PRODUCTION
• How firms make production decisions?
• How do firms optimally choose the quantity
and types of inputs to use in the production
process.
• How many units of a product to produce?
• In what combination are inputs to be used for
production?
• We assume that production process utilizes
two inputs— capital (K)and labor (L) to
produce output (Q)
• Technology available for converting K and L
into Q is summarized in the production
PRODUCTION
FUNCTION function
• Production function defines the maximum
amount of output that can be produced with a
given set of inputs
• How do firms meet unforeseen increase in
demand??
• Does output adjust instantaneously to change
in demand??
• Can a firm vary all the inputs to meet
unforeseen changes in demand
• Short run: time frame over which at least one
of the factors cannot be changed
SHORT RUN ₋ Fixed factors of production
VS ₋ Variable factors of production
LONG RUN
• Long Run: time horizon over which all the
inputs used in the production
• Total Product: The maximum level of output
that can be produced with a given amount of
inputs
• Average Product: output produced per unit of
MEASURES OF input
PRODUCTIVITY and
• Marginal Product: change in total output
attributable to the last unit of an input
and
K* L Q
2 0 0 - -
2 1 76 76 76
2 2 248 124 172
2 3 492 164 244
2 4 784 196 292
2 5 1100 220 316
2 6 1416 236 316
2 7 1708 244 292
2 8 1952 244 244
2 9 2124 236 172
2 10 2200 220 76
2 11 2156 196 – 44
Increasing Decreasing Negative
TP marginal marginal marginal
AP returns to labor returns to labor returns to labor
MP
Total product (TP) The law of diminishing
marginal returns: the
MP of an input declines
as more of that input is
used along with fixed
factors of production
Average product (APL)
0 Marginal product (MPL) Labor
(holding capital constant)
• Ensure that the firm operates on the
production function
ROLE OF • Ensure that the firm uses the correct level of
MANAGERS inputs
IN THE – To maximize profits, a manager should
PRODUCTION
PROCESS use inputs such that the marginal benefit
from using the input equals the marginal
cost.
• The cost of each additional unit of labor is
wage paid (w)
ROLE OF • The benefit of each additional unit of labor is
MANAGERS
value marginal product (VMP) of labor
IN THE
PRODUCTION • The VMP of an input is the value of the
PROCESS output produced by the last unit of that input
and
L
0 - -
1 76 228
2 172 516
3 244 732
4 292 876
Price of the product (P) = $3 5 316 948
Wage (w) = $400
6 316 948
7 292 876
8 244 732
9 172 516
10 76 228
11 – 44 -132
Linear Production Function
ALGEBRAIC • assumes a perfect linear relationship between
FORMS OF all inputs and total output
PRODUCTION • implies that inputs are perfect substitutes
FUNCTIONS
Leontief Production Function
ALGEBRAIC • assumes that inputs are used in fixed
FORMS OF proportions
PRODUCTION • implies that inputs are perfect complements
FUNCTIONS
Cobb-Douglas Production Function
ALGEBRAIC • assumes some degree of substitutability
FORMS OF between the inputs (not perfect
PRODUCTION substitutability)
FUNCTIONS
If the production function is of the form
• Find AP, MP of capital and labor
PROBLEM • If capital is fixed at 1 unit in the short run,
how much labor should the firm employ to
maximize profits if the wage rate is $2, and
price of the product produced is $10
1/ 2 1/ 2
𝑄=𝐾 𝐿
PROBLEM:
SOLUTION
1/ 2 1/ 2
𝑄=𝐾 𝐿
PROBLEM:
SOLUTION
If ,
PROBLEM: For profit maximization:
SOLUTION
• How is optimal choice of capital and labor in
the long run different.
• E.g. an automobile assembly line can produce
1,000 cars per hour by using 10 workers and
one robot or only two workers and three
robots
ISOQUANT • Isoquant is a tool that helps in understanding
how alternative inputs can be used to produce
output
• Isoquant defines the combinations of inputs
(K and L) that yield the producer the same
level of output
Capital
A
𝐾1
𝑄3
𝐾2 B
𝑄2
𝑄𝐼
ISOQUANT
0 𝐿1 𝐿2 Labor
• The slope of the IQ is given by marginal rate
of technical
• Movement substitution
from (MRTS); rate
A to B: substituting at L
K with
whichIQ
• Higher a producer
representscan substitute
higher levelsbetween two
of output
inputs and maintain the same level of output
MRTS can be expressed in terms of and
MRTS AND MP Along an IQ the total
ALTERNATIVE
PRODUCTION
FUNCTION AND • The shape of the IQ depends on the
ISOQUANTS production function
• Linear production function assumes inputs
are perfect substitutes
and
• MRTS is constant for linear production
function
• This implies isoquants will be linear
ALTERNATIVE
PRODUCTION
FUNCTION AND
ISOQUANTS • Leontief production function assumes inputs
are used in fixed proportion
• This implies that you cannot substitute
between capital and labor and maintain the
same level of output and hence there is no
MRTS
• Isoquants will be L shaped
Capital Input
A
∆𝐾 3
3 =− =− 3
∆𝐿 1
B
∆𝐾 1
C =− =−1
∆𝐿 1
DIMINISHING ∆ 𝐾 =1 D
MRTS 𝑄0
0 ∆ 𝐿=1 ∆ 𝐿=1 Labor Input
• MRTS diminishes along an IQ – isoquants
are convex to the origin
• Isocosts describe the combinations of inputs
that costs the firm the same amount
• Isocost line represents the combinations of
ISOCOSTS inputs that will cost the producer the same
amount of money.
Capital Input
𝐶
𝑟
ISOCOST LINE
𝐶
0 𝐿 Labor Input
𝑤
• The slope of the isocost line is given by
Capital Input
1
𝐶
𝑟
0
𝐶
𝑟
CHANGES IN
ISOCOSTS
0 𝐶0 𝐶
1
Labor Input
𝑤 𝑤
• If the producer wishes to use more of both
inputs, more money must be spent
• For given input prices, isocosts farther from the
origin are associated with higher costs.
Capital Input
1
𝐶
𝑟
2
𝐶 𝐴
𝑟
𝑀𝑃 𝐿 𝑤
𝑀 𝑅𝑇𝑆= =
𝑀𝑃 𝐾 𝑟
𝐵
COST
MINIMIZATION
=100 units
1
0 𝐶2 𝐶 Labor Input
𝑤 𝑤
At cost minimization point the slope of the
isoquant is equal to the slope of the isocost line
• To minimize the cost of production, a firm
should employ inputs such that the marginal
rate of technical substitution is equal to the
ratio of input prices
COST
MINIMIZATION • To minimize the cost of producing a given level
of output, the marginal product per dollar spent
should be equal for all inputs
Terry’s Lawn Service rents five small push
mowers and two large riding mowers to cut the
lawns of neighborhood households. The marginal
product of a small push mower is three lawns per
day, and the marginal product of a large riding
mower is six lawns per day. The rental price of a
PROBLEM small push mower is $10 per day, whereas the
rental price of a large riding mower is $25 per
day. Is Terry’s Lawn Service utilizing small push
mowers and large riding mowers in a cost-
minimizing manner? If not suggest what they
should do to minimize cost
and
10 and
For cost minimization
PROBLEM
SOLUTION • The firm is not minimizing costs
• Since the MP per dollar spent on small push
mowers is higher the firm should use more of
these and less of large riding mowers
Capital Input
I
F Suppose wage increases
B
𝐾2
OPTIMAL INPUT A
SUBSTITUTION 𝐾1
𝑄0
H J
0 𝐿2 𝐿1 G Labor Input
To minimize the cost of producing a given level
of output, the firm decreases the use of the input
whose price increases and increases the use of
other inputs.
Suppose that a firm’s production function is
The cost of a unit of labor is Rs. 20 and the cost of a
unit of capital is Rs.80.
• The firm is currently producing 100 units of output
and has determined that the cost-minimizing
PROBLEM quantities of labor and capital are 20 and 5,
respectively. The firm now wants to increase
output to 140 units. If capital is fixed in the short
run, how much labor will the firm require?
• Find the optimal level of capital and labor required
to produce the 140 units of output in the long run.
Output to be produced in 140 and K=5
PROBLEM So,
SOLUTION
In the long run optimal level of labour and capital
will be given at
PROBLEM At optimal level:
SOLUTION Substiting in production function:
Managerial Economics and Business Strategy (Baye
and Prince)
READING -– Chapter 5
