Production Function

Production function relates physical output of a production process to physical

inputs or factors of production. The production function is one of the key concepts
of mainstream neoclassical theories, used to define marginal product and to
distinguish allocative efficiency, the defining focus of economics. The primary
purpose of the production function is to address allocative efficiency in the use of
factor inputs in production and the resulting distribution of income to those
factors, while abstracting away from the technological problems of achieving
technical efficiency, as an engineer or professional manager might understand it.
Production function denotes an efficient combination of inputs and outputs.

The Production Function in the Short Run

Because there is only one input (labor) to the short-run production function, it's
pretty straightforward to depict the short-run production function graphically. As
shown in the above diagram, the short-run production function puts the quantity
of labor (L) on the horizontal axis (since it's the independent variable) and the
quantity of output (q) on the vertical axis (since it's the dependent variable).

The short-run production function has two notable features. First, the curve starts
at the origin, which represents the observation that the quantity of output pretty
much has to be zero if the firm hires zero workers. (With zero workers, there isn't
even a guy to flip a switch to turn on the machines!) Second, the production
function gets flatter as the amount of labor increases, resulting in a shape that is
curved downward. Short-run production functions typically exhibit a shape like
this due to the phenomenon of diminishing marginal product of labor.

In general, the short-run production function slopes upwards, but it is possible for
it to slope downwards if adding a worker causes him to get in everyone else's way
enough such that output decreases as a result.

The Production Function in the Long Run

Because it has two inputs, the long-run production function is a bit more
challenging to draw. One mathematical solution would be to construct a three-
dimensional graph, but that is actually more complicated than is necessary.
Instead, economists visualize the long-run production function on a 2-dimensional
diagram by making the inputs to the production function the axes of the graph, as
shown above. Technically, it doesn't matter which input goes on which axis, but it
is typical to put capital (K) on the vertical axis and labor (L) on the horizontal axis.
You can think of this graph as a topographical map of quantity, with each line on
the graph representing a particular quantity of output. (This may seem like a
familiar concept if you have already studied indifference curves!) In fact, each line
on this graph is called an "isoquant" curve, so even the term itself has its roots in
"same" and "quantity." (These curves are also crucial to the principle of cost
minimization.)
Why is each output quantity represented by a line and not just by a point? In the
long run, there are often a number of different ways to get a particular quantity of
output. If one were making sweaters, for example, one could choose to either hire
a bunch of knitting grandmas or rent some mechanized knitting looms. Both
approaches would make sweaters perfectly fine, but the first approach entails a
lot of labor and not much capital (i.e. is labor intensive), while the second requires
a lot of capital but not much labor (i.e. is capital intensive). On the graph, the
labor heavy processes are represented by the points toward the bottom right of
the curves, and the capital heavy processes are represented by the points toward
the upper left of the curves.
In general, curves that are further away from the origin correspond to larger
quantities of output. (In the diagram above, this implies that q3 is greater than
q2, which is greater than q1.) This is simply because curves that are further away
from the origin are using more of both capital and labor in each production
configuration. It is typical (but not necessary) for the curves to be shaped like the
ones above, as this shape reflects the tradeoffs between capital and labor that are
present in many production processes.

Isoquadrants
An isoquant is a contour line drawn through the set of points at which the same
quantity of output is produced while changing the quantities of two or more
inputs. While an indifference curve mapping helps to solve the utility-maximizing
problem of consumers, the isoquant mapping deals with the cost-minimization
problem of producers. Isoquants are typically drawn along with isocost curves in
capital-labor graphs, showing the technological tradeoff between capital and labor
in the production function, and the decreasing marginal returns of both inputs.
Adding one input while holding the other constant eventually leads to decreasing
marginal output, and this is reflected in the shape of the isoquant. A family of
isoquants can be represented by an isoquant map, a graph combining a number
of isoquants, each representing a different quantity of output. Isoquants are also
called equal product curves.

Iso Costs
 In economics an isocost line shows all combinations of inputs which cost the same
total amount. Although similar to the budget constraint in consumer theory, the
use of the isocost line pertains to cost-minimization in production, as opposed to
utility-maximization. For the two production inputs labour and capital, with fixed
unit costs of the inputs, the equation of the isocost line is

rK+wL=C

where w represents the wage rate of labour, r represents the rental rate of capital,
K is the amount of capital used, L is the amount of labour used, and C is the total
cost of acquiring those quantities of the two inputs.

The absolute value of the slope of the isocost line, with capital plotted vertically
and labour plotted horizontally, equals the ratio of unit costs of labour and capital.
The slope is:

w/r .

The isocost line is combined with the isoquant map to determine the optimal
production point at any given level of output. Specifically, the point of tangency
between any isoquant and an isocost line gives the lowest-cost combination of
inputs that can produce the level of output associated with that isoquant.
Equivalently, it gives the maximum level of output that can be produced for a
given total cost of inputs. A line joining tangency points of isoquants and isocosts
(with input prices held constant) is called the expansion path.

Isocost v. Isoquant Graph. Each line segment is an isocost line representing one
particular level of total input costs, denoted TC in the graph and C in the article's
text. PL is the unit price of labor (w in the text) and PK is the unit price of physical
capital (r in the text).

Cost Minimization
The rationale in cost minimization is straightforward. If cost can be lowered then profits can be
increased. Thus one condition to
maximize profits is to minimize costs.
With regards to our analysis that would
mean choosing the combination of
labor and capital that costs the least to
produce a given amount of output. For
a given amount of output suggests that
we are restricted to a single isoquant.
Finding the least cost combination of
labor and capital would mean we need
to be on the lowest feasible isocost.
 K - Capital

That occurs at the tangency between

isocost and isoquant as in the diagram.
L* and K* are the lowest cost
combination of L and K on Q0 given the
wage rental rate depicted as the slope
of the isocost.
Q0
The least cost input bundle lies on the isocost
L* L - labor line tangent to the Isoquant. In other words the
slopes of the two are equal: -MPL/MPK = -w/r.
Cross multiplying leads to MPL/w = MPK/r,
K* which is interpreted as that the output per $
spent is equal across all inputs. If this were not
the case then the firm could substitute the
cheaper input for the more expensive and thus lower costs.

Profit Maximization
profit maximization is the short run or long run process by which a firm
determines the price and output level that returns the greatest profit. There are
several approaches to this problem. The total revenuetotal cost perspective
relies on the fact that profit equals revenue minus cost and focuses on maximizing
this difference, and the marginal revenuemarginal cost perspective is based on
the fact that total profit reaches its maximum point where marginal revenue
equals marginal cost.

Profit Maximization using Totals Approach Profit maximization using the

marginal approach