Theory of Production

Chapter Overview
Chapter Outline
• The production function
• Short- versus long-run decisions
• Measures of productivity
• Manager’s role in production process
• Algebraic forms of the production function and productivity
• Isoquants and isocosts
• Cost minimization and optimal input substitution

5-2
 Chapter Overview
Introduction
• Chapter 4 focused on how consumers adjust
consumption decisions in reaction to price and
income changes. The theory developed illustrates the
underlying principles of individual and market
demand curves.
• This chapter examines how managers select the
optimal mix of inputs that minimize production costs.

5-3
 The Production Function

The Production Function

• Mathematical function that defines the maximum
amount of output that can be produced with a given
set of inputs.

, where
• is the level of output.
• is the quantity of capital input.
• is the quantity of labor input.

5-4
 The Production Function
Short-Run versus Long-Run Decisions:
Fixed and Variable Inputs
• Short-run
• Period of time where some factors of production (inputs)
are fixed, and constrain a manager’s decisions.
• Long-run
• Period of time over which all factors of production (inputs)
are variable, and can be adjusted by a manager.

5-5
 The Production Function

Measures of Productivity
• Total product (TP)
• Maximum level of output that can be produced with a
given amount of inputs.
• Average product (AP)
• A measure of the output produced per unit of input.
• Average product of labor:
• Average product of capital:
• Marginal product (MP)
• The change in total product (output) attributable to the last
unit of an input.
• Marginal product of labor:
• Marginal product of capital:

5-6
 The Production Function

Measures of Productivity in Action

• Consider the following production function when 5
units of labor and 10 units of capital are combined
produce: .
• Compute the average product of labor.
units per worker
• Compute the average product of capital.
units capital unit

5-7
Schedule
Units of Land Units of Labour Total Product Marginal Average Product Stages
(TP) Product (MP) (AP)
10 1 50 50 50
Stage 1
10 2 130 80 65
10 3 210 90 70
10 4 250 40 62.5 Stage 2
10 5 260 10 52
10 6 260 0 43.3
10 7 250 -10 35.7 Stage 3
 The Production Function
Relation between Productivity Measures in
Action
Total product Decreasing
Increasing Negative
Average product marginal
marginal marginal
Marginal product returns to labor
returns to labor returns to labor

Total product (TP)

Average product (APL)

0 Marginal product (MPL) Labor input

(holding capital constant)

5-9
Relationship between TP, AP and MP
• 1. When MP increases then TP increases at increasing rate and AP
also Increases.

• 2. When MP is zero TP is Maximum

• 3. When MP is negative TP starts falling.

 The Production Function
The Manager’s Role in the
Production Process
• Produce output on the production function.
• Aligning incentives to induce maximum worker effort.
• Use the right mix of inputs to maximize profits.
• To maximize profits when labor or capital vary in the short
run, the manager will hire:
• Labor until the value of the marginal product of labor equals the
wage rate: , where
• Capital until the value of the marginal product of capital equals the
rental rate: , where

5-11
 The Production Function
Manager’s Role in the Production
Process in Action
• Suppose a firm sells its output in a competitive
market where its output is sold at $5 per unit. If
workers are also hired at a competitive wage of $200,
what is the marginal productivity of the last worker?
• Since, and , then,
units
• The marginal productivity of the last unit of labor is 40
units.
• Alternatively, management should hire labor such that the
last unit of labor produces 40 units.

5-12
Long Run Production Function

• ( All the factors of Production are Variable)

Change in input Change in Output Stage of Production

+ 50% +70% Increasing Returns to scale
+50% +50% Constant Returns to Scale
+50% +25% Diminishing Returns to
Scale
 The Production Function
Isoquants and Marginal Rate of
Technical Substitution
• Isoquants capture the tradeoff between combinations
of inputs that yield the same output in the long run,
when all inputs are variable.
• Marginal rate of technical substitutions (MRTS)
• The rate at which a producer can substitute between two
inputs and maintain the same level of output.
• Absolute value of the slope of the isoquant.

5-14
Isoquant (Similar to IC)
• A curve showing various combinations of two factors (inputs)yielding
same level of output.

• Isocost Line (Similar to Budget Line)

• Different combinations of factor inputs within the reach of producer

 The Production Function
Isoquants and Marginal Rate of
Technical Substitution in Action
Capital Input
t
u t pu
i ngo
s
ncrea
I

A
Su
bs
tit
uti 300 units of output
ng
l ab B
or
fo 200 units of output
rc
ap
ita
l =100 units of output

0 Labor Input

5-16
 The Production Function

Diminishing Marginal Rate of Technical

Substitution in Action
Capital Input (K)

D
Slope (at C):
3

C
Slope (at A):
B
∆ 𝐾 =1 A

=100 units

0 Labor Input (L)

∆ 𝐿=− 1 ∆ 𝐿=− 1

5-17
 The Production Function

Isocost Line
Capital Input (K)

𝐶
𝑟

𝐶
0 𝐿 Labor Input (L)
𝑤

5-18
 The Production Function

Changes in the Isocost Line

Capital Input (K)
𝐶1
𝑟
𝐶0 More expensive input
𝑟 bundles

Less expensive input

bundles

0
𝐶0 𝐶1
Labor Input (L)
𝑤 𝑤

5-19
 The Production Function

Changes in the Isocost Line

Capital Input (K)
𝐶
𝑟

Due to increase in wage rate

𝐶 𝐶
0 1 0 Labor Input (L)
𝑤 𝑤

5-20
 The Production Function

Cost-Minimization Input Rule in Action

Capital Input (K)
𝐶1
𝑟
𝐶2 𝐴
𝑟
𝑤
𝑀𝑅𝑇𝑆 𝐾𝐿=
𝑟

=100 units

0
𝐶2 𝐶1
Labor Input (L)
𝑤 𝑤

5-21
 The Production Function
Cost Minimization and the
Cost-Minimizing Input Rule
• Cost minimization
• Producing at the lowest possible cost.
• Cost-minimizing input rule
• Produce at a given level of output where the marginal
product per dollar spent is equal for all inputs:

• Equivalently, a firm should employ inputs such that the

marginal rate of technical substitution equals the ratio of
input prices:

5-22
 The Production Function

Cost-Minimizing Input Rule in Action

• Suppose that labor and capital are hired at a
competitive wage of $10 and $25, respectively. If the
marginal product of capital is 6 units and the marginal
product of labor is 3 units, is the firm hiring the cost-
minimizing units of capital and labor?
• Since , the marginal product per dollar spent on labor
exceeds the marginal product per dollar spent on capital.
• The firm is not minimizing costs and should use fewer units
of capital and more labor.

5-23
 The Production Function

Optimal Input Substitution in Action

Capital Input (K)
I

New cost-minimizing
point due to higher wage

F
B
𝐾2 Initial point of cost minimization
A
𝐾1
𝑄0
H J
0 𝐿2 𝐿1 G Labor Input (L)

5-24