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Chapter 9 Production - University of Victoria

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Page 1: Chapter 9 Production - University of Victoria

Chapter 9 page 1

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Topic 4 Extra page1

Topic 4: The Production Function 1) The Production Function 2) Changing Factors of Production in the Short and Long

runs 3) The Short-Run Production Function Total Product Average Product Marginal Product

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Production functions◦ Average product, marginal product and related concepts

Properties of the production technologies◦ No free lunch, Non reversibility, convexity, Free

disposability

Production in the short run (SR) ◦ Idea of Diminishing returns

Production in the long run (LR)◦ Isoquants

◦ Marginal rate of technical substitutions (MRTS)

2Ch 9: Production

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Topic 4 Extra page2

Objective: To examine how firm and industry supply curves are derived.

Introduction: Up to this point we have examined how the market demand function is derived. Next, we will examine the supply side of the market. We will explore how firms minimize costs and maximize productive efficiency in order to produce goods and services. By effectively combining labour and capital, the firm develops a production process with the objective of efficient resource allocation and cost minimization. The firm is assumed to produce a given output at minimum cost.

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The Production Function Definitions: Factors of Production: are factors used to produce output. Example: Labour Capital - machines -buildings Land Natural resources State of technology: consists of existing knowledge about method of production.

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Topic 4 Extra page4

The quantity that a firm can produce with its factors of production depends on the state of technology. The relationship between factors of production and the output that is created is referred to as the production function.

“The production function describes the maximum quantity of output that can be

produced with each combination of factors of production given the state of technology.”

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Topic 4 Extra page5

For any product, the production function is a table, a graph or an equation showing the maximum output rate of the product that can be achieved from any specified set of usage rates of inputs. The production function summarizes the characteristics of existing technology at a given time; it shows the technological constraints that the firm must deal with.

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What is a production function?◦ A production function is the relationship by which inputs

are combined to produce output.

◦ Naturally we need some technology that efficiently converts inputs into outputs.

Some common assumptions on technology◦ No free lunch: without input there is no output.

◦ Non-reversibility: Can’t run the production process in reverse.

◦ Free disposability: Throw away the excess without any cost or using more inputs.

◦ Convexity:

3Ch 9: Production

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Mathematically,

Let x1 and x2 be inputs then output is produced by the following:

Y = F(x1,x2).

Frequently encountered inputs: Capital (K) and Labor (L)

4Ch 9: Production

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The Production“Mountain”

5Ch 9: Production

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Important production functions

1. The Leontief technology (fixed-proportions

technology)

Y(x1,x2) = min(ax1,bx2)

Example: Y(K,L) = min(1/6L,K)

2. The Cobb-Douglas technology (More realistic)

Example Cobb-Douglas p.f.:

3. Perfectly substitutable inputs p.f.:

Y(K,L)=aK+bL

2/12/1 LKY

6Ch 9: Production

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Topic 4 Extra page6

Model Assumption: The quantity produced per period is ‘q’, and the two factors of production are labour and capital.

Notation: The Production Function of the Firm: q=f(L, K)

where f , the function, describes the relationship between the inputs L, K and the output each different combination produces per period.

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Topic 4 Extra page7

Changing Factors of Production in the Short and Long Runs

We must make a distinction between the short and long run. In the short run, a firm is able to change some of the factors of production, but at least one factor is fixed. In the long run, all factors of production can be varied

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Topic 4 Extra page8

The Short-Run Production Function Model: consider the simplest case where there is one input whose quantity is fixed and one input whose quantity is variable.

Suppose that the fixed input is the number of machines (capital) and the variable input is labour.

In the short run the firm cannot change the number of

machines quickly without incurring a high cost.

With one fixed input the short-run production function shows how total output changes as the variable factor changes.

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Topic 4 Extra page9

The Total, Average and Marginal Product of Labour Total Product Function: expresses the relationship between the variable input and the total output. →The total product function of labour: TPL: shows the various amounts of output that is produced when the amount of labour is varied with a given fixed amount of capital.

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TPL(L,K*)=f(L, K*) Quantity TPL(L,K*) Labour The diagram illustrates what occurs when the amount of the variable input increases.

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Topic 4 Extra page11

The total product (output) increases when the amount of labour increases, holding the amount of capital fixed at K*. Quantity increases initially at an increasing rate, but eventually quantity increases at a decreasing rate when more labour is employed.

Algebraically: ∂

2

2 0TP L K

LL ( , )*

> at first;

and then eventually, ∂

2

2 0TP L K

LL ( , )*

< (becomes negative). At some point, adding more labour units no longer increases output.

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Topic 4 Extra page12

We can derive the average and marginal product function of labour from the total product function.

The average product function, APL, measures output per unit of labour:

Average product of labourTotal product of labourNumber of labour units

AP (L,K )TP (L,K )

LL* L

*

=

=

Average product of labour is the measure of productivity of labour. Average product of labour, APL, measures output per unit of labour.

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Topic 4 Extra page13

It is the slope of a ray drawn from the origin to any point on the TPL function. The average product of labour for any given level of employment is equal to the slope of a straight line drawn from the origin to the total product function at that employment level. Generally, the APL increases at first as labour is increased. I.e. the output per worker increases initially. Further increases in labour reduce APL. APL declines when employment increases.

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Topic 4 Extra page14

The marginal product of an input is the addition to total output resulting from the addition of the last unit of the input when the amount of other inputs used is held constant. The marginal product function of labour, MPL, measures the change in quantity due to a change in the labour input, or the slope of the total product function of labour:

Marginal product of labour in total product of labour in number of labour units

MP (L,K ) TP (L,K )LL

* L*

=

= =

ΔΔΔ

Δ∂∂TPKL

L

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Topic 4 Extra page15

There is a distinct relationship between marginal product and average product: When: MP>AP , AP is increasing MP<AP , AP is decreasing MP=AP , AP is constant and at a maximum The law of diminishing returns describes the eventual decline in the marginal product of the variable factor as the variable factor increases with other factors held constant. The law of diminishing returns applies only to situations where one factor is increasing and the other factors are fixed.

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Topic 4 Extra page16

“The law of diminishing marginal returns: if equal increments of an input are added, and

the quantities of other inputs are held constant, the resulting increments of product will decrease beyond some point; that is, the marginal product of the input will diminish.”

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Topic 4 Extra page17

Output Labour Output/L Labour

TPL

Average Product

Marginal Product

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Topic 4 Extra page18

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Marginal product of an input ◦ Marginal = “extra”

◦ Compare this to the concept of Marginal Utility

Guiding thought: ◦ “By how much does production increase if we increase an

input by a small amount?”

◦ Example: the marginal product of capital =

“small amount” = infinitesimally small amount, i.e. ◦ but loose interpretation is often 1 unit change.

K

LKFMPK

),(

K

7Ch 9: Production

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Total Product: ◦ The amount of output produced at given the level of inputs.

Marginal Product: ◦ The change in the total product that occurs in response to a

unit change in the variable input (all other inputs held fixed).

Example,

Average Product (of a variable input): ◦ is defined as the total product divided by the quantity of that

input.

Example, AP of labor=Y/L

◦ Geometrically, it is the slope of the line joining the origin to the corresponding point on the total product curve.

K

LKFMPK

),(

8Ch 9: Production

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Short run:

◦ the longest period of time during which at least one of the

inputs used in a production process cannot be varied.

Assuming K is fixed at , the short run production

function is then

Law of diminishing return:

◦ if other inputs are fixed, the increase in output from an

increase in the variable input must eventually decline. In other

word, the marginal product will increase then decrease as

more variable input is added. This is a short run phenomenon.

0KBLKLKY 0),(

9Ch 9: Production

Chapter 9 page 27

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10Ch 9: Production

Chapter 9 page 28

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11Ch 9: Production

Chapter 9 page 29

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12Ch 9: Production

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Some key things to remember:

◦ When marginal product curve lies above the average

product curve, the average product curve must be rising

and vice versa.

◦ Allocate the resource so that its marginal product is the

same across different activities.

◦ Always allocate resource to the activity that yields higher

marginal product.

13Ch 9: Production

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Long run:

◦ The shortest period of time required to alter the amounts of

all inputs used in a production process.

◦ In other words, all inputs are variable in the LR.

Isoquants:

◦ is the set of all input combinations that yield a given level

of output. Similar to the indifference curve in consumer

theory.

14Ch 9: Production

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1) The Long-Run Production Function ►Marginal Rate of Technical Substitution ►Returns to Scale ►Cobb-Douglas Production Function

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The Long-Run Production Function

In the long run, all factors of production are variable. Substitution Among Factors Similar to the notion of substituting between goods to maintain constant utility along an indifference curve, firms usually can produce the same output quantity by substituting between factors of production.

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The important question that needs to be addressed is:

“What combination of factors should be used to

produce this output?”

This question is difficult to answer because there is more than one way to produce the product.

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This can be illustrated with the aid of isoquant analysis.

The amount of capital is on the vertical axis and number of labour units is on the horizontal axis. The curve with an output of ‘q0’ is called an isoquant.

“Iso” means equal

“quant” means quantity.

The amount produced is the same along the isoquant. The points along the isoquant q0 represent the different factor combinations that can produce q0 units per period.

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“An isoquant shows the different combinations of factors of production that can produce a

given quantity of output.” Capital

K1

K2 q0 (Isoquant)

0 L1 L2 Labour

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15Ch 9: Production

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Marginal rate of technical substitution◦ It is the rate at which one input can be exchanged for

another without altering the total level of output.

16Ch 9: Production

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MRTS=- slope of the isoquant

Derivation:

L

K

L

K

MP

MPMRTS

MP

MP

L

FK

F

dK

dL

dLL

FdK

K

FcLKF

isoquant Slope

isoquant Slope

0),(

17Ch 9: Production

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The Marginal Rate of Technical Substitution

The marginal rate of technical substitution (MRTS) measures the rate of substitution of one factor for another along an isoquant.

“The marginal rate of technical substitution is the rate at which a firm can substitute capital

and labour for one another such that the output is constant.”

MRTSKLconstant

==

ΔΔKL q where Δ ΔK L is the slope

between two points on an isoquant.

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Note: An isoquant cannot have a positive slope.

An increase in one factor of production causes output to increase. Hence this increase in one factor must be offset by a decrease in other factor in order to keep output at the same level.

As the firm moves along the isoquant from left to right, the slope increases. The firm substitutes labour for capital, but at a diminishing rate. When this occurs there is a diminishing marginal rate of technical substitution.

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The MRTS and MP of Both Factors of Production The MRTS and marginal product of labour and capital are related. Suppose the firm decides to increase the amount of capital it employs, holding the amount of labour constant. Output will increase by the amount ΔqK because of the increase in capital ΔK . The increase in output is approximated by

Δ Δq MP KK K=

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If the firm holds capital constant and decreases the amount of labour it employs, output decreases by ΔqL , where the amount of labour decreases by ΔL.

The decrease in output is approximated by Δ Δq MP LL L= .

Along a given isoquant, output must be constant. If the firm increases capital by ΔK , labour must decrease by

an amount ΔL such that: ΔqK + ΔqL =0 in order to remain on the same isoquant.

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Substituting in these expressions, the condition becomes:

MP K MP LK LΔ Δ+ = 0

Rearranging such that we have an expression for the MRTS in terms of the marginal products of the two factors:

MRTS

KL

MPMPKL

L

K≡ = −

ΔΔ

The MRTS of K for L equals the negative of the ratio of the marginal product of L and K.

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Returns to Scale In general, the level of a firm’s productivity changes as the quantity produced by the firm changes. Returns to scale refers to the percentage change in output to a percentage change in inputs.

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Returns to scale: It tells us that what happens to output when all inputs are

increased by exactly the same proportion.

Guiding thought: What happens if we doubled all inputs?

Now, if

Output doubles too constant returns to scale

Output less than doubles decreasing returns to scale

Output more than doubles increasing returns to scale

18Ch 9: Production

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Three Cases:

1) When the percentage increase in inputs is smaller than the percentage increase in output, there are increasing returns to scale.

2) When the percentage increase in inputs leads to the

same percentage increase in output, there are constant returns to scale.

3) When the percentage increase in inputs is larger than

the percentage increase in output, there are decreasing returns to scale.

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Returns to Scale and the Cobb-Douglas Production Function A common production function is the Cobb-Douglas production function. Algebraically: q=ALaKb where A, a and b are constant and greater than zero.

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To determine the returns to scale for this function, we could change labour and capital by a factor ‘m’ and then determine if output changes by more than, equal to or less than ‘m’ times. q=A (mL)a(mK)b q=AmaLam b K b q=ma+b[ALaK b] Since originally output was q=ALaKb, we can determine if output will increase by either less than m times if a+b<1 (because ma+b<m), by exactly m times if a+b=1 or by more then m times if a+b>1.

Chapter 9 page 50


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