Adigrat University Department of Economics Microeconomics 2010E.

CHAPTER TWO

THEORY OF PRODUCTION

2.1. The Production Function

The production function is a purely technical relation which connects factor-inputs and outputs. It describes the
laws of proportion, which is the transformation of factor inputs into products (outputs) at any particular time
period. The production function represents the technology of a firm of an industry, of the economy as a whole.
The production function includes all the technically efficient methods of production.

A production function is a mathematical relationship between the quantities of inputs used and the maximum
quantity of output that can be produced with those quantities of inputs.

The firm’s production function for a particular good (X) shows the maximum amount of the good that can be

produced using alternative combinations of capital (K) and labor (L) x = f(K,L)

The Short and Long run Production Theories

The production function describes the relationship between inputs and output. In other words it is the process of
using the services of different inputs to obtain output. From this definition it follows that the production function
 Adigrat University Department of Economics Microeconomics 2010E.C

is the relationship between any combinations of input services and the maximum output attainable, given the
technology.

The Period of Production

The production period, during which the output level can depend on the condition of the input combinations, is
divided into two: short run and long run.

 (A) Short run

In the short run a firm’s plant capacity is assumed to be fixed. The term short run refers to a period of time in
which producers are able to change the quantity of some, but not all of the resources they employ. It is a period in
which some resources (usually plant) are fixed and some are variable.

Variable inputs are inputs whose use must change for output to change. Fixed inputs are those inputs whose use is
constant regardless of the level of output. For example, in the corn production fertilizer, seeds, insecticides and
gasoline are variable inputs while farm buildings, machinery and truck are fixed inputs.

The Law of Diminishing Returns

As successive increments of a variable resource are added to fixed resources, the marginal product of the variable
resource will eventually decrease. The law of diminishing returns indicates that, beyond some point, output will
 Adigrat University Department of Economics Microeconomics 2010E.C

increase by diminishing amounts as more units of a variable resource (labor) are added to a fixed resource
(capital).

The Stages of Production

As more and more of an input are supplied, the effect of this addition on production changes and the change is
explained by three stages.

Stage I – the quantity of output increases more rapidly than the quantity of the input (increasing marginal
returns),

Stage II – the quantity of output increases less rapidly than the quantity of the input (diminishing marginal returns),
and

Stage III – the quantity of output declines as the quantity of the input increases (negative marginal returns)

Among these stages of production Stage II, being the stage where profit maximization takes place, is the most
relevant one. Observe that not all production processes have all the three stages of production.

Short run Production Functions

 Adigrat University Department of Economics Microeconomics 2010E.C

 Total, Average and Marginal Products

 Total Product

The total product shows the relationship between the amounts of an input used and how much is produced.

Table 1: Total, Average and Marginal Schedules

Number Total Marginal Average

of Product Product
Workers Product Stages
Number Tones Tones Tones
0 0 - -
1 20 20 20
2 50 30 25
3 90 40 30

I
4 120 30 30
5 140 20 28
6 150 10 25
7 150 0 21.43

II
8 140 -10 17.5
9 120 -20 20

III
Adigrat University Department of Economics Microeconomics 2010E.C

The above table and the figure below show how much corn can be produced as the variable inputs used, the
number of workers employed, varies when it is used together with the fixed inputs, land.

The total product curve for corn production

150

140
Total Product
120 Curve
90

50

20 Stage I Stage II Stage III

0
0 1 2 3 4 5 6 7 8 9
Number of employed workers

A unit increase in labor initially has an increasing corn yields up to the fourth unit of labor, in the first stage of
production – increasing marginal returns. At the fifth point the average product is at its maximum value. Starting
from the fifth unit of labor, as the input increases by one unit, corn production still increases but at a decreasing
rate, i.e., each additional increment on labor generates a smaller increase in output than the last, this is exhibited
in the second stages of production – diminishing marginal returns. This continues until output reaches its
 Adigrat University Department of Economics Microeconomics 2010E.C

maximum, i.e., the second stage provides the optimum amount of labor at the eighth unit of labor. Any further
additional labor unit after this point will result in a decline in output, such a movement happens at the third stage
of production - negative marginal returns.

 Average Product

Average product (AP) is the total output produced per unit of a resource employed (total product divided by the
quantity of that employed resource) and indicates the productivity of the input used. The formula is given by

Quantity of Output Q
AP   o
Quantity of Variable Input Qi

At low levels of labor unit, as the amount of labor is increased, the corn output per unit of labor also increases
and reaches its maximum value at the end of Stage I of the production function. Additional amounts of labor in
Stage II still increase corn production, but output is increasing at a decreasing rate. This implies that at the second
stage the AP falls although output increases until total product reaches at its maximum at the end of Stage II.
Even in Stage III, where increasing more labor results in a decrease in corn production, the AP continues to fall
and becomes smaller and smaller but never has a value of zero.
 Adigrat University Department of Economics Microeconomics 2010E.C

Corn product
The AP and MP curves

40
30
25
20
15 AP
5
0 Stage I Stage II Stage III
-10 1 2 3 4 5 6 7 8 9 1
-20
-30
X=0.02K2L2111111111111111111111111111
Labor input
111111111=0.02K2L2

 Marginal Product

The additional output produced when one additional unit of a resource is employed (the quantity of all other
resources employed remaining constant); equal to the change in total product divided by the change in the
quantity of a resource employed.
 Adigrat University Department of Economics Microeconomics 2010E.C

 Quantity of Output Qo

MP  
 Quantity of Variable Input Qi

The MP is the change in the TP (corn) for a one-unit change in the input (labor).

Important Relationships

(a) Between TP and MP

 As MP is increasing TP is also increasing at the increasing rate.

 As MP starts to decline TP still increases but at a decreasing rate.
 As MP becomes zero TP reaches a maximum point
 As MP becomes negative TP starts to decline

(b) Between MP and AP

 When MP > AP, AP is increasing ,i.e. the MP curve (broken line) lies above the AP curve
 when MP = AP, AP is at its maximum ,i.e., AP crosses MP
 when MP < AP, AP is falling, i.e. MP lies below AP
 Adigrat University Department of Economics Microeconomics 2010E.C

 (B) Long run

 In the long run a firm can vary its plant size and firms can enter or leave the industry. A period of time long
enough to enable producers of a product to change the quantities of all the resources they employ. It is a period,
in which all the resources and costs are variable and no resources or costs are fixed.

The actual period of time that is required to vary the plant size or to change the quantities of fixed inputs is likely
to vary from industry to industry. In sum industries it might take less than a year while in others it might take a
decade or more. Long run time period is considered as a planning period during which the firm can make a plan

whether to change the use of fixed inputs. And the production function is as follows x = f(K,L)

Cobb-Douglas Production Function

The Cobb-Douglas Production function is the most popular long-run production function .Mathematically the
Cobb-Douglas function is of the form

X  b0 .Lb1 .K b2
 Adigrat University Department of Economics Microeconomics 2010E.C

To indicate magnitude of production function we allow parameters to take arbitrary values. The parameter b
measures, the scale of production: how much output we would get if we used one unit of each input. The
parameter b1 and b2 measure how the amount of output responds to the changes in the input.

1. The Marginal Product of factors

a. The MPL

X b 1
MPL   b1.b0 .L 1 , K b1
L

b b A
= b1 (b0 L 1 K 2 ) L

X
= b1.  b1 ( APL )
L

Where APL = the average product of labor

b. Similarly
 Adigrat University Department of Economics Microeconomics 2010E.C

X
MPK  b2 .  b2 ( APK )
K

Isoquant

 Isoquant means any combination of labor and capital along a given isoquant allows the firm to produce the same
quantity of output.

 An isoquant shows those combinations of K and L that can produce a given level of output (X0) f(K,L) = X0

 The slope of an isoquant is marginal rate of technical substitution (RTS) and shows the rate at which L can be
substituted for k

 Given a single product X and its product function as follows f(K,L) = X0

 Adigrat University Department of Economics Microeconomics 2010E.C

 Take the total differential of the production function:

Adigrat University Department of Economics Microeconomics 2010E.C

f f
dx   dL   dK  MPL  dL  MPK  dK
L K

MPL  dL   MPK  dK

 dK MPL
RTS ( L for K )  
dL x  x0 MPK

2.2 LAWS OF PRODUCTION

The laws of production describe the technically possible ways of increasing the level of production. Output may
increase in various ways.

Output can be increased by changing all factors of production. Clearly this is possible only in the long run. Thus
the laws of returns to scale refer to the long run analysis of production.

In the short run output may be increased by using more of the variable factor(s), while capital (and possibly other
factors as well) are kept constant. The marginal product of the variable factor(s) will decline eventually as more
and more quantities of this factor are combined with the other constant factors. The expansion of output with one
Adigrat University Department of Economics Microeconomics 2010E.C

factor (at least) constant is described by the law of diminishing returns of the variable factor, which is often
referred to as the law of variable proportions.

2.2.1 LAWS OF RETURNS TO SCALE: Long-run Analysis of Production.

The long run expansion of output may be achieved by varying all factors. In the long run all factors are variable.
The laws of returns to scale refer to the effects of scale relationships.

In the long run output may be increased by changing all factors by the same proportion, or by different
proportions. Traditional theory production concentrates on the first case that is the study of output as all inputs
change by the same proportion. The term returns to scale refers to the changes in output as all factors change by
the same proportion.

Suppose we start from an initial level of inputs and output.

X 0  f ( L, K ) And we increase all the factors by the same proportion k, we will clearly obtain a new level of

output X*, higher than the original level X0,

X *  f ( mL, mK )
Adigrat University Department of Economics Microeconomics 2010E.C

If X* increases by the same proportion as the inputs, we say that there are constant returns to scale.

If X* increases less than proportionally with the increase in the factors, we have decreasing returns to scale.

If X* increases more than proportionally with the increase in the factors, we have increasing returns to scale.7I

Returns to scale and Homogeneity of the Production Function

Suppose we increase both factors of the function

X0 = f(L,K

by the same proportion k, and we observe the resulting new level of outputx.

X* = f(mL,mK)

If k can be factored out (that is may be taken out of the brackets as a common factor), then the new level of
output X* can be expressed as a function of k and the initial level of output

X* = kvf(L,K) or X* = kv.X0
 Adigrat University Department of Economics Microeconomics 2010E.C

And the production function is called homogeneous. If k cannot be factored out, the production is non-
homogeneous. Thus a homogeneous function is a function such that if each of the inputs is multiplied by k, then k
can be completely factored out of the function. The power v of k is called the degree of homogeneity of the
function and is a measure of the returns to scale. This production function sometimes called linear homogeneous.

 If v < 1 we have decreasing returns to scale.

 if v > 1 We have increasing returns to scale
 If v = 1 we have constant returns to scale.

2.3 CHOICE OF OPTIMAL COMBINATION OF FACTORS OF PRODUCTION

In this section we shall show the use of the production function in the choice of the optimal combination of
factors by the firm. In part a firm will examine two cases in which the firm is faced with a single decision,
namely maximizing output for a given cost and minimizing cost subject to a given output. Both these decisions
comprise cases of constrained profit maximization in a single period.

In above cases it is assumed that the firm can choose the optimal combination of factors, that it can employ any
amount of any factor in order to maximize its profits. This assumption is valid if the firm is new, or if the firm is
in the long-run. However, an existing firm may be pressurized, due to pressure of demand, to expand its output
in the short-run, when at least one factor, usually capital, is constant.
 Adigrat University Department of Economics Microeconomics 2010E.C

A. Short-run Decision of the Firm

The problem facing the firm is that of constrained output maximization with single variable input and other
incomes being fixed. Hence the firm decides to hire a level of input in which the marginal product the variable
input is equal to its price. Mathematically if let the variable input is labor, the condition is MP L=W, where W is
wage

Example 2.1

Let the production function is for product x is as follows; x=0.02k 2L2 and the respective prices of capital and
labor are 6 and12 respectively. The firm’s short-run total cost is 90 birr being capital is fixed at 10.

(a) Find the optimal level of labor that maximizes output.

(b) Find the maximum output of x.

Solutions

A) Constructing the langrage function

  0.02 K 2 L2   (90  6 K  12 L)

  2 L2   (30  12 L)
 Adigrat University Department of Economics Microeconomics 2010E.C


 4 L  12  0
L
4 L  12
L3

B) The maximum output will be

x=0.02k2L2

x=0.02(10)2(3)2

x=18 unit

B. Long run decision

But the long-run decision of the firm follows the condition

MU L w dK
  = MRSL,K
MU K r dL

The iso-cost line is defined by the cost equation

C  (r )( K )  ( w)( L) And the slope=w/r

Adigrat University Department of Economics Microeconomics 2010E.C

Where w = wage rate, and r = price of capital services

The iso-cost line is the locus of all combinations of factors the firm can purchase with a given monetary
cost outlay.

The slope of the iso-cost line is equal to the ratio of the price of the factors of production. Slope of isocost line =
w/r

Maximization of output subject to a cost constraint (Financial constraint)

Assume (a) A given production function X = f (L, K)

and (b) given factor prices w, r, for labor and capital respectively.

The firm is in equilibrium when it maximizes its output given its total cost outlay and the prices of the factors, w
and r.

In fig.3 the maximum level of output the firm can produce, given the cost constraint, is X 2 defined by the
tangency of the isocost line, and the highest isoquant. The optimal combination factors of production is K2 and
Adigrat University Department of Economics Microeconomics 2010E.C

L2, for prices w and r. Higher levels of output (to the right of e) are desirable but not attainable due to the cost
constraint.

X3
K
X2

K2 e

0 L2 B L
Fig. 3

Other points on ABO, below it lie on a lower isoquant than X2. Hence X2 is the maximum output possible under
the above assumptions (of given cost outlay, given production function, and given factor prices). At the point of
tangency (e) the slope of the isocost line (w/r) is equal to the slope of the isoquant (MP L/MPK). This constitutes
the first condition for equilibrium. The second condition is that the isoquants be convex to the origin. In
summary: the conditions for equilibrium of the firm are:
 Adigrat University Department of Economics Microeconomics 2010E.C

(a) Slope of isoquant = Slope of isocost

w MPL X / L
   MRS L , K
r MPK X / K

(b) The isoquants must be convex to the origin; if the isoquant is concave the point of tangency of the isocost
curves does not define an equilibrium position Fig.3

Example

Given the above example in short run decision. By relaxing the assumption that capital fixed since it is long run
capital is now variable.

A. Find the optimal values of capital and labor.

B. Find the maximum output
 Adigrat University Department of Economics Microeconomics 2010E.C

Solutions

A. Constructing a langrage function as follows

  0.02 K 2 L2   (90  6 K  12 L)


 0.04 KL2  12  0
k
0.04 KL2

12

And
 Adigrat University Department of Economics Microeconomics 2010E.C


 0.04 K 2 L  6  0
L
0.04 K 2 L

6
 
0.04 KL2 0.04 K 2 L

12 6
2
0.04 KL 12

0.04 K 2 L 6
L 12

K 6
L  2K
C  6 K  12 L
90  6 K  12 L
90  6 K  12( 2 K )
90  30 K
K 3
L  2 K  2(3)  6

Hence the firm hires 3 labor and 6 capital to maximizes his output.

B. The maximum total product is

X=0.02K2L2

X=0.02(3)2(6)2

X=0.02*9*36
Adigrat University Department of Economics Microeconomics 2010E.C

X=6.48unit is the maximum output of x