ECO 211: INTERMEDIATE

MICROECONOMICS

THE THEORY OF PRODUCTION

University of Malawi
Department of Economics

SEMESTER I
 The Production Function

• Possible combinations of inputs and outputs for a firm are

determined by technological constraints.
• Technology is an abstract description of the process
by which inputs are physically transformed into outputs

• The set of all combinations of inputs and outputs that

comprise a technologically feasible way to produce is called a
production set

• The production set shows the possible technological choices

facing a firm

• The maximum possible output that you can get from a given
amount of input is called the production function
 The Production Function

In the figure we have an • Any point (x, y ) in the

example of a production set production set implies that
which have one input, measured it is technologically possible
by x , and one output, measured to produce y amount of
by y . output if you have x
amount of input.

• The boundary of the

production set (maximum
output at a given level of
input), measures the
production function
 The Production Function

• We can also present a production function with more than one

inputs - f (x1, x2)

• This measures the maximum amount of output y that can be

produced using alternative combinations of x1 and x2.

• In the two-input case there is a convenient way to depict

production relations known as the isoquant.

• An isoquant is the set of all possible combinations of inputs 1

and 2 that are just sufficient to produce a given amount of
output.
 The Production Function
Properties of Production Technology
• Monotonic: if you increase the amount of at least one of the
inputs, it should be possible to produce at least as much output as
you were producing originally.

• Convex: If you have two ways to produce y units of output, (x1,

x2) and (z1, z2), then their weighted average will produce at least y
units of output.

• Suppose we have two production techniques a and b such that

1 unit of output is produced by using (a1, a2) or (b1, b2)

• We can further assume that (100a1, 100a2) and

(100b1, 100b2) will produce 100 units of output

• Convexity means that if you have 25a1 + 75b1 units of factor 1 and
25a2 + 75b2 units of factor 2 you can still produce 100 units of
output
 The Production Function

Properties of Production Technology

If you can operate production activities independently, then
weighted averages of production plans will also be feasible.
Thus the isoquants will have a convex shape.
 The Production Function
Marginal Product
• Marginal product of an input is the additional output that
can be produced by employing one more unit of that input
while holding all other inputs constant

• If we are operating at some point, (x1, x2), and that we

consider using a little bit more of factor 1 while keeping factor
2 fixed at the level x2, the marginal product is defined as
f (x 1 + △ x 1 ,x 2 )−f (x1,x2)
MP1(x1, x2) = △y
=
△x △x1

• The slope of the production function measures the marginal

product

• Typically, we expect that the marginal product of a factor will

diminish as we get more and more of that factor - law of
diminishing marginal product
 The Production Function
The Technical Rate of Substitution
• The technical rate of substitution (TRS)measures the rate
at which the firm will have to substitute one input for another
in order to keep output constant

• It measures the tradeoff between two inputs in production.

• From the definition of marginal product, the change in output
due to change in input 1 can be given as MP1(x1, x2)△x1

• We can therefore define the change in output along an

isoquant as follows;
△y = MP1(x1, x2)△x1 + MP2(x1, x2)△x2 = 0

• This equation can be solved to get, TRS(x1, x2):

MP1(x1,x2)
TRS(x1, x2) = △x2
△x1 =- MP2(x1,x2)
 The Production Function

Technical Rate of Substitution

• Assumption of diminishing technical rate of substitution
states that as we increase the amount of factor 1, and adjust
factor 2 so as to stay on the same isoquant, the technical rate
of substitution declines

• The assumption of diminishing TRS means that the slope of

an isoquant must decrease in absolute value as we move along
the isoquant in the direction of increasing x1, and it must
increase as we move in the direction of increasing x2.
 The Production Function
Examples of Production Technologies
Fixed proportions

Consider the following • It means that the inputs are

production function is written as used in fixed proportions to
f (x1, x2) = min{ax1, bx2}. produce a unit of output.

• min implies that the level

of output is given by the
smaller of the two inputs
• The firm characterised by
this technology will always
operate along the ray where
the ratio xx12 is constant
• On the ray, xx12 = b
a
 The Production Function
Examples of Production technologies
Perfect Substitutes

Consider the following • The isoquants are parallel

production function lines with slope −b
a
f (x1, x2) = ax1 + bx2. • The RTS for this
technology is constant

• Rare to encounter in life

because you cannot
produce an output with one
input in most cases
 The Production Function
Examples of Production technologies
Cobb Douglas Production Function

Consider the following • A measures the scale of

production function production
f (x1, x2) = Ax1ax2b .
• a and b measures elasticity
of of output to inputs.

• The linear form of the

Cobb Douglas production
function is given as

lny = lnA + alnx1 + blnx2

 The Production Function
Examples of Production technologies
Cobb Douglas Production Function
• Consider the following Cobb-Douglas Production function
y = 10x10.5x 20.5

• To find total output when x1 = 25 and x2 = 16, we just

substitute
y = 10 × 5 × 4 = 200
• To find the marginal product of factor 1, we find the partial
derivative of the production function with respect to x1
∂y 5x20.5
∂x1 = x10.5
= 5x1−0.5 x20.5

• Marginal product of factor 2 is

∂y 5x10.5 = 5x10.5 x2−0.5
∂x2 = x20.5
 The Production Function

Returns to Scale
• In production theory, we distinguish short run and long run
• The short run refers to the production period where some
factors of production are kept constant

• The long run refers to the production period where all factors
of production change

• Returns to scale describes what happens when you increase

all inputs

• If we increase both inputs by a factor m and output increases

by the same factor, we have constant returns to scale
f (mx1, mx2) = mf (x1, x2)
 The Production Function
Returns to Scale
• If we increase both inputs by a factor m and output increases
by more than the factor, we have increasing returns to scale
f (mx1, mx2) > mf (x1, x2)
• If we increase both inputs by a factor m and output increases
by less than the factor, we have decreasing returns to scale
f (mx1, mx2) < mf (x1, x2)