Microeconomics Department of Agricultural Economics

CHAPTER FOUR

THEORY OF PRODUCTION

4.1. Basic concepts of production

A. Production: It is a process of using the service of inputs (factors of production) to make goods
and services.
B. Production function: It is the relationship between the quantity of inputs used and the
maximum output that can be produced keeping technology constant. For example the production
function for a firm that used only labor and capital is Q=f (L, K)
C. fixed input: Is an input which is used in a fixed quantity for a certain level of output; i.e. its
quantity does not change with the change in output or we can call it input with inelastic supply in
the short run.
D. Variable input: Is an input whose quantity changes with the change in output. In the short run
its supply is elastic. Corresponding to fixed and variable inputs, production period classified as
short run and long run production period.
E. Short run: It refers to a period of time in which the supply of some inputs (i.e. building, plant,
machineries etc) is fixed or inelastic. In the short run therefore, production of commodity can be
increased only by using more of variable inputs.
F. Long run: It refers to a period of time in which all inputs are variable and has elastic supply in
the long run. Therefore, production of commodity can be increased by employing more of all
inputs.

4.2 Production with one variable input (short run)

This is a phenomenon of short run production period. Production is carried out with capital as a
fixed factor and labor as a variable factor. Since we have one variable input i.e. labor, we use
different amount of labor with fixed capital to change the amount of production. As a result there
will be a change in factor proportions. Because of this, we call this production process the law of
a variable proportions; more popularity the law of diminishing returns

4.2.1. Total, Average and marginal product and their relationship

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Dear students, do you remember what is meant by total utility and marginal utility from the
previous chapter discussion? Then what do you suggest about total product, marginal and average
product?
______________________________________________________________________________
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Total product: is the total amount of output that can be produced by efficiently utilizing a specific
combination of labor and capital. The total product curve, thus, represents various levels of output
that can be obtained from efficient utilization of various combinations of the variable input, and
the fixed input. It shows the output produced for different amounts of the variable input, labor.
Dear students, do you think that output can always be increased by increasing the variable input
while there is a fixed input?

Any ways, increasing the variable input (while some other inputs are fixed) can increase the total
product only up to a certain point. Initially, as we combine more and more units of the variable
input with the fixed input output continues to increase. But eventually, increasing the unit of the
variable input may not help output increase. Even as we employ more and more unit of the variable
input beyond the carrying capacity of a fixed input, out put may tends to decline. Thus increasing
the variable input can increase the level of output only up to a certain point, beyond which the total
product tends to fall as more and more of the variable input is utilized. This tells us what shape a
total product curve assumes. The shape of the total variable curve is nearly S-shape (see fig 2.1
Panel A)

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). Before deciding whether to hire one more worker, a manager wants to determine how
much this extra worker (L =1) will increase output, q. The change in total output resulting from
using this additional worker (holding other inputs constant) is the marginal product of the worker.
If output changes by q when the number of workers (variable input) changes by ∆L, the change
in out put per worker or marginal product of the variable input, denoted as MPL is found as

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Q dTP
MPL = orMPL 
L dL

Thus, MPL measures the slope of the total product curve at a given point. In the short run, the MP
of the variable input first increases reaches its maximum and then tends to decrease to the extent
of being negative. That is, as we continue to combine more and more of the variable inputs with
the fixed input, the marginal product of the variable input increases initially and then declines.
Average Product (AP)
The AP of an input is the ratio of total output to the number of variable inputs.
totalproduct TP
APlabour  
numberofL 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.

Example 4.2

Suppose the production function that a firm faces is given as

2
Q  f ( L) K  8 L2  L3
3

This production function shows the maximum output that can be produced from various levels of
labor employment, therefore represents TP. The AP is, then, derived as

2
8L2  L3
TP 3  8L  2 L2
AP  
L L 3

Given the AP function, the point of diminishing average productivity occurs where the slope AP
is zero.

dAC 4
The slope of AP = 8 L  0
dL 3

4
L8 L6
3

Similarly, MP is derived as

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2
d (8L2  L3 )
dTP 3
MP    16L  2 L2
dL dL

Given the MP function, the point of diminishing marginal productivity occurs where the slope of
MP is zero.

dMP
The slope of MP =  16  4 L  0
dL

4L  16 L  4.

Graphing the short run production curves

The following figures shows how the TP, MP and AP of the variable (labor) input vary with the
number of the variable input.
Table 4.2 Relation b/n Ap,MP AND Total product.

K(fixed input) in Variable input(L) TPL APL MPL Stages of production

birr
2000 1 4 4 4
2000 2 9 4.5 5 Stage I
2000 3 15 5 6
2000 4 20 5 5
2000 5 24 4.8 4
2000 6 27 4.5 3 Stage II
2000 7 28 4 1
2000 8 28 3.5 0
2000 9 27 3 -1 Stage III
2000 10 25 2.5 -2

Output

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TP3

TP2 TP

TP1

Units of labor (variable input)

L1 L2 L3
APL, MPL

APL

Units of labor (variable input)

L1 L2 L3
MPL

(note :the graph is not drawn based on the above table .so consider each of them as a separate
concept)

Fig 4.2 Total product, average product and marginal product curves: As the number of the labor
hired increases (capital being fixed), the TP curve first rises, reaches its maximum when L3 amount

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of labor is employed, beyond which it tends to decline. Assuming that this short run production
curve represents a certain car manufacturing industry, it implies that L3 numbers of workers are
required to efficiently run the machineries. If the numbers of workers fall below L3, the machine
is not fully operating, resulting in a fall in TP below TP3. On the other hand, increasing the number
of workers above L3 will do nothing for the production process because only L3 number of
workers can efficiently run the machine. Increasing the number of workers above L3, rather results
in lower total product because it results in overcrowded and unfavorable working environment.

Marginal product curve increases until L1 number of labor reaches its maximum at L1, and then it
tends to fall. The MPL is zero at L3 (when the TP is maximal); beyond which its value assumes
zero indicating that each additional worker above L3 tends to create over crowded working
condition and reduces the total product. Thus, in the short run (where some inputs are fixed), the
marginal product of successive units of labor hired increases initially, but not continuously,
resulting in the limit to the total production. Geometrically, the MP curve measures the slope of
the TP. The slope of the TP curve increases (MP increases) up to L1, it decreases from L1 to L3
and it becomes negative beyond L3.

The average product curve increases up to L2, beyond which it continuously declines. The AP
curve can be measured by the slope of rays originating from the origin to a point on the TP curve.
For example, the APL at L2 is the ratio of TP2 to L2. This is identical to the slope of ray a.
The relationship between AP and MP of the variable input
The relationship between MPL and APL can be stated as follows:
 For all number of workers (Labor) below L2, MPL lies above APL.
 At L2, MPL and APL are equal.
 Beyond L2, MPL lies below the APL
Thus, the MPL curve passes through the maximum of the APL curve from above. This relationship
between APL and MPL can be shown algebraically as follows:
Suppose the production function is given as
TP = f (L), K -being constant
Given the total product function,

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dTP df ( L) TP f ( L)
MPL   and APL  =
dL dL L L

To determine the relationship between APL and MPL, consider the slope of the APL function.
f ( L) df ( L) dL
d( ) .L  . f ( L)
dAPL L dL dL
Slope of APL = = = -------- (quotient rule of
dL dL L2
differentiation)

df ( L)
.L
f ( L) ab a b
Slope of APL = dL2 - 2
----------------------------- (note that   )
L L c c c
df ( L) f ( L)
= dL - L
L L

MPL  APL df ( L) f ( L)
Slope of APL = , because = MPL and = APL
L dL L
Now – 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)

Here we will see total product(TP) and two other concepts which are used to explain the input
output relationships i.e. marginal product(MP)and average product(AP) and we shall look the
relationship exists among them through deriving MP and AP curve from TP curve geometrically.

4.2.2. The Law of Diminishing Returns /LDR/

LDR can be stated as follows. That is if more and more of a variable input is applied to a fixed
input, the total output may initially increases at an increasing rate; but beyond a certain level of
output, it increases at a diminishing rate. More precisely, if some factors held constant, use of more
and more variable factor brings a fail in marginal product of that variable input. In the above
example, the total product increases at an increasing rate up to the use of 3 units of labor and after
wards it increases at a diminishing rate. This fact is clearly reveled in marginal product curve. The

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marginal product curve initially increases and reaches maximum that is 5 units of output up to
using 3 units of labor. But beyond the use of 3 units of labor marginal product of labor starts
diminishing.
4.2.3. Stages of production
Table 4.2 and fig 4.1 above present the three stages in the operation of the law of diminishing
returns. Now we shall see what the three stages look like.

Stage 1-Increasing returns

In this stage total product increases at an increasing rate (up to point a) in fig 4.1 which means the
marginal product (MP) rises (i.e. up to point X). From point a onwards the total product goes on
rising at diminishing rate (i.e. marginal product falls but still positive). It ranges from the origin to
MP is maximum. Stage I is known as the stage of increasing returns because marginal product of
the variable factor increases throughout this stage. If a smaller number of workers are used, capital
will remain underutilized. When more and more units of labor are used, capital gets more and more
fully utilized. It increases productivity of both labor and capital. As a result, productivity of labor
goes increasing in this stage. But since we don’t use the required amount of labor that should be
employed on fixed input, maximum amount of total product cannot be attained in this stage. In
other words, there is under utilization of variable input in stage I.

Stage II-stage of diminishing returns

As fig4 panel a in stage II, the total product continues to increase at a diminishing rate until it reach
its maximum point (point c) where the second stage ends. In this stage the marginal product of the
variable factor (labor) is diminishing but positive. At the end of this stage marginal product of the
variable factor is zero. This stage is called stage of diminishing returns as marginal product of the
variable factor continuously falls throughout this stage.

Stage III – stage of negative returns

In this stage total product declines (i.e. starting from point c on wards. marginal product of the
variable factor ( labor) is negative and the marginal product curve goes below the X axis ( this is
shown by fig.4.1 panel b i.e. beyond point z ). In this stage the variable factor is too much relative
to the fixed factor. This stage is called stage of negative returns, since the marginal product of the
variable factor (labor) is negative during this stage. Now an important question is in which stage a

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rational producer (profit making firm) will seek to produce. It is obvious that a rational producer
will never choose to produce in stage III where marginal product of the variable factor (labor) is
negative

A rational producer will never be found producing in stage I and stage III. Thus stage I and III
represent non economic region in production process. A rational producer (profit maximizing firm)
will always seek to produce in stage II where the marginal profit is diminishing but still positive
.As a result, we call stage II optimum stage of production.

2: The Long run Production Function (production with two variable factor)

4.2.1. The Production Function

Suppose that a production process involves just two factors labor (L) and capital (K). In this case
the production function is defined as:

Q  f ( L, K )

The production function we saw under section 4.1 was drawn on the assumption that all other
factors of production except labor are fixed. However, with two variable factors L and K, the
relevant production function is defined by a set of isoquants.

An isoquant is the locus of all technically efficient methods (all combinations of factors of
production) for producing a given level of output; i.e. it shows the different combinations of L
and K that can be used to produce a given level of output. The production isoquant may assume
various shapes depending on the degree of substitutability of factors.

Smooth, Convex Isoquant – assumes continuous substitutability of K and L only over a certain
range, beyond which factors cannot substitute each other. The isoquant appears as a smooth
curve convex to the origin. Substitution of one factor by the other is possible only on the convex
segment of the isoquant. The smooth, convex isoquant is a limiting case of the kinked isoquant
with infinite number of kinks. Traditional theory of production mostly adopted the continuous
isoquants because; they are mathematically simple to handle by simple rules of calculus.

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Isoquant

0 L
Figure 4.10: Smooth, Convex Isoquant.

4.2.2. Characteristics of Isoquants

Isoquants have the same Properties as indifference curves. The only difference is that isoquant
holds quantity constant where as indifference curve holds utility constant. We shall now discuss
these properties of isoquants:
 Isoquants, like indifference curves, slope downward from left to right (i.e. they have negative
slope). This happens because, when the quantity of one factor increased the quantity of the other
must be decreased so as to keep output constant.
 Isoquants do not cross each other as the intersection of two isoquants implies that a certain
combination of two inputs can produce two different quantities which is impossible.
 Isoquants are convex to the origin
The convexity of isoquant curve means that as we move dawn the curve successively, smaller
units of capital are required to be substituted by a given increment of labor so as to keep the level
of output the same. Thus the convexity of the isoquant is due to the diminishing marginal rate of
technical substitution of one factor for another. We shall discuss marginal rate of technical
substitution in the next sub top

K
a d

b
c I

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e II
0 L
Figure 4.11: Non-intersection of Isoquants

In Figure 4.11, isoquants I and II cross each other at point b. Points a, b and c are located on the
same isoquant, therefore, represent the same level of output. Similarly points d, b and e are
located on the same isoquant, therefore represent the same level of output. Point d is, however,
located to the right of point a; and must represent a higher level of output. By rule of transitivity,
since d represents higher level of output than a and the same level of output as b, therefore, b
must represent higher level of output than a. Yet, this is not true.

4.2.3. The Efficient Stage of Production

A production function shows the different levels of output that can be produced using different
combinations of inputs. Hence, it is defined by a set of isoquants each of which representing a
different level of output. It shows how output varies as the factor inputs change.

K1 a
K2 b Q1
K3 c Q2
Q3
0 L1 L2 L3 L
Figure 4.12: Long run Production Function

Each of the three isoquants in Figure 4.12 above represents distinct level of output with Q1
greater than Q2 which in turn is greater than Q3.

Do you remember what we have said while discussing short-run production function? We have
said that the general theory of production concentrates on ranges over which marginal product of
factors is positive but decreasing. With two variable factors involved in the production process,
the efficient stage of production is that the marginal product of labor and the marginal product of
capital are both positive but decreasing.

Mathematically:

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Q Q
= MPL > 0 and = MPK > 0
L K

 2Q MPL
Slope of MPL =  < 0 and
L2 L

 2 Q MPK
Slope of MPK =  <0
K 2 K

Consider isoquant Q2 in Figure 4.12 above. At point a, the firm uses L1 labor and K1 capital to
produce Q2 output. At point b, the firm uses more labor and less capital to produce the same
amount of output. At point c, the amount of labor required to produce Q2 further increases while
the amount of capital decreases.

As we move along an isoquant from left to right, the quantity of labor increases while that of
capital decreases; implying increase in productivity of capital and decrease in the productivity of
labor. Eventually, the marginal productivity of labor becomes zero. As we move from right, in
order to produce the same level of output, the firm uses more and more units of capital and less
and less units of labor. This implies that the productivity of labor increases and that of capital
decreases. Eventually the marginal productivity of capital becomes zero.

Figure 4.13 below shows the efficient range of production with a production function involving
two variable inputs (labor and capital). For various levels of output, joining the points at which
the marginal product of labor and the marginal product of capital are zero yields what are called
ridge lines. Along a ridge line either the marginal product of labor or marginal product of capital
is zero.

K
Upper ridge line

Lower ridge line

Q3
Q2

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Q1

0 L
Figure 4.13: Efficient Stage of Production.
The upper ridge line is formed by joining points on successive isoquants at which MPK is zero.
Similarly, the lower ridge line is formed by joining points on successive isoquants at which MPL
is zero.

Efficient production techniques are those inside the ridge lines. Outside the ridge lines MP of
factors is negative implying that techniques of production in this region are inefficient since they
involve more of at least one factor but not less of the other. The condition of positive but
declining marginal products of the factors defines the range of efficient production (the range in
which isoquants are convex to the origin).

4.2.4. Substitution of Inputs

let us, now, turn to the discussion of substitutability between two factors. Along a convex
isoquant, a firm has to increase the quantity of one factor of production (L) for any fall in the
quantity of the other factor (K) in order to produce the same level of output.

  dK 
The slope of an isoquant   could be defined to show the degree of substitutability of
 dL 
factors of production. It declines in absolute value as we move from left to right along an
isoquant. The slope of an isoquant is called Marginal Rate of Technical Substitution of labor for
capital (MRTSL,K).

 dK MPL
MRTSL,K = =
dL MPK

4.2.5. Laws of Returns to Scale

here, we are going to discuss another important concept, returns to scale, which is a long run
phenomenon.

Laws of returns to scale relate to long-run analysis of production. In the long-run, output could
be expanded by varying all factors of production because in the long run all factors are variable.

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Factors could be varied in the same proportion (all factors are simultaneously increased or
decreased by the same percentage) or in different proportions. The traditional theory of
production deals with the former case.

Definition: Returns to scale measure the responsiveness of output as all factors are increased by
the same proportion. Suppose the initial level of inputs and the corresponding output are given
by

Q0 = f (L, K)

If now both inputs L and K are increased by the proportion c, the level of output will increase to
Q1. The new level of output is given as

Q1 = f (cL, cK)

 If Q increases by the proportion c as both L and K are increased by the proportion c, we

say the production function exhibits constant returns to scale.

 If Q increases by a proportion greater than c as both L and K are increased by the

proportion c, we say the production function exhibits increasing returns to scale.

 If, on the other hand, increase by the proportion c of both L & K causes a less than
proportionate increase in Q, we say the production function exhibits decreasing returns
to scale.

[Link]. Homogeneous functions

Homogeneity of production functions have interesting implication to the returns to scale implied
by the production functions.

Given a production function

Q0 = f (L , K)

If both inputs are increased by the proportion c and the function can be rewritten in the form

Q1 = f (cL, cK) = cV(L, K)

The function is called a homogeneous function.

Definition: A homogeneous function is a function such that if each of the inputs is multiplied by
c, then c can be completely factored out of the function. The power v of c is called the degree of

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homogeneity of the function and is a measure of the returns to scale. It shows by what percentage
output responds to a given percentage increase in both factors.

 If v = 1  constant returns to scale.

 If v > 1  increasing returns to scale.

 If v < 1  decreasing returns to scale.

If, however, c cannot be factored out of the function, the function will be non-homogeneous.

Example 4.5

In order to understand the relationship between homogeneity and returns to scale consider the
following equations.

Suppose a production function is defined as Q  LK . If the quantity of both L and K is increased

by a proportion c, the new level of output will be

Q  (cL )  (cK )

Q  c 2 LK

But Q = LK.

Q  c 2 Q

Since the exponent (power) of c is 2, this function is said to be homogenous of degree two.

This result implies that an increase in L and K by a proportion c increases output two fold. To put
it differently, since v >1, the production function exhibits increasing returns to scale.

Suppose the production function is, rather, defined as Q  2 L  4 K . If both L and K are
increased by c, the new level of output will be

Q  2cL  4cK

Q  c(2 L  4 K )

But Q = 2L + 4K

Q  cQ

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In this case since v = 1, the function, therefore, is linearly homogenous. This indicates that the
production function reveals constant returns to scale, i.e. output increases by c as both L and K
are increased by c.

L
Now, suppose the production function is given as Q  . Rise in both L and K by c leaves the
K
level of output at

cL
Q 
cK

cL
Q  0.5
c K

L
Q  c 0.5
K

L
But Q 
K

Q  c 0.5Q

Since v < 1, the production function exhibits decreasing returns to scale.

In relation to returns to scale, Cobb-Douglas production function has an interesting feature.

Consider the Cobb – Douglas production function below

Q =  L1 K  2

Where, α, 1 and 2 are all positive constants.

It can be shown that the returns to scale implied by the function is measured by the sum of the
exponents of the factors used in production (  1 +  2).

Proof:

Q  L1 K  2

If both L and K are increased by c Q   (cL ) 1 (cK )  2

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 c 1 L1 c  2 K  2
 c ( 1   2 )L1 K  2

But Q  L1 K  2

Q  c ( 1   2 ) Q

 v = (1 + 2)

The returns to scale implied by a Cobb-Douglas production function is, therefore, the sum of the
exponents of factors used in production.

Exercise 4.5
?
Given two production functions Q  4 L0.5 K 0.5 and Q  2 L0.7 K 0.8 , which production
P
function yields the highest output for any given increase in L and K? Why?
1

4.2.6. Isocost Lines

What do you think is the constraint to be faced by the firm in the production of a given product?
Yes, it is the cost to be incurred in using different factors. In order to show the production
decision of a firm we need to see the constraint that the firm faces. This constraint is given by
isocost lines.

If the production function of a firm is defined as Q = f (L, K), the total cost of the firm consists of
cost on labor and capital. This cost is summarized by the isocost line.

Definition: an Isocost line is a locus of all combination of factors a firm can purchase with a
given monetary outlay. It is given by the cost equation

C  wL  rK

Where, w is price of labor (wages) and r is price of capital (interest rate). The bar over C
indicates constant level of cost.

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Isocost lines have the feature that cost of production is constant along an isocost line and that a
higher isocost line represents a higher cost condition than a lower isocost line.

The equation of the isocost line is obtained by solving for K.

C w
K=  L
r r

The slope of the isocost line is the ratio of the prices of labor and capital.

dK w
Slope of isocost line is 
dL r

K
C /r

Isocost line

0 C /w L
Figure 4.15: Isocost Line

4.2. Equilibrium of the Firm

What do you think is the major objective for firms to produce a given product?

The firm’s objective is the maximization of its profit, which is defined as the difference between
revenue and costs, for given factor prices and price of the product.

Definition: a firm is said to be at equilibrium when it maximizes its profit.

Max  = R – C, where  is profit, R is total revenue, and C is total cost.

To maximize its profit, a firm can adopt two approaches;

 Maximizing output for a given cost, factor prices and price of the product − this involves
determining the best combination of L and K. which enables the firm achieve the highest possible
output for any constant level of monetary outlay.

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 Minimizing cost for a given output and output price − this one involves finding the L and
K combination which costs the firm the least for any constant level of output.

Let us see each approach one by one as follows:

[Link]. Maximization of Output Subject to Cost Constraint

In this case, the equilibrium of the firm is defined at the tangency of the isocost curve with the
highest possible isoquant. For any given cost condition represented by the isocost curve, the
highest attainable level of output is the one represented by the isoquant tangent to the isocost
curve.

The optimal combination of the two factors L & K is, consequently, given by L* and K* in Figure
4.16 below. Other points along the isocost line such as a and b lie below isoquant II and hence
correspond to lower levels of output. Operation on isoquant III is desirable but is not attainable.
Thus, given isocost AB, the optimal level of output is reached at point e.

A
a
*
K e III
II
b I
0 L* B L
Figure 4.16: Equilibrium of the Firm: Output Maximization.
w
At point e, the slope of the isoquant (MRTSL, K) is equal to the slope of the isocost line ( ). This
r
constitutes the first condition for equilibrium. The second condition requires that the isoquant be
convex to the origin. If the isoquant is concave, for example, the point of tangency will not
represent equilibrium.

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K1
K* e

0 L* L1 L
Figure 4.17: Equilibrium with Concave Isoquant

Figure 4.17 shows what equilibrium would look like if the isoquant were concave. The point of
tangency e does not represent equilibrium of the firm; because the firm can produce the same
level of output at a lower cost by operating either at the vertical intercept of the isoquant (with K1
capital and no labor) or at the horizontal intercept of the isoquant (with no capital and L1 labor).
We have a corner solution in this case.

Formal derivation of the equilibrium

Maximize Q = f (L, K)

Subject to C  wL  rK

The bar over C represents that the level of monetary outlay is constant.

Rewriting the constraint using a Lagrange multiplier  gives

 (C  wL  rK )  0 ; Since C  wL  rK  0

Here the firm maximizes its output for a given cost constraint, by differentiating the Lagrange
function  with respect to L, K and the Lagrange multiplier .

  Q   (C  wL  rK )

First order condition:

 Q
    w  0
L L

Q MPL
 w   
L w

 Q
    r   0
K K

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Q MPK
 r   
K r


 C  wL  rk  0  C  wL  rK


At equilibrium of the firm,

MPL MPK MPL w

=   
w r MPK r

Second order condition:

 2  2 Q  2  2 Q
  0 and  0
L2 L2 K 2 K 2

This second order condition implies that the MPL and the MPK be decreasing, which is the case
in stage II.

At equilibrium, therefore, the slope of the isoquant must be equal to the slope of the isocost
curve. Furthermore, the isoquant must be convex to the origin.

Example 4.6

Suppose the production function of a firm is Q  20L0.7 K 0.3 . If the maximum production
expenditure is Birr 600, wage rate (w) is Birr 20 and interest rate (r) is Birr 30, find the profit
maximizing level of labor and capital employment.

The cost constraint that the firm faces is 600  20L  30K

MPL w
The first order condition for equilibrium is 
MPK r

Q Q
MPL   14L0.3 K 0.3 and MPK   6 L0.7 K 0.7
L K

MPL 14L0.3 K 0.3 7 K

 
MPK 6 L0.7 K 0.7 3L

Therefore, at equilibrium

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7 K 20

3L 30

20 3L
K 
30 7

2
K L
7

Substituting this into the constraint function

2
600  20L  30( L)
7

2
L  21 K (21)  6
7

 2Q  2Q
The second order condition for equilibrium requires that  0 and  0.
L2 K 2

 2Q
 4.2 L1.3 K 0.3  0 for all positive L and K.
L 2

 0.14

 2Q
 4.2 L0.7 K 1.7  0 for all positive L and K.
K 2

 1.68

Since the second order condition is satisfied, the firm will maximize its profit by employing 21
units of labor and 6 units of capital.

Exercise 4.6
?
Suppose the production function of a firm that uses two factors L and K is Q  4 L0.5 K 0.5 .
P
The firm plans to spend Birr 100 on production. If wage rate (w) is Birr 5 and interest rate (r) is
1
Birr 10, find the profit maximizing L and K combination.

[Link]. Cost Minimization for a Given Level of Output

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 Microeconomics Department of Agricultural Economics

like the case with output maximization, the equilibrium of the firm in the case of cost
minimization is defined by the tangency of an isoquant with an isocost line.

The firm wants to produce a given level of output with the least possible cost. Thus, we have a
single isoquant representing a given output level and a set of isocosts each denoting different
cost condition. These isocosts are parallel to one another (have the same slope) because they are
drawn on the assumption of a given factor prices.

The least cost combination of L and K is defined at the tangency e of Figure 4.18. Cost
conditions below e are preferred by a rational producer, but they are not compatible with output
level Q1. Points above e, on the other hand, represent higher cost conditions, therefore, are not
preferred. The least cost combination of factors is defined at point e with K* amount of capital
and L* amount of labor.

K* e
Q1

0 L* L
Figure 4.18: Equilibrium of the Firm: Cost Minimization.

Formal Derivation of Equilibrium

The problem that the firm faces in this case is given as

Minimize C = wL + rK

Subject to Q = f (L, K)

Rewriting the constraint, we have  (Q  f ( L, K ))  0 .

  C   (Q  f ( L, K ))

  wL  rK   (Q  f ( L, K )

First order condition:

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 Microeconomics Department of Agricultural Economics

 f ( L, K ) Q
=w = 0; (because Q is a constant and  0)
L L L

f ( L, K )
 w
L

 f ( L, K ) Q
 r   0 ; (because Q is a constant and  0)
K K K

f ( L, K )
r 
K


 Q  f ( L, K )  0


 Q  f ( L, K )

f ( L, K )
w   MPL
L

MPL
 
w

f ( L, K )
r  =  MPK
K

MPK
 =
r

At the firm’s equilibrium

MPL MPK MPL w

  =
w r MPK r

This equilibrium condition implies that the ratio of the MP of labor and capital (slope of the
isoquant) must be equal to the ratio of prices of factors L and K (slope of the isocost line).

Second order condition:

 2  2 f ( L, K )  2 f ( L, K )  2 Q
=   >0   2 0
L2 L2 L2 L

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 Microeconomics Department of Agricultural Economics

 2  2 f ( L, K )  2 f ( L, K )  2 Q
   >0   0
K 2 k 2 K 2 K 2

Exercise 4.7
?
Suppose a firm’s production function is Q  160.2 L0.7 K 0.8 . Wage rate (w) is Birr 42 and
P
interest rate (r) is Birr 3. Find the cost minimizing L and K combination if the firm wishes to
1
produce 128 units of output.

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