Micro Economics –ECO402 VU

LESSON 17
PRODUCTION (Continued)

PRODUCTION WITH TWO VARIABLE INPUTS

There is a relationship between production and productivity. Long-run production K& L are
variable. Isoquants analyze and compare the different combinations of K & L and output.

The Shape of Isoquants

Capital
per 5 E In the long run both
year labor and capital are
4 variable and both
experience
diminishing
3 returns
A B C
2
Q3 = 90
1 D Q2 = 75
Q1 = 55
1 2 3 4 5 Labor per year

DIMINISHING MARGINAL RATE OF SUBSTITUTION

Reading the Isoquant Model
1) Assume capital is 3 and labor increases from 0 to 1 to 2 to 3. Notice output increases
at a decreasing rate (55, 20, 15) illustrating diminishing returns from labor in the short-
run and long-run.
2) Assume labor is 3 and capital increases from 0 to 1 to 2 to 3. Output also increases at
a decreasing rate (55, 20, 15) due to diminishing returns from capital.

SUBSTITUTING AMONG INPUTS

Managers want to determine what combination if inputs to use. They must deal with the trade-
off between inputs. The slope of each isoquant gives the trade-off between two inputs while
keeping output constant. The marginal rate of technical substitution equals:

MRTS = - Change in capital/Change in labor input

MRTS = − ∆K (for a fixed level of Q )

∆L
MARGINAL RATE OF TECHNICAL SUBSTITUTION

Capital 5
per year
Isoquants are downward
2 sloping and convex
4 like indifference
curves.
1
3
1
1
2
2/3 Q3 =90
1
1/3 Q2 =75
1 1
Q1 =55
1 2 3 4 5 Labor per month

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OBSERVATIONS:
1) Increasing labor in one unit increments from 1 to 5 results in a decreasing MRTS from
1 to 1/2.
2) Diminishing MRTS occurs because of diminishing returns and implies isoquants are
convex.

MRTS AND MARGINAL PRODUCTIVITY

The change in output from a change in labor equals:
(MP L )( ∆ L)
The change in output from a change in capital equals:
(MP K )( ∆ K)
If output is constant and labor is increased, then:

(MP L )( ∆ L) + (MP K )( ∆ K) = 0
(MP L )(MP K ) = - ( ∆ K/ ∆ L) = MRTS
Isoquants When Inputs are perfectly substitutable
Capital per A
month

C
Q1 Q2 Q3 Labor per
month

OBSERVATIONS WHEN INPUTS ARE PERFECTLY SUBSTITUTABLE:

1) The MRTS is constant at all points on the isoquant.
2) For a given output, any combination of inputs can be chosen (A, B, or C) to generate
the same level of output (e.g. toll booths & musical instruments).

Fixed-Proportions Production Function

Capital
per
month

Q3
C
Q2
B

K1 Q1
A
Labor
per
month
L1

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Micro Economics –ECO402 VU

OBSERVATIONS WHEN INPUTS MUST BE IN A FIXED-PROPORTION:

1) No substitution is possible. Each output requires a specific amount of each input (e.g.
labor and jackhammers).
2) To increase output requires more labor and capital (i.e. moving from A to B to C which
is technically efficient).

A PRODUCTION FUNCTION FOR WHEAT

Farmers must choose between a capital intensive or labor intensive technique of production.

ISOQUANT DESCRIBING THE PRODUCTION OF WHEAT

Capital
(Machine Point A is more
hour per 120 capital-intensive, and
year) A B is more labor-
intensive.
100 ∆K = -10 B
90
80 ∆L = 260
Output = 13,800
bushels per year

40
Labor
(hours per year)
250 500 760 1000

OBSERVATIONS:
1) Operating at A:
L = 500 hours and K = 100 machine hours.

2) Operating at B
Increase L to 760 and decrease K to 90 the MRTS < 1:
MRTS = - ∆K = −(10 / 260) = 0.04
∆L

3) MRTS < 1, therefore the cost of labor must be less than capital in order for the farmer
substitute labor for capital.

4) If labor is expensive, the farmer would use more capital (e.g. U.S.).

5) If labor is inexpensive, the farmer would use more labor (e.g. India).

RETURNS TO SCALE
Measuring the relationship between the scale (size) of a firm and output

INCREASING RETURNS TO SCALE: output more than doubles when all inputs are doubled
• Larger output associated with lower cost (autos)
• One firm is more efficient than many (utilities)
• The isoquants get closer together

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Capital Increasing Returns: A

(machine The isoquants move closer
hours) together

30

2 20

10

Labor (hours)
0 5 10

CONSTANT RETURNS TO SCALE: output doubles when all inputs are doubled.
• Size does not affect productivity
• May have a large number of producers
• Isoquants are equidistant apart

Capital
(machine
hours) A
6

30

4 Constant Returns:
Isoquants are
20 equally spaced

10

Labor (hours)
0 5 10 15

DECREASING RETURNS TO SCALE: output less than doubles when all inputs are doubled
• Decreasing efficiency with large size
• Reduction of entrepreneurial abilities
• Isoquants become farther apart

Capital A
(machine
hours)
Decreasing Returns:
Isoquants get further
apart
4

30

2
20
10

0 5 10 Labor (hours)

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RETURNS TO SCALE IN THE CARPET INDUSTRY

The carpet industry has grown from a small industry to a large industry with some very large
firms.

Question:
Can the growth be explained by the presence of economies to scale?

The U.S. Carpet Industry

Carpet Shipments, 1996
(Millions of Dollars per Year)

1. Shaw Industries $3,202 6. World Carpets $475

2. Mohawk Industries 1,795 7. Burlington Industries 450

3. Beaulieu of America 1,006 8. Collins & Aikman 418

4. Interface Flooring 820 9. Masland Industries 380

5. Queen Carpet 775 10. Dixied Yarns 280

Are there economies of scale?

Costs (percent of cost)

• Capital -- 77%
• Labor -- 23%

Large Manufacturers
• Increased in machinery & labor
• Doubling inputs has more than doubled output
• Economies of scale exist for large producers

Small Manufacturers
• Small increases in scale have little or no impact on output
• Proportional increases in inputs increase output proportionally
• Constant returns to scale for small producers

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