Production Function Chapter 6

Production Function
Inputs Land Labor Capital Process Output

Product or service generated value added

Basic Concepts of Production Theory

Production function
Maximum amount of output that can be produced

from any specified set of inputs, given existing technology

Technical efficiency
Achieved when maximum amount of output is

produced with a given combination of inputs

Economic efficiency
Achieved when firm is producing a given output at

the lowest possible total cost

Basic Concepts of Production Theory

Inputs

variable or Fixed

Variable input
An input for which the level of usage may be changed quite

readily

Fixed input
level of usage cannot readily be changed must be paid even if no output is produced

Quasi-fixed input
An input employed in a fixed amount for any positive level of

output that need not be paid if output is zero

Basic Concepts of Production Theory

Short run At least one input is fixed All changes in output achieved by changing usage of variable inputs Long run All inputs are variable Output changed by varying usage of all inputs

Short Run Production

In the short run, capital is fixed Only changes in the variable labor input can change the level of output Short run production function

Q f ( L,K ) f ( L )

Production with one variable input

TPL = f(K,L ) Total product of labor (TPL) is defined as maximum rate of out put forthcoming from combining varying rates of labor input with a fixed capital input. Similarly, TPk = f(K,L ) Marginal Product of Labor MPL = Q/ L

Production with one variable input (contd.)

Marginal Product of Capital MPk = Q/ K Using Cobb-Douglas: Q =AKL MPL = dQ/dL = AKL-1 MPk = dQ/dK= AK-1L Average Product of Labor APL =TPL/L Average Product of Labor APK =TPK/K

Average & Marginal Products

Average product of labor AP = Q/L Marginal product of labor MP = Q/L When AP is rising, MP is greater than AP When AP is falling, MP is less than AP When AP reaches it maximum, AP = MP Law of diminishing marginal product
As usage of a variable input increases, a point is reached

beyond which its marginal product decreases

Total, Average, & Marginal Products of Labor, K = 2

Number of workers (L) 0 Total product (Q) Average product (AP=Q/L) 0 -52 56 56.7 55 51.6 47.7 43.4 39.3 Marginal product (MP=Q/L) -52 60 58 50 38 28 18

1
2 3 4

52
112 170 220

5
6 7 8 9 10

258
286 304 314 318 314

10
4 -4

35.3
31.4

Total, Average & Marginal Products, K = 2

Total, Average & Marginal Product Curves

Q2 Q1

Panel A
Q0

Total product

L0

L1

L2

Panel B
Average product

L0

L1

L2

Marginal product

Explaining TP, AP and MP

with a one-unit change in the variable input (i.e., MPL= Q/L) or the first derivative of the production function with respect to the variable input (MPL= dQ/dL), Average product is the rate of output produced per unit of the variable input employed (APL= Q/L), The law of diminishing marginal returns states that when increasing rates of a variable input are combined with a fixed rate of anotherinput, a point will be reached where marginal product will decline.
Marginal product is the change in output associated

Explaining Marginal Revenue Product

Marginal revenue product (MRP) is found by multiplying the marginal product function by marginal revenue ( i.e., MRP = MR.MP), The marginal revenue product function for a productive factor is the demand curve for that factor, Additional units of productive factor should be hired until the value of the marginal product of the input is equal to the prices of that input.

Cobb Douglas Production Function

There are various types of production functions, one is CobbDouglas production function: Q =AKL or, log Q = log A + log K + log L

Combination

A
B C D

6
3 2 1

1
2 3 6

Three important relationships can be found

1. Substitutability between Factors: There are a variety of ways to produce a particular rate of output (example: to produce a fixed units, any combination can be used). Therefore, the question of labor or capital-intensive production arises. 2. Return to Scale: If input rates are doubled, the output rate also doubles. [example: 200 = 1K + 4L, if 2K + 8L the Q would be = 400]. The relationship between output change and proportionate changes in both inputs is referred to Return to Scale. 3. Returns to Factor: When output changes because one input changes while the other remains constant, the changes in the output rates are referred to as Return to Factor. [example: 200 = 1K + 4L 1K + 8L = 250

Stages of Production
Q Increasing Marginal Returns

Diminishing Marginal Returns

Negative Marginal Returns

Q=F(K,L)

AP

MP

Isoquant
The combinations of inputs (K, L) that yield the

producer the same level of output. The shape of an isoquant reflects the ease with which a producer can substitute among inputs while maintaining the same level of output.
L

Linear Isoquants
Capital and labor are perfect substitutes
K

Increasing Output

Q1

Q2

Q3

Leontief Isoquants
Capital and labor are perfect complements
Capital and labor are
K Q1

Q3
Q2

Increasing Output

used in fixedproportions

Cobb-Douglas Isoquants
Inputs are not perfectly substitutable Diminishing marginal rate of technical substitution Most production processes have isoquants of this shape
K
Q2 Q1 Q3 Increasing Output

OPTIMAL EMPLOYMENT OF A FACTOR OF PRODUCTION

The marginal revenue product (MRP) of the last unit employed is equal to the cost of input

Data Set

Marginal Revenue Product is the labor demand function for the firm

Costs Theory and Analysis

Short run Diminishing marginal returns results

from adding successive quantities of variable factors to a fixed factor Long run Increases in capacity can lead to increasing, decreasing or constant returns to scale

Short Run Production Costs

Total variable cost (TVC) Total amount paid for variable inputs Increases as output increases Total fixed cost (TFC) Total amount paid for fixed inputs Does not vary with output Total cost (TC)

TC = TVC + TFC

Short-Run Total Cost Schedules

Output (Q) 0 100 200 300 400 500 600 Total fixed cost (TFC) taka 6,000 6,000 6,000 6,000 6,000 6,000 6,000 Total variable cost (TVC) Taka 0 4,000 6,000 9,000 14,000 22,000 34,000 Total Cost Taka TC=TFC+TVC) 6,000 10,000 12,000 15,000 20,000 28,000 40,000

Total Cost Curves

Average Costs

Short Run Marginal Cost

Short run marginal cost (SMC) measures rate of

change in total cost (TC) as output varies

Average & Marginal Cost Schedules

Output (Q) Average Average fixed cost variable cost (AFC=TFC/Q) (AVC=TVC/Q) -60 30 20 15 12 10 -40 30 30 35 44 56.7 Average total cost (ATC=TC/Q= AFC+AVC) -100 60 50 50 56 66.7 Short-run marginal cost (SMC=TC/Q) -40 20 30 50 80 120

100
200 300 400

500
600

Average & Marginal Cost Curves

Short Run Average & Marginal Cost Curves

Short Run Cost Curve Relations

AFC decreases continuously as output increases
Equal to vertical distance between ATC & AVC

AVC is U-shaped
Equals SMC at AVCs minimum

ATC is U-shaped
Equals SMC at ATCs minimum

Short Run Cost Curve Relations

SMC is U-shaped
Intersects AVC & ATC at their minimum points
Lies below AVC & ATC when AVC & ATC are

falling
Lies above AVC & ATC when AVC & ATC are

rising

Relations Between Short-Run Costs & Production

In the case of a single variable input, short-run costs

are related to the production function by two relations

Short-Run Production & Cost Relations

Relations Between Short-Run Costs & Production

When marginal product (average product)

is increasing, marginal cost (average cost) is decreasing When marginal product (average product) is decreasing, marginal cost (average variable cost) is increasing When marginal product = average product at maximum AP, marginal cost = average variable cost at minimum AVC

Isocost
The combinations of inputs that cost the
K

producer the same amount of money For given input prices, isocosts farther from the origin are associated with higher costs. Changes in input prices change the slope of the isocost line

C0 K

C1

New Isocost Line for a decrease in the wage (price of labor).

Cost Minimization
K
Point of Cost Minimization
Slope of Isocost = Slope of Isoquant

Revenue
Total revenue the total amount received

from selling a given output TR = P x Q Average Revenue the average amount received from selling each unit AR = TR / Q Marginal revenue the amount received from selling one extra unit of output MR = TRn TR n-1 units

Profit
Profit = TR TC
The reward for enterprise Profits help in the process of directing resources to

alternative uses in free markets Relating price to costs helps a firm to assess profitability in production

Profit
Normal Profit the minimum amount

required to keep a firm in its current line of production Abnormal or Supernormal profit profit made over and above normal profit
Abnormal profit may exist in situations where firms

have market power Abnormal profits may indicate the existence of welfare losses Could be taxed away without altering resource allocation

Profit
Sub-normal Profit profit below normal profit Firms may not exit the market even if sub-normal profits made if they are able to cover variable costs Cost of exit may be high Sub-normal profit may be temporary (or perceived as such!)

Profit
Assumption that firms aim to maximise profit
May not always hold true

there are other objectives Profit maximising output would be where MC = MR

Cost/Revenue
150 145 140 Total 120 added Added to Added to total profit to total profit profit 40 30 Reduces total profit by this amount

Profit

Why? MC

20 18

If Assume output is at the firm were to The firm decides to Ifproduce the 104th unit, the process continues 100 The cost of forMC units. The MC of each successive MR unit addition produce one more unit thisproducingwould cost last the ONE producingrevenue th unit produced. 100 as toto produce than total the the 101st the addition it more is 20. of unit extra unit MC a cost of toProvided the now(-105) total in revenue is 18, earns resultis production MR it less than received from the total the The MR reduce total addition to this producing one would willmorethat 100th unit be worth selling so of revenue is 140would not profit and unit the firm expanding output as 150. producing. willis output the price be add 128 to firm can worth The profit. difference it the received from isadd theexpanding of worth difference The sellingmaximising profit that extra between and the the output.costthe two is output isto received from ADDED where MR = unit. revenue total profit MC that 100th unit to profit (130) MR

100

101

102

103

104

Output

Example
A micro-entrepreneur produces caps and hats for

women. The output-cost data of the business is reproduced below:

Output Total Cost 50 100 150 200 250 300 350 870 920 990 1240 1440 1940 2330 a. Estimate the total cost function and then use that equation to determine the average and marginal cost functions. Assume a cost function. b. Determine the output rate that will minimize average cost and the per-unit cost at that rate of output. c. The current market price of caps and hats per unit is Tk. 6.00 and is expected to remain at that level for the foreseeable future. Should the firm continue its production?

Estimate of Example
First we assume the cost function as

TC = c0+c1Q + c2Q2 +c3Q3 Results TC= 954.29 -2.46Q +0.02Q2 -.0002Q3 (5.9) (-0.75) (1.04) (-0.07) R2 = 0.99 F = 197.78 Comments: t-statistics are not acceptable though R2 and F are good. Second, we assume the cost function as TC = c0+c1Q + c2Q2 Results TC = 944.29 -2.24Q + 0.02Q2 t Stat (12.51) (-2.58) (8.45) R2 = 0.99 F = 394.86 Comments: t-statistics are acceptable and R2 and F are good.

Answer to Question (a)

a. The t-statistics, shown in the parenthesis of

the second estimation, indicate that the coefficient of each of the independent variables are significantly different from zero. The value of the co-efficient of determination means that 99 percent of the variation in total cost is explained by changes in the rate of output.

Answer (a) contd.

Answer (b)
The output rate that results in minimum per-unit cost

is found by taking the first derivative of the average cost function, setting it equal to zero, and solving for Q.

Answer (b) contd.

Sign mistake

Answer (c)
Because the lowest possible cost is Tk. 6.45 per unit,

which is above the market price of Tk. 6.00, the production should not be continued.

Assignment
Output Total Cost

25 100 150

700 920 990

200 280
360 460 600

1240 1440
1940 2330 3500