ECN 2115: Lecture 3.

1: Production

3.1.1: Introduction

In Topic 3 of the course, we shall deal with the theory of the firm. This
covers production and cost theory. We start with production theory.

In consumer theory we tried to understand the behaviour of consumers.

From that we derived the demand curve or demand function. That
explains one part of our market structure. We now look at producers to
complete the other part of the market structure.

What is production? This is a process through which a producer combines

inputs to create or produce something. That is an output. Thus, we can
combine land, labour and capital to produce an output.

We can then define a production function as the relationship by which

inputs are combined to produce output. You can think of a box into which
inputs are fed and output is discharged from it. This obviously assumes a
state of existing technology.

We can then describe the production process by a production function

described as:

Q = f (K, L)

Where Q is output, K is capital input and L is labour input.

3.1.2: Technology

In studying production, we first look at the constraints facing a producer

or firm’s behaviour. It is the behaviour of the producer that is important in
the theory of production.

A producer makes choices. In that it faces many constraints. These

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constraints are imposed by its customers, its competitors and nature.

When we look at the technology of the producer, we are looking at the

constraints imposed on the producer by nature. Nature imposes the
constraint that there are only certain feasible ways to produce outputs
from inputs. There are therefore, only certain kinds of technological
choices that are possible. This technology is described in our production
possibility curve. This is depicted in the figure 3.1.1 below

Figure 3.1.1: Production Possibility Curve.

In this case we have a production, Q = F (X, Y) where Q is output and X

and Y are inputs. The given state of technology can produced the level of
output Q given by the curve. This output can be produced at different
combinations of X and Y. An improvement in technology will shift the
curve outward to the right. Our production function is therefore a
relationship between any combination of inputs and the maximum
attainable output from that combination. Note that we are talking about
the maximum feasible output and not any output. And, as we pointed out,
production functions are defined for a given technology.

3.1.3: Fixed and Variable Inputs

In the production function, we have inputs going in and output coming

out of the production process. We can define fixed and variable inputs.
Fixed inputs are those that remain fixed for a certain level of output. A

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variable input is one that changes with changes in output.

3.1.4: Short-run and Long-run.

The reference to the time period involved in the production process is an

important concept in production analysis. The two reference periods are
the short-run and the long-run. These are defined in terms of control.

The short =run refers to the period in which the use or supply of a certain
input is fixed. Output in the production function can only be increased by
increasing the use of the variable inputs. This is usually true of inputs like
labour and raw materials. Please note that this does not refer to any fixed
time period but to the fixity of an input.

The long-run refers to the period in which the use or supply of inputs is
not fixed. They are all variable. However, the period should not be long
enough to permit a change in technology. We can therefore define the
short-run and long-run it terms of our production functions.

We have our short-run production function depicted as:

Q = F (X, Y0 )

Where Q is output, X is the variable input and Y0 is the fixed input. This
is our short-run production function. We standard expression is that we
shall combine capital (K) and labour (L) to produce output (Q). We can
then write our short-run production function as follows:

Q = f (K0 , L) where Q is output; L is labour which we can vary

and K0 is capital equipment, which in the short-run is fixed. We can show
this in figure 3.1.2.

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Figure 3.1.2: Short-run production function.

We can define the long-run production function as;

Q = f (K, L).

In this case all the inputs, K and L are variable. We can then say that the
long-run is the period of production so long that producers have adequate
time to vary all of the inputs used to produce a good. We can show this by
an isoquant map in figure 3.1.3.

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Figure 3.1.3: Isoquant Map.

Assumptions of a production function

A production function is based on the following assumptions:

i) Perfect divisibility of both inputs and outputs

ii) There are only two inputs of production, capital (K) and labour (L).

iii) There are limited substitution of one input for the other, i.e., labour
and capital are imperfect substitutes

iv) A given technology; and

v) The existence of fixed inputs in the short-run.

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3.1.5: Types of production functions.

We are going to work with three types of production functions. These are
defined according to the substitutability between the two inputs. These
are the linear production function, the fixed-coefficients production
function and the Cobb-Douglas production function.

Linear production function

In this case the inputs are perfect substitutes. Thus we have;

Q= αL +βK

Where α > 0 and β > 0.

This is depicted in figure 3.1. 4.

Figure 3.1.4: Linear production function

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Fixed co-efficient production function.

In this case the inputs are complete complements. Thus we have;

Q= min [L/α ; K/β]

Where α > 0 and β >0

This is depicted in figure 3.1.5.

Figure 3.1.5: Fixed co-efficient production function.

Cobb-Douglas production function.

The third type of production function we have is a Cobb-Douglas

production function. In this case the inputs are imperfectly substituted.
This is shown in figure 3.1.6 below.

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Figure 3.1.6: Cobb-Douglas production function

3.1.5. Production in the Short-run.

Economic theory analyses the production process in terms of the short-

run and long-run. We look at the input-output relationships under those
conditions.

As we saw earlier on, in the short-run the input-output relations are

studied with one input fixed. This is usually capital. The laws of
production that we develop are called “the laws of variable proportions”

In the long-run, the input-output relationships studied assume that all

inputs are variable. These are referred to as “Laws of Returns to Scale”.

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Laws of Variable Proportions.

The Law of variable proportions gives us the law of diminishing returns.

This states that when more and more units of a variable input are applied
to a given quantity of fixed inputs, the total output may initially increase
at an increasing rate and then at a constant rate but it will eventually
increase at a diminishing rate. Thus the marginal increase in total output
eventually decreases when additional units of variable inputs are applied
to a given quantity of fixed inputs.

Assumptions

The law of diminishing returns is based on the following assumptions:

a) The state of technology is given

b) Where we have two inputs, capital and labour, labour is

homogeneous

c) Input prices are given.

Let us show the law of diminishing returns with an example from coal
mining at Maamba Coal mines. The mine has a set of mining machinery as
its capital (K 0 ). This amount of machinery is fixed in the short-run.
However, the mine can employ more mine workers to increase its coal
production. Thus we can build a short-run production function from this
information in the form:

Q = f (L, K0 )

Where Q is the quantity of coal produced, L is labour and K0 is the fixed

capital.

This is a general form. We can estimate a specific production function

from this. This may take the form;

Q = - L3 + β L2 + αL.

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When we estimate this with actual data, we get the form below.

Q = - L3 + 15 L2 + 10 L.

Using the above short-run production function, we can substitute

different values of L in the function to find out how much of coal is being
produced. Let us say, we have L = 5. We have the following;
3 2
Q = -5 + 15 (5 ) + 10 ( 5)

= -125 + 375 +50

= 300

We can then an array of workers, i.e. 1, 2, 3, ,,,,,,,, 12. We can produce a

schedule below as depicting the short-run production function. This
shows the total, marginal and average product.

No. of mine Total coal Marginal Average Stage of

workers ( L) output Product Product returns
(TPL ) ( MP L ) ( APL )
(1) (2) (3) (4) (5)
1 24 24 24 I
2 72 48 36 Increasing
3 138 66 46 returns
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II
8 528 66 66 Diminishing
9 576 48 64 returns
10 600 24 60
11 594 -6 54 III
12 552 -42 46 Negative
returns

To see the trend, let us look at the marginal product of labour and average
product of labour, since in the schedule we have held capital constant.

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Marginal product of labour

We can obtain this from the short-run production function. Thus,

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MPL = ∂Q /∂ L = -3L +30 L +10.

When we substitute the various amounts of the labour input, we get the
marginal product of labour at various labour input levels.

From the schedule, we can also obtain this by finding the differences in
output at various input levels. Thus,

MPL = TPt - TPt-1

We can get this from column (3) in the schedule.

Average product of labour

We can obtain the average product of labour by dividing output by the

amount of labour used at each level of production. Thus,

APL = Q / L = - L3 +15 L2 +10 L / L

= - L2 + 15L + 10

We substitute the various units of labour to get the APL .

Both the marginal and average product for labour curves are shown in
figure 3.1.8.

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Figure 3.1.7: Total Product Curve.

Figure 3.1.8: Average and Marginal Product of Labour Curves.

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The three stages in the schedule depict the stages in the law of
diminishing returns. Conclusively, we can state, the law of diminishing
returns as: Given the employment of a fixed factor (Capital) when more
and more workers are employed, the return from the additional worker
may initially increase but will eventually decrease. This is an empirical law,
often observed in various production activities.

Graphical Derivation of the Marginal Product Curve

We can also derive the marginal product curve from the total product
curve. We define the marginal product of labour ( MPL ) as;

MP = ∂TPL / ∂L

This is the slope of the total product curve. We can depict this is the
figure 3.1.9 below,

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Figure 3.1.9: Marginal product of labour curve

Graphical Derivation of the average product curve.

We can also graphically derive the average product curve. We define the
average product of labour ( APL ) curve. That is,

APL = Q / L

We draw it by taking the slope of the total product curve from the origin
to any point on the total product curve. This is shown in figure 3.1.10.

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Figure 3.1.10. The Average product of labour curve.

The Three Stages of Production.

We identify three stages of production when we are operating in the short

–run. We have stages 1, II and III.

Stage I

In this stage, the marginal product of the variable input (labour) is higher
than the average product. i.e. MPL > APL. . This starts at production
when the input of labour is zero and ends at the point where the input of
labour gives you the maximum APL .

Stage II

In this stage, the marginal product of labour (the variable input) is below

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its average product, i.e., MPL < APL . But both must be greater than zero.
This begins at a labour input where the APL is at a maximum and ends at a
labour input where the marginal product is zero, MPL = 0.

Stage III

In this stage the marginal product of labour turns negative, while the
average product of labour remains greater than zero.

We can explain this further by looking at the labour-capital ratio ( L /K ).

In stage I, the proportion of the L/K is too low relative to that for which
the productive plant has been designed. Therefore, capital, the fixed input
is underutilized in this stage.

In this stage, there are increasing returns from increasing the proportion
of labour, the variable input, to capital, the fixed input.

In stage III, there is too much labour relative to capital. The marginal
product of labour is negative. There is too much of the variable input
relative to the fixed input.

In stage II, we have the only stage in which there is neither a redundancy
of capital nor a redundancy of labour. This is the range of production for
which the plant is designed. Throughout this stage, the AP L declines, but
MPL is positive.

3.1. 6: Production in the Long Run.

We now discuss the theory of production with two variable inputs. This is
long-run phenomenon. The producer can vary the amounts of both inputs
that they use. So we have our usual production function.

Q = f( K, L ).

In this case a producer is able to increase both inputs in order to increase

the scale of production. We analyse our production process we develop

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the concept of an isoquant. We define this as a locus of points
representing different combinations of two inputs (labour and capital)
that yields the same output. The isoquant is depicted in figure 3.1.11
below.

Figure 3.1.11: Isoquant

Assumptions

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Isoquants are drawn on the basis of the following assumptions.

a) There are only two inputs, labour (L) and capital (K) to produce an
output, say X.

b) The two inputs (L and K) can be substituted for one another at a

diminishing rate, up to a certain limit.

c) The production function is continuous, implying that labour and

capital are perfectly divisible and can be substituted in any small quantity.

Given the above assumptions, it is always possible to produce a given

quantity of a good, X with various combinations of capital and labour. This
is as represented in the isoquant. We can therefore draw an isoquant map
giving us various levels of output as depicted in figure 3.1.12.

Figure 3.1.12: Isoquant Curves.

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Properties of Isoquant Curves

a) Isoquants have a negative slope. This is in the relevant range or

economic region.

b) Isoquants are convex to the origin. Convexity of isoquants implies

that there is substitution between inputs and there is also a diminishing
marginal rate of technical substitution (MRTS) between the two inputs in
the relevant range.

c) Isoquants cannot intersect or be tangent to each other.

d) Upper isoquants represent a higher level of output.

Marginal Rate of Technical Substitution.

The marginal rate of technical substitution (MRTS) is the rate at which one
input can be substituted for another, output remaining constant. It is
therefore a measure of the amount of capital input that can be
substituted for labour without increasing or decreasing production. Thus
we have,

MRTSKL = - ∆ L/ ∆K

This is the slope of the isoquant. It is negative. A negatively sloped

isoquant assumes that the MPL and MPK are positive. That is that we
are in stage II of the production process.

Elasticity of Substitution.

The convex shape of the isoquant implies that the MRTSKL tends to
decline as capital is actually substituted for labour along an isoquant. The
reason for declining MRTS is that inputs tend to complement each other.
The curvature of the isoquants indicates the difficulty with which one

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input can be substituted for other without sacrificing production.

A measure of the ease with which one input can be substituted for
another in production is called, the elasticity of input substitution. This is
formally defined as the percentage change in the capital-labour ratio ( K/L)
divided by the percentage change in the marginal rate of technical
substitution ( MRTS).

α KL = (percentage change in K/L) / (percentage change in

MRTS)

We find that the elasticity of input substitution is between 0 and ∞ . i.e.,

0< αKL >∞ .

In this respect, a fixed proportions production function will give us a zero

elasticity of input substitution because ∆ MRTSKL = ∞ . Therefore αKL =
0

A linear isoquant will give us an infinity elasticity of input substitution

because ∆MRTSKL = 0. Therefore αKL = ∞ .

A Cobb-Douglas production function will give us an elasticity of

substitution of any positive number between zero and infinity.

Laws of Returns to Scale

We use isoquants to analyse the production process when both inputs (K

and L) are variable. And their output is changed proportionately and
simultaneously. When inputs are changed proportionately, this means the
scale of productions changes. That is the size of the firm changes. We
look at the input- output relationships under this condition. This is

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obviously a long-term phenomenon. It is described by the Laws of Returns
to Scale.

When all the inputs are increased proportionately, there are technically
three possible ways in which output can increase.

a) Output may increase more than proportionately

b) Output may increase proportionately

c) Output may increase less than proportionately.

These three types of phenomenon give rise to the three laws of returns to
scale. These are respectively:

a) The law of increasing returns to scale

b) The law of constant returns to scale

c) The law of decreasing returns to scale.

Let us explain and illustrate these laws in production theory.

a) Increasing Returns to Scale.

The long run production function exhibits increasing returns to scale

when if inputs are doubled, output is more than doubled. Let us say we
have a production function,

1K + 1L = 10

If we double inputs, we have,

2K+ 2L =25

We doubled both K and L, but Q more than doubled.

b) Constant Returns to Scale

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In this case, if we doubled both inputs, K and L, output also doubles. Thus
we have

1K + 1L = Q = 10

2K + 2L = 2Q = 20

3K + 3L = 3Q = 30.

c) Decreasing Returns to Scale.

In this case, if we double both inputs, K and L, output increases by less

than double. Thus we have,

1K +1L = Q =10

2K + 2L = Q = 15

Production Function and Returns to Scale.

The laws of returns to scale can be explained more clearly through a

production function.

Assume a production function with output, Q and inputs, K and L. We

have the production,

Q = f( K, L)

Let us assume a production homogeneous of degree 1. A production

function is said to be homogeneous of degree 1 if when all the inputs are
increased in the same proportion and this proportion can be factored out.

If all inputs are increased in the certain proportion (say k) and output
increases in the same proportion, (k). Then the production function is
said to be homogenous of degree 1. This is known as a “linear
homogenous production function”.

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Therefore, a homogeneous function of degree 1 may be expressed as:

kQ = f(kK,kL)

kQ = k(K,L).

A linear production function implies constant returns to scale.

We can generalize this by having a production function,

hQ=f(kK,kL)

Where h denotes h-times increase in Q as a result of k-times increase in

inputs, K and L.

Then the proportion k may be greater than, equal to or less than k. We

can then express this in terms of our laws of returns to scale

a) If h =k ; the production function reveals constant returns to scale

b) If h > k; the production function reveals increasing returns to scale

c) if h < k: the production function reveals decreasing returns to scale.

Cobb-Douglas function and Returns to Scale

Let us use the Cobb-Douglas function to show the laws of returns to scale.
We have the function,

Q = A Kα Lβ

Where A , α , β are positive and β = 1 –α

α gives the elasticity of output with respect to capital. That is a change in

output for one percent change in capital. It is also the relative share of
capital in the output.

Β gives the elasticity of output with respect to labour. That is a change in

output for a one per cent change in labour. It also gives the relative share
of labour in output.

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We can then conclude as follows:

a) if α + β > 1, we have increasing returns to scale

b) if α + β = 1, we have constant returns to scale

c) if α + β < 1, we have decreasing returns to scale

Properties of Cobb-Douglas production function.

The Cobb-Douglas function has useful properties.

a) The average and marginal products of labour and capital depends on

their ratio in the production function.

b) The production function in the form Q = A Kα Lβ can be converted

to a log linear form,

log Q = log A + α log K + β log L.

c) The function is a homogeneous function and the degree of its

homogeneity is determined by the sum of the exponents, α and β. If
α + β = 1, the function is homogeneous of degree 1 . This implies
constant returns to scale.

d) The exponents α and β represent the elasticity coefficients of

output for inputs , K and L respectively.

e) The Cobb-Douglas production function in its general form , Q = Kα

L1-α indicates that at zero cost, there will be zero production.

Exercise: Derive the above properties of the Cobb-Douglas function.

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