PPA 723: Managerial Economics

Lecture 10: Production

Managerial Economics, Lecture 10: Production

Outline Production Technology in the Short Run Production Technology in the Long Run

Managerial Economics, Lecture 10: Production

Production
A production process transform inputs or factors of production into outputs. Common types of inputs:
capital (K): buildings and equipment labor services (L) materials (M): raw goods and processed products.

Managerial Economics, Lecture 10: Production

Production Functions
A production function specifies:
the relationship between quantities of inputs used and the maximum quantity of output that can be produced given current knowledge about technology and organization. For example, q = f(L, K)

Managerial Economics, Lecture 10: Production

Short Run versus Long Run

Short run: A period of time so brief that at least one factor of production is fixed.
Fixed input: A factor that cannot be varied practically in the short run (capital). Variable input: a factor whose quantity can be changed readily during the relevant time period (labor). Long run: A time period long enough so that all inputs can be varied.

Managerial Economics, Lecture 10: Production

Total, Average, and Marginal Product of Labor

Total product: q

Marginal product of labor: MPL = q/L

Average product of labor: APL = q/L The graphs for these concepts appear smooth because a firm can hire a "fraction of a worker" (part time).

(a)

Output, Units per day

q, 110 C

Managerial Economics Lecture 10: Production

APL = Slope of straight line to the origin

90 B

APL = MPL at maximum APL MPL = Slope of total product curve

56

Figure 6.1 Production Relationships with Variable Labor

0 (b)

4 a

11

L
20

, Workers

per day

AP L , MPL

15

b Average product,APL

Marginal product,MPL c 0 4 6 11

L , Workers per day

Managerial Economics, Lecture 10: Production

Effects of Added Labor

APL
Rises and then falls with labor. Equals the slope of line from the origin to the point on the total product curve.

MPL
First rises and then falls. Cuts the APL curve at its peak. Is the slope of the total product curve.

Managerial Economics, Lecture 10: Production

Managerial Economics, Lecture 10: Production

Law of Diminishing Marginal Returns

As a firm increases an input, holding all other inputs and technology constant,
the marginal product of that input will eventually diminish,

which shows up as an MPL curve that slopes downward above some level of output.

Managerial Economics, Lecture 10: Production

Long-Run Production: Two Variable Inputs

Both capital and labor are variable.

A firm can substitute freely between L and K.

Many different combinations of L and K produce a given level of output.

Managerial Economics, Lecture 10: Production

Isoquant
An isoquant is a curve that shows efficient combinations of labor and capital that can produce a single (iso) level of output (quantity):

q f ( L, K )

Examples:
A 10-unit isoquant for a Norwegian printing firm 10 = 1.52 L0.6 K0.4 Table 6.2 shows four (L, K) pairs that produce q = 24

Managerial Economics, Lecture 10: Production

Managerial Economics, Lecture 10: Production

K, Units of capital per day 6 a

Figure 6.2 Family of Isoquants

3 e

f q = 35

d q = 24 q = 14

L , Workers per day

Managerial Economics, Lecture 10: Production

Isoquants and Indifference Curves

Isoquants and indifference curves have most of the same properties.
The biggest difference:
An isoquant holds something measurable (quantity) constant An indifference curve holds something that is unmeasurable (utility) constant

Managerial Economics, Lecture 10: Production

Three Key Properties of Isoquants

1. The further an isoquant is from the origin, the greater is the level of output.
2. Isoquants do not cross.

3. Isoquants slope downward.

Managerial Economics, Lecture 10: Production

The Shape of Isoquants

The slope of isoquant shows how readily a firm can substitute one input for another Extreme cases:
perfect substitutes: q = x + y fixed-proportions (no substitution): q = min(x, y)

Usual case: bowed away from the origin

Managerial Economics, Lecture 10: Production

Figure 6.3a Perfect Substitutes: Fixed Proportions

y, Idaho potatoes per day

q=1

q=2

q=3

x, Maine potatoes per day

Managerial Economics, Lecture 10: Production

Figure 6.3b Perfect Complements

Boxes per day

q= 3 q= 2 q= 1

45 line
Cereal per day

Managerial Economics, Lecture 10: Production

Figure 6.3c Substitutability of Inputs

K, Capital per unit of time

q=1

L , Labor per unit of time

Managerial Economics, Lecture 10: Production

Marginal Rate of Technical Substitution

The slope of an isoquant tells how much a firm can increase one input and lower the other without changing quantity.
The slope is called the marginal rate of technical substitution (MRTS). The MRTS varies along a curved isoquant, and is analogous to the MRS.

Managerial Economics, Lecture 10: Production

K, Units of capital per year

39

Figure 6.4 How the Marginal Rate of Technical Substitution Varies Along an Isoquant

K = 18 b L= 1 7 1 4 1 2 1

21 14 10 8

c d

q = 10

L , Workers per day

Managerial Economics, Lecture 10: Production

The Slope of an Isoquant

If firm hires L more workers, its output increases by MPL = q/L A decrease in capital by K causes output to fall by MPK = q/K To keep output constant, q = 0: (MPL L) (MPK K ) 0
or
MPL K MRTS MPK L

Managerial Economics, Lecture 10: Production

Returns to Scale
Returns to scale (how output changes if all inputs are increased by equal proportions) can be: Constant: when all inputs are doubled, output doubles, Increasing: when all inputs are doubled, output more than doubles, or Decreasing: when all inputs are doubled, output increase < 100%.

Managerial Economics, Lecture 10: Production

(c) Concrete Blocks and Bricks: Increasing Returns to Scale K, Units of capital per year 600 q = 100 500 400 300 200 100 0 50 100 150 200 250 300 350 400 450 500 L, Units of labor per year q = 200 q = 251