Chapter 6:

Production

The Theory and Estimation of

Production
The Production Function
Short-Run Analysis of Total, Average,
and Marginal Product
Long-Run Production Function
Estimation of Production Functions
Importance of Production Functions in
Managerial Decision Making

The Production Function

Production function: defines the
relationship between inputs and the
maximum amount that can be produced
within a given period of time with a given
level of technology.
Mathematically, the production function
can be expressed as
Q=f(X1, X2, ..., Xk)
Q: level of output
X1, X2, ..., Xk: inputs used in the
production process

The Production Function

Key assumptions
Some given state of the art in the
production technology.
Whatever input or input combinations
are included in a particular function, the
output resulting from their utilization is
at the maximum level.

The Production Function

For simplicity we will often consider a
production function of two inputs:
Q=f(X, Y)
Q: output
X: Labor
Y: Capital

The Production Function

The short-run production function
shows the maximum quantity of good or
service that can be produced by a set of
inputs, assuming the amount of at least
one of the inputs used remains
unchanged.
The long-run production function
shows the maximum quantity of good or
service that can be produced by a set of
inputs, assuming the firm is free to vary
the amount of all the inputs being used.

Short-Run Analysis of Total,

Average, and Marginal Product
Alternative terms in reference to
inputs
Inputs
Factors
Factors of production
Resources

Alternative terms in reference to

outputs
Output
Quantity (Q)
Total product (TP)
Product

Short-Run Analysis of Total,

Average, and Marginal Product
Marginal product (MP): change in
output (or Total Product) resulting
from a unit change in
Q a variable
MPX
input.
X
Average Product (AP): Total Product per
unit of input used. Q
APX

Short-Run Analysis of Total,

Average, and Marginal Product
If MP > AP then
AP is rising.
If MP < AP then
AP is falling.
MP=AP when AP
is maximized.

Short-Run Analysis of Total,

Average, and Marginal Product
Law of Diminishing Returns: As
additional units of a variable input
are combined with a fixed input, at
some point the additional output (i.e.,
marginal product) starts to diminish.
Nothing says when diminishing returns
will start to take effect, only that it will
happen at some point.
All inputs added to the production
process are exactly the same in
individual productivity

Short-Run Analysis of Total,

Average, and Marginal Product
The Three Stages of Production in the
Short Run
Stage I: From zero units of the variable
input to where AP is maximized (where
MP=AP)
Stage II: From the maximum AP to where
MP=0
Stage III: From where MP=0 on

Short-Run Analysis of Total,

Average, and Marginal Product
In the short run, rational firms should
only be operating in Stage II.
Why not Stage III?
Firm uses more variable inputs to produce
less output

Why not Stage I?

Underutilizing fixed capacity
Can increase output per unit by increasing
the amount of the variable input

Short-Run Analysis of Total,

Average, and Marginal Product
What level of input usage within
Stage II is best for the firm?
The answer depends upon how many
units of output the firm can sell, the
price of the product, and the
monetary costs of employing the
variable input.

Short-Run Analysis of Total,

Average, and Marginal Product
Total Revenue Product (TRP): market
value of the firms output, computed
by multiplying the total product by
the market price.
TRP = Q P

Marginal Revenue Product (MRP):

change in the firms TRP resulting
TRP
from a unit
change in the number of
X
inputs used.
MRP = = MP P

Short-Run Analysis of Total,

Average, and Marginal Product
Total Labor Cost (TLC): total cost of
using the variable input, labor,
computed by multiplying the wage
rate by the number of variable inputs
employed.
TLC = w X

Marginal Labor Cost (MLC): change in

total labor cost resulting from a unit
change in the number of variable
inputs used. Because the wage rate
is assumed to be constant regardless
of the number of inputs used, MLC is
the same as the wage rate (w).

Short-Run Analysis of Total,

Average, and Marginal Product
Summary of relationship between
demand for output and demand for
input
A profit-maximizing firm operating in
perfectly competitive output and input
markets will be using the optimal
amount of an input at the point at which
the monetary value of the inputs
marginal product is equal to the
additional cost of using that input.
MRP = MLC

Short-Run Analysis of Total,

Average, and Marginal Product
Multiple variable inputs
Consider the relationship between the
ratio of the marginal product of one
input and its cost to the ratio of the
marginal product of the other input(s)
MP1 MP2 MPk
and their cost.

w1
w2
wk
Other factors may outweigh this
relationship
Political/Economic risk factors`

The Long-Run Production Function

In the long run, a firm has enough
time to change the amount of all its
inputs.
Effectively, all inputs are variable.

The long run production process is

described by the concept of returns
to scale.

The Long-Run Production

Function
If all inputs into the production
process are doubled, three things
can happen:
output can more than double
increasing returns to scale (IRTS)

output can exactly double

constant returns to scale (CRTS)

output can less than double

decreasing returns to scale (DRTS)

The Long-Run Production

Function
One way to measure returns to scale
is to use a coefficient of output
elasticity:
Percentage change in Q
EQ
Percentage change in all inputs
If EQ > 1 then IRTS
If EQ = 1 then CRTS
If EQ < 1 then DRTS

The Long-Run Production

Function
Returns to scale can also be
described using the following
equation
hQ = f(kX, kY)
If h > k then IRTS
If h = k then CRTS
If h < k then DRTS

The Long-Run Production

Function
Graphically, the returns to scale
concept can be illustrated using the
following graphs.
Q

IRTS
Q

X,Y

DRTS

CRTS
Q

X,Y

X,Y

Estimation of Production
Functions
Forms of Production Functions

Short run: existence of a fixed factor to

which is added a variable factor
One variable, one fixed factor
Q = f(L)K

Increasing marginal returns followed by

decreasing marginal returns
Cubic function
Q = a + bL + cL2 dL3

Diminishing marginal returns, but no Stage I

Quadratic function
Q = a + bL - cL2

Estimation of Production
Functions
Forms of Production Functions
Power function

Q = aLb
If b > 1, MP increasing
If b = 1, MP constant
If b < 1, MP decreasing
Can be transformed into a linear equation
when expressed in logarithmic terms
logQ = loga + bLogL

Estimation of Production
Functions
Forms of Production Functions
Cobb-Douglas Production Function: Q = aLbKc
Both capital and labor inputs must exist for Q to be
a positive number
Can be increasing, decreasing, or constant returns
to scale
b + c > 1, IRTS
b + c = 1, CRTS
b + c < 1, DRTS

Permits us to investigate MP for any factor while

holding all others constant
Elasticities of factors are equal to their exponents

Estimation of Production
Functions
Forms of Production Functions
Cobb-Douglas Production Function
Can be estimated by linear regression analysis
Can accommodate any number of independent
variables
Does not require that technology be held constant
Shortcomings:
Cannot show MP going through all three stages in one
specification
Cannot show a firm or industry passing through
increasing, constant, and decreasing returns to scale
Specification of data to be used in empirical estimates`

Estimation of Production
Functions
Statistical Estimation of Production
Functions
Inputs should be measured as flow
rather than stock variables, which is
not always possible.
Usually, the most important input is
labor.
Most difficult input variable is capital.
Must choose between time series and
cross-sectional analysis.

Estimation of Production
Functions
Aggregate Production Functions
Many studies using Cobb-Douglas did not
deal with individual firms, rather with
aggregations of industries or an economy.
Gathering data for aggregate functions can
be difficult.
For an economy: GDP could be used
For an industry: data from Census of
Manufactures or production index from Federal
Reserve Board
For labor: data from Bureau of Labor Statistics

Importance of Production Functions in

Managerial Decision Making
Production levels do not depend on how
much a company wants to produce, but
on how much its customers want to buy.
Capacity Planning: planning the amount
of fixed inputs that will be used along
with the variable inputs. Good capacity
planning requires:
Accurate forecasts of demand
Effective communication between the
production and marketing functions

Copyrights
Kea and Young