CHAPTER 7

ESTIMATION OF PRODUCTION
THE
PRODUCTION
FUNCTION
 Production
Function
Statement of the relationship between a firm's scarce
resources (i.e., its inputs) and the output that results from
the use of these resources.

Where:
Q = Output
X..... X, = Inputs used in the production process
 ECONOMIC
COST ANALYSIS

• Can then be seen as the application of a

monetary unit such as dollars to
measure the value of this input usage in
the production process.
 Production
Function
• There are two other key assumptions that you should be aware
of.

1. We are assuming some given "state of the art" in the production

technology. Any innovation in production (e.g.. the use of
robotics in manufacturing or a more effcient software package
for financial analysis) would cause the relationship between
given inputs and their output to change.
2. We are assuming that whatever input or input combinations are
included in a particular function, the output resulting from their
utilization is at the maximum level.
 Production
Function

• A production function defines the relationship

between inputs and the maximum amount
that can be produced within a given period of
time with a given level of technology.
 Production
Function
The Xs could represent raw materials, such as carbon
ated water, sweeteners, and flavorings; labor, such as
assembly line workers, support staff, and supervisory
personnel; and fixed assets, such as plant and equipment.
For purposes of analysis, let us reduce the whole array of
inputs in the produe tion function to two, X and Y. Restating
Equation (7.1) gives us:
Q=f(X, Y)

where Q= Output
X= Labor
Y = Capital
 Production
Function
Notice that although we have designated
one variable as labor and the other as
capital, we have elected to keep the all-
purpose symbols X and Y as a reminder
that any two inputs could have been
selected to represent the array.
 Production
Function
• Short-run production function shows
the maximum quantity of a good or
service that can be produced by a set of
inputs, assuming that the amount of at
least one of the inputs used remains
unchanged.
 Production
Function

• Long-run production function shows

the maximum quantity of a good or
service that can be produced by a set of
inputs, assuming that the firm is free to
vary the amount of all the inputs being
used.
A SHORT-RUN ANALYSIS
OF TOTAL, AVERAGE,
AND MARGINAL
PRODUCT
The Marginal Product and Average Product

• In the short-run analysis of the production function two other

terms besides the quantity of output are important
measures of the outcome. They are mar ginal product (MP)
and average product (AP). If we assume X to be the variable
input, then
The Marginal Product and Average Product

• In other words, the marginal product can

be defined as the change in output or
total product resulting from a unit change
in a variable input, and the average
product can be defined as the total
product (TP) per unit of input used.
The Law of
Diminishing
Returns
The Law of Diminishing Returns

The key to understanding the pattern of change in Q.

AP, and MP is the phenomenon known as the law of
diminishing returns. This law states:

As additional units of variable input are combined with a

fixed input, at some point the additional output (.e, marginal
product) starts to diminish.
The Law of Diminishing Returns

1. The Sorting of Refillable Glass Bottles

2. Development of Applications Software
3. Response Time on a Data Network
THE THREE STAGES
OF PRODUCTION
IN THE SHORT RUN
 STAGE 1
• Runs from zero to four units of the
variable input X (to the point at
which average product reaches its
maximum).
 STAGE 2
• Begins from this point and proceeds
to seven units of input X (to the
point at which total product is
maximized).
 STAGE 3

Continues on from the point.

DERIVED DEMAND AND
THE OPTIMAL LEVELOF
VARIABLE INPUT
USAGE
 Total Revenue
Product (TRP)
• The market value of the firm’s output,
computed by multiplying the total
product by the market price.

QxP
 Marginal Revenue
Product (MRP)

• The change in the firm’s total revenue product

resulting from a unit change in the number of
inputs used.
▲TRP/▲X
• It can also be computed by multiplying the
marginal product by the product price.
MP x P
 Total Labor
Cost (TLC)
• The total cost of using the variable input, labor,
computed by multiplying the wager rate (which
we assume to be some given and constant
dollar amount) by the number of variable inputs
employed

Wage rate x X
 Marginal Labor
Cost (MLC)
• The change in total labor cost resulting from a
unit change in the number of variable inputs
used. Because the wage rate is assumed to be
constant regardless of the number of inputs
used, the MLC is the same as the wage rate.
 Wage Rate
• This term is also referred to as
marginal resource cost (MRC) and
marginal factor cost (MFC).
 A profit-maximizing firm operating in
perfectly competitive output and input
markets will be using the optimal amount of
an input at the point at which the monetary
value of the input’s marginal product is
equal to the additional cost of using that
input- in other words, when MRP=MLC.
 THE LONG-RUN
PRODUCTION FUNCTION

• In the long run, a firm has time

enough to change the amount of all
of its inputs. Thus, there is really no
difference between fixed and
variable inputs.
 THE LONG-RUN
PRODUCTION FUNCTION

• The maximum quantity of a good or

service that can be produced by a
set of inputs, assuming that the firm
is free to vary the amount of all inputs
being used.
 THE LONG-RUN
PRODUCTION FUNCTION

Returns to Scale
The resulting increase in the total
output as the two inputs increase.
 THE LONG-RUN
PRODUCTION FUNCTION

• According to economic theory, if an increase in a

firm’s inputs by some proportion results in an
increase in output by a greater proportion, the firm
experiences increasing returns to scale. If output
increases by the same proportion as the inputs
increase, the firm experiences constant returns to
scale. A less than proportional increase in output is
called decreasing returns to scale.
 THE LONG-RUN
PRODUCTION FUNCTION

• One way to measure returns to scale is to use a coefficient of

output elasticity:

E▫= Percentage change in Q

Percentage change in all inputs
Thus,
If E > 1, we have increasing returns to sale (IRTS).
If E = 1, we have constant returns to scale (CRTS).
If E < 1, we have decreasing returns to scale (DRTS).
 THE VARIOUS FORMS OF A
PRODUCTION FUNCTION
The short-run is characterized by the existence
of a fixed factor to which we add a variable factor.
Thus, the simple function, containing just one
variable factor and one fixed factor, can be written
as follows:
Q= f(L)ꝃ
Where output Q is determined by the quantity of
the variable factor L (labor) with the fixed factor K
(capital) given.
 THE VARIOUS FORMS OF A
PRODUCTION FUNCTION
The theoretical part of this chapter assumed that the
production function starts with increasing marginal returns
followed by decreasing marginal returns. In other words, all
three stages of production are present. This situation is
represented by a cubic function:
Q= a + bL +c𝐿2 - d𝐿3

Where a is the constant and b, c, and d are the coefficients.

 THE VARIOUS FORMS OF A
PRODUCTION FUNCTION
In performing empirical research, it may be
possible to identify a linear production function, Q=
a t bL.
This function exhibits no diminishing returns; the
total product will be a straight line with slope b, and
both the MP and AP lines will be horizontal and
equal. Of course, a straight-line production function
may hold in some real situations.
 THE VARIOUS FORMS OF A
PRODUCTION FUNCTION

Another form of the production function is the

power function, which takes in the following form:

Q=B𝑳𝟐
The Cobb-Douglas Production Function

Charles W. Cobb Paul H. Douglas

 The Cobb-Douglas
Production Function
It was introduced in 1928, and it is still a
common functional form in economic studies
today. It has been used extensively to estimate
both individual firm and aggregate production
functions. It has undergone significant criticism
but has endured.
 WANT TO KNOW MORE?
• The formula for the production function, which was
suggested by Cobb, was of the following form:

Q = aL bK¹ -b

• However, in later studies, they (as well as other

researchers) relaxed this requirement and rewrote
the equation as follows:

Q = aLb Ke c
 WANT TO KNOW MORE?
c
Q = aL Ke
b

Where:

Q - total output
L- labor input
K - capital input
Parameter A – Total Factor Productivity (TFP)
alpha - The elasticity of production of labor
beta - The elasticity of production of capital
• Isoquant
A curve representing different combinations
of two inputs that produce the same level of
output.
SUBSTITUTING INPUT FACTORS
Marginal Rate of Technical Substitution (MRTS)
• an economic theory that illustrates the rate at which one factor must
decrease so that the same level of productivity can be maintained when
another factor is increased.

• Algebraically, the marginal rate of technical s stitution of X for Y can be

expressed as:
MRTS(X for Y)=ΔY/ΔX

where:
Y=Capital
X=Labor
MP=Marginal products of each input
ΔY/ΔX=Amount of capital that can be reduced when labor is increased
(typically by one unit)
Marginal Rate of Technical Substitution
• Isocost
A line representing different combinations of two inputs
that a firm can purchase with the same amount of money. In
production analysis, the isocost indicates a firm's budget
constraint.
THANK YOU