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ME Production & Cost Theory
ME Production & Cost Theory
Production
Creation of utility
Factors of Production
INPUTS
Land
Labor
Capital
Immobile
Passive
Heterogen
eous
Active
Mobile
Variable
productivity
Structures
Equipment
Cap.goods
Money
Enterprise
Innovative function
Risk
Decision making
INPUTS
CAPITAL
LABOR
Workers
Entrepreneur
Land &
Structures
Machinery
plant &
equipment
Natural
Resources
Factors of Production
Inputs
Fixed Inputs
Variable Inputs
Concept of Product
Q = f(L, K)
10
12
12
10
7
3
1
24
28
28
23
18
8
2
31
36
36
33
28
12
3
36
40
40
36
30
14
4
40
42
40
36
30
14
5
39
40
36
33
28
12
6 L
TP = Q = f(L)
Marginal Product
TP
MPL =
L
Average Product
TP
APL =
L
Production or
Q/Q
=
E
Output Elasticity L L/L
Q/ L = MPL
APL
Q/L
L
0
1
2
3
4
5
6
Q
0
3
8
12
14
14
12
MPL
3
5
4
2
0
-2
APL
3
4
4
3.5
2.8
2
EL
1
1.25
1
0.57
0
-1
L
0
1
2
3
4
5
6
Q
0
3
8
12
14
14
12
MPL
3
5
4
2
0
-2
APL
3
4
4
3.5
2.8
2
EL
1
1.25
1
0.57
0
-1
Production Function
with One Variable Input
14
12
TP
10
8
6
4
2
Marginal
& Average
Product
Labor
6
5
D
E
AP
1
0
-1
-2
-3
MP
Labor
14
12
TP
10
4
2
Marginal
& Average
Product
Stage I of Labor
Stage II of Labor
B
Labor
AP
1
0
-1
-2
-3
MP
Labor
Marginal Revenue
Product of Labor
Marginal Resource
Cost of Labor
MRPL = (MPL)(MR)
TC
MRCL =
L
MPL
4
3
2
1
0
MR = P
$10
10
10
10
10
MPL
4
3
2
1
0
MR = P
$10
10
10
10
10
MRPL
$40
30
20
10
0
MRCL
$20
20
20
20
20
30
20
MRCL = w = $20
10
dL = MRPL
0
2.5
3.0
3.5
4.0
4.5
Exercise
MRPL = MRCL = w
28 20 Not efficient
L = 196
10
12
12
10
7
3
1
24
28
28
23
18
8
2
31
36
36
33
28
12
3
36
40
40
36
30
14
4
40
42
40
36
30
14
5
39
40
Q
36
33
28
12
6 L
Isoquants
dK= (-) Q/ L
dL
Q/ K
Q/ L = MPL and Q/ K = MPK
dK = - MPL = MRTS
dL
MPK
(L) MPL = -(K) MPK
Perfect Substitutes
Perfect Complements
2K
1L
Capital
Capital
6
4
6
B
4
-1K
2L
A
8
10
12
Labor
Labor
C Total Cost
w Wage Rate of Labor ( L)
C w
K L
r r
r Cost of Capital ( K )
Isocost Lines
Capital
10
AB
C = $100, w = r = $10
slope = -w/r = -1
vertical intercept = 10
1K
1L
2
B
10
Labor
Isocost Lines
Capital
14
Isocost Lines
10
8 A
AB
C = $100, w = r = $10
AB
C = $140, w = r = $10
AB
C = $80, w = r = $10
AB*
4
B
0
10 12 14 16
B*
20
Labor
C = $100, w = r = $10
AB
C = $140, w = r = $10
AB
C = $80, w = r = $10
MRTS = w/r
Product lines
A product line shows the movement
from one isoquant to another as we
change both factors or a single factor.
The product line describes the
technically possible alternative paths of
expanding output and what path
actually be chosen by the firm will
depend on the prices of factors.
w
r
MPL = MPK
w
r
Profit Maximization
MRP(input) = MRC(input)
with constant input prices
MRP(input) = input price
To maximize Profits:
MRPL = w = (MPL)(MR)
MRPK = r = (MPK)(MR)
MPL = w
MPK r
MPL = MPK
w
r
Returns to Scale
Production Function Q = f(L, K)
Q = f(hL, hK)
If = h, constant returns to scale.
If > h, increasing returns to scale.
If < h, decreasing returns to scale.
Returns to Scale
Constant
Returns to
Scale
Increasing
Returns to
Scale
Decreasing
Returns to
Scale
Q=ALa Kb
Exercise
Do the following production functions have constant,
increasing or decreasing returns of scale? ( K, L, M
are inputs)
a.
b.
c.
d.
e.
Q = 0.5X + 2Y + 40Z
Q = 3L + 10K + 500
Q = K0.3 L0.5
Q = 4A2 + 6B2 + 8AB
Q = 10L 0.5 K 0.6
Exercise
a.
b.
a)
(27*25*8)/ 18000 = (48*25*8) / 32000 = 0.3
In both instances, the last dollar spent on each machine
increased output by the same 0.3 units, indicating an
optimal mix of testing machines.
Exercise
The marginal product of labor for international
trading is given by the equation
MPL = 10K0.5/L0.5
Currently the firm is using 100 units of capital and
121 units of labor. The capital stock is constant but
the labor can be varied. If the price of labor is 10/and price of output is Rs. 2/- per unit, is the firm
operating efficiently in the short run? If not,
determine the optimal rate of labor input.
Answer: K= 0.8L,
L= 11.18 and K= 8.94,
L = 7.905 and K = 12.65