Session Objectives

• The Production Function

• Production in the Short Run
– Total, Average, and Marginal Product
– Law of Diminishing Returns
– Stages of Production
– Optimal Input Usage
• Production in the Long Run
– Returns to Scale

January 3, 2021 Session - Production 1

 Production
Transforming inputs into output

“An input is simply anything which the firm buys for use in
its production or other processes”. – Baumol
“An output is any good or service which comes out of
production process”.

January 3, 2021 Session - Production 2

 The Production Function
• A production function defines the relationship
between inputs and the maximum amount
that can be produced within a given time
period with a given technology.

January 3, 2021 Session - Production 3

 The Production Function
• Mathematically, the production function can
be expressed as
Q=f(X1,X2,...,Xk)
• Q is the level of output
• X1,X2,...,Xk are the levels of the inputs in the
production process

January 3, 2021 Session - Production 4

 Short Run
• The period in which firms can adjust
production only by changing variable factors
such as materials and labor but cannot change
fixed factors such as capital.

January 3, 2021 Session - Production 5

 Long run
Long run is a period sufficiently long enough so
that all factors in the production function,
including capital can be adjusted.

•The distinction between long run and short run

is important in production analysis as each one
has a different analysis.

January 3, 2021 Session - Production 6

 The Production Function
Economists often consider a production function of
two inputs:

Q=f (L,K)
•Q is output
•L is Labor
•K is Capital

January 3, 2021 Session - Production 7

 The Production Function
• When discussing production, it is important to
distinguish between two time frames.
• The short-run production function describes
the maximum quantity of good or service that
can be produced by a set of inputs, assuming
that at least one of the inputs is fixed at some
level.

January 3, 2021 Session - Production 8

 The Production Function
• The long-run production function describes
the maximum quantity of good or service that
can be produced by a set of inputs, assuming
that the firm is free to adjust the level of all
inputs.

January 3, 2021 Session - Production 9

 Production in the Short Run
• When discussing production in the short
run, three definitions are important.

•Total Product
•Marginal Product
•Average Product

January 3, 2021 Session - Production 10

 Production in the Short Run
• Total Product (TP) is the maximum level of
output that can be produced given amount of
inputs
• The total product function is the same as the
short run production function.

January 3, 2021 Session - Production 11

 Production in the Short Run
• The marginal product (MP) of a variable input
is the change in output (or TP) resulting from a
one unit change in the input.
OR
Is the change in the output (or TP) resulting
from a one unit change in the input.
• MP tells us how output changes as we change
the level of the input by one unit.

January 3, 2021 Session - Production 12

 Production in the Short Run
• The average product (AP) is a measure of the
output produced per unit of input.
• OR it is the total product divided by the level
of the input.
• AP tells us, on average, how many units of
output are produced per unit of input used.

January 3, 2021 Session - Production 13

 Production in the Short Run
• Consider the two input production function
Q=f(X,Y) in which input X is variable and input
Y is fixed at some level.
• The marginal product of input X is defined as

Q
MPX 
X
holding input Y constant.

January 3, 2021 Session - Production 14

 Production in the Short Run
• The average product of input X is defined as
Q
APX 
X
holding input Y constant.

January 3, 2021 Session - Production 15

 Production in the Short Run
The table below represents a firm’s
production function, Q=f(X,Y):
Units of Y
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of X Employed
January 3, 2021 Session - Production 16
 Production in the Short Run
In the short run, let Y=2. The row highlighted below
represents the firm’s short run production function.

Units of Y
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of X Employed
January 3, 2021 Session - Production 17
 Production in the Short Run

• Rewriting this row, Variable

Input Total Product
we can create the (X) (Q or TP)
following table and 0 0
calculate values of 1 8
marginal and 2 18
3 29
average product. 4 39
5 47
6 52
7 56
8 52
January 3, 2021 Session - Production 18
 Calculation of Marginal Product

January 3, 2021 Session - Production 19

 Calculation of Marginal Product

January 3, 2021 Session - Production 20

 Calculation of Average Product

January 3, 2021 Session - Production 21

 Calculation of Average Product
Variable Total Average
Input Product Product
(X) (Q or TP) (AP)
0 0 ---
1 8 8
2 18 9
3 29 9.67
4 39 9.75
5 47 9.4
6 52 8.67
7 56 8
8 52 6.5
January 3, 2021 Session - Production 22
 Production in the Short Run
• The figures
illustrate TP, MP,
and AP
graphically.

January 3, 2021 Session - Production 23

 Production in the Short Run
• If MP is positive
then TP is
increasing.
• If MP is negative
then TP is
decreasing.
• TP reaches a
maximum when
MP=0

January 3, 2021 Session - Production 24

 Production in the Short Run

• If MP > AP then AP
is rising.
• If MP < AP then AP
is falling.
• MP=AP when AP is
maximized.

January 3, 2021 Session - Production 25

 The Law of Diminishing Returns to
Factor
• Definition
– 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.
• Assumptions
– Factor (L) is the only variable input, others remaining constant
– Factor is homogenous
– The state of technology is given
– Input prices are given

January 3, 2021 Session - Production 26

 Diminishing Returns
Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0 8
1 8 10 Diminishing
2 18 11 Returns
3 29 10 Begins
4 39 8 Here
5 47
6 52 5
7 56 4
8 52 -4
January 3, 2021 Session - Production 27
 The Law of Diminishing Returns
• Reasons
Increasing Returns
Teamwork and Specialization
MP Diminishing Returns Begins
Fewer opportunities for teamwork
and specialization

X
MP
January 3, 2021 Session - Production 28
 The Three Stages of Production
• Stage I
– From zero units of the variable input to where AP
is maximized
• Stage II
– From the maximum AP to where MP=0
• Stage III
– From where MP=0 on

January 3, 2021 Session - Production 29

 The Three Stages of Production

January 3, 2021 Session - Production 30

 The Three Stages of Production
• In the short run, rational firms should only
be operating in Stage II.
• Why 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.
January 3, 2021 Session - Production 31
 Optimal Level of Variable Input Usage
• Consider the following short run production
process.
Labor Total Average Marginal
Unit Product Product Product
(X) (Q or TP) (AP) (MP)
0 0
Where 1 10,000 10,000 10,000
2 25,000 12,500 15,000
is 3 45,000 15,000 20,000
Stage 4 60,000 15,000 15,000
5 70,000 14,000 10,000
II? 6 75,000 12,500 5,000
7 78,000 11,143 3,000
8 80,000 10,000 2,000
January 3, 2021 Session - Production 32
 Optimal Level of Variable Input
Usage
Labor Total Average Marginal
Unit Product Product Product
(X) (Q or TP) (AP) (MP)
0 0
1 10,000 10,000 10,000
2 25,000 12,500 15,000
3 45,000 15,000 20,000
4 60,000 15,000 15,000
5 70,000 14,000 10,000
6 75,000 12,500 5,000
Stage II 7 78,000 11,143 3,000
8 80,000 10,000 2,000
January 3, 2021 Session - Production 33
 Optimal Level of Variable
Input Usage
• Define the following
– Total Revenue Product (TRP) = Q*P
– Marginal Revenue Product (MRP) =
TRP (Q * P) P * Q
   P * MP
X X X

– Total Labor Cost (TLC) = w*X

TLC
– Marginal Labor Cost (MLC) = w
X
January 3, 2021 Session - Production 34
 Value Marginal Product
Also referred to as Marginal Revenue Product
(MRP)
The value of the output produced by the last unit
of an input
(OR) the market value of one additional unit of
output

for labor: VMPL = P x MPL

for capital: VMPK = P x MPK
January 3, 2021 Session - Production 35
 Optimal Level of Variable Input Usage
Where Price (P) = Rs. 2
Total Marginal Total Margina
Labor Total Average Marginal Revenue Revenue Labor l Labor
Unit Product Product Product Product Product Cost Cost TRP- MRP-
(X) (Q or TP) (AP) (MP) (TRP) (MRP) (TLC) (MLC) TLC MLC
0 0 0 0 0
1 10,000 10,000
2 25,000 20,000
3 45,000 30,000
4 60,000 40,000
5 70,000 50,000
6 75,000 60,000
7 78,000 70,000
8 80,000 80,000
January 3, 2021 Session - Production 36
 Optimal Level of Variable
Input Usage
Total Marginal Total Marginal
Labor Total Average Marginal Revenue Revenue Labor Labor
Unit Product Product Product Product Product Cost Cost TRP- MRP-
(X) (Q or TP) (AP) (MP) (TRP) (MRP) (TLC) (MLC) TLC MLC
0 0 0 0 0
1 10,000 10,000 10,000 20,000 20,000 10,000 10,000 10,000 10,000
2 25,000 12,500 15,000 50,000 30,000 20,000 10,000 30,000 20,000
3 45,000 15,000 20,000 90,000 40,000 30,000 10,000 60,000 30,000
4 60,000 15,000 15,000 120,000 30,000 40,000 10,000 80,000 20,000
5 70,000 14,000 10,000 140,000 20,000 50,000 10,000 90,000 10,000
6 75,000 12,500 5,000 150,000 10,000 60,000 10,000 90,000 0
7 78,000 11,143 3,000 156,000 6,000 70,000 10,000 86,000 -4,000
8 80,000 10,000 2,000 160,000 4,000 80,000 10,000 80,000 -6,000
January 3, 2021 Session - Production 37
 Optimal Level of Variable
Input Usage
Total Marginal Total Marginal
Labor Total Average Marginal Revenue Revenue Labor Labor
Unit Product Product Product Product Product Cost Cost TRP- MRP-
(X) (Q or TP) (AP) (MP) (TRP) (MRP) (TLC) (MLC) TLC MLC
0 0 0 0 0
1 10,000 10,000 10,000 20,000 20,000 10,000 10,000 10,000 10,000
2 25,000 12,500 15,000 50,000 30,000 20,000 10,000 30,000 20,000
3 45,000 15,000 20,000 90,000 40,000 30,000 10,000 60,000 30,000
4 60,000 15,000 15,000 120,000 30,000 40,000 10,000 80,000 20,000
Stage 5 70,000 14,000 10,000 140,000 20,000 50,000 10,000 90,000 10,000
6 75,000 12,500 5,000 150,000 10,000 60,000 10,000 90,000 0
II
7 78,000 11,143 3,000 156,000 6,000 70,000 10,000 86,000 -4,000
8 80,000 10,000 2,000 160,000 4,000 80,000 10,000 80,000 -6,000

January 3, 2021 Session - Production 38

 Optimal Level of Variable
Input Usage
• 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
input’s marginal product is equal to the
additional cost of using that input.
• Where MRP=MLC.

January 3, 2021 Session - Production 39

 Optimal Level of Variable
Input Usage
• When the firm employs multiple variable
inputs, the firm should choose the level of the
inputs which equates the marginal product
per dollar across each of the inputs.
Mathematically,

MP1 MP2 MPk

  
w1 w2 wk
January 3, 2021 Session - Production 40
 Input Combination Choice
• Production Isoquants
– Technical efficiency is least-cost production.
• Input Factor Substitution
– Isoquant shape shows input substitutability.
– C-shaped isoquants are common and imply
imperfect substitutability.
 Marginal Rate of Technical
Substitution
– MRTSXY=-MPX/MPY
• Rational Limits of Input Substitution
– MPX<0 or MPY<0 are never observed.
 Optimal Combination of Multiple
Inputs
• Budget Lines
– Least-cost production occurs when MPX/PX = MPY/PY and
PX/PY = MPX/MPY
• Expansion Path
– Shows efficient input combinations as output grows.
• Illustration of Optimal Input Proportions
– Input proportions are optimal when no additional output
could be produce for the same cost.
– Optimal input proportions is a necessary but not sufficient
condition for profit maximization.
 Optimal Levels of Multiple Inputs
• Optimal Employment and Profit Maximization
– Profit maximization requires optimal input
proportions plus an optimal level of output.
• Illustration of Optimal Levels of Multiple
Inputs
 Production in the Long Run

• In the long run, all inputs are variable.

• The long run production process is described
by the concept of returns to scale.
• Returns to scale describes what happens to
total output as all of the inputs are changed
by the same proportion.

January 3, 2021 Session - Production 48

 Production in the Long Run
• 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)

January 3, 2021 Session - Production 49

 Production in the Long Run
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 E>1 then IRTS

• If E=1 then CRTS
• If E<1 then DRTS

January 3, 2021 Session - Production 50

 Production in the Long Run
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

January 3, 2021 Session - Production 51

 Production in the Long Run
• Graphically, the returns to scale concept can
be illustrated using the following graphs.

IRTS CRTS DRTS

Q Q Q

X,Y X,Y X,Y

January 3, 2021 Session - Production 52

 Production in the Long Run
• Economists
hypothesize that a
firm’s long run
production function
may exhibit at first
increasing returns,
then constant returns,
and finally decreasing
returns to scale.
January 3, 2021 Session - Production 53
 Cobb Douglass Production Function
It is a functional form of the production function,
used to represent the technological relationship
between the amounts of two or more inputs –
labor and capital – and the amounts that can be
produced by those inputs.

Standard form for the production of a single good

with two factors is
Y=AKL
January 3, 2021 Session - Production 54
 Cobb-Douglas Production Function
Y=AKL
Where

• Y = total production (the real value of all goods produced in

a year)
• L = labour input (the total number of person-hours worked
in a year)
• K = capital input (the real value of all machinery,
equipment, and buildings)
• A = total factor productivity
• α and β are the output elasticities of capital and labour
The Cobb-Douglas is homogeneous of degree  = (+ ).
 Properties of Cobb-Douglas Production Function

If  =1 (+=1) then CRS

If  >1 (+>1) then IRS
If  <1 (+<1) then DRS
Properties of Cobb-Douglas Production Function
Output Elasticity Y=AKLβ

Y K For Capital
. 
K Y

Y L
.  For Labour
L Y
Properties of Cobb-Douglas Production Function
Y=AKLβ
Marginal Product of Capital

 . APk

Marginal Product of Labor

 . APL
 Some Uses of the Cobb-Douglas
Production Function
• Estimating returns to scale in different
industries.
• Accounting for sources of growth.
• Estimating productivity growth (or decline).

January 3, 2021 Session - Production 59

                                                 
CES Production Function
The CES production function is a type of production
function that displays constant elasticity of
substitution.

Where Q = output
F = factor productivity
a = share parameter
K and L = capital and labor
r = (s-1)/s
s = 1/ (1-r) = elasticity of substitution
January 3, 2021 Session - Production 60
 Thank you

January 3, 2021 Session - Production 61