Intermediate Micro Test 2 Review

Chapter 6: Production
1. theory of the firm
a. Explanation of how a firm makes cost-minimizing production decisions and how
its cost varies with its output.
2. Production Technology:
a. Technology: We need a practical way of describing how inputs (such as labor,
capital, and raw materials) can be transformed into outputs (such as cars and
televisions)
3. Cost Constraints:
a. Firms must take into account the prices of labor, capital, and other inputs. Just as
a consumer is constrained by a limited budget, the firm will be concerned about
its cost of production
4. Input Choices
a. Given its production technology and the prices of labor, capital, and other inputs,
the firm must choose how much of each input to use in producing its output.
5. factors of production
a. Inputs into the production process (e.g., labor, capital, and materials).
6. production function: q=F(K,L)
a. Function showing the highest output that a firm can produce for every
specified combination of inputs.
7. short run
a. Period of time in which quantities of one or more production factors cannot be
changed.
8. fixed input
a. Production factor that cannot be varied.
9. long run
a. Amount of time needed to make all production inputs variable.
10. average product (AP=q/L)
a. Output per unit of a particular input. Measures the productivity of the firms
workforce in terms of how much output each worker produces on average
11. marginal product: Change in q(output)/ change in Labor
a. Additional output produced as an input is increased by one unit.
i. For example, with capital fixed at 10 units, when the labor input increases
from 2 to 3, total output increases from 40 to 69, creating an additional
output of 29 (i.e., 69–40) units

12. The
total output curve in (a) shows the output produced for different amounts of labor input.
The average and marginal products in (b) can be obtained (using the data in Table 6.1)
from the total product curve. At point A in (a), with 3 units of labor, the marginal product
is 29 because the tangent to the total product curve has a slope of 29. The average product
of labor, however, is 23, which is the slope of the line from the origin to point A. Also,
the marginal product of labor reaches its maximum at this point. At point B, with 5 units
of labor, the marginal product of labor has dropped to 24 and is equal to the average
product of labor. Thus, in (b), the average and marginal product curves intersect (at point
D). Note that when the marginal ­product curve is above the average product, the average
product is increasing. When the labor input is greater than 5 units, the marginal product is
below the average product, so the average product is falling. Once the labor input exceeds
9 units, the marginal product becomes negative, so that total output falls as more labor is
added.
13. If the output of an additional worker is greater than the average output of each existing
worker (i.e., the marginal product is greater than the average product), then adding the
worker causes average output to increase.
a. In Table 6.1, two workers produce 40 units of output, for an average product of 20
units per worker. Adding a third worker increases output by 29 units (to 69),
which raises the average product from 20 to 23.
14. when the marginal product is less than the average product, the average product is
decreasing. This is the case when the labor input is greater than 5 in Figure 6.1(b). In
Table 6.1, six workers produce 138 units of output, for an average product of 23. Adding
a seventh worker contributes a marginal product of only 9 units (less than the average
product), reducing the average product to 21.
15. We have seen that the marginal product is above the average product when the average
product is increasing and below the average product when the average product is
decreasing. It follows, therefore, that the marginal product must equal the average
product when the average product reaches its maximum. This happens at point D in
Figure 6.1(b).
16. The average product of labor is the total product divided by the quantity of labor input.
At A, for example, the average product is equal to the output of 69 divided by the input of
3, or 23 units of output per unit of labor input. This ratio, however, is exactly the slope of
the line running from the origin to A in Figure 6.1(a). In general, the average product of
labor is given by the slope of the line drawn from the origin to the corresponding point on
the total product curve.
17. law of diminishing marginal returns
a. Principle that as the use of an input increases with other inputs fixed, the
resulting additions to output will eventually decrease.
18. Labor productivity (output per unit of labor) can increase if there are improvements in
technology, even though any given production process exhibits diminishing returns to
labor. As we move from point A on curve O1 to B on curve O2 to C on curve O3 over
time, labor productivity increases.19 m

19. labor productivity

a. Average product of labor for an entire industry or for the economy as a whole.
20. stock of capital
a. Total amount of capital available for use in production.
21. technological change: Development of new technologies allowing factors of production
to be used more effectively.
22. isoquant
a. Curve showing all possible combinations of inputs that yield the same output.
23. isoquant map
a. Graph combining a number of isoquants, used to describe a production function.
24. Diminishing Marginal Returns
a. Even though both labor and capital are variable in the long run, it is useful for a
firm that is choosing the optimal mix of inputs to ask what happens to output as
each input is increased, with the other input held fixed. The outcome of this
exercise is described in Figure 6.5, which reflects diminishing marginal returns to
both labor and capitalor example, when labor is increased from 1 unit to 2 (from
A to B), output increases by 20 (from 55 to 75). However, when labor is increased
by an additional unit (from B to C), output increases by only 15 (from 75 to 90).
Thus there are diminishing marginal returns to labor both in the long and short
run. Because adding one factor while holding the other factor constant eventually
leads to lower and lower incremental output, the isoquant must become steeper as
more capital is added in place of labor and flatter when labor is added in place of
capital.
25. Substitution Among Inputs
a. With two inputs that can be varied, a manager will want to consider substituting
one input for another. The slope of each isoquant indicates how the quantity of
one input can be traded off against the quantity of the other, while output is held
constant. When the negative sign is removed, we call the slope the marginal rate
of technical substitution (MRTS)
i. The marginal rate of technical substitution of labor for capital is the
amount by which the input of capital can be reduced when one extra unit
of labor is used, so that output remains constant. This is analogous to the
marginal rate of substitution (MRS) in consumer theory
26. MRTS = -change in capital input / change in labor input
 a. =-change in K / change in L (for fixed level of q)

27. The diminishing MRTS tells us that the productivity of any one input is limited. As more
and more labor is added to the production process in place of capital, the productivity of
labor falls. Similarly, when more capital is added in place of labor, the productivity of
capital falls. Production needs a balanced mix of both inputs.
28. The additional output resulting from the increased labor input is equal to the additional
output per unit of additional labor (the marginal product of labor) times the number of
units of additional labor:
a. Additional output from increased use of labor = (MP L) (change in L)
b. Reduction in output from decreased use of capital =(MP k) (Change in K)
29. (MP L) / (MP K) = - (change in K / change in L) = MRTS
30. Production Functions—Two Special Cases
 a. Two extreme cases of production functions show the possible range of input
substitution in the production process. In the first case, shown in Figure 6.7,
inputs to production are perfect substitutes for one another. Here the MRTS is
constant at all points on an isoquant. As a result, the same output (say q3) can be
produced with mostly capital (at A), with mostly labor (at C), or with a balanced
combination of both (at B). For example, musical instruments can be
manufactured almost entirely with machine tools or with very few tools and
highly skilled labor.

31. When the isoquants are straight lines, the MRTS is constant. Thus the rate at which
capital and labor can be substituted for each other is the same no matter what level of
 inputs is being used. Points A, B, and C represent three different capital-labor
combinations that generate the same output q3.
32. fixed-proportions production function (page 206)
a. Production function with L-shaped isoquants, so that only one combination of
labor and capital can be used to produce each level of output.

b. When the isoquants are L-shaped, only one combination of labor and capital can
be used to produce a given output (as at point A on isoquant q1, point B on
isoquant q2, and point C on isoquant q3). Adding more labor alone does not
increase output, nor does adding more capital alone.
 c. In Figure 6.8 points A, B, and C represent technically efficient combinations of
inputs. For example, to produce output q1, a quantity of labor L1 and capital K1
can be used, as at A. If capital stays fixed at K1, adding more labor does not
change output. Nor does adding capital with labor fixed at L1. Thus, on the
vertical and the horizontal segments of the L-shaped isoquants, either the
marginal product of capital or the marginal product of labor is zero. Higher output
results only when both labor and capital are added, as in the move from input
combination A to input combination B.
33. returns to scale
a. Rate at which output increases as inputs are increased proportionately.
34. increasing returns to scale
a. Situation in which output more than doubles when all inputs are doubled.
35. constant returns to scale
a. Situation in which output doubles when all inputs are doubled.
36. decreasing returns to scale
a. Situation in which output less than doubles when all inputs are doubled.

When a firm’s production process exhibits constant returns to scale as shown by a

movement along line 0A in part (a), the isoquants are equally spaced as output increases
proportionally. However, when there are increasing returns to scale as shown in (b), the
isoquants move closer together as inputs are increased along the line.
 Chapter Summary

1. A production function describes the maximum output that a firm can produce for each
specified combination of inputs.
2. In the short run, one or more inputs to the production process are fixed. In the long run,
all inputs are potentially variable.
3. Production with one variable input, labor, can be usefully described in terms of the
average product of labor (which measures output per unit of labor input) and the marginal
product of labor (which measures the additional output as labor is increased by 1 unit).
4. According to the law of diminishing marginal returns, when one or more inputs are fixed,
a variable input (usually labor) is likely to have a marginal product that eventually
diminishes as the level of input increases.
5. An isoquant is a curve that shows all combinations of inputs that yield a given level of
output. A firm’s production function can be represented by a series of isoquants
associated with different levels of output.
6. Isoquants always slope downward because the marginal product of all inputs is positive.
The shape of each isoquant can be described by the marginal rate of technical substitution
at each point on the isoquant. The marginal rate of technical substitution of labor for
capital (MRTS) is the amount by which the input of capital can be reduced when one
extra unit of labor is used so that output remains constant.
7. The standard of living that a country can attain for its citizens is closely related to its
level of labor productivity. Decreases in the rate of productivity growth in developed
countries are due in part to the lack of growth of capital investment.
8. The possibilities for substitution among inputs in the production process range from a
production function in which inputs are perfect substitutes to one in which the
proportions of inputs to be used are fixed (a fixed-proportions production function).
9. In long-run analysis, we tend to focus on the firm’s choice of its scale or size of
operation. Constant returns to scale means that doubling all inputs leads to doubling
output. Increasing returns to scale occurs
 Questions for Overview

What is a production function? How does a long-run production function differ from a short-run
production function?
Why is the marginal product of labor likely to increase initially in the short run as more of the
variable input is hired?
Why does production eventually experience diminishing marginal returns to labor in the short
run?
You are an employer seeking to fill a vacant position on an assembly line. Are you more
concerned with the average product of labor or the marginal product of labor for the last person
hired? If you observe that your average product is just beginning to decline, should you hire any
more workers? What does this situation imply about the marginal product of your last worker
hired?
What is the difference between a production function and an isoquant?
Faced with constantly changing conditions, why would a firm ever keep any factors fixed? What
criteria determine whether a factor is fixed or variable?
Isoquants can be convex, linear, or L-shaped. What does each of these shapes tell you about the
nature of the production function? What does each of these shapes tell you about the MRTS?
Can an isoquant ever slope upward? Explain.
Explain the term “marginal rate of technical substitution.” What does a mean?
Explain why the marginal rate of technical substitution is likely to diminish as more and more
labor is substituted for capital.
Is it possible to have diminishing returns to a single factor of production and constant returns to
scale at the same time? Discuss.
Can a firm have a production function that exhibits increasing returns to scale, constant returns to
scale, and decreasing returns to scale as output increases? Discuss.
Suppose that output q is a function of a single input, labor (L). Describe the returns to scale
associated with each of the following production functions:
a) q= L / 2
b) q = L2 + L
 Practice Questions

1. The menu at Joe’s coffee shop consists of a variety of coffee drinks, pastries, and
sandwiches. The marginal product of an additional worker can be defined as the number
of customers that can be served by that worker in a given time period. Joe has been
employing one worker, but is considering hiring a second and a third. Explain why the
marginal product of the second and third workers might be higher than the first. Why
might you expect the marginal product of additional workers to diminish eventually?
2. Suppose a chair manufacturer is producing in the short run (with its existing plant and
equipment). The manufacturer has observed the following levels of production
corresponding to different numbers of workers:
Number of Workers Number of Chairs
1 10
2 18
3 24
4 28
5 30
6 28
7 25
1. Calculate the marginal and average product of ­labor for this production function.

2. Does this production function exhibit diminishing returns to labor? Explain.

3. Explain intuitively what might cause the marginal product of labor to become negative.
Fill in the gaps in the table:

1. A political campaign manager must decide whether to emphasize television

advertisements or letters to potential voters in a reelection campaign. Describe the
production function for campaign votes. How might information about this function (such
as the shape of the isoquants) help the campaign manager to plan strategy?
2. For each of the following examples, draw a representative isoquant. What can you say
about the marginal rate of technical substitution in each case?
a. A firm can hire only full-time employees to produce its output, or it can hire some
combination of full-time and part-time employees. For each full-time worker let
go, the firm must hire an increasing number of temporary employees to maintain
the same level of output.
b. A firm finds that it can always trade two units of labor for one unit of capital and
still keep output constant.
c. A firm requires exactly two full-time workers to operate each piece of machinery
in the factory.
 d. A firm has a production process in which the inputs to production are perfectly
substitutable in the long run. Can you tell whether the marginal rate of technical
substitution is high or low, or is further information necessary? Discuss.
3. The marginal product of labor in the production of computer chips is 50 chips per hour.
The marginal rate of technical substitution of hours of labor for hours of machine capital
is 1/4. What is the marginal product of capital?
4. Do the following functions exhibit increasing, constant, or decreasing returns to scale?
What happens to the marginal product of each individual factor as that factor is increased
and the other factor held constant?
a. q = 3L +2K
b. q= (2L+2K)½
c. Q= 3LK ^2
d. q= L ^½ K ^½
e. q= 4L ½ +4k
5. The production function for the personal computers of DISK, Inc., is given by:
a. Q=10K .5 L.5
6. where q is the number of computers produced per day, K is hours of machine time, and L
is hours of labor input. DISK’s competitor, FLOPPY, Inc., is using the production
function
i. q=10K .6 L.4
b. If both companies use the same amounts of capital and labor, which will generate
more output?
c. Assume that capital is limited to 9 machine hours, but labor is unlimited in supply.
In which ­company is the marginal product of labor greater? Explain.
7. In Example 6.4, wheat is produced according to the production function:
1. q=100(K .8 L.2 )
b. Beginning with a capital input of 4 and a labor input of 49, show that the marginal
product of labor and the marginal product of capital are both decreasing.
c. Does this production function exhibit increasing, decreasing, or constant returns
to scale?
8. Suppose life expectancy in years (L) is a function of two inputs, health expenditures (H)
and nutrition expenditures (N) in hundreds of dollars per year. The production function is:
a. L = c H.8 N.2
b. Beginning with a health input of $400 per year and a nutrition input of $4900 per
year show that the marginal product of health expenditures and the marginal
product of nutrition expenditures are both decreasing.
c. Does this production function exhibit increasing, decreasing, or constant returns
to scale?
d. Suppose that in a country suffering from famine, N is fixed at 2 and that Plot the
production function for life expectancy as a function of health expenditures, with
L on the vertical axis and H on the horizontal axis.
e. Now suppose another nation provides food aid to the country suffering from
famine so that N increases to 4. Plot the new production function.
f. Now suppose that and You run a charity that can provide either food aid or
health aid to this country. Which would provide a greater benefit: increasing H by
1 or N by 1?