4.

0 PRODUCTION THEORY
PRODUCTION FUNCTION
Output=f (Input)
Q=f(K,L)
input or factors capital (K) and labor(L)
Production function-shows the maximum
rate of output (Q) obtained from a given
rate of capital and labor input
Two types of production function:
a)Linear function Q = KL +2KL +L2
b) Cobb Douglas Production function
Q = 100K0.5L0.5
1% change in K will change Q by 0.5%
1% change in L will change Q by 0.5%
1

INPUT-OUTPUT TABLE (PRODUCTION TABLE)

e.g Q= 4L + 3LK + K2
Labor

Capital

15

22

14

24

34

22

35

48

PRODUCTION FUNCTION WITH ONE

VARIABLE
INPUT IN SHORT RUN
Short run- at least one factor is fixed
Long run-all inputs are variable
Production functions
1.Total Product (TP) or Output
-maximum output from combining different rates of
labor input with a fixed capital input

TP=f(K,L)
2

Marginal Product (MP)- change in output per

one unit change in variable input
MP of Labor =dQ/dL
MP of capital=dQ/dL

2.

3.

Average Product(AP)= Total product per unit

of variable input
AP of labor=Q/L
AP of capital=Q/K
Relationships among the product functions

TP

II

TP

III
Q

AP, MP
AP
DMR
MP

MP and TP
1. TP increases at increasing rate-MP
increases
2. TP increases at decreasing rate-MP
decreases
3. TP increases at maximum-MP = 0
4. TP decreases -MP is negative
MP and AP
5. MP > AP-----------AP increases
6. MP = AP-----------AP maximum
7. MP < AP-----------AP decreases
Output elasticity of labor = % change in Q
% change in L
= MP L
AP L
=d Q x L
dL Q
4

OPTIMAL EMPLOYMENT OF A
FACTOR OF PRODUCTION
To maximize profit, a firm should hire labor as
long as the additional revenue associated
with hiring another unit of labor exceeds
the cost of employing that unit
Marginal Revenue Product=Marginal Factor
Cost
MRP= wage (w)
MRP= cost of capital (r)
Note: MRP= MP x Product Price
MFC= wage rate or cost of capital

Production with two variable input.

If labor & capital are variable.
Production Isoquant
lsoquant the set of all combination of capital
and labor that yield a given output level.
-Output rate corresponding to every
combination of input rate.
Q =f(K,L)
Combination of K & L that satisfy this
equation define the isoquant for output rate.
Slope of isoquant -MRTS (marg. rate of
technical substitution)

Most production function isoquant is

convex to the origin
-MRTS decreases as one input is substituted
for another.
-Takes more and more workers to replace one
machine
Slope of isoquant, MRS = -MPL/MPK
MRS= K/L
Q= MPLxL
Q= MPKxK
-MPK x K = MPLx L
AK/AL = -MPL/MPK = slope of isoquant = (MRS)

The Production Isocost.

-cost information.
Total expenditure (C) on K & L.
C=rK+wL
r= - price of capital per unit
w= price of labor
For any given cost, C , the isocost line
defines all combination of capital & labor
inputs that can be purchased for certain
constant cost expenditure
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K= Co- w L
r r
Slope of isocost = -w/r
e.g w=2,r=3, C=40
Isocost line : 40= 3K+2L
K=40/32/3 L
K=13. 33-2/3L

K
13.33

CHANGES IN ISOCOST LINE

A) Changes in budget

) Isocost lines will have parallel

shift due to changes in budget
-Shift to the right for an
increase in budget

B) If input prices changes:

Co = $40 w=5
K =40/r5/r L
lf r increases from RM 2 to RM3
K =40/2 -5/2 L
K=40/3-5/3 L
i) If there is a change in price of capital (r)
K

If r increases

ii) If there is a change in price of labor(w)

K

If w increases:

L
10

OPTIMAL EMPLOYMENT OF TWO INPUTS

a)
Minimize cost of a given rate of output
K
b

Q= 20
Q=10

Optimal input combinations

Tangency point (a) where isoquant is tangent to isocost
line
Slope of isoquant =slope of isocost
MRTS = Price of labor
Price of capital
MRTS = -w/r
MPL = w or MPk = r
MPK r
MPL w
MPL = MPK
w r

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b) To maximize output given a budget

constraint
Optimal point: tangency between isoquant
and isocost
MRTS =-w/r
Efficient Resource allocation or efficient
Employment of K and L
Isoquant tangent to isocost line
Slope of lsoquant= Slope of isocost
MRTS=- w/r
-MPL= - w
MPK r
MPL = MPK
w
r
Marginal product per dollar of cost of input
must be the same for both inputs
If MPL < MPK
w
r
Employ more capital and less labor.
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c) To Maximize Profit
Both inputs must be employed until Marginal
revenue product equals marginal factor cost
of inputs for both capital and labor
Marginal revenue product = Marginal factor
of labor
cost of labor
MRPL = w
Marginal revenue product = Marginal factor
of capital
cost of capital
MRPK= r
Note:
MRPL=MP Lx Product Price
MRPK =MP Kx Product Price
MFCL = price of labor or wage rate
MFCK= price of capital or rate of capital
To maximize profit, firm should also fulfill
the efficient combination of input
13

EXPANSION PATH
If output increases, how much K and L will
be hired?
Firm expands by moving from tangency
(efficient production point) to another
These efficient points represents expansion
path
A set of combinations of K and L that meet
efficiency condition:
e.g Expansion path: K=0.8 L
Expansion path indicates the optimal input
combination but not the specific output
associated with that rate of input use
K
K=0.8L
Q1

Q3
Q2

L
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RETURNS TO SCALE
The change in output in relation to a change
in the scale of production (or the change in
inputs)
1. Increasing returns to scale
-Proportion increase in output > increase
in input
2. Decreasing returns to scale
-Proportion increase in output < increase
in input
3. Constant returns to scale
-Proportion increase in output = increase
in input
RULE:

a) Linear production function

e.g Q= 20 L + 4L2 +3KL
i) Increasing returns to scale(IRS)-If we
double the input proportion,output is more
than double
ii) Decreasing returns to scale(DRS)-If we double the
input proportion,output is less than double
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iii) Constant returns to scale(CRS)-If we

double the input proportion,output is also
double
b) Cobb Douglas Production function
e.g Q= I00KaLb
i)IRS: a +b > 1
e.g Q= 100K0.5L0.7
0.5+ 0.7=1.2
ii) DRS: a +b < 1
e.g Q= 100K0.5L0.3
0.5+ 0.3=0.8
iii) CRS: a +b = 1
e.g Q= 100K0.5L0.5
0.5+ 0.5=1
Reasons for IRS
1. Higher level of technology
2. Labor specialization
3. Managerial specialization
Reasons for DRS
1. Inefficient management
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Production function: Lagrangian Model

-To maximize output given cost constraint
Example 1: Q =50 K 0.5 L 0.5
10L + 15K =RM 4000
LQ= 50K 0.5 L 0.5 - (10L + 15K -4000)
Solution: L=20 K=13.3
Q=815.5
Example 2: Q =100 K 0.5 L 0.5
w=5 r=4
Cost constraint= RM 2000
Solution: L=200
K=250
=11.2
RM 1 increase in cost constraint will increase
in output by 11.2 units

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