Chapter 3

Theory of Production
 3.1 Production function
 A technology is a process by which inputs are
converted to an output.
 The production function is a purely technical
relation which connects factor inputs and
outputs.
 It describes the laws of proportion, that is, the
transformation of factor inputs into products
(outputs) at any particular time period.
 The production function represents the
technology of a firm of an industry, or of the
economy as a whole.
 The production function includes all the
technically efficient methods or production.
 3.1 Production function
 A method of production (process, activity) is a
combination of factor inputs required for the
production of one unit of output.
 Usually a commodity may be produced by
various methods of production.
 So which method do we chose?
 We chose the one technically and economically
efficient.
 Note that a technically efficient method is not
necessarily economically efficient.
 3.1 Production function
 An isoquant includes (is the locus of) all the
technically efficient methods (or all the
combinations of factors of production) for
producing a given level of output.
 The production isoquant may assume various
shapes depending on the degree of
substitutability of factors.
1. Linear isoquant.
2. Input-output isoquant.
3. Kinked isoquant.
4. Smooth, convex isoquant.
 3.1 Production function
 Fixed inputs: are inputs that their quantity can not be
changed during an immediate requirement.
 Variable inputs: are those inputs whose quantity can
be changed almost instantaneously in response to
desired changes in output.
 Short run: short run refers to that period of time in
which the quantity of at least one input is fixed.
 Long run: is that time period (planning horizon) which
is sufficient to change the quantities of all inputs.
Thus there is no fixed input in the long-run.
 3.2 Short run production:
 Assumptions:
1. Perfect divisibility of inputs and outputs
2. Limited substitution between inputs
3. Constant technology
4. Production with one variable input,(other inputs fixed)
 Now assume 𝑄 = 𝑓 𝐿, 𝐾 = f(L), K being constant
Where ● 𝑄 is the output level
● 𝐿 is the quantity of labor used (variable input)
● 𝐾 is the quantity of capital (fixed input)
 The firm can increase output only by increasing the
amount of labor it uses.
 3.2 Short run production:
 Total product(TP): is the total amount of output that can be
produced by efficiently utilizing a specific combination of
labor and capital.
 The total product curve: represents various levels of output
that can be obtained from efficient utilization of various
combinations of the variable input, and the fixed input.
 increasing the variable input (while some other inputs are
fixed) can increase the total product only up to a certain
point.
 as we employ more and more unit of the variable input
beyond the carrying capacity of a fixed input, output may
tend to decline. TP curve is nearly S-shape.
 3.2 Short run production:
 Marginal Product (MP): The marginal product of variable
input is the addition to the total product attributable to the
addition of one unit of the variable input to the production
process, other inputs being constant (fixed).
𝑀𝑃𝐿 = ∆𝑄
∆𝐿
or 𝑀𝑃𝐿 = 𝑑𝑇𝑃
𝑑𝐿
 𝑀𝑃𝐿 measures the slope of the total product curve at a
given point.
 As we continue to combine more and more of the variable
inputs(L) with the fixed input(K), the marginal product of the
variable(𝑀𝑃𝐿 ) input increases initially and then declines.
 3.2 Short run production:
 Average Product (AP): The AP of an input is the ratio of
total output to the number of variable inputs.
𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑇𝑃 𝑄
𝐴𝑃𝐿 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐿𝑎𝑏𝑜𝑟 𝑢𝑛𝑖𝑡𝑠
= =
𝐿 𝐿
 The average product of labor first increases with the
number of labor (i.e. TP increases faster than the increase
in labor), and eventually it declines.
 Graphs of the short run production curves(𝑇𝑃𝐿 , 𝑀𝑃𝐿 , 𝐴𝑃𝐿 )
 (for the explanation read from the hand out)
 3.2 Short run production:
𝑶𝒖𝒕 𝒑𝒖𝒕 𝑎
. 𝑻𝑷𝟑
𝑻𝑷𝟐
𝑻𝑷

𝑻𝑷𝟏

𝑳𝟏 𝑳𝟐 𝑳𝟑 𝐿(𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑖𝑛𝑝𝑢𝑡
𝑴𝑷𝑳 , 𝑨𝑷𝑳

𝑨𝑷𝑳
𝐿(𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑖𝑛𝑝𝑢𝑡)
𝑴𝑷𝑳
 3.2 Short run production:
 Relation Ship between 𝑴𝑷𝑳 𝐚𝐧𝐝 𝑨𝑷𝑳
 production function: 𝑻𝑷 = 𝒇 𝑳 , 𝑲 𝒃𝒆𝒊𝒏𝒈 𝒄𝒐𝒏𝒔𝒕𝒂𝒏𝒕.
𝑑𝑇𝑃 𝑑𝑓(𝐿) 𝑇𝑃 𝑓(𝐿)
𝑀𝑃𝐿 = 𝑑𝐿
= 𝑑𝐿
and 𝐴𝑃𝐿 = 𝐿
=
𝐿
𝑓(𝐿)
𝑑 𝑑𝑓(𝐿) 1 𝑑(𝐿−1 )
Slope of 𝐴𝑃𝐿 = 𝑑(𝐴𝑃𝐿 )
𝑑𝐿
= 𝐿
𝑑𝐿
=
𝑑𝐿
∗ 𝐿 + 𝑓 𝐿 ∗ 𝑑𝐿
𝑑𝑓(𝐿) 1 − 𝑓 𝐿 = 𝑑𝑓 𝐿 ∗ 1 − 𝑓 𝐿 ∗ 1
= ∗
𝑑𝐿 𝐿 𝐿2 𝑑𝐿 𝐿 𝐿 𝐿
1 𝑑𝑓 𝐿 𝑓 𝐿 𝑑𝑓 𝐿 𝑓 𝐿
= − 𝐿 ∗ but = 𝑀𝑃𝐿 𝑎𝑛𝑑 = 𝐴𝑃𝐿
𝐿 𝑑𝐿 𝑑𝐿 𝐿
1
Slope of 𝐴𝑃𝐿 = 𝑀𝑃𝐿 − 𝐴𝑃𝐿 = 𝑀𝑃𝐿 −𝐴𝑃𝐿
𝐿
𝐿
 3.2 Short run production:
 Relation Ship between 𝑴𝑷𝑳 𝐚𝐧𝐝 𝑨𝑷𝑳 (Cont.)
1
Slope of 𝐴𝑃𝐿 =
𝑀𝑃𝐿 −𝐴𝑃𝐿
𝑀𝑃𝐿 − 𝐴𝑃𝐿 = 𝐿
, Thus,
𝐿
● When 𝑀𝑃𝐿 > 𝐴𝑃𝐿 , Slope of 𝐴𝑃𝐿 is positive (𝐴𝑃𝐿 rises)
● When 𝑀𝑃𝐿 = 𝐴𝑃𝐿 , Slope of 𝐴𝑃𝐿 is zero (𝐴𝑃𝐿 is at its
maximum).
● When 𝑀𝑃𝐿 < 𝐴𝑃𝐿 , Slope of 𝐴𝑃𝐿 is negative (𝐴𝑃𝐿 falls)

Thus, the 𝑀𝑃𝐿 curve passes through the maximum of the 𝐴𝑃𝐿
curve from above.
3.2.1 The law of diminishing marginal returns (LDMR)

 It states that other variables being fixed, from a certain level

of the variable input onwards, as we employ more and
more of that variable input the marginal product of that
input diminishes.
 The LDMR is a short run law of production.
 The LDMR applies to a given production technology (when
the level of technology is fixed).
 3.2.2 Stages of production:
𝑶𝒖𝒕 𝒑𝒖𝒕 I 𝐈𝐈 𝐈𝐈I
. 𝑻𝑷𝟑
𝑻𝑷𝟐
𝑻𝑷

𝑻𝑷𝟏

𝑳𝟏 𝑳𝟐 𝑳𝟑 𝐿(𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑖𝑛𝑝𝑢𝑡
𝑴𝑷𝑳 , 𝑨𝑷𝑳

𝑨𝑷𝑳
𝐿(𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑖𝑛𝑝𝑢𝑡)
𝑴𝑷𝑳
 3.2.2 Stages of production
● 𝑺𝒕𝒂𝒈𝒆 − 𝑰: ranges from the origin to the point of equality of
the 𝐴𝑃𝐿 and 𝑀𝑃𝐿 .
● 𝑺𝒕𝒂𝒈𝒆 − 𝑰𝑰: starts from the point of equality of 𝐴𝑃𝐿 and 𝑀𝑃𝐿
and ends at a point where 𝑀𝑃𝐿 is equal to zero.
● 𝑺𝒕𝒂𝒈𝒆 − 𝑰𝑰𝑰: covers the range of labor over which the MPL
is negative.
 Now, which stage of production is efficient and preferable?
 The efficient region of production is stage II.
 3.3 Long run Production
 For the sake of simplicity, assume that the firm uses two
inputs (labor and capital) and both are variable.
𝑄 = 𝑓(𝐿, 𝐾)
 The firm can now produce its output in a variety of ways by
combining different amounts of labor and capital.
 Isoquants: An isoquant is a curve that shows all possible
efficient combinations of inputs that can yield equal level of
output.
 The equation of an isoquant, where output is held constant
at 𝑞 is 𝑞 = 𝑓(𝐿, 𝐾)
 3.3 Long run Production
 Isoquant maps: when a number of isoquants are combined
in a single graph, we call the graph an isoquant map.
 An isoquant map is another way of describing a production
function.
 Each isoquant represents a different level of output and the
level of outputs increases as we move up and to the right.
 Isoquants show the fact that long run production process is
very flexible.
Isoquants with Two Variable Inputs
K

𝒒𝟒 8

𝒒𝟑 
𝒒𝟐 
𝒒𝟏 
L

Fig. Isoquant and isoquant map.

 3.3 Long run Production
 Properties of isoquants:
1. Isoquants slope downward
2. The further an isoquant lays away from the origin, the
greater the level of output it denotes.
3. Isoquants do not cross each other.
4. Isoquants must be thin.

Special shape of isoquants

 Isoquants can have different shapes (curvature) depending
on the degree to which factor inputs can substitute each
other. Here we will see four types of Isoquants.
 3.3 Long run Production
1. Linear isoquants: Isoquants would be linear when
labor and capital are perfect substitutes for each other.
● In this case the slope of an isoquant is constant.
● As a result, the same output can be produced with only
capital or only labor or an infinite combination of both.
 Linear Isoquants
𝑸 = 𝒇 𝑳, 𝑲 = 𝑳 + 𝟑𝑲
K
𝐿 + 3𝐾 = 18 = 𝒒𝟑
𝐿 + 3𝐾 = 36 = 𝒒𝟐
𝐿 + 3𝐾 = 48 = 𝒒𝟏
8
6
All are linear and parallel
3

9 18 24 L
 3.3 Long run production:
2. Input output isoquant: This assumes strict
complementarities or zero substitutability of factors of
production.
 It is also called Leontief isoquant.
 There is only one method of production for any one
commodity.
 The isoquant takes the shape of a right angle.
 3.3 Long run production:
K Example 𝑸 = 𝒎𝒊𝒏 𝑳, 𝟐𝑲

𝐿 = 2𝐾

7 min*𝐿, 2𝐾+ = 14
4 min*𝐿, 2𝐾+ = 8
2 min*𝐿, 2𝐾+ = 4
4 8 14 L
Fig: L-shaped Isoquant(Input output isoquant)
 3.3 Long run production:
3. Kinked isoquant. This assumes limited
substitutability of K and L.
 Inputs can substitute each other only at some points.
 Thus, the isoquant is kinked and there are only a few
alternative combinations of inputs to produce a given level
of output.
4. Smooth, convex isoquants: This shape of
isoquant assumes continuous substitution of
capital and labor over a certain range, beyond
which factors cannot substitute each other.
 3.3 Long run production:
3. Kinked isoquant. This assumes limited
substitutability of K and L.
 Inputs can substitute each other only at some points.
 Thus, the isoquant is kinked and there are only a few
alternative combinations of inputs to produce a given level
of output.
4. Smooth, convex isoquants: This shape of isoquant
assumes continuous substitution of capital and labor over
a certain range, beyond which factors cannot substitute
each other.
 The isoquant appears as a smooth curve convex to the
origin. From now on we use the smooth and convex
isoquants to analyze the long run production.
 3.3 Long run production
K higher output

q
q q
L
Fig. The smooth and convex isoquant.
 3.3 Long run production:
Marginal rate of technical substitution (MRTS)
 MRTS is the slope of an isoquant.
 The slope of an isoquant (-ΔK/ΔL) indicates how the
quantity of one input can be traded off against the quantity
of the other, while output is held constant.
 The absolute value of the slope of an isoquant is called
marginal rate of technical substitution (MRTS).
 The MRTS shows the amount by which the quantity of one
input can be reduced when one extra unit of another input
is used, so that output remains constant.
 MRTS of labor for capital, denoted as 𝑀𝑅𝑇𝑆𝐿,𝐾 shows the
amount by which the input of capital can be reduced when
one extra unit of labor is used, so that output remains
constant.
 3.3 Long run production:
𝑀𝑃𝐿
 𝑀𝑅𝑇𝑆𝐿,𝐾 = 𝑀𝑃 , how?
𝐾

 For a given level of output let 𝑞 = 𝑓(𝐿, 𝐾)

𝜕𝑓(𝐿,𝐾) 𝜕𝑓(𝐿,𝐾)
𝑑𝑞= 𝜕𝐿 𝑑𝐿 + 𝜕𝐾 𝑑𝐾 = 0, for 𝑞 (constant q)
𝜕𝑓(𝐿,𝐾) 𝜕𝑓(𝐿,𝐾)
𝜕𝐿
𝑑𝐿 + 𝜕𝐾
𝑑𝐾 = 0 ,
𝜕𝑓(𝐿,𝐾) 𝜕𝑓(𝐿,𝐾)
But = 𝑀𝑃𝐿 and = 𝑀𝑃𝐾 , Thus
𝜕𝐿 𝜕𝐾
𝑀𝑃𝐿 𝑑𝐿 + 𝑀𝑃𝐾 𝑑𝐾 = 0
𝑀𝑃𝐿 𝑑𝐿 = −𝑀𝑃𝐾 𝑑𝐾, −𝑑𝐾 =
𝑑𝐿 𝑀𝑃
𝑀𝑃𝐿
𝐾
𝑀𝑃𝐿
𝑀𝑅𝑇𝑆𝐿,𝐾 = 𝑀𝑃𝐾
, since −𝑑𝐾
𝑑𝐿
= 𝑀𝑅𝑇𝑆𝐿,𝐾

Therefore, the slope of an isoquant is the ratio of

marginal products of inputs.
 3.3 Long run production:
 Elasticity of substitution(𝛿): is defined as the
percentage change in the capital labor ratio,
divided by the percentage change in the rate of
technical substitution.
percentage change in 𝐾𝐿
𝛿 =
percentage change in 𝑀𝑅𝑇𝑆𝐿,𝐾
∆ 𝑲 𝑳 𝑲 𝑳
𝛿 =
∆ 𝑴𝑹𝑻𝑺𝑳,𝑲 𝑴𝑹𝑻𝑺𝑳,𝑲
 The elasticity of substitution is a pure number
independent of the units of measurement of K and L
 3.3 Long run production:
The efficient region of production:
 Similarto the short run, efficient region of
production in the long run prevails when the
marginal product of all variable inputs is positive
but decreasing.
 Graphically this can be represented by the
negatively slopped part of an isoquant.
 Ridge lines: The locus of points of isoquants
where the marginal products of factors are zero
form the ridge line. (See on the hand out)
 3.3 Long run production:
 The upper ridge line implies that the MP of capital
is zero.
 𝑀𝑃𝐾 is negative for all points above the upper
ridge line and positive for points below the ridge
line.
 The lower ridge line implies that the 𝑀𝑃𝐿 is zero.
 For all points below the lower ridge line the 𝑀𝑃𝐿
is negative and positive for points above the line.
 Production techniques are technically efficient
inside the ridge lines symbolically;
 3.3 Long run production:
 in the long run efficient production region can be
illustrated as:
𝜕𝑀𝑃𝐿
𝑀𝑃𝐿 > 0, but <0
𝜕𝐿
𝜕𝑀𝑃𝐾
𝑀𝑃𝐾 > 0, but <0
𝜕𝐾
 Thus efficient region of production is defined by
the range of isoquants over which they are
convex to the origin.
 The law of returns to scale: LR
 The laws of production describe the technically
possible ways of increasing the level of
production.
 Output may increase in various ways.
 In the long run output can be increased by
changing all factors of production.
 This long run analysis of production is called Law
of returns to scale.
 The law of returns to scale: LR :
1. Increasing Returns to Scale: A certain
percentage increase in all inputs results in a
higher percentage increase in output.
2. Decreasing Returns to Scale: A certain
percentage increase in all inputs results in a
lower percentage increase in output.
3. Constant Returns to Scale: A certain
percentage increase in all inputs results in an
equal percentage increase in output.
 The law of returns to scale: LR :
Mathematical Treatment of Returns to scale
 Suppose 𝑄𝑜 = 𝑓(𝐿, 𝐾)
 If we increase or scale up both 𝐿 and 𝐾 by 𝒕 units
𝑄 ∗ = 𝑓(𝑡𝐿, 𝑡𝐾)
 If we can factor out 𝒕 such that
𝑄 ∗ = 𝑡 v 𝑓(𝐿, 𝐾)
𝑄 ∗ = 𝑡 v 𝑄0
 then, the production function is called
homogeneous. If 𝑡 cannot be factored out, the
production function is non-homogeneous.
 The law of returns to scale: LR :
 The power v of 𝑡 is called the degree of
homogeneity of the function and is a measure of
the returns to scale:
 If v = 1, we have constant returns to scale. This
production function is sometimes called linear
homogeneous.
 If v < 1, decreasing return to scale prevails
 If v > 1, increasing return to scale prevails
 The law of returns to scale: LR :
 For a Cobb-Douglas production function
𝑄 = 𝑏0 𝐿𝑏1 𝐾𝑏2
the returns to scale are measured by the sum
𝑏1 + 𝑏2 = v. How?
 Let 𝐿 and 𝐾 increase by 𝑡. The new level of
output is 𝑄 ∗ = 𝑏0 (𝑡𝐿)𝑏1 (𝑡𝐾)𝑏2
𝑄 ∗ = 𝑡 (𝑏1+𝑏2 ) 𝑏0 𝐿𝑏1 𝐾𝑏2
𝑄 ∗ = 𝑡 (𝑏1+𝑏2 ) 𝑏0 𝐿𝑏1 𝐾𝑏2
𝑄 ∗ = 𝑡 (𝑏1+𝑏2) 𝑄 = 𝑡 v Q
Thus, v = 𝑏1 + 𝑏2
 Equilibrium of the firm:
 Choice of optimal combination of factors of
production.
 technical efficiency and economic efficiency.
 technical efficiency is a necessary condition,
but not a sufficient condition for economic
efficiency.
 To determine the economically efficient input
combinations we need to have the prices of
inputs.
 Equilibrium of the firm:
 Determining the economically efficient input
combination: say 𝐿∗ and 𝐾 ∗ in two input case.
 Assumptions:
1. The goal of the firm is maximization of profit .
𝜋 = 𝑅 − 𝐶, where 𝜋, 𝑅 and 𝐶 are profit, revenue
and cost respectively.
2. The price of the product is given and it is equal
to 𝑃
3. The prices of inputs are given (constant). Price
of a unit of labor is 𝑤 and that of capital is 𝑟.
 Equilibrium of the firm:
Isocost Line
 An isocost line is the locus points denoting all
combination of factors that a firm can purchase
with a given monetary outlay, given prices of
factors. 𝐶 = 𝑤𝐿 + 𝑟𝐾 --------- Isocost line
 Given the cost outlay 𝐶, the maximum amounts of
capital and labor that the firm can purchase are
equal to 𝐶𝑟 and 𝑤𝐶 respectively.
 The straight line that connects these points is the
isocost line.
 Equilibrium of the firm:
𝐶𝑎𝑝𝑖𝑡𝑎𝑙(𝐾).

𝑪 𝐼𝑠𝑜𝑐𝑜𝑠𝑡 𝐿𝑖𝑛𝑒
𝒓
𝑪 = 𝒘𝑳 + 𝒓𝑲
𝒘
𝑺𝒍𝒐𝒑𝒆 = −
𝒓
𝑪 𝐿𝑎𝑏𝑜𝑟 (𝐿)
𝒘
 Equilibrium of the firm:
 Case1: Maximization of output subject
to cost constraint:
 Given: production function: 𝑄 = 𝑓(𝐿, 𝐾) and
Cost Constraint: 𝐶 = 𝑤𝐿 + 𝑟𝐾
 The equilibrium point is graphically defined by the
tangency of the firm’s isocost line with the highest
possible isoquant. At this point, the slope of the
𝒘
isocost line is equal to the slope of the
𝒓
𝑴𝑷𝑳
isoquant .
𝑴𝑷𝑲
 Equilibrium of the firm:
 The condition of equilibrium under this case is,
𝒘 𝑴𝑷𝑳
thus: 𝑴𝑹𝑻𝑺𝑳,𝑲 = =
𝒓 𝑴𝑷𝑲
Method 1:
𝑴𝑷𝑳
1. First calculate 𝑴𝑹𝑻𝑺𝑳,𝑲 =
𝑴𝑷𝑲
𝒘
2. Equate 𝑴𝑹𝑻𝑺𝑳,𝑲 with the input price ratio
𝒓
𝒘
i.e. 𝑴𝑹𝑻𝑺𝑳,𝑲 = ………………..(1)
𝒓
3. Cost line: 𝐶 = 𝑤𝐿 + 𝑟𝐾 ..............(2)
 Equilibrium of the firm:
 Method 1: (cont.)
4. Solve 𝐸𝑞. (1) and 𝐸𝑞. (2) Simultaneously to find
𝐿∗ and 𝐾 ∗ .
 This works for Well behaved technologies, as the
second order condition is also satisfied by the
convexity of the isoquant.
 If isoquant is concave to the origin the point of
tangency of the isocost line and the isoquant
does not define the equilibrium combination of
factor inputs. With a concave isoquant, we have a
corner solution.
 Equilibrium of the firm:
K The highest possible Isoquant

𝑪 = 𝒘𝑳 + 𝒓𝑲
𝑪 Type equation here.𝒘
𝒓 𝑴𝑹𝑻𝑺𝑳,𝑲 =
𝒓
𝑲∗

𝑪
𝑳∗ 𝒓
L
 Equilibrium of the firm:
 Mathematical derivation of the equilibrium condition
:
The problem can be stated as:
Maximize: 𝑄 = 𝑓(𝐿, 𝐾) ……𝑂𝑏𝑗𝑒𝑐𝑡𝑖𝑣𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛
Subject to: 𝐶 = 𝑤𝐿 + 𝑟𝐾 ……Cost 𝐶𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛
or 𝑤𝐿 + 𝑟𝐾 − 𝐶 = 0
set the Lagrangian function as:
𝜙 = 𝑄 − 𝝺 𝑤𝐿 + 𝑟𝐾 − 𝐶
 Maximization of the 𝜙 function implies maximization
of the output.
 Equilibrium of the firm:
 The first condition for the maximization of a function
is that its partial derivatives be equal to zero.
 The partial derivatives of the above function with
respect to 𝐿, 𝐾 and 𝝺 are:
𝜕𝜙 𝜕𝑄
= − 𝝺w = 0 (1)
𝜕𝐿 𝜕𝐿

𝜕𝜙 𝜕𝑄
= − 𝝺r = 0 (2)
𝜕𝐾 𝜕𝐾

𝜕𝜙
= 𝑤𝐿 + 𝑟𝐾 − 𝐶 = 0 (3)
𝜕𝝺
 Equilibrium of the firm:
 Solving the first two equations for 𝝺 we obtain
𝜕𝑄
𝜕𝑄 𝜕𝐿 𝑀𝑃𝐿
= 𝝺w 𝑜𝑟 𝝺 = =
𝜕𝐿 𝑤 𝑊
𝜕𝑄
𝜕𝑄 𝜕𝐾 𝑀𝑃𝐾
= 𝝺𝑟 𝑜𝑟 𝝺= =
𝜕𝐿 𝑟 𝑟
 The two expressions must be equal; thus
𝑀𝑃𝐿 𝑀𝑃𝐾 𝑀𝑃𝐿 𝑤
= or =
𝑊 𝑟 𝑀𝑃𝐾 𝑟
 This firm is in equilibrium when it equates the ratio
of the marginal productivities of factors to the ratio
of their prices.
 Equilibrium of the firm:
 The second-order conditions for equilibrium of the
firm require that the marginal product curves of the
two factors have a negative slope.
 The slope of the marginal product curve of labor is
the second derivative of the production function:
𝜕2 𝑄
Slope 𝑀𝑃𝐿 𝐶𝑢𝑟𝑣𝑒 =
𝜕𝐿2
Similarly for capital:
𝜕2 𝑄
Slope 𝑀𝑃𝐾 𝐶𝑢𝑟𝑣𝑒 =
𝜕𝐾 2
 Equilibrium of the firm:
 The second-order conditions are
𝜕2 𝑄 𝜕2 𝑄
<0 and <0
𝜕𝐿2 𝜕𝐾 2
and
2
𝜕2 𝑄 𝜕2 𝑄 𝜕2 𝑄
>
𝜕𝐿2 𝜕𝐾 2 𝜕𝐿𝜕𝐾
 These conditions are sufficient for establishing the
convexity of the isoquants.
 Equilibrium of the firm:
 Example: 𝑄 = 2𝐿0.5 𝐾 0.5 , 𝑤 = $5, 𝑟 = $10 and
𝐶 = $600. Find the combination of labor and capital
that maximizes the firm’s output and the maximum
output.
 Equilibrium of the firm:
 Case -2: Minimization of cost for a given level of
output
 The conditions for equilibrium of the firm are formally
the same as in Case 1. That is, there must be tangency
of the (given) isoquant and the lowest possible isocost
line, and the isoquant must be convex.
 However, the problem is conceptually different in the
case of cost minimization.
 The entrepreneur wants to produce a given output, 𝑄
with the minimum cost outlay.
 Technical Rate-of-Substitution
The minimum possible Isocost line
𝐾

𝐸𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚
𝒘
∗
𝑴𝑹𝑻𝑺𝑳,𝑲 =
𝑲 e 𝒓

Q𝑸

𝐿
𝑳∗
 Equilibrium of the firm:
 In this case we have a single isoquant which
denotes the desired level of output, but we have a
set of isocost curves.
 The firm minimizes its costs by employing the
combination of 𝐾 and 𝐿 determined by the point of
tangency of the 𝑄 isoquant with the lowest isocost
line.
 Points below e are desirable because they show
lower cost but are not attainable for output 𝑄.
 Points above e show higher costs.
 Equilibrium of the firm:
 Hence point e is the least-cost point, the point
denoting the least-cost combination of the factors
𝐾 and 𝐿 for producing 𝑄
 Clearly the conditions for equilibrium (least cost)
are the same as in Case 1, that is, equality of the
slopes of the isoquant and the isocost curves, and
convexity of the isoquant.
 Equilibrium of the firm:
 Formally:
Minimize 𝐶 = 𝑤𝐿 + 𝑟𝐾
Subject to 𝑄 = 𝑓(𝐿, 𝐾)
Rewrite the constraint in the form
𝑓 𝐿, 𝐾 − 𝑄
Form the Lagrangian function
𝜙 = 𝐶 − 𝝺 𝑓 𝐿, 𝐾 − 𝑄
𝜙 = 𝑤𝐿 + 𝑟𝐾 − 𝝺 𝑓(𝐿, 𝐾) − 𝑄
Take the partial derivatives of 𝜙 with respect to 𝐿, 𝐾
and 𝝺 and equate to zero:
 Equilibrium of the firm:
𝜕𝜙 𝜕𝑓 𝐿, 𝐾 𝜕𝑄
=𝑤−𝝺 =0=w−𝝺
𝜕𝐿 𝜕𝐿 𝜕𝐿

𝜕𝜙 𝜕𝑓 𝐿, 𝐾 𝜕𝑄
=𝑟−𝝺 =0=r−𝝺
𝜕𝐾 𝜕𝐾 𝜕𝐾

𝜕𝜙
= −𝑓 𝐿, 𝐾 + 𝑄 = 0
𝜕𝝺
 From the first two expressions we obtain
𝜕𝑄 𝜕𝑄
w=𝝺 and r=𝝺 , respectively
𝜕𝐿 𝜕𝐾
 Equilibrium of the firm:
 Dividing through these expressions we find
𝑤 𝜕𝑄 𝜕𝐿
= = 𝑀𝑅𝑇𝑆𝐿,𝐾
𝑟 𝜕𝑄 𝜕𝐾
 This condition is the same as in Case 1 above.
 The second (sufficient) condition, concerning the
convexity of the isoquant, is fulfilled by the
assumption of negative slopes of the marginal
product of factors as in Case 1, that is
2
𝜕2 𝑄 𝜕2 𝑄 𝜕2 𝑄 𝜕2 𝑄 𝜕2 𝑄
<0 and < 0 and >
𝜕𝐿2 𝜕𝐾2 𝜕𝐿2 𝜕𝐾2 𝜕𝐿𝜕𝐾
 Equilibrium of the firm:
 Example: 𝑄 = 2𝐿0.5 𝐾 0.5 = 464.758 = 𝑄, 𝑤 = $5, 𝑟 = $10.
Find the combination of labor and capital that minimizes
cost and the minimum cost.
 Equilibrium of the firm:

 Other methods of solving for the optimal

amount of inputs given cost function:
1. The Corner solution. For example, for
perfect substitutes.
2. The Kink solution, e.g. for perfect
complements.
(Read for those methods, they are
analogous to the utility maximization case)
 Derivation of Cost functions from
production functions
 In applied research one of the most
commonly used forms of production
function is the CobbDouglas form
𝑸 = 𝒃𝒐 𝑳𝒃𝟏 𝑲𝒃𝟐
 Given this production function and the
cost equation 𝑪 = 𝒘𝑳 + 𝒓𝑲
 we want to derive the cost function, that
is, the total cost as a function of output
𝑪 = 𝒇(𝑸)
 Derivation of Cost functions from
production functions
 We begin by solving the constrained
output maximisation problem:
Maximize: 𝑄 = 𝑓(𝐿, 𝐾) ……𝑂𝑏𝑗𝑒𝑐𝑡𝑖𝑣𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛
Subject to: 𝐶 = 𝑤𝐿 + 𝑟𝐾 …cost constraint function
or 𝑤𝐿 + 𝑟𝐾 − 𝐶 = 0
We form the 'composite' function
𝜙 = 𝑄 − 𝝺 𝑤𝐿 + 𝑟𝐾 − 𝐶 ,
where 𝝺 = 𝐿𝑎𝑔𝑟𝑎𝑛𝑖𝑎𝑛 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟=
 Derivation of Cost functions from
production functions
 The first condition for maximization is that
the first derivatives of the function with
respect to 𝐿, 𝐾 and 𝝺 be equal to zero:
𝜕𝜙 𝜕𝑄
= − 𝝺w = 0 (1)
𝜕𝐿 𝜕𝐿

𝜕𝜙 𝜕𝑄
= − 𝝺r = 0 (2)
𝜕𝐾 𝜕𝐾

𝜕𝜙
= 𝑤𝐿 + 𝑟𝐾 − 𝐶 = 0 (3)
𝜕𝝺
 Derivation of Cost functions from
production functions
 From equation (1) we have:
𝜕𝜙
= 𝑏1 𝑏𝑜 𝐿𝑏1−1 𝐾𝑏2 − 𝝺w = 0 (1)
𝜕𝐿
𝜕𝜙 𝑏𝑜 𝐿𝑏1 𝐾𝑏2
= 𝑏1 − 𝝺w = 0
𝜕𝐿 𝐿
since 𝑏𝑜 𝐿𝑏1 𝐾𝑏2 = 𝑄, we can write it as
𝜕𝜙 𝑄
= 𝑏1 − 𝝺w = 0
𝜕𝐿 𝐿
𝑄
This implies 𝑏1 = 𝝺w ……….(1.1)
𝐿
 Derivation of Cost functions from
production functions
 Similarly, from equation (2)
𝜕𝜙
= 𝑏2 𝑏𝑜 𝐿𝑏1 𝐾𝑏2−1 − 𝝺r = 0 (1)
𝜕𝐾
𝜕𝜙 𝑏𝑜 𝐿𝑏1 𝐾𝑏2
= 𝑏2 − 𝝺r = 0
𝜕𝐾 𝐾
since 𝑏𝑜 𝐿𝑏1 𝐾𝑏2 = 𝑄, we can write it as
𝜕𝜙 𝑄
= 𝑏2 − 𝝺r = 0
𝜕𝐾 𝐾
𝑄
This implies 𝑏2 = 𝝺r ……….(2.1)
𝐾
 Derivation of Cost functions from
production functions
 DividingEquation (1.1) by Equation (2.1)
we obtain
𝑏1 𝐾 𝑤
This implies =
𝑏2 𝐿 𝑟
𝑤 𝑏2
Solving for K, K= L …………(4)
𝑟 𝑏1
 Derivation of Cost functions from
production functions
Substituting K into the production function we
obtain 𝑸 = 𝒃𝒐 𝑳𝒃𝟏 𝑲𝒃𝟐
𝒃𝟐
𝒃
𝑤 𝑏2
𝑸 = 𝒃𝒐 𝑳 𝟏 L
𝑟 𝑏1
𝒃𝟐
𝑤 𝑏2
𝑸 = 𝒃𝒐 𝑳(𝒃𝟏 +𝑏2)
𝑟 𝑏1
The term in brackets is the constant term of the
function: it includes the three coefficients of the
production function,𝑏𝑜 , 𝑏1 , 𝑏2 and the prices of the factors
of production.
 Derivation of Cost functions from
production functions
Solving the above form of the production function
for L, we find
𝒃𝟐
𝑤 𝑏2
𝑸 = 𝒃𝒐 𝑳(𝒃𝟏 +𝑏2)
𝑟 𝑏1
(𝒃𝟏 +𝑏2 )
𝑄
𝑳 = 𝒃𝟐
𝑤 𝑏2
𝒃𝒐
𝑟 𝑏1
1
𝑄 𝒃𝟏 +𝑏2
𝐿= 𝒃𝟐
𝑤 𝑏2
𝒃𝒐
𝑟 𝑏1
 Derivation of Cost functions from
production functions
Or we can write it as
𝒃𝟐 𝟏
𝑟 𝑏1 𝒃𝟏 +𝑏2 𝑄 𝒃𝟏 +𝑏2
𝑳= … … … … . . (5)
𝑤 𝑏2 𝒃𝒐
Substituting the value of L from Eq. (5) into Eq.
(4) for capital K we obtain
𝑤 𝑏2
K= L …………(4)
𝑟 𝑏1
𝒃𝟐 𝟏
𝑤 𝑏2 𝑟 𝑏1 𝒃𝟏 +𝑏2 𝑄 𝒃𝟏 +𝑏2
𝑲=
𝑟 𝑏1 𝑤 𝑏2 𝒃𝒐
 Derivation of Cost functions from
production functions
Or we can write it as
−𝒃𝟐 𝟏
𝑤 𝑏2 𝑤 𝑏2 𝒃𝟏 +𝑏2 𝑄 𝒃𝟏 +𝑏2
𝑲=
𝑟 𝑏1 𝑟 𝑏1 𝒃𝒐

(𝒃𝟏 +𝒃𝟐 −𝒃𝟐 ) 𝟏

𝑤 𝑏2 𝒃𝟏 +𝑏2 𝑄 𝒃𝟏 +𝑏2
𝑲=
𝑟 𝑏1 𝒃𝒐
𝑏1 𝟏
𝑤 𝑏2 𝒃𝟏 +𝑏2 𝑄 𝒃𝟏 +𝑏2
𝑲= … … . . (6)
𝑟 𝑏1 𝒃𝒐
 Derivation of Cost functions from
production functions
Substituting expression (5) and (6) into the cost
equation C = wL + rK we find
C =
𝒃𝟐 𝟏
𝑟 𝑏1 𝒃𝟏 +𝑏2 𝑄 𝒃𝟏 +𝑏2
𝑤 +
𝑤 𝑏2 𝒃𝒐
𝑏1 𝟏
𝑤 𝑏2 𝒃𝟏 +𝑏2 𝑄 𝒃𝟏 +𝑏2
𝒓
𝑟 𝑏1 𝒃𝒐

 But we can simplify it

 Derivation of Cost functions from
production functions
 We can rewrite it as
𝐶 =
𝟏 𝒃𝟐 𝑏1
1 𝒃𝟏 +𝑏2 𝑟 𝑏1 𝒃𝟏 +𝑏2 𝑤 𝑏2 𝒃𝟏 +𝑏2
𝑤 +𝒓
𝒃𝒐 𝑤 𝑏2 𝑟 𝑏1
 You can further simplify it if you want
 Derivation of Cost functions from
production functions
𝐶 =
𝟏 𝒃𝟐 𝑏1
1 𝒃𝟏 +𝑏2 𝑏1 𝒃𝟏 +𝑏2 𝑏2 𝒃𝟏 +𝑏2
𝒃𝒐 𝑏2
+
𝑏1
*
𝑏1 𝑏2 𝟏
𝑤 (𝑏1+𝑏2) 𝑟 (𝑏1+𝑏2) 𝑸 𝒃𝟏 +𝑏2
 This is the cost function, that is, the cost
expressed as a function of:
 Derivation of Cost functions from
production functions
i. Output 𝑄
ii. The production function
coefficients(parameters) 𝒃𝒐 , 𝒃𝟏 , 𝒃𝟐
iii. The prices of factors(inputs) 𝒘, 𝒓
 If prices of factors are given (the usual assumption
in the theory of the firm), cost depends only on
output 𝑄, and we can draw the usual diagrams of
cost curves, which express graphically the cost
function
𝑪 = 𝒇(𝑸)
[Link] of production

End of Chapter Three!