Chapter 6

Production

Production Decisions of a Firm

Production decisions can be understood in 3 steps:
1. Production Technology: How inputs (such as labor, capital, and raw materials) can be
transformed into outputs
2. Cost Constraints: How inputs (such as labor, and raw materials) can be transformed
into outputs
3. Input Choices: Just as consumer is constrained by a limited budget, the firm is
concerned about the cost of production and the prices of labor, capital, and other
inputs

Firms and their Production Decisions

Production function: Function showing the highest output that a firm can produce for every
specified combination of inputs

The Short Run versus the Long Run

Short run: Period of time in which quantities of one or more production factors cannot be
changed
Typical in Short Run that capital is fixed
We leave something constant (capital) and look at what happens to output when we
increase input (typically labor)

Fixed input: production factor cannot be varied

Long run: Amount of time needed to make all production inputs variable
Chapter 6

Production with two Variable Inputs

Isoquant map: Graph combining a number of isoquants, sued to describe a production

function

You can substitute labor for capital.

If you go to 1 labor, then you need to add
more machines from 1-3 to be able to
produce the same quantity.

Marginal rate of technical substitution

(MRTS) Amount of which the quantity of one input can be reduced when one extra unit of
another input is used, so that outputs remains constant.
Chapter 6

Returns to Scale

Production (Chapter 6)
Production function: q = F(K, L)

- Indicates the highest output q that a firm can produce for every specified combination of inputs
Production with one variable Input (Labor)
Average Products (AP)
- Output per unit of particular (here labor) input
- AP = total output q/total input L
- Average product of labor measures the productivity of the firm’s workforce in terms of how
much output each worker produces on average
Marginal Products (MP) ∆q/∆L (of labor)

- Additional out produced as the (labor) input is increased by 1 unit

- Average product of labor = Output/labor input = q/L
- Marginal product of labor = Change in output/change in labor input = ∆q/∆L
Chapter 6

Law of Diminishing Marginal Return

= Principle that as the use of an input increases with other inputs fixed, the resulting additions to
output will eventually decrease
- Usually applies to the short run when at least one input is fixed
- It can also apply to long run
- Diminishing marginal returns results from limitations on use of other fixed inputs (machinery),
not from declines in worker quality  declining marginal product, but not necessarily negative
one

“Productivity of any input can increase if

there are improvements in technology
despite diminishing marginal returns”

o law of diminishing marginal returns applies to a given production technology

o over time inventions and improvements in technology may allow the entire total product
curve to shift upward, so more output can be produced with same inputs
o Improvements in technology allow curve to shift upward, from O1 to O2 and later to O3
o For example, as labor is increased in agricultural production, technology improvements are
being made  e.g. powerful fertilization, better farm equipment  as result Output
changes from A to B to C
o Move from A to B to C relates in increase in labor input to an increase in output and makes
it appear that there are no diminishing marginal returns when in fact there are
Chapter 6

Chapter 6:
1. Isoquant
- Curves showing all possible combinations of inputs that yield the same output
- The isoquant curve demonstrates the principle of the marginal rate of technical
substitution, which shows the rate at which you can substitute one input for
another, without changing the level of resulting output.
2. Isocost
- An isocost shows all combination of factors that cost the same to employ
3. Marginal rate of technical substitution MRTS
- Amount by which the quantity of one input can be reduced when one extra unit of
another input is used, so that output remains constant.

Use the same concept to explain why more flexibility in the long run can reduce the cost of
production.

 In a diagram with labour on the horizontal axis and capital on the vertical axis, we start at
an optimal point where the slope of the two curves are the same. If capital is fixed in the
short run, the only way of expanding production is by increasing labour. Then the absolute
value of MRTS goes down as the more labour used. Then MRTS < W/r which means that too
much labour is used in relation to capital. In the long run with both capital and labour as
variables, more capital, less labour would be more efficient.

Nash equilibrium

The Nash equilibrium is a decision-making theorem within game theory that states a player
can achieve the desired outcome by not deviating from their initial strategy.
In the Nash equilibrium, each player's strategy is optimal when considering the decisions of
other players. Every player wins because everyone gets the outcome they desire.