level of output produced with
a given amount of inputs
2. Average Product (AP): AP of an input is the ratio of total
product to the amount of inputs used,
Q Q
APL = APK =
L K
3. Marginal Product (MP): The additional output that can be
produced by adding one more unit of a specific input,
∆Q dQ ∆Q dQ
MPL = = MPK = =
∆L dL ∆K dK
Average Product
What is AP at L0 ?
It is the slope of the line from origin to point A
Q Where does AP attain its maximum?
TP
A
Q0
L0 L
Average Product
What is AP at L0 ?
It is the slope of the line from origin to point A
Q Where does AP attain its maximum?
TP
A
Q0
L0 L
Marginal Product
What is MP at L1 ?
It is the slope of the line from A and B
Q Where does MP attain its maximum?
TP
L1 L
Marginal Product
What is MP at L1 ?
It is the slope of the line from A and B
Q Where does MP attain its maximum?
TP
L1 L
Total product
∆Q Q
L ∆L Q ∆L L
0 - 0 - -
1 1 76 76 76
2 1 248 172 124
3 1 492 244 164
4 1 784 292 171
5 1 1100
6 1 1416
7 1 1708
8 1 1952
9 1 2124
10 1 2200
11 1 2156
Relationship between AP and MP
As soon as AP is increasing, MP > AP
As soon as AP is decreasing, MP < AP
MP intersect AP at the point where AP attains maximum
Lf 0 (L)−f (L)
dAP
dL = L2
= 0 ⇒ f 0 (L) = f (L)
L
B
A
AP
O
Q
MP
Production with two Inputs
I One input production function is just for intuitive
understanding
I Consider a production Q = f (K , L)
I A fixed level of output could be produced with different
combination of labour and capital
I Like the indifference curves, we can draw a curve for a fixed
level of output with various combination K and L
I This curve is known as isoquant
Isoquants and Isocosts
Isoquant
K
L
Maps of Isoquants
Q3
Q2
Q1
L
Isoquants
I Isoquant: A graph that shows all the combinations of capital
and labor that can be used to produce a given amount of
output
I The downward slope isoquants shows that trade-off between
capital and labour
I Consider the production function whose equation is given by
the formula √
Q = KL
What is the equation of the isoquant corresponding to
Q = 20?
I
∆Q ∂Q
MPL = =
∆L K is held constant ∂L
∆Q ∂Q
MPK = =
∆K L is held constant ∂K
Construction of Isoquant
K
uneconomic region
MPK < 0
MPL < 0
economic region Q2
Q1
L
Marginal Rate of Technical Substitution
I marginal rate of technical substitution of labour for
capital (MRTSL,K ): The rate at which a firm can substitute
capital for labor and hold output constant
I In other words:
I The rate at which the quantity of capital can be decreased for
every one-unit increase in the quantity of labor, holding the
quantity of output constant, or
I The rate at which the quantity of capital must be increased
for every one-unit decrease in the quantity of labor, holding
the quantity of output constant.
I
∆K
MRTSL,K = −
∆L
Diminishing Marginal Rate of Technical Substitution
I MRTSL,K gets smaller and smaller as we substitute capital
with more labors.
I This property is known as diminishing marginal rate of
technical substitution
I Connection between MRTSL,K and MPL and MPK :
∆Q = change in output from change in quantity of capital
+ change in output from change in quantity of labor
= MPK × ∆K + MPL × ∆L
I For a given isoquant, ∆Q = 0, thus,
0 = MPK × ∆K + MPL × ∆L
∆K MPL
− = = MRTSL,K
∆L MPK
