R.S.

Dauda
 Introduction
 The Production Function
 Laws of Production
 Equilibrium of the Firm
 Euler’s Theorem
 Our first topic deals with the demand side of the market—the preferences and
behaviour of consumers.

 Topic two focuses on the supply side, which examines the behaviour of
producer/firm.

 Issues such as how firms can produce efficiently and how their costs of
production change with changes in both input prices and the level of output are
of impotance in this second topic

 The firm is the second important actor on the microeconomic stage.

 A firm is a technical unit in which commodities are produced.

 It is an entity or company within an industry created by individuals for some

purposes such as profit making, output maximization, etc.

 This entity typically acquires inputs and combines them to produce output.

 Examples of a firm is Mountain Top University, Nestle Nigeria Plc, Zenith Bank,
etc.

 Firm’s theory thus, deals with the actions of the firm as they relate to
production, cost, revenue and profit.
 Irrespective of the objective of any firm, one of the prime concerns of every
business manager is efficiency in production or cost minimisation for a given
production activity.
 The manager seeks to produce at competitive costs for the
survival of the firm, particularly in a competitive environment.

 To do this the following issues become critical:

1. Production optimization or costs minimization

2. Output behaviour as input rises
3. Effect of technology on production costs
4. Achievement of least-cost combination of input
5. Given the technology, what happens to the rate of return
when more plants are added to the firm?

The theory of production helps to address these issues, using

abstract models built under hypothetical conditions.

Thus, providing tools and techniques for analyzing production

conditions and finding solutions to practical business problems.

 Production theory in general therefore deals with quantitative

relationships between inputs and outputs.
 Production Decisions of a Firm
 The production decisions of firms can be understood in three steps:

 1. Production Technology: This is the practical way of describing

how inputs (are combined by firms in the process of production.

 2. Cost Constraints: This has to do with input prices in addition to

the money outlay.

 3. Input Choices: Given its production technology and the prices of

inputs, the firm must choose the quantity of inputs to combine in
producing its output.

 These three steps are the building blocks of the theory of the firm.
 Firms production decisions are taken in two specific time periods of
short and long run.

 In the short run , at least one input is fixed while the Long-Run all
inputs become variables.

 Generally, a firm operates in the short-run and plans

increases/expansion or reductions in its scale of operation in the
long-run.
 The principal activity of any firm is to turn inputs into outputs.
 Production function is a technical relation which connects inputs and outputs.
 It describes the laws of proportion (the transformation of inputs into outputs) at
any particular time period.
 Moreover production function represents the technology of a firm or of the
economy as a whole.

 It describes and includes all the technically efficient methods or production

 Production process: This is the or activity that involves the combination of
inputs required for the production of output.

 Usually a commodity may be produced using various methods of production.

 This for example, could be capital or labour intensive methods

 The basic theory of production concentrates only on efficient methods. A

rational firm/manager/entrepreneur will not use inefficient methods.

 A method of production A is technically efficient relative to any other method

B, if A uses less of at least one factor and no more from the other factors as
compared with B. From Figure 2.1 below A is efficient while B is technically
inefficient

 Figure 2.1Production methods

 However if a process A uses less of some factor(s) and
more of some other(s) as compared with any other process
B, then A and B cannot be directly compared on the
criterion of technical efficiency.

 In Figure 2.2 below A and B are not directly comparable.

 Figure 2.2 Production methods

 Both processes are considered as technically efficient and

are included in the production function (the technology).

 However, the choice of either at any given time depends

input prices

 The choice of any particular technique (among the set of

technically efficient processes) is an economic decision,
based on prices, and not a technical one.
 We assume two inputs of capital (K) and labour (L). Production
function therefore is given as
 Q = f(K, L) (2.1)

 Production function with an input with the

corresponding output can be shown as
 Forms of PF
 There are several forms of specifying PF.
Some of these are:
 Note that AP without specific input is indicated as APL.
 MP without specific input is indicated as ∂Q/∂L.

 Given a CD PF of the type Q  AK  L1

 with A, α & 1-α being parameters.

 Where: A is productivity parameter, α and 1-α are share of output
accruing to capital and labour respectively. It is further assumed that 0
≤α≤ 1

 Determine the following:

 APL = TP/L = Q/L
 APK = TP/K = Q/K
 MPL= ∂TP/∂L = ∂Q/∂L or ΔQ/∂L
 MPK = ∂TP/∂K = ∂Q/∂K or ΔQ/∂K
 
 1    
Q AK L AK LL AK L AK K
APL       A 
L L L LL L L

 1    
Q AK L AK LL AK L L K L K
APK      A  A  
K K K KL K L KL


TP Q  1 1    1 K K
MPL    AK (1   ) L  AK (1   ) L  AK (1   )   A(1   )   A(1   ) 
L L L L L


TP Q  1 1  1  K L L K LK
MPK    AK L  AK K LL  A  A  A  
K K K L K L KL
 Production functions involve concepts which
are useful tools in all fields of economics. The
main concepts are:

 1. Marginal productivity of inputs.

 2. Marginal rate of (technical) substitution and
the elasticity of substitution.
 3. Factor intensity.
 4. Production efficiency.
 5. Returns to scale.
 Types of Production Functions
 There are three basic types of production
function thee are:

 1. Cobb Douglas production function

 2. Leontief Production Function

 3. Constant Elasticity Substitution (CES)
Production Function
 THE COBB–DOUGLAS (CD)PRODUCTION FUNCTION
 The CD PF was developed by two American economists, Charles W.
Cobb and Paul. H Douglas

 CD PF is the most widely used functional form of PF for empirical and

instructional purposes

 This is due to some desirable mathematical properties it possesses,

which include:
1. substitutability of inputs;
2. returns to scale; and
3. the law of diminishing marginal product

 Given a CD PF of the type Q  AK  L1 (2.2)

 with A, α & 1-α being parameters.

 Where: A is productivity parameter, α and 1-α are share of output

accruing to capital and labour respectively.

 It is further assumed that 0 ≤α≤ 1.

 Equation (2.2) can be used to determine:
 Average product (AP) and Marginal
Product (MP) for each of the inputs as:
 TP = Q

 APL = TP/L = Q/L

 APK = TP/K = Q/K
 MPL= ∂TP/∂L = ∂Q/∂L or ΔQ/∂L

 MPK = ∂TP/∂K = ∂Q/∂K or ΔQ/∂K

 Example: Given that production function is represented by
 Q = F(K,L) = 600K2L2 - K3L3
 Determine MPL and APL when K = 10

 2. Leontief Production Function (LPF)

 The Leontief production function was developed by W. Wassily Leontif

 It uses fixed proportion of inputs having no substitutability between them.

 This implies that if the input-output ratio is independent of the scale of
production, it is an indication that the Leontief production function exists .

 The LPF assumes strict complementarity of factors of production.

 The function is some times referred to as fixed proportion production function.

 The LPF can be specified as follows:

 Q= min (Z1/a, Z2/b)
 Where, Q = quantity of output produced
 Z1 = uses quantity of input 1
 Z2 = employs quantity of input 2
 a and b = constants which are the fixed input requirements for producing a
single unit of output.
 Minimum implies that the total output depends on the smaller of the two
ratios.
 CES Production Function
 The CES production function was developed by Arrow,
Chenery, Minhas and Solow in 1961

 The CES PF is given as

Q = A [aK-θ+ (l-α)L-θ] -1/θ

 where Q is the total output, K is capital, L is labour, and

A is the efficiency parameter indicating the state of
technology and organisational aspects of production.

 The CES PF has the homogeneity degree of 1 that implies

that output would be increased with the same proportion
of increase in inputs.

 Thus, the CES production function is homogeneous of

degree one.
 The laws of production describe the technically possible ways of
increasing the level of production.
 Output may increase in various ways.
 For instance, output can be increased by changing all factors of
production, which is possible only in the long run.

 Thus, the laws of returns to scale refer to the long-run analysis

of production.

 In the short run output may be increased by using more of the

variable factor(s) while fixed inputs are held constant.

 The marginal product of the variable factor(s) will decline

eventually as more and more quantities of this factor are
combined with the other constant factors.

 The expansion of output with one factor (at least) constant is

described by the law of (eventually) diminishing returns of the
variable factor, which is often referred to as the law of
variable proportions.
 A. Laws of returns to scale: long-run analysis of production
 In the long run all inputs are variable. To expand output all inputs may be
varied.

 In the long run all factors are variable.

 The laws of returns to scale refer to the effects of scale relationships.

 The term 'returns to scale' refers to the changes in output as all inputs change
by the same proportion.

 Assume an initial level of inputs and output given as

 Q0 = f(L, K) (2.3)
 If we raise all the inputs by the same proportion, c.

 The new level of output, will be

 Q* = f(cL, cK) (2.4)

 Which will definitely be than the original level of output, Q0

 If Q* rises by the same proportion, c as the inputs, then we have Constant

returns to scale.

 If it rises less than the proportion, then we have decreasing returns to scale.

 If it increases more than the proportion, then we increasing returns to scale.

 The table below shows different outputs that can be produced in the
long run with combination of capital and labour, both of which are
variables
 The table shows three stages of production
 Behaviour of TP,MP & AP during the three stages of production.

 From the table only stage II is rational, which means relevant

range for a rational firm to operate.
 In stage I, it is profitable for the firm to keep on increasing
employment of labour.
 In stage III, MP is negative and hence it is not advisable to use
or employ additional labour.
 An important way to measure returns to scale
is to use a coefficient of output elasticity:

 OUTPUT ELASTICITY
Q L

 Q L . Q
E = Output elasticity of labour

Q K
 EQ  .
K Q
= Output elasticity of capital

 if EQ > 1 then IRTS

 if EQ = 1 then CRTS
 if EQ < 1 then DRTS
 Returns to scale and homogeneity of the production function
 Suppose we increase both inputs in equation (2.3)
by the same proportion c to have our equation (2.4)
 Q* = f(cL, cK)

 If c can be factored out, then the new level of

output Q* can be expressed as a function of c (to
any power λ) and the initial level of output
 Q* = c•f(L, K) (2.5)
 remains
 The production function is called homogeneous.

 If c cannot be factored out, the production

function is non-homogeneous.
 A homogeneous function is a function such that if each of
the inputs is multiplied by a constant , say c, and then c
can be completely factored out of the function.

 The power λ of c is called the degree of homogeneity of

the function and is a measure of the returns to scale:

 If λ = 1 we have constant returns to scale. This

production function is sometimes called linear
homogeneous.
 If λ < 1 we have decreasing returns to scale.
 If λ > 1 we have increasing returns to scale.

 Question:
 Differentiate between ‘returns to scale' and 'economies
of scale'.
 Returns to scale are measured mathematically by the
coefficients of the production function.
 For example, in a Cobb-Douglas production function

Q   0 L1 K  2 (2.6)
 The returns to scale are measured by the sum 1   2  
 Proof: Let L and K increase by c.
 The new level of output will be

 Q *   0 (cL) 1 (cK )  2 (2.7)

 This can be rewritten as Q *  c ( 1   2) (  0 L1 K  2 )

 Where   1   2 Q *  c  (  0 L1 K  2 )

Q *  c ( 1   2 ) Q Q*  c  Q

 Given a production function of the type

F (K,AL) = Kα(AL)1−α, 0< α < 1.
 Show that the function is homogenous of degree 1
  Graphical solution: Isoquant and Isocost
 Isoquant is a graphical representation of all possible
combinations of inputs (e.g. L & K) that result in the
production of a given level of output per unit of time.

 Q = f ( K, L) Slope = MPL/MPK = MRTS

K =-dk/dl. It shows the rate at
which labour can be
substituted for capital while
holding output constant
along an isoquant

Q4
Q3
Q2
Q1 L
 The shape of an isoquant is usually concave due to the law of
diminishing returns.

 Marginal rate of technical/factor substitution

 The marginal rate of technical substitution also
known as marginal rate of substitution illustrates the
rate at which an input is substituted for another to
maintain the same level of productivity.

 It is also defined as the amount of one factor (e.g.

K) that can be replaced by one factor (e.g. L).

L L
 Symbolically, it is given as: MRTS  
K K
 Isoquant and Isomap
 Isocost: An isocost is a graphical illustration of all the possible
combinations of two factors that can be used at given costs and for a
given producer’s budget.

 It shows various combinations of labour and capital that the firm can
buy for a given factor prices

Cost/r Cost = rK + wL
where r = price of capital
w = wage rate

Slope = w/r

0 L
Cost/w
  Input Optimizing Rule
 In general, to minimize total production costs subject to a fixed level of
output, or to maximize total output subject to a fixed operating budget,
 the marginal product per last money spent on each input must be the same for
all inputs. This is the same as MPL w
MPL

MPK 
w r MPK r
 This implies that efficient production requires that the isoquant be tangential
to the isocost line.

Cost/r Cost = r.K +w. L

Slope = w/r

Q2

Q1
L
 Input Optimizing Rule…
 Functional derivation of the equilibrium conditions
 Max: Q = f(L, K) (output or isoquant) (2.8)
 St: C = wL + rK (cost constraint or isocost) (2.9)
 From equation (2.9)
 C- wL- rK = 0 (2.10)
 From equations (2.8) and (2.10) a composite function can be
formed as
 Θ = Q + λ(C - wL - rK) (2.11)
 It can be shown that maximisation of equation (2.11) implies
maximisation of the output.

 The first condition for the maximisation of a function is that

its partial derivatives be equal to zero.

 The partial derivatives of equation (2.11) with respect to L, K

and λ . are:
 (2.12)
 Q
   ( w)  0
 L L (2.13)
 Q
   (r )  0
 K K (2.14)

 C  wL  rK  0

 Solving the first two equations for λ will give

Q Q / L MPL
  
  w which implies w w
L
Q Q / K MPK
 And also  r and implies   
L r r
 Both expressions must be equal for output maximization
resulting from the combination of both inputs L and K
because the condition for equilibrium requires that this firm
must equate the ratio of the marginal productivities of factors
to the ratio of their prices (This is the necessary condition).

Q / L Q / K MPL Q / L w
 Thus  and  
w r MPK Q / K r
 It can be shown that the second-order condition for
equilibrium of the firm requires that the marginal
product curves of the two factors have a negative
slope.
 The slope of the marginal product curve of labour is
the second derivative of the production function:
 The slope of MPL is  2Q
L2

 And the slope of MPK is  2Q

K 2

The second-order conditions are:

 Q 2

  Q  0 and
2
0
K 2
L 2

 These are necessary conditions for equilibrium to

hold or for optimisation
  Cost minimisation for a given level of output

 The firm minimises its costs by employing the combination of K and L

determined by the point of tangency of the Q isoquant with the lowest isocost
line as shown in the Figure.
 Points below e are desirable because they show lower cost but are not
attainable for output Q. Points above e show higher costs. Hence point e is the
least-cost point, the point denoting the least-cost combination of the factors K
and L for producing Q.

 Clearly the conditions for equilibrium (least cost) are the same as the case of
output.

Cost/r Cost = r.K +w. L

Slope = w/r

 e


 0 Q1
L
 Cost minimisation for a given level of output...
 Functionally, this can be derived as:
 Min: C = f(Q) = wL + rK (cost constraint or isocost) (2.15)
 St: Q = f(L, K) (output or isoquant) (2.16)
 Equation (2.16) can be rewritten as
 Q - f(L, K) =0 (2.17)
 From equations (2.15) and (2.17) a composite function can be
formed as

 Θ = C – λ{Q - f(L, K)} (2.18)

 Equation (2.18) is the same as

 Θ = (wL + rK) – λ{Q - f(L, K)} (2.19)

 Taking the partial derivative of equation (2.19) with respect to L,

K and λ and equating them to zero gives:
 (2.20)

 f ( L, K ) Q
 w  w 0
 L L L (2.21)
 f ( L, K ) Q
  r   r  0 (2.22)
K K K


 Solving equations (2.20) and (2.21) will give  - {f(Q - L, K)}  0

Q Q

w r 
L L

So, w Q / L

  MRS L , K
 r Q / K (2.23)


 Equation (2.23) is the necessary condition

 The second order condition (sufficient condition) holds is fulfilled by the assumption of
negative slopes of the marginal product of factors

 2Q  2Q
0 0
L2 K 2
 In the long run all inputs vary and so, there is no limitation (technical or financial) to the
expansion of output.

 The firm's objective is the choice of the optimal way of expanding its output, so as to
maximise its profits.

 With given input prices (w, r) and given production function, the optimal expansion path is
determined by the points of tangency of successive isocost lines and successive isoquants.
 Expansion path (a scale line) of the firm is the locus of all efficient input combinations.

 It is the path that connects optimal input combinations as the scale of production expands.
 1. Suppose you are given the production function
 If the input prices are PL = N20 and PK = N30. Determine the expansion path.
 SOLUTION MPL MPK
 The expansion path is determined by equation  .Where
Q Q PL PK
 MP  and MP  .
L K
L K

0.5(30 ) K 0.7 L0.5 0.7(30 ) K 0.3 L0.5

 Therefore, 
20 30

 Solving for K shows that K  0.9L

 This implies that the expansion path is linear with a slope of 0.9 and a zero intercept.
 Generally the expansion path of all Cobb–Douglas production functions is linear with a zero
intercept.

 Practice question: Given the following production function: Q = 250(L+ 4K). And that the
price of labour (w) is N25 per hour and the rental price of capital (r) is N100 per hour.

 a. What is the optimal capital/labour ratio?

 b. Suppose that the price of capital were lowered to N25 per hour? What is the new optimal
ratio of capital to labour?
 Euler's Theorem states that if a production function is
homogeneous of degree one (i.e. Constant Returns to Scale) and
the factors are paid equal to their marginal products, the total
product is exhausted with no surplus and deficit.

 Thus, the theorem shows that for a production function with

constant returns to scale
Q Q
Q L K
 x1f1 + x2f2 = kf(x1,x2) or L K

 Where: f1  Q  MPPL and f2 

Q
 MPPK
L K
 Total output equals the MP of X1 multiplied by its quantity plus
the MP of X2 muitiplied by its quantity.

 If the firm were to pay the suppliers of an input its marginal

physical product, total output would just be exhausted.

 Total output would exceed payments if the degree of

homogeneity were greater than one and would be less than
payments if it were less than one.
 Proof of Euler's theorem
 A production function, Q = f(L, K), is homogeneous of degree v if
 f(λL, λK) = λv f(L, K)
df df
 Differentiating with respect to λ we obtainL K K  vv1 f ( L, K )
dL dK
 With constant returns to scale v = 1, and we have
L.( MPPL )  K .( MPPK )  f ( L, K )

 Given that f(L, K) = Q, Therefore Q  L.( MPPL )  K .( MPPK )

 Total physical (real) payments to inputs would exhaust the total

physical output.

 Multiplying through by P, the price of output, we see that in the case

of constant returns to scale
PQ  L.( MPPL .P)  K .( MPPK .P)
 This means that payment of inputs according to their VMP exhausts
the value of output, and share inputs add up to unity.

 Euler's theorem is an identity: it holds true for all values of the

variables.
 Euler's theorem played a major role in the
development of the marginal productivity theory of
distribution.

 The basic postulates of this theory are :

 (1) each input is paid the value of its marginal
product, and
 (2) total output is just exhausted.

 Since these conditions are satisfied by production

functions homogeneous of degree one, it was
generally assumed that all production functions are
of this type.
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