MICROECONOMICS I

TOPIC IV :
PRODUCTION FUNCTION
(Chapter 6, GLS; Chapter 7, PR)
Purificación Granero Gómez
Universidad de Alcalá
ENI, Course 19-20, 2nd year, first term
 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

1. We now turn to the supply side (of the supply and demand model)

2. Firms as production economic agents

3. • How do firms decide whether and how much to produce?

4. • How do firms choose between inputs, such as capital and labor?

5. • How does the timeframe of analysis affect firm decisions?

 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

 Introduction
 The production function
 Production in the short-run
 Production in the long-run
 Returns to scales
 Microeconomics I – ENI
TOPIC IV: Production Function
INTRODUCTION: SOME CONCEPTS
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

• Inputs: Resources, such as labour, capital and raw material,

that firms use to produce goods or services.
• Output: goods or services produced by firms.
• Final goods are purchased by consumers (e.g., bread)
• Intermediate goods are used as inputs in other production processes
(e.g., wheat used to produce bread)
• Production: Transformation of inputs into outputs. Process by
which an entity turns raw inputs into a good or service.
• Technology: The way to use inputs to produce specific
amounts of output.
 Microeconomics I – ENI
TOPIC IV: Production Function
SIMPLIFYING ASSUMPTIONS
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

• The firm produces a single good

• The firm has already chosen which product to produce
• Firms minimize costs associated with every level of
production
• Necessary condition for profit maximization
• Only two inputs are used in production: capital and labor
• In the short run, firms can choose the amount of labor
employed, but capital is assumed to be fixed in total supply
 Microeconomics I – ENI
TOPIC IV: Production Function
SIMPLIFYING ASSUMPTIONS
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

• Output increases with inputs

• Inputs are characterized by diminishing returns
• If the amount of capital is held constant, each additional worker
produces less incremental output than the last, and vice versa
• The firm can employ unlimited capital and labor at fixed prices
• Capital markets are well functioning
 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

• Production function: (mathematical) relationship between

amount of output and various combinations of inputs.
It shows the maximum quantity of output that can be attained by the
firm for any given quantity of inputs.

Q = F(L,K)
where Q is the quantity of output, K is the quantity of capital, and L is
quantity of labor
Some examples: Q=10K+5L Linear production function
Q=K0.5L0.5 : Cobb-Douglas production function
 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

Short run versus long run

• The “short run” refers to the case in which the level of capital
is fixed.
• The “long run” refers to the period of time long enough to
allow firms to adjust the amount of every input used in
production. It varies according to the production process.
 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION IN THE SHORT RUN
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

In short run, the level of capital is fixed: Q cp  F(K, L)

How production changes as we vary the amount of labour ? Q = f(L)

 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION IN THE SHORT RUN
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

Technical efficiency: The firm is technically efficient if it produces as

much output as it can with the production function given the level of
inputs. (C and D)
Q =F(L,K)

Technical inefficiency: The firm is technically inefficient if it produces less

output than it can with the production function given the level of inputs.
(A and B)
Q < F(L,K)
 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION IN THE SHORT RUN
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

• Marginal product: refers to the additional output that a firm can

produce using an additional unit of an input
Marginal product of labor MPL = change in output (ΔQ ) resulting from a
one-unit change in labor inputs (ΔL)
When ΔL is very small, we can compute MPL as the derivative of Q with
respect to L:
∆𝑄 𝜕𝑄
𝑀𝑃𝐿 = =
∆𝐿 𝜕𝐿

Generally assumed to fall as more of an input is used (diminishing marginal

product)
 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION IN THE SHORT RUN
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

• Average product: refers to the total output divided by the total

amount of an input used
𝑄
𝐴𝑃𝐿 =
𝐿

Is there any relationship between the marginal and the average product?
 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION IN THE SHORT RUN
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

Example:
• Cobb-Douglas production function: Q=K0.5L0.5
• In the short run, K=4, so production function in the short run is:
Q=40.5L0.5  Q=2L0.5

𝜕𝑄 0.5−1 −0.5
1
𝑀𝑃𝐿 = = 2 ∗ 0.5𝐿 =𝐿 = 0.5
𝜕𝐿 𝐿
𝑄 2𝐿0.5 1
𝐴𝑃𝐿 = = = 2 0.5
𝐿 𝐿 𝐿
 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION IN THE SHORT RUN
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

(a) MPL is the slope of the production function. As the quantity of labour increases, the
marginal product decreases, from MPL = 1 when L = 1 to MPL = 0.45 when L = 5 and the
slope flattens.
(b) Using the production function in panel a, we can derive the MPL curve. The downward
slope of the curve shows the diminishing marginal returns to labour.
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run

PRODUCTION FUNCTION IN THE SHORT RUN Production in the long-run

Returns to scales

At point A in (a), the marginal

product is 20 because the tangent
to the total product curve has a
slope of 20.
At point B in (a) the average product
of labor is 20, which is the slope of
the line from the origin to B.
The average product of labor at
point C in (a) is given by the slope of
the line 0C.
20

Copyright © 2013 Pearson Education, Inc. • Microeconomics • Pindyck/Rubinfeld, 8e. 15 of 30

 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION IN THE SHORT RUN
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

To the left of point E in (b), the

marginal product is above the average
product and the average is increasing;
to the right of E, the marginal product
is below the average product and the
average is decreasing.
As a result, E represents the point at
which the average and marginal
products are equal, when the average
product reaches its maximum.
At D, when total output is maximized,
the slope of the tangent to the total 20
product curve is 0, as is the marginal
product.

Copyright © 2013 Pearson Education, Inc. • Microeconomics • Pindyck/Rubinfeld, 8e. 16 of 30

 Microeconomics I – ENI
TOPIC IV: Production Function
PRODUCTION FUNCTION IN THE LONG RUN
Introduction
The production function
Production in the short-run
Production in the long-run
Returns to scales

• The long run is defined as a period of time long enough to allow firms to
adjust the amount of every input used in production.
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run
Production in the long-run

t
PRODUCTION FUNCTION IN THE LONG RUN Returns to scales

Isoquant
• Isoquant: curve representing
combinations of inputs that allow a
firm to make a certain quantity of
output
• The slope of an isoquant describes
how inputs may be substituted to
produce a fixed level of output
• Marginal rate of technical
substitution:
MRTSL,K = ∆K /∆L
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run

PRODUCTION FUNCTION IN THE LONG RUN Production in the long-run

Returns to scales

The marginal rate of technical substitution of labor L for capital

K (MRTSL,K) is the negative of the isoquant.

If at point A, MRTSL,K = 2,5. The firm can

maintain the same level of output by
replacing 2.5 machine-hours of capital
services with an additional man-hour of
labour.
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run

PRODUCTION FUNCTION IN THE LONG RUN Production in the long-run

Returns to scales

Total Change in Output:

∆Q = Change in L * Contribution of L to Q +
Change in K * Contribution of K to Q

Moving along the isoquant, Q does not change, so ∆Q =0

∆Q =MPL∗∆L+MPK ∗∆K = 0

Rearranging yields the MRTSL,K

MPK ∗∆K =−MPL∗∆L→MRTSL,K =−∆K /∆L = MPL / MPK

• As you move down an isoquant, the slope gets smaller, meaning the firm has less
capital and each unit is relatively more productive
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run

PRODUCTION FUNCTION IN THE LONG RUN Production in the long-run

Returns to scales

The Curvature of Isoquants: Substitutes and Complements

How easy is it to substitute among inputs?

• The shape of an isoquant reveals information about the relationship
between inputs to production  degree of substitutability
• Relatively straight isoquants imply that the inputs are relatively
substitutable
• Relatively curved isoquants imply the inputs are relatively
complementary
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run

PRODUCTION FUNCTION IN THE LONG RUN Production in the long-run

Returns to scales
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run

PRODUCTION FUNCTION IN THE LONG RUN Production in the long-run

Returns to scales

• When inputs are perfect substitutes, they can be traded off at a constant rate as
part of a production process (constant MRTS)
• When inputs are perfect complements, they must be used in a fixed ratio as part
of a production process
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run

RETURNS TO SCALE Production in the long-run

Returns to scales

• A production function is said to have constant returns to scale if

changing the amount of capital and labor by some multiple
changes the quantity of output by exactly the same multiple.
• A production function has increasing returns to scale instead if
changing all inputs by some multiple changes output more than
proportionately
• Doubling capital and labor more than doubles output
• Decreasing returns to scale exist if adjusting all inputs by the
same multiple changes output by less than that multiple
• Output does not fully double when inputs are doubled
 Microeconomics I – ENI Introduction
The production function
TOPIC IV: Production Function
Production in the short-run

RETURNS TO SCALE Production in the long-run

Returns to scales