Economics 2141

2021
Mudzanani Ronewa
 PRODUCTION
• The purpose of any firm is to turn inputs into output
• Firm Any organization that turns inputs into outputs.
• The relationship between inputs and outputs is formalized by a
production function of the form
q=f(K, L, M...)
• where q represents the output of a particular good during a period, K
represents the machine (that is, capital) use during the period, L
represents hours of labor input, and M represents raw materials used
• Production function The mathematical relationship between inputs
and outputs.
• The form of the notation indicates the possibility of
other variables affecting the production process.
• The production function summarizes what the firm
knows about mixing various inputs to yield output.
• The important question about this production
function from an economic point of view is how the
firm chooses its levels of q, K, L, and M
 Two-Input Production Function
• We simplify the production function here by assuming that the firm’s
production depends on only two inputs: capital (K) and labor (L). Hence, our
simplified production function is now:
• q=f(K, L)
• The decision to focus on capital and labor is for convenience only. Most of
our analysis here holds true for any two inputs that might be investigated
 MARGINAL PRODUCT
• Def: The additional output that can be produced by adding one more unit of
a particular input while holding all other inputs constant.
• The first question we might ask about the relationship between inputs and
outputs is how much extra output can be produced by adding one more unit
of an input to the production process.
• For our two principal inputs of capital and labor, the marginal product of
labor (MPL) is the extra output obtained by employing one more worker
while holding the level of capital equipment constant.
• Similarly, the marginal product of capital (MPK) is the extra output obtained
by using one more machine while holding the number of workers constant.
• Example: consider the case of a farmer hiring one more person to harvest a
crop while holding all other inputs constant.
• The extra output produced when this person is added to the production
team is the marginal product of labor input. The concept is measured in
physical quantities such as bushels of wheat, crates of oranges, or heads of
lettuce.
• We might, for example, observe that 25 workers in an orange grove are able
to produce 10,000 crates of oranges per week, whereas 26 workers (with the
same trees and equipment) can produce 10,200 crates.
• The marginal product of the 26th worker is 200 crates per week.
 Diminishing Marginal Product
• We might expect the marginal product of an input to depend on how much
of it used.
• For example, workers cannot be added indefinitely to the harvesting of
oranges (while keeping the number of trees, amount of equipment, fertilizer,
and so forth fixed) without the marginal product eventually deteriorating.
• At first, adding new workers also increases output significantly, but these
gains diminish as even more labor is added and the fixed amount of capital
becomes overutilized
 Average Product
• When people talk about the productivity of workers, they usually do not have in
mind the economist’s notion of marginal product. Rather, they tend to think in
terms of ‘‘output per worker.
• In our orange grove example, with 25 workers, output per worker is 400
(=10,000 /25) crates of oranges per week. With 50 workers, however , output per
worker falls to 240(=12,000/50)crates per week.
• Because the marginal productivity of each new worker is falling , output per
worker is also falling.
• Notice, however, that the output-per-worker figures give a misleading
impression of how productive an extra worker really is.
• With 25 workers, output per worker is 400 crates of oranges per week, but
adding a 26th worker only adds 200 crates per week.
• Indeed, with 50 workers, an extra worker adds no additional output even though
output per worker is a respectable 240 crates per week.
 ISOQUANT MAPS
• Isoquant map A contour map of a firm’s production function.
• Isoquant A curve that shows the various combinations of inputs that will
produce the same amount of output.
• To show the various combinations of capital and labor that can be employed
to produce a particular output level, we use an isoquant (from the Greek iso,
meaning ‘‘equal’’ )
• For example , all the combinations of K and L that fall on the curve labeled
q=10 in graph below are capable of producing 10 units of output per period.
This single isoquant records the many alternative ways of producing 10 units
of output
 Rate of Technical Substitution
• The slope of an isoquant shows how one input can be traded for another while
holding output constant.
• . Examining this slope gives some information about the technical possibilities
for substituting labor for capital—an issue that can be quite important to firms.
• The slope of an isoquant (or, more properly, its negative) is called the marginal
rate of technical substitution (RTS) of labor for capital
• Specifically, the RTS is defined as the amount by which capital input can be
reduced while holding quantity produced constant when one more unit of
labor input is used.
• Marginal rate of technical substitution (RTS) The amount by which one input
can be reduced when one more unit of another input is added while holding
output constant. The negative of the slope of an isoquant
 The RTS and Marginal Products
• If the quantity of labor employed by the firm increases, the firm should be
able to reduce capital input and still keep output constant.
• Because labor presumably has a positive marginal product, the firm should
be able to get by with less capital input when more labor is used.
• If increasing labor actually required the firm to use more capital, it would
imply that the marginal product of labor is negative, and no firm would be
willing to pay for an input that had a negative effect on output.
• We can show this result more formally by noting that the RTS is precisely
equal to the ratio of the marginal product of labor to the marginal product
of capital. That is,
• RTS(of L for K)= MPL/MPK
• Suppose, for example, that MPL =2 and MPK =1. Then, if the firm employs
one more worker, this will generate two extra units of output if capital input
remains constant.
• Put another way, the firm can reduce capital input by two when there is
another worker and output will not change—the extra labor adds two units
of output, whereas the reduced capital reduces output by two. Hence, by
definition, the RTS is 2—the ratio of the marginal products.
• It is clear that if the RTS is negative, one of the marginal products must also
be negative.
• But no firm would pay anything for an input that reduced output. Hence, at
least for those portions of isoquants where firms actually operate, the RTS
must be positive (and the slope of the isoquant negative).
 Diminishing RTS
• The isoquants in Figure6.2 are drawn not only with negative slopes (as they
should be)but also as convex curves. Along any one of the curves, the RTS is
diminishing.
• For a high ratio of K to L, the RTS is a large positive number , indicating that a
great deal of capital can be given up if one more unit of labor is employed.
• On the other hand , when a lot of labor is already being used , the RTS is low ,
signifying that only a small amount of capital can be traded for an additional
unit of labor if output is to be held constant.
• The more labor (relative to capital) that is used, the less able labor is to
replace capital in production.
• A diminishing RTS shows that use of a particular input can be pushed too far.
• Firms will not want to use ‘‘only labor’’ or ‘‘only machines’’ to produce a
given level of output.
 Returns to scale
• Returns to scale The rate at which output increases in response to
proportional increases in all inputs.
• The shape and properties of a firm’s production function are important for a
variety of reasons.
• Using such information, a firm may decide how its research funds might best
be spent on developing technical improvements.
• Or, public policy makers might study the form of production functions to
argue that laws prohibiting very large-scale firms would harm economic
efficiency
Graph Illustrations
Self Study
• Numerical Example on
• Production function
• Isoquants Map