Chapter 6 (production theory and analysis)
The general production problem facing the firm is to determine how much output to produce and
how much labor and capita to employ to produce that output most [Link] answer these
questions we use a) productions functions b) information on prices of outputs and inputs.
The production functions
The production function Q =f(K,L) defines the maximum rate of output Q per unit of time
obtainable from a given rate of capital (K) and labor(L) input. The production function is an
engineering concept that is devoid of economic [Link] simply relates output and input rates.
The production function does not yield information on the least cost capital labor combination
for producing a given level of output nor does it reveal the output rate that would yield maximum
profit. Prices of the inputs and the price of output must be used with the production function to
determine which of the many possible input combination is best given the firm’s objective.
Linear production function =additive form
Non linear production function =multiplicative form
Cobb-Douglas production function
Q = AKα Lβ (multiplicative form)
Here Q = output
A =parameter (technology)
K =capital
L = labor
α+β ≤ 1
Let A=100 α =0.5 and β= 0.5
Then Q = 100 K0.5 L0.5
If K=4 and L=2 then Q = 100 √ 4 √2 = 100(2) (1.41) = 283
If K =8 and L =2 Q = 100 √ 8 √ 2 = 400
Three important relationships are shown by the data in the production table
1)There are a variety of ways to produce a particular rate of [Link] implies tht there is
substitutability between the factors of production process characterized by combination a , a
labor intensive process such as d or a process that uses a resource combination somewhere
between these extremes such as b or c.
Capital intensive =a production system where the ratio of capital to labor is relatively high
Labor intensive = capital to labor ratio is relatively low
2)If input rates are doubled the output rate also [Link] example , maximum production with
one unit of capital and four units of labor is [Link] the input rates to K=2 , L=8 results in
the rate of output doubling to Q = [Link] relationship between output change and proportionate
changes in both inputs is referred to as returns of [Link] the production is characterized by
constant returns to scale this means that if both input rates increase by the same factor(eg. Both
input rates double),the rate of output will also will double.
[returns to scale =scale of production/quantity of production]
There are 3 types of returns to scale .
i)Constant returns to scale-if both K(capital) and L(labor) inputs are doubled then both outputs
rate are also doubled.
ii)Increasing returns to scale-if both input rates are increased by same factors and output rate
increases by more than that proportion then it is known as increasing returns to scale. Eg. if both
input rates are doubled and output increased by three times then we will say that increasing
returns to scale
iii)Decreasing returns to scale- both input rates are doubled by same factors but output increase
by less than double then we will say that decreasing returns to scale.
3)In contrast to the concept of returns to scale when output changes because one input changes
while the other remains constant, the changes in the out output rates are referred to as returns to
a factor. Note in the table that if the rate of one input is held constant while the other is increased,
output increases but the successive increments become smaller. For example from the table 6.1 it
is seen that if the rate of capital input is held constant at 2 and labor is increased from L=1 to
L=6,the successive increases in output are 59,45,38,33 and [Link] is the basis for an important
economic principle known as the law of diminishing marginal returns.
Diminishing marginal returns
The law states that when increasing amount of the variable inputs are combined with a fixed
level of another input, a point will be reached where the marginal product of the variable input
will decline.
MPL = (∆Q/∆L)
Here, ∆L =change in output when labor is increased by 1 unit.
MPL = marginal product of labor
If MPL is very small then
MPL = dQ/dL