Technology

and
Production
chapter 7
 Learning Objectives
• Explain how to identify a firm’s efficient
production methods.
• Calculate average product and marginal product
and explain how they measure a firm’s
productivity.
• Discuss input substitution with two variable
inputs.
• Understand the concept of returns to scale and
its causes.
• Discuss the sources of productivity differences
across firms and over time.
 Overview
• Among all possible production technologies, firms
use the most efficient methods
• The simplest production function produces one
output using one input - but usually we encounter
two or more variable inputs to produce multiple
outputs.
• As firms grow and increase the use of all inputs, the
effect on production may not be proportional –
returns to scale
 Production Technologies
• Outputs: the physical products or services a firm
produces
• Inputs: the materials, labor, land, or equipment that
firms use to produce their outputs
• Production technology: summarizes all possible
methods for producing output
• Efficient: when there is no way for the firm to
produce a larger amount of output using the same
amounts of inputs
 Production Possibilities Set and
Efficient Production Frontier
• Production possibilities
set: contains all
combinations of inputs
and outputs that are
possible given the firm’s
technology
• Efficient production
frontier: contains the
combinations of inputs
and outputs that the firm
can achieve using efficient
production methods
 Production Functions

• Production function: states the MAXIMUM amount

of output a firm can produce from given amounts of
inputs using efficient production methods
– Output = F(Inputs)

AS IN CONSUMER THEORY, IN PRODUCTION THEORY THIS FUNCTION IS

ASSUMED TO BE SUCH THAT THE LEVEL SETS (indifference curves in consumer
theory, now called ISOQUANTS in production theory) ARE STRCITLY CONVEX.

ONE WAY TO ENSURE THIS IS ASSUME QUASI-CONCAVE OR CONCAVE

PRODUCTION FUNCTION.
 Production in the Short Run and
the Long Run
• Variable input: can be adjusted over the time period
being considered
• Fixed input: cannot be adjusted over the time period
being considered
• Short run: a period of time over which one or more
inputs is fixed
• Long run: a period of time over which all inputs are
variable
 Average Product
• Average product of labor: the amount of output
divided by the number of workers employed

Q F(L)
– APL = =
L L
 Production Function and Average
Product Curve

TYPICALLY OBSERVED PRODUCTION

FUNCTION OF SINGLE INPUT
 Marginal Product
• Marginal product of labor: the extra output
produced due to the L marginal units of labor, per
unit of labor

DQ F(L)- F(L - DL)

– MPL = =
DL DL
Production Function and Marginal
Product
 Law of Diminishing Marginal
Returns
• Law of diminishing marginal returns: states the
general tendency for the marginal product of an
input to eventually decline as its use is increased
holding all other inputs fixed

7-12
 Average and Marginal Product
• TYPICALLY, If the
marginal worker is
more productive
than average, she
brings the average
up. If she is less
productive than
average, she drives
the average down.

7-13
 MALTHUS AND THE FOOD CRISIS
• The law of diminishing marginal returns was
central to the thinking of political economist INDEX OF WORLD FOOD
Thomas Malthus (1766–1834). PRODUCTION PER CAPITA
YEAR INDEX
• Malthus predicted that as both the marginal and 1948-52 100
average productivity of labor fell and there were
1961 115
more mouths to feed, mass hunger and
starvation would result. 1965 119
1970 124
• Malthus was wrong (although he was right 1975 125
about the diminishing marginal returns to labor).
1980 127

• Over the past century, technological 1985 134

improvements have dramatically altered food 1990 135
production in most countries (including
1995 135
developing countries, such as India). As a result,
the average product of labor and total food 2000 144
output have increased (SHIFTING UP OF THESE 2005 151
CURVES).
2009 155

• Hunger remains a severe problem in some areas,

in part because of the low productivity of labor
there.
Technological Improvement vs the Law of Diminishing Marginal Returns

THE EFFECT OF TECHNOLOGICAL

IMPROVEMENT
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.
 MALTHUS’ FOOD CRISIS NEVER HAPPENED

CEREAL YIELDS AND THE WORLD PRICE OF FOOD

Cereal yields have increased. The average world price of food increased temporarily in
the early 1970s but has declined since.
 Production with Two Variable
Inputs
• Two inputs: labor (L) and capital (K)

• Production function: Q = F(L, K)

Input Substitution
 Isoquants
• Isoquant: identifies
all the input
combinations a firm
can use to efficiently
produce a given
amount of output

• Family of isoquants:
consists of the
isoquants
corresponding to all
possible output
levels

7-19
 Productive Input Principle
Increasing the amounts of all inputs strictly increases
the amount of output the firm can produce (using
efficient production methods).

Analogous to the More-is-better principle in consumer

theory.
 Properties of Isoquants
• Isoquants are thin
Output in A > B due
to productive input
principle ⇒ B and A
cannot belong in the
same isoquant
 Properties of Isoquants
• Isoquants are thin Output in A > B due
• Isoquants do not slope to productive input
principle ⇒ A and B
upward cannot belong in the
same isoquant
 Properties of Isoquants
• Isoquants are thin
• Isoquants do not slope upward
• An isoquant is the boundary
between input combinations
that produce more than a
given amount of output and
those that produce less
 Properties of Isoquants
• Isoquants are thin However, this is impossible
since the output in C > B due
to the productive input
• Isoquants do not slope principle

upward ByBytransitivity,
transitivity,BBand
produce
producethe thesame
andCCshould
sameoutput
should
output

• An isoquant is the boundary Similarly,

Similarly,bybybeing
beingon
onthe
thesame
same
isoquant,
isoquant,AAandandCCproduce
producethe
the
between input combinations same
sameoutput.
output.

that produce more than a CC

given amount of output and
those that produce less ByBybeing
beingon
isoquant,
onthe
thesame
isoquant,AAand
andBB
same
BB
• Isoquants for the same
produce
producethe
thesame
same
output.
output.

technology do not cross

 Properties of Isoquants
• Isoquants are thin
• Isoquants do not slope
upward
• An isoquant is the boundary
between input combinations
that produce more than a
given amount of output and
those that produce less
• Isoquants for the same
technology do not cross
• Higher-level isoquants lie
farther from the origin
 Substitution between Labor and Capital
Along an Isoquant and the MRTS
Marginal rate of
technical substitution
(MRTS) for input X
with input Y: the rate
at which a firm must
replace units of X
with units of Y to
keep output
unchanged starting at
a given input
combination

7-26
Declining MRTS
MRTS and Marginal Products
Along the Same Isoquant
(MPL ´DL)+(MPK ´DK) = 0

-DK DL = MPL MPK

MPL
MRTSLK =
MPK
 Input Substitution for Three
Special Production Technologies
• Perfect substitutes
• Perfect complements (fixed proportions)
• The Cobb-Douglas production function
 Perfect Substitutes
• If the functions of
two inputs are
identical, so that a
firm can exchange
one for another at a
fixed rate

7-30
 Perfect Complements (Fixed
Proportions)

• When two inputs

must be combined
in a fixed ratio

7-31
 The Cobb-Douglas Production
Function

Q = F(L, K) = ALa K b

MPL = a ALa-1K b

MPK = b ALa K b-1

a K
MRTSLK = ( )( )
b L
7-32
 Returns to Scale
• Constant returns to scale
• Increasing returns to scale
• Decreasing returns to scale
 Returns to Scale
• Constant returns to
scale: when a
proportional change in
all inputs produces the
same proportional
change in output

7-34
 Returns to Scale
• Increasing returns to
scale: when a
proportional change in
all inputs produces a
more than proportional
change in output

7-35
 Returns to Scale
• Decreasing returns to
scale: when a
proportional change in
all inputs produces a
less than proportional
change in output

7-36
 Productivity and Technological
Change

Technological change: when a firm’s

ability to turn inputs into output changes
over time
 Productivity Improvement
• Higher productivity:
when a firm can
produce more
output using the
same amounts of
inputs
• Factor-neutral
technical change: a
productivity
improvement that
keeps the MRTS
unchanged at every
input combination

7-38
 Reasons for Productivity
Differences
• Firms may be subject to different regulations
or market circumstances
• Examples: labor laws, union contracts
• Firms may have different levels of technical,
organizational knowledge, research and
development; learning by doing
 Review
• A production method is efficient if there is no way to
produce larger amounts of outputs using the same amounts
of inputs
• Production with one variable input: when the marginal
product of labor is (larger than/smaller than/equal to) the
average product of labor, the average product is (increased
by/decreased by/unchanged by) the marginal units of labor.
• A firm has (constant/increasing/decreasing) returns to scale
if a proportional change in all inputs leads to (the same/a
greater than/a less than) proportional change in output.
• A firm is more productive when it can produce more output
using the same amount of inputs.