Review of Consumer Choice

1. Consumer’s problem
• Which factors determine consumer’s choice?

2. Single consumer’s demand function

3. What happens when some variables change?

• Income changes
• Price changes
• Why is this important?

4. Example of an economic model:

• Difference between exogenous and endogenous variables.
• Role of the assumptions
 New topic: Producer’s Choice
2

Key question:

Price What factors influence supply?

Supply

700 Eu •

400 Eu •

0 600 1500 Quantity

 Firm’s decisions
3

Each firm has to decide

1. To operate or not?

2. Which product(s) to produce?

3. Which materials and in which combinations to use?

4. How many units to produce?

 Production Function
4

Resources, such as labor and capital equipment, that firms use to manufacture
goods and services are called inputs or factors of production.
The amount of goods and services produced by the firm is the firm’s output.

The production function gives the maximum amount of output the firm can
produce for any given quantity of inputs.
 Production Function
5

The production function gives the maximum amount of output the firm can produce for
any given quantity of inputs.
Example: One input 1
Q  f ( L)  L2

Q = f(L)

D
7 •

4 •C

Labor
16 49
 Example
6

Suppose that a firm produces only with labor and the production function is
𝑄=𝐹 𝐿 = 𝐿

That is, L units of labor produce 𝐿 units of output.

If the firm has to pay a wage of w=$10 for each unit of labor and can sell each unit
of output for the price p=$10, how many units will the firm produce?
 Production Function
7

Ipad 2:
• The tablet itself is assembled in China (and by the end of 2011 also in Brazil) by Taiwan-based
Foxconn.
• The displays are believed to be manufactured by LG Display and, more recently, by Samsung, both of
which are based in South Korea.
• The distinctive touch panel is produced by Wintek, a Taiwan-based company that also owns plants in
China, India, and Vietnam.
• The case is provided by another Taiwanese company, Catcher Technologies, with operations in
Taiwan and China.
• The battery pack, also originates in Taiwan and is sold by Simplo Technologies and Dynapack
International.
• A variety of chips and other small technical components provided by various firms, non-exhaustive
list includes Korea’s Samsung (again), which is believed to manufacture the main processor
(designed by Apple) and possibly the flash memory, Japan’s Elpida contributing the SDRAM,
Germany’s Infineon and US Qualcomm both supplying 3G modules, and Italo-French
STMicroelectronics, Japan’s AKM Superconductors, and US TAOS each contributing key sensors.
 Production Function
8

The marginal product of an input is the change in output that results from a small
change in the input : MPL =  F(L)/L

The average product of an input is the total output divided by the quantity of the
input: APL=F(L)/L

Increasing returns to labor: the production function increases with labor: “the more
workers, the more output”.

We say that there are increasing marginal returns to labor if the marginal productivity
of labor is increasing (that is, the slope of the production function increases)

We say that there are diminishing marginal returns to labor if the marginal
productivity is decreasing.
 Production Function
9

Q  f (L)

Q
Increasing returns

Increasing Decreasing
Decreasing
marginal returns
marginal
returns returns

Labor
 Production Function: Two Inputs
10

Two inputs: Labor and Capital

1 1
Example: Q  f ( L, K )  L K 2 2

The marginal product of an input is the change in output that results from a
small change in an input holding the levels of all other inputs constant.

Changein the quantity of output, Q

MPL  K is held const
Changein the quantity of Labor, L

F ( L, K )
MPL ( L, K ) 
L
K is held const

F ( L, K )
MPK ( L, K ) 
K
L is held const
 Example
11

1 1
Q  f ( L, K )  L K2 2

K: 0 10 20 30 40 50
L:
0 0 0 0 0 0 0

10 0 10 14 17 20 22

20 0 14 20 24 28 32

30 0 17 24 30 35 39

40 0 20 28 35 40 45

50 0 22 32 39 45 50
 Isoquant
12

An isoquant traces all the combinations of inputs (labor and capital) that
produce the same amount of output.

K All combinations of (L,K) along the

isoquant produce Q units of output.

Does the figure remind you of

anything from consumer theory?

Q = 32
Q = 14
L
 Example
13

1 1
K
Q  f ( L, K )  L K 2 2

K: 0 10 20 30 40 50
20 • • L:
0 0 0 0 0 0 0

10 0 10 14 17 20 22

20 0 14 20 24 28 32

30 0 17 24 30 35 39

Q = 32 40 0 20 28 35 40 45
Slope=-K/L
Q = 14 50 0 22 32 39 45 50

10 50 L
Marginal rate of technical substitution
14

The marginal rate of technical substitution between labor and capital,

𝑀𝑅𝑇𝑆𝐿, 𝐾(𝐿0 , 𝐾0 ), is the negative of the slope of the isoquant that goes through
𝐿0 , 𝐾0 .
It measures the rate at which the firm can exchange labor for capital and still
produce the same output as before.

The marginal rate of technical substitution is (minus) the slope of the isoquant curve:

MRTSL,K = -K/L (for a constant level of output)

Marginal products and the MRTS are related:

F ( L, K )
K MPL ( L, K ) L
MRTS L , K ( L, K )    
L MPK ( L, K ) F ( L, K )
K
Marginal rate of technical substitution
15

Properties of MRTS:

1. If both marginal products are positive, the slope of the isoquant is negative.

2. If the MRTS also diminishes as the quantity of labor increases along an

isoquant, the isoquants are convex to the origin.
 Returns to scale
16

How much will output increase when all inputs increase by a

particular factor?

We say that a production function f ( K , L) exhibits:

1. Increasing returns to scale if f ( K , L)  f (L, K ) for   1
2. Decreasing returns to scale if f ( K , L)  f (L, K ) for   1
3. Constant returns to scale if f ( K , L)  f (L, K ) for   1
 Returns to scale: examples
17

1. A hair salon can produce 100 haircuts a day if it employs 10 hairdressers and
160 haircuts a day if it employs 20 hairdressers. Is the salon’s production
function exhibiting decreasing, increasing, or constant returns to scale?

2. A café needs exactly one baker and 30kg of ingredients to produce 30 cakes a
day. What is the café’s cake production function? Does it have decreasing,
constant, or increasing returns to scale?

3. A firm’s production function is F(K,L) = KaLb. For which values of a and b are its
returns to scale increasing? Decreasing? Constant?