2/12/2023

Chapter 6: Firms and production

Chapter 6 Outline
6.1 Skipped
6.2 Production
6.3 Short Run Production: One Variable and One
Fixed Input
6.4 Long Run Production: Two Variable Inputs
6.5 Returns to Scale

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Relating Output to Inputs

Factors of production – inputs or ingredients mixed together by a firm
through its technology to produce output
Production function – a relationship between inputs and output that
identifies the maximum output that can be produced per time period by
each specific combination of inputs
Q = f(L,K)
Technologically efficient – a condition in which the firm produces the
maximum output from any given combination of labor and capital
inputs
A firm is an organization that converts inputs (labor, materials, and
capital) into outputs.

The “Runs” in Production

A firm can more easily adjust its inputs in the long run than in
the short run.
• The short run is a period of time so brief that at least one factor
of production cannot be varied (the fixed input).
• The long run is a long enough period of time that all inputs can
be varied.
•If labor and capital are assumed to be the only factors of
production, usually we assume capital to be fixed in the short
run.

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Functional Forms of
Production Functions
Functional Forms
◦ Linear
◦ Q = a + bL + cK
◦ Multiplicative
◦ Cobb-Douglas production function: Q = aLbKc

Linear Forms of Production Functions

If a=0, b=4 and c=3

Q = a + bL + cK; and K=1

𝑄 = 𝑎+𝑏 1 +𝑐 1 = 0+4 1 +3 1 = 7

𝑄 = 𝑎 + 𝑏 2 + 𝑐 1 = 0 + 4 2 + 3 1 = 11

𝑄 = 𝑎 + 𝑏 2 + 𝑐 1 = 0 + 4 3 + 3 1 = 15

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Multiplicative Forms of Production

Functions: Cobb-Douglas as an Example
If a=2, b=0.5 and c=1; and K=1

𝑄 = 𝑎𝐿𝑏 𝐾 𝑐

𝑄 = 2(10.5 )(11 ) = 2

𝑄 = 2(20.5 )(11 ) ≅ 2 1.424 (1) ≅ 2.83

𝑄 = 2(30.5 )(11 ) ≅ 2 1.732 (1) ≅ 3.46

Multiplicative Forms of Production

Functions: Cobb-Douglas as an Example
If a=2, b=0.5 and c=1; and L=1

𝑄 = 𝑎𝐿𝑏 𝐾 𝑐

𝑄 = 2(10.5 )(11 ) = 2

𝑄 = 2(10.5 ) 21 = 4

𝑄 = 2(10.5 ) 31 = 6

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What Owners Want

We assume firms’ owners are driven to maximize profit.
• Profit is the difference between revenue (R), what it earns from
selling its product, and cost (C), what it pays for labor, materials,
and other inputs.
where R = pq.
To maximize profits, a firm must produce as efficiently as
possible, where efficient production means it cannot produce its
current level of output with fewer inputs.

Production When Only One Input is Variable:

The Short Run
Fixed inputs - resources a firm cannot feasibly vary over the time
period involved
Total product - the total output of the firm
Average product - the total output (or total product) divided by the
amount of the input used to produce that output
Marginal product - the change in total output that results from a one-
unit change in the amount of an input, holding the quantities of other
inputs constant

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Short Run Production: One

Variable and One Fixed Input
In the short run (SR), we assume that capital is a fixed input and
labor is a variable input.
• SR Production Function:

• q is output, but also called total product; the short run

production function is also called the total product of labor
• The marginal product of labor is the additional output produced
by an additional unit of labor, holding all other factors constant.

• The average product of labor is the ratio of output to the

amount of labor employed.

SR Production with Variable Labor

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In the previous slide, the Short Run product of

labor function is given by:
𝑞 = 𝐿 + 30𝐿2 − 𝐿3

SR Production with Variable

Labor
Interpretations of the graphs:
• Total product of labor curve shows output rises with labor
until L=20.
• APL and MPL both first rise and then fall as L increases.
◦ Initial increases due to specialization of activities; more workers are a good thing
◦ Eventual declines result when workers begin to get in each other’s way as they struggle with
having a fixed capital stock

• MPL curve first pulls APL curve up and then pulls it down,
thus, MPL intersects APL at its maximum.

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Law of Diminishing Marginal

Returns (LDMR)
The law holds that, if a firm keeps increasing an input, holding all
other inputs and technology constant, the corresponding
increases in output will eventually becomes smaller.
• Occurs at L=10 in previous graph
Mathematically:

Note that when MPL begins to fall, TP is still increasing.

LDMR is really an empirical regularity more than a law.

Long Run Production: Two

Variable Inputs
In the long run (LR), we assume that both labor and capital are
variable inputs.
The freedom to vary both inputs provides firms with many
choices of how to produce (labor-intensive vs. capital-intensive
methods).
Consider a Cobb-Douglas production function where A, a, and b
are constants:

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LR Production Isoquants
A production isoquant graphically summarizes the efficient
combinations of inputs (labor and capital) that will produce a
specific level of output.

LR Production Isoquants
Properties of isoquants:
1. The farther an isoquant is from the origin, the greater
the level of output.
2. Isoquants do not cross.
3. Isoquants slope downward.
4. Isoquants must be thin.
The shape of isoquants (curvature) indicates how
readily a firm can substitute between inputs in the
production process.

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LR Production Isoquants
Types of isoquants:
1. Perfect substitutes (e.g. q = x + y)

LR Production Isoquants
Types of isoquants:
2. Fixed-proportions (e.g. q = min{g, b} )

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LR Production Isoquants
Types of isoquants:
3. Convex (e.g. q = L0.5K0.5 )

Substituting Inputs
The slope of an isoquant shows the ability of a firm to replace one
input with another (holding output constant).
Marginal rate of technical substitution (MRTS) is the slope of an
isoquant at a single point.

• MRTS tells us how many units of K the firm can replace with an extra
unit of L (q constant)

◦ MPL = marginal product of labor; MPK = marginal product of capital

Thus,

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In-class Question
What is the marginal rate of technical substitution (MRTS) for a general
Cobb-Douglas function 𝑞 = 𝐴𝐿𝑎 𝐾 𝑏

Substituting Inputs
MRTS diminishes along a convex isoquant
• The more L the firm has, the harder it is to replace K with L.

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Returns to Scale
How much does output change if a firm increases all its inputs
proportionately?

Production function exhibits constant returns to scale when a percentage

increase in inputs is followed by the same percentage increase in output.
• Doubling inputs, doubles output  f(2L, 2K) = 2f(L, K)

Returns to Scale
Production function exhibits increasing returns to scale when a
percentage increase in inputs is followed by a larger percentage
increase in output.
• f(2L, 2K) > 2f(L, K)
• Occurs with greater specialization of L and K; one large plant
more productive than two small plants
Production function exhibits decreasing returns to scale when a
percentage increase in inputs is followed by a smaller
percentage increase in output.
• f(2L, 2K) < 2f(L, K)
• Occurs because of difficulty organizing and coordinating activities
as firm size increases.

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In-class Question
For a general Cobb-Douglas function 𝑞 = 𝐴𝐿𝑎 𝐾 𝑏
Show how output changes if both inputs are doubled.

Implication:
if a+b>1:
if a+b=1:
if a+b<1:

Returns to Scale
Constant returns to scale – a situation in which a proportional increase
in all inputs increases output in the same proportion

Increasing returns to scale – a situation in which output increases in

greater proportion than input use

Decreasing returns to scale – a situation in which output increases less

than proportionally to input use

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Factors Giving Rise to Increasing Returns

Division and specialization of labor and capital

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Mass Production Case Study:

Ford Assembly Line
http://www.history.com/this-day-in-history/fords-assembly-line-starts-
rolling
On this day in 1913, Henry Ford installs the first moving assembly line
for the mass production of an entire automobile. His innovation
reduced the time it took to build a car from more than 12 hours to two
hours and 30 minutes.
Principle:
◦ Place the tools and the men in the sequence of
the operation so that each component part shall
travel the least possible distance while in the
process of finishing.

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Factors Giving Rise to Decreasing Returns

Inefficiency of managing large operations:
◦ Coordination and control become difficult
◦ Loss or distortion of information
◦ Complexity of communication channels
◦ More time is required to make and implement decisions

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Varying Returns to Scale

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