Microeconomics

I. Production Function

By

Dr. Chandrakanti
Grading Pattern
Unit of
Components Evaluation Item* Weightage (%) Evaluation
1
Class Participation 10 Individual

2 Quiz 10 Individual

Clash of Traders (Eco

3 Fest) 20 Group

4 Project 20 Individual and

Group

5 End Term 40 Individual

 Production Function
• Inputs are factors of production, such as labour, capital, land, and any
other element that the firm can transform into units of output.
• The production function represents how a certain amount of inputs is
transformed into an amount of output q.

• For simplicity, we assume that:

This production function describes how specific amounts of labour and

capital are transformed into an amount of output.
 Production Function
• Time Horizon: Short-Run and Long-Run

How will we distinguish the SR and the LR??

 Production Function

• Fixed Inputs and Variable Inputs

• Quasi-fixed Inputs (between SR and LR)

• In the short run, some inputs are fixed; while in the long run, all
inputs are variable
 Production Function
• Example:
SR Scenario: Imagine a small bakery that bakes cakes and pastries. The
bakery has a fixed number of ovens and kitchen space, but it can hire
more workers or adjust their working hours to meet demand in the
short run.
Long run: The bakery can make decisions to improve its production
capacity, such as buying additional ovens, expanding its kitchen space,
or even relocating to a larger building. The bakery can also invest in
automation or new technologies that improve efficiency.
 Production Function
• Example:
Short Run:
1. Fixed Factors: The bakery has a fixed number of ovens and kitchen space.
2. Adjustable Factors: The bakery can adjust the number of workers, but only to
a limited extent.
3. Constraints: Even if the bakery hires more workers, it can only produce as
many cakes as its ovens allow. Adding more labor doesn't always increase
output efficiently.
4. Focus: In the short run, the bakery focuses on utilizing its existing capacity
and adjusting labor to meet short-term demand.
 Production Function
• Example:
Long Run:
1. All Factors Are Variable: The bakery can buy new ovens, expand its space, or
invest in automation.
2. Flexible Expansion: The bakery has the ability to scale production up or down
by adjusting both labour and capital.
3. Optimization: In the long run, the bakery can make decisions that optimize
its production process by investing in new equipment, training workers, or
finding new ways to produce more efficiently.
 Production Function

• Ex: For a coffee shop, buying a coffee maker is possible within a few
weeks, so here the long run can be considered as a month.
Now, what about a car company? Can we consider a month as
a LR?
 Average Product

• The average product is the total units of output per unit of input.

The average product of labor is =

The average product of capital is =
• If a firm produces q=100units of output, and hire L=5 workers, its
average product per worker is
???
 Average Product

What happens to the ratio = , When labor productivity in a country

grows?
 Average Product
• When labor productivity in a country grows, the ratio = must go up.
• Possible Scenarios:
Total output increases while number of employed workers remains
constant.
Total output remains unaffected, but workers are fired after firms
automate the production process.
Total output increases as more workers are hired
 Average Product

Exercise: Consider the Production function ,

Find out the , at and ?
 Average Product
• Consider Production function 𝑞 = 100
𝐿:
𝐿𝐴 = 4.
• At•𝐴,
• 𝑞𝐴 = 200.
• 𝐴𝑃𝐿A =
4
200
= 50
units.
𝐵,• 𝐿𝐵 = 16.
• At

• 𝑞𝐵 = 400.
• 𝐴𝑃𝐿 =
1
400
= 25
𝐵
units. 6
 Marginal Product
• The marginal product is the rate at which total output increases as the
firm uses an additional unit of either input.

• The marginal product of labour is =

• Graphically, the marginal product of an input can be interpreted as

the slope of the function when we marginally increase the amount of
that input.
 Marginal Product
No of Workers Output
0 0 0
1 50 50
2 90 40
3 120 30
4 140 20
5 150 10
6 155 5
 Marginal Product

Exercise: Consider the Production function ,

Find out the , at and ?
 Marginal Product

𝑀𝑃𝐿 as the slope of

the production 𝑀𝑃𝐿 is
function diminishing.
 Marginal Product
is diminishing
• Additional workers bring more production to the firm, but a
decreasing rate. Why so?
 Marginal Product
Example:
• The bakery has only three ovens, and no new ovens can be
purchased immediately (fixed capital).
• However, the bakery can hire more workers, or existing
workers can work overtime (variable labor).
Scenario:
If the bakery needs to increase its production of cakes to meet a
surge in demand (e.g., for a local event), it could hire additional
workers to help bake and decorate the cakes.
 Marginal Product

1. Because the bakery only has three ovens, adding more

workers beyond a certain point won’t increase the number of
cakes produced at a proportional rate — some workers will be
standing around waiting for their turn to use the ovens.
2. In this scenario, the bakery is limited by the fixed number of
ovens, and adding more workers beyond a certain level will lead
to inefficiencies and diminishing returns to labour.
Relation Between Marginal and Average
Product
 Relationship between APL and
MPL

•When the 𝐴𝑃𝐿 curve is increasing, 𝑀𝑃𝐿 lies above 𝐴𝑃𝐿;

•When the 𝐴𝑃𝐿 curve is decreasing, 𝑀𝑃𝐿 lies below 𝐴𝑃𝐿;
•When the 𝐴𝑃𝐿 curve is increasing, 𝑀𝑃𝐿 curve crosses 𝐴𝑃𝐿.
Intermediate Microeconomic Theory 23
 Relationship between APL and
MPL
Example: Consider grades in a class.
•You take a midterm exam. A few days later, the instructor informs how your
average grade in the class is affected by the midterm:
1. the midterm increases your average if the midterm grade is higher than your
previous average (MP > AP); or
2. the midterm decreases your average if the midterm grade is lower
than your previous average (MP < AP); or
3. The midterm does not affect your average if the midterm grade
coincides with your previous average (MP = AP)
 Relationship between APL and
MPL

The curve crosses the curve at the maximum point (the peak) of the curve.
Practice Exercise
The following table shows the Total Output (Q) produced by a firm
using varying amounts of labor (L), while other factors (like capital) are
held constant.
Q1. Find out the 𝐴𝑃𝐿 and 𝑀𝑃𝐿 .
Q2. Draw the graphs. You can use excel for clearer representation.
Practice Exercise 1
No of Workers Output
0 0
1 10
2 25
3 40
4 50
5 55
6 58
Answer
Excercise

15 15

13.33
12.5 12.5

11
10 10
9.67

0
0 1 2 3 4 5 6

MPL APL
Practice Exercise 2
The following table shows the Total Output (Q) produced by a firm
using varying amounts of labor (L), while other factors (like capital) are
held constant.
Q1. Find out the 𝐴𝑃𝐿 and 𝑀𝑃𝐿 .
Q2. Draw the graphs. You can use excel for clearer representation.
Practice Exercise 2
L Total Product (TP)
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 72
 Exercise 2
25

20 20

15 15 15 15
14
12.5 12.5
10.71
10 10 10
9

5 5

0 0 0
0 1 2 3 4 5 6 7 8

-3
-5

Marginal Product (MP) Average Product (AP)

Isoqua
nts

32
 Isoquants
• The isoquant curve represents combinations of
labour and capital that yield the same amount of output.

• At 𝐴, the firm uses an

input combination intense
in capital.
• At 𝐵, it uses a labor-
intense input

the same 𝑞 = 100 than

combination, producing

at 𝐴.
• At 𝐶, the firm reaches a
higher output, 𝑞 = 200.
33
 Isoquants
•The isoquant curve represents
combinations of labour and
capital that yield the same amount of
output.
•The shaded
areas are
unprofitable
for the firm.

choose 𝐴2 or
•It would not

𝐴3
34
 Isoquants

Ans: because it can reach the same output with fewer inputs at 𝐴1.
Perfectly substitutable inputs
K

0 L
 Non-substitutable inputs
K

0 L
Marginal Rate of Technical
Substitution (MRTS)
Marginal Rate of Technical
Substitution
• The slope of the isoquant (MRTS)
answers the question:

“How many units of capital must the firm give up to maintain

its output level unaffected after hiring an extra worker?”

• Marginal rate of technical substitution (MRTS). After increasing the

quantity of labour by 1 unit, the MRST measures the amount by
which capital must be reduced so that output remains constant.
Marginal Rate of Technical
Substitution (MRTS)
Marginal Rate of Technical
Substitution (MRTS)
Why MRTS is declining?
Marginal Rate of Technical
Substitution (MRTS)
• Intuitively,

 When capital is abundant, the firm is willing to give up many units of

capital to hire one more worker.
 When capital becomes more scarce, the firm is less willing to replace
it with workers.
 Returns to Scale

What happens when we increase all inputs? How does q respond to it?
Does it increase/decrease proportionally?
 Returns to Scale

Consider that all inputs are increased by a common factor, >1.

• > (when 𝑎 > 1), the firm exhibits increasing returns to scale.
Hence, L is increased to , and K is increased to . If the firm increases as follows:

• < (when 𝑎 < 1), the firm exhibits decreasing returns to scale.
• = (when 𝑎 = 1), the firm exhibits constant returns to scale.
Returns to Scale
Consider a firm doubling the units of all inputs (𝛿 = 2):

• If output increases more than proportionally (more than double),

we have increasing returns to scale.
• If output increases less than proportionally (it falls short from
doubling), we have decreasing returns to scale.
• If output increases proportionally (exactly doubling), we have
constant returns to scale.
 constant returns to scale

500

K, Units of Capital per year

400

300

200

100 q = 200

q = 100

0 100 200 300 500

400

L, Units of Labor Per Year

Isoquants with increasing and decreasing returns to scale

Decreasing Returns to Scale Increasing Returns to Scale

500 500
K, Units of capital per year

K, Units of capital per year

400 400
q = 200

300 300

200 200
q = 236

q = 142
100 100 q = 200

q = 100 q = 100

0 100 200 300 400 500 0 100 200 300 400 500

L, Units of labor per year L, Units of labor per year

CLASS QUIZ
1. Which of the following is not a property of an isoquant?

A. Always non-linear
B. Do not cross
C. Downward sloping
D. Further out is better
2. What is the difference between the short-run and the long-run
from the perspective of production theory?

A. In the short run, all inputs are invariable, and in the long run they
are variable.
B. In the short run, all inputs are variable, and in the long run they
are invariable.
C. In the short run, only capital varies, and in the long run both labor
and capital vary.
D. In the short run, only labor varies, and in the long run both labor
and capital vary.
3. What is the term used to describe a production function in
which you can double all inputs and output increases by more
than double?

1. Constant Returns to Scale

2. Increasing Returns to Scale
3. Decreasing Returns to Scale
4. Leontief
4. What does the Average Product (AP) of labor represent?

A) The total output produced by all units of labor

B) The additional output produced by each additional unit of labor
C) The total output divided by the number of units of labor employed
D) The change in total output due to a change in capital
5. When Marginal Product (MP) is greater than Average Product
(AP), what will happen to AP?

A) AP will increase
B) AP will decrease
C) AP will remain the same
D) AP will be zero
6. If the Marginal Product of labor is negative, what happens to the
Average Product of labor?

A) It increases
B) It decreases
C) It stays the same
D) It becomes zero
7. At what point does the Marginal Product curve intersect the
Average Product curve?

A) When both curves are increasing

B) When both curves are decreasing
C) When Average Product reaches its maximum
D) When Marginal Product reaches its minimum
8. Which of the following best describes the production function
with Leontief inputs?

A) Inputs can be substituted for each other at a constant rate.

B) Inputs must be used in fixed proportions, and there is no
substitution between them.
C) Inputs can be substituted for each other at an increasing rate.
D) Inputs are used in any proportion, but their total contribution is
fixed.