ARSI UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
MICROECONOMICS I
CHAPTER THREE
THE THEORY OF
PRODUCTION
LECTURE NOTES
COMPILED BY: ASSEFA
D.
2024
The Firm and Its Economic Problem
• A firm is an institution that hires factors
of production and organizes them to
produce and sell goods and services.
The Firm’s Goal
• A firm’s goal is to maximize profit.
• If the firm fails to maximize its profit, the
firm is either eliminated or bought out
by other firms seeking to maximize
profit.
Theory of Firm and Production
• The theory of the firm describes how a
firm makes cost-minimizing production
decisions and how the firm’s resulting
cost varies with its output.
• Production may be defined as the act of
creating those goods/services which have
exchange value for sale (not for personal
consumption)
Theory of Firm and Production
• In order to get utility from raw materials,
first they must be transformed into output.
• However, transforming raw materials into
final products require factor inputs such
as land, labor, and capital and
entrepreneurial ability.
Production function
Q = F( K, L )
Function showing the highest output that a firm
can produce for every specified combination of
inputs.
Q= Total Product
K= Capital (Fixed factor of Production)
L=Labor (Variable factor of Production)
The Short Run versus the Long Run
short run Period of time in which quantities
of one or more production factors cannot
be changed.
long run Amount of time needed to make
all production inputs variable.
fixed input Production factor that cannot
be varied in the short run
Variable input Production factor that can
be varied in the short run
A. SHORT RUN PRODUCTION: PRODUCTION
WITH ONE VARIABLE INPUT (LABOR)
Assumption of short run production
Analysis
1. Perfect divisibility of inputs and outputs
•Factor inputs and outputs are so divisible that one
can hire, for example a fraction of labor and we an
produce a fraction of output, such as a fraction of
automobile.
2. Limited substitution between inputs
•Factor inputs can substitute each other up to a
certain point, beyond which they cannot substitute
each other.
A. SHORT RUN PRODUCTION: PRODUCTION
WITH ONE VARIABLE INPUT (LABOR)
3. Constant technology
• They assumed that level of technology of
production is constant in the short run.
• Suppose a firm that uses two inputs:
Capital (which is a fixed input) and labor
(which is variable input).
A. SHORT RUN PRODUCTION: PRODUCTION
WITH ONE VARIABLE INPUT (LABOR)
• Given the assumptions of short run
production, the firm can increase output
only by increasing the amount of labor it
uses.
A. SHORT RUN PRODUCTION: PRODUCTION
WITH ONE VARIABLE INPUT (LABOR)
Average and Marginal Products
●average product Output per unit of a
particular input.
● marginal product Additional output
produced as an input is increased by one unit.
• Average product of labor = Output/labor
input = Q/L
• Marginal product of labor = Change in
output/change in labor input
= dQ/dL
Production Function
With One Variable Input
Total Product TP = Q = f(L)
dTP
Marginal Product MPL =
dL
Average Product TP
APL =
L
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
Production with One Variable Input
Amount Amount Total Average Marginal
of Labor (L) of Capital (K) Output (q) Product (q/L) Product (∆q/∆L)
0 10 0 — —
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 4
10 10 100 10 8
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
The Slopes of the Product Curve
Production with One Variable Input
The total product 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), the marginal
product is 20 because the tangent
to the total product curve has a
slope of 20.
At point B in (a) the average
product of labor is 20, which is the
slope of the line from the origin to B.
The average product of labor at
point C in (a) is given by the slope
of the line 0C.
The Law of Diminishing Returns (Law of Variable
Proportion)
• As additional units of a variable input are combined
with a fixed input, after a point the additional output
(marginal product) starts to diminish. This is the
principle that after a point, the marginal product of a
variable input declines.
Increasing Returns
MP Diminishing Returns Begins
X
MP
• If MP > AP then AP is
rising.
• If MP < AP then AP is
falling.
• MP=AP when AP is
maximized.
The three stages of production
Stage I: The range of increasing average product of the
variable input.
From zero units of the variable input to where AP is
maximized
Stage II: The range from the point of maximum AP of the
variable to the point at which the MP of is zero.
From the maximum AP to where MP=0
Stage III: The range of negative marginal product of the
variable input.
From where MP=0 and MP is negative.
The three stages of Production
In the short run, rational firms should only be
operating in Stage II.
Why not Stage III?
Firm uses more variable inputs to produce less
output
Why not Stage I?
Underutilizing fixed capacity
Can increase output per unit by increasing the
amount of the variable input
What level of input usage within
Stage II is best for the firm?
The answer depends upon how many units
of output the firm can sell, the price of the
product, and the monetary costs of
employing the variable input.
B. Production in the long run
Production in the long run
• Isoquants show combinations of two inputs that
can produce the same level of output.
• Firms will only use combinations of two inputs
that are in the economic region of production,
which is defined by the portion of each isoquant
that is negatively sloped.
PRODUCTION WITH TWO VARIABLE INPUTS
Isoquants TABLE 6.4 Production with Two Variable Inputs
LABOR INPUT
Capital 1 2 3 4 5
Input
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120
● isoquant Curve showing
all possible combinations of
inputs that yield the same
output.
PRODUCTION WITH TWO VARIABLE INPUTS
Isoquants
● isoquant map Graph combining a number of
isoquants, used to describe a production function.
Production with Two Variable Inputs
(continued)
A set of isoquants, or isoquant
map, describes the firm’s
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D),
to isoquant q2 (75 units per year
at points such as B) and
to isoquant q3 (90 units per year
at points such as C and E).
Marginal Rate of Technical Substitution
• Marginal Rate of Technical Substitution: The
absolute value of the slope of the iso-quant.
• It equals the ratio the marginal products of the
two inputs. (It diminishes)
• Slope of iso-quant indicates the quantity of one
input that can be traded for another input, while
keeping output constant.
Decreasing Marginal Rate of Technical
Substitution
• MRTS L,K decreases as the firm continues to
substitute labor for capital (or as more of labor
is used).
• The reason is that when the number of capital
is large and that of labor is low, the productivity
of capital is relatively lower and that of labor is
higher (due to the law of diminishing marginal
returns).
• Thus, at this point relatively large amount of
capital is required to replace one unit of labor
(or one unit of labor can replace relatively large
amount of capital).
Marginal Rate of Technical Substitution
Marginal Rate of Technical Substitution
Marginal Rate of Technical Substitution
Properties of Isoquants
• Isoquants are negatively sloped
• A higher Isoquants represent a larger
output
• No two isoquants intersect or touch each
other
• Isoquants are convex to the origin
PRODUCTION WITH TWO VARIABLE INPUTS
Substitution Among Inputs
● marginal rate of technical substitution (MRTS) 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 = − Change in capital input/change in labor input
Marginal rate of technical
substitution
= − ΔK/ΔL (for a fixed level of q)
Like indifference curves,
isoquants are downward
sloping and convex. The
slope of the isoquant at
any point measures the
marginal rate of technical
substitution—the ability of
the firm to replace capital
with labor while maintaining
the same level of output.
On isoquant q2, the MRTS
falls from 2 to 1 to 2/3 to
1/3.
(MP ) / (MP ) (K / L) MRTS
L K
Shape of Isoquant
• Isoquants can have different shapes (curvature)
depending on the degree to which factor inputs
can substitute each other.
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.
Shape of Isoquant
Shape of Isoquant
2. Input- output isoquant
•It is also called Leontief isoquant.
•This assumes strict complementarities or zero
substitutability of factors of production. (In this
case, it is impossible to make any substitution
among inputs)
•Each level of output requires a specific
combination of labor and capital
•Additional output cannot be obtained unless more
capital and labor are added in specific proportions.
As a result, the Isoquants are L-shaped. (See the
following fig.)
Shape of Isoquant
3. Kinked Isoquants
•This assumes limited substitution between inputs.
•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.
•These Isoquants are also called linear
programming Isoquants or activity analysis
Isoquants. See the figure below.
Shape of Isoquant
Shape of Isoquant
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.
•Basically, kinked Isoquants are more realistic:
•There is often limited (not infinite) method of
producing a given level of output.
Shape of Isoquant
• However, traditional economic theory mostly
adopted the continuous isoquant because they
are mathematically simple to handle by the
simple rule of calculus, and they are
approximation of the more realistic isoquant
(the kinked Isoquants).
• From now on we use the smooth and convex
Isoquants to analyze the long run production.
Optimal Combination of Inputs
Isocost lines represent all combinations of
two inputs that a firm can purchase with
the same total cost.
C wL rK C Total Cost
w Wage Rate of Labor ( L )
C w
K L r Cost of Capital ( K )
r r
dK/dL=w/r-Slope of IL
Isocost Lines
• An isocost line is a line that identifies all
the combinations of capital and labor, two
factor inputs, that can be purchased at a
given total cost.
• The line intersects each axis at the
quantity of that input that the firm could
purchase if only that input were
purchased.
• The slope of an isocost line is (minus) the
ratio of input prices, w/r, indicating the
relative prices of inputs.
Isocost Lines
Producer Equilibrium
• A point of tangency between an isocost
line and an isoquant show the least costly
way of producing a given output level.
• Alternatively, a point of tangency shows
the maximum output attainable at a given
cost as well as the minimum cost
necessary to produce that output.
Long-run Production Function and Least Cost
Condition
K
KE E
Q3
Q1 Q2
TC
LE L
Equilibrium
• A firm is said to be in equilibrium when it
employs those levels of inputs that will
maximize its profit.
• This means the goal of the firm is profit
maximization (maximizing the difference
between revenue and cost).
• Thus the problem facing the firm is that of
constrained profit maximization, which
may take one of the following forms:
Equilibrium
• A firm is said to be in equilibrium when it
employs those levels of inputs that will
maximize its profit.
• This means the goal of the firm is profit
maximization (maximizing the difference
between revenue and cost).
• The mathematical derivation of the above
equilibrium condition is as follows.
• A rational producer seeks the maximization of
its output, given total cost outlay and the prices
of factors.
• That is, Maximize X = f (K, L)
subject to C = wL + rK his is a constrained
optimization which can be solved by using
the Lagrangean method.
• The steps are as follows:
• a. Rewrite the constraint in the form:
wL + rK – C = 0
b. Multiply the constraint by a constant λwhich is
the Lagrangean multiplier: λ(wL + rK – C) = 0.
c. Form the composite function: Z = X – λ(wL + rK
– C)
d. Partially differentiate the function with respect
to the factors and the multiplier, and then equate
to zero.
Interpreting the Tangency Points
• Golden rule of cost minimization: a rule
that says that to minimize cost, the firm
should employ inputs in such a way that
the marginal product per dollar spent is
equal across all inputs
MPL/w = MPK/r
If the firm is not producing at a
tangency point…
• Whenever MPL/w > MPK/r, a firm can increase
output without increasing production cost by
shifting outlays from capital to labor.
• Whenever MPL/w < MPK/r, a firm can increase
output without increasing production cost by
shifting outlays from labor to capital.
Returns to scale
• reflects the responsiveness of total product
when all the inputs are increased
proportionately
• Three important cases should be distinguished:
• constant returns to scale – where a change in
all inputs leads to an equally large increase in
output,
• decreasing returns to scale – when a balanced
increase of all inputs leads to a less-than-
proportional increase in total output,
• increasing returns to scale – arises when an
increase in all inputs leads to a more-than-
proportional increase in the level of output .