Production Function

Production Function Qt= (inputst)

 Qt=output rate  inputt=input rate  where is technology? Q= (Kt,Lt)

Qt

Firms try to be on the surface of the PF.

 Inside the function implies there is waste, or technological inefficiency.

Kt

Lt
1

Difference between LR and SR

LR is time period where all inputs can be varied.

 Labor, land, capital, entrepreneurial effort, etc.

SR is time period when at least some inputs are fixed.

 Usually think of capital (i.e., plant size) as the fixed input, and labor as the variable input.

LR production function as many SR production functions.

Long Run: Q = f (K,L)  Suppose there are two different sized plants, K1 and K2.  One Short Run: Q = f ( K1,L) i.e., K fixed at K1  A second Short Run: Q = f ( K2,L) i.e., K fixed at K2



Show this graphically

3

Two Separate SR Production Functions

Q Q = f( K2, L ) Q = f( K1, L ) K 2 > K1

L
4

What Happens when Technology Changes?

This shifts the entire production function, both in the SR and in the LR.

Technology Changes

Q TP after computer TP before computer

L
6

SR Production Function in More Detail

Qt= (Kfixed,Lt)
Express this in two dimensions, L and Q, since K is fixed. Define Marginal Product of Labor. Slope is MPL=dQ/dL Identify three ranges
 I: MPL >0 and rising  II: MPL >0 and falling  III: MPL<0 and falling

II

III

Where Diminishing Returns Sets In

As you add more and more variable inputs to fixed inputs, eventually marginal productivity begins to fall. As you move into zone II, diminishing returns sets in! Why does this occur?

II

Why Diminishing Returns Sets In

Since plant size (i.e., capital) is fixed, labor has to start competing for the fixed capital. Even though Q still increases with L for a while, the change in Q is smaller.

II

Define APL and MPL

Average Product = Q / L
 output per unit of labor.  frequently reported in press.

Marginal Product = dQ/dL

 output attributable to last unit of labor used.  what economists think of.

10

Average Productivity Graphically

Take ray from origin to the SR production function. Derive slope of that ray (Q=Q1 (L=L1 Thus, (Q/(L =Q1 /L1

Q=f(KFIXED,L)

Q1 (Q L1 L
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(L

Average Productivity Graphically

APL rises until L2 Beyond L2 , the APL begins to fall. That is, the average productivity rises, reaches a peak, and then declines

Q Q=f(KFIXED,L) Q2

Q/L

L2

APL L2
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Average & Marginal Productivity

There is a relationship between the productivity of the average worker, and the productivity of the marginal worker. Think of a batting average.
 Think of your marginal productivity in the most recent game.  Think of average productivity from beginning of year.

When MP > AP, then AP is RISING When MP < AP, then AP is FALLING When MP = AP, then AP is at its MAX

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Average Productivity Graphically Q

MPL rises until L1 Beyond L1 , the MPL begins to fall. Look at AP i. Until L2, MPL >APL and thus APL
rises. ii. At L2, MPL=APL and thus APL peaks. iii. Beyond L2, MPL<APL and thus APL falls.

L1 Q/L

L2

MPL

APL
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L1 L2

Intuitive explanation

Anytime you add a marginal unit to an average unit, it either pulls the average up, keeps it the same, or pulls it down.
 When MP > AP, then AP is rising since it pulls it the average up.  When MP < AP, then AP is falling since it pulls the average down.  When MP = AP, then AP stays the same.

Think of softball batting average example.

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LR Production Function

Qt Kt Isoquants
(i.e.,constant quantity)

Lt
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Define Isoquant
Different combinations of Kt and Lt which generate the same level of output, Qt.

Isoquants & LR Production Functions

ISOQUANT MAP
Qt = Q(Kt, Lt) Output rate increases as you move to higher isoquants. Slope represents ability to tradeoff inputs while holding output constant.
 Marginal Rate of Technical Substitution. Substitution.

K
Q3 Q2 Q1

Closeness represents steepness of production hill.

L
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Slope of Isoquant

Slope is typically not constant.

 Tradeoff between K and L depends on level of each.

Can derive slope by totally differentiating the LR production function. Marginal rate of technical substitution is MPL/MPK

Kt

Q Lt

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Extreme Cases

No Substitutability

Perfect Substitutability

Q
2

Q2 Q1 L L Tradeoff is constant
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Q1

Inputs used in fixed proportions!

Substitutability

Low Substitutability

High Substitutability

Q1 L Slope of Isoquant changes a lot

Q1 L Slope of Isoquant changes very little

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Isoquants and Returns to Scale

Returns to scale are cost savings associated with a firm getting larger.

Increasing Returns to Scale

Production hill is rising quickly. Lines on the contour map get closer with equal increments in Q.

Q=40 Q=30 Q=20 Q=10

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Decreasing Returns to Scale

K
Q=40

Production hill is rising slowly. Lines on the contour map get further apart with equal increments in Q.

Q=30 Q=20 Q=10

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How Can You Tell if a PF has IRS, DRS, or CRS?

It is possible that it has all three, along various ranges of production. However, you can also look at a special kind of function, called a homogeneous function.
 Degree of homogeneity is an indicator returns to scale.

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Homogeneous Functions of Degree H

A function is homogeneous of degree k
 if multiplying all inputs by P, increases the dependent variable byPH  Q = f ( K, L)  So, PH Q = f(PK, P L) is homogenous of degree k.

Cobb-Douglas Production Functions are homogeneous of degree E

+F

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CobbCobb-Douglas Production Functions

Q=AKELF
PH Q

is a Cobb-Douglas Production Function

Degree of Homogeneity is derived by increasing all the inputs by P

= A (P K)E (P L) F PH Q = A P E KE P F LF PH Q = P EF A KE LF

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CobbCobb-Douglas Production Functions

This is a Constant Elasticity Function

 Elasticity of substitution W = 1

Coefficients are elasticities

E is the capital elasticity of output, EK F is the labor elasticity of output, E L

If Ek or L <1 then that input is subject to Diminishing Returns. C-D PF can be IRS, DRS or CRS
 if E + F! 1, then CRS  if E + F< 1, then DRS  if E + F> 1, then IRS

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Technical Change in LR

Technical change causes isoquants to shift inward

 Less inputs for given output

May cause slope to change along ray from origin

 Labor saving  Capital saving

May not change slope

 Neutral implies parallel shift

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Technical change

Labor Saving

Capital Saving

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Lets now turn to the Cost Side

What is Goal of Firm?

Define Isocost Line

Put K on vertical axis, and L on horizontal axis. Assume input prices for labor (i.e., w) and capital (i.e., r) are fixed. Define: TC=w*L + r*K Solve for K: r*K= TC-w*L K=(TC/r) - (w/r)*L

Isocost Line

K
TC/r

Slope=Slope=-w/r

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TC constant along Isocost line.

TC1/r

L TC1/w
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in TC parallel shifts Isocost

K TC2/r TC1/r

TC2 > TC1

L TC1/w TC2/w
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Change in input price rotates Isocost

w2 < w 1
TC/r

L TC/w1 TC/w2
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Optimal Input Levels in LR

Suppose Optimal Output level is determined (Q1). Suppose w and r fixed. What is least costly way to produce Q1?

Q1 L

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Optimal Input Levels in LR

Suppose Optimal Output level is determined (Q1). Suppose w and r fixed. What is least costly way to produce Q1? Find closest isocost line to origin!
 Optimal point is point of allocative efficiency.

K1

Q1 L1 L
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Cost Minimizing Condition

Slopes of Isoquant and Isocost are equal

Slope of Isoquant=MRTS=- MPL/ MPK Slope of Isocost=input price ratio=-w/r At tangency, - MPL/ MPK = -w/r

Rearranging gives: MPL/w= MPK /r In words:

 Additional output from last $ spent on L = additional output from last $ spent on K.

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The LR Expansion Path

Costs increase when output increases in LR! Look at increase from Q1 to Q2. Both Labor and Capital adjust. Connecting these points gives the expansion path.

K expansion path
K2 K1

Q2 Q1 L
L1 L2
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We can show that LR adjustment along the expansion path is less costly than SR adjustment holding K fixed!

Start at an original LR equilibrium (i.e., at Q1).

K1

Q1 L
L1
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LR Adjustment

LR adjustment:
 K increases (K1 to K2)  L increases (L1 to L2)  TC increases from black to blue isocost.

K2 K1

Q2 Q1
L1 L2

L
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SR Adjustment

SR adjustment.
 K constant at K1.  L increases (L1 to L3)  TC increases from black to white isocost.

K1

Q2 Q1
L1 L3

L
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LR Adjustment less Costly

White Isocost (i.e., SR) is further from the origin than the Blue Isocost (LR). Thus, the more flexible LR is less costly than the less flexible SR.

K2 K1

Q2 Q1
L1 L2 L3

L
44

Impact of Input Price Change

Start at equilibrium.
 Recall slope of isocost=(K/(L= -w/r

Suppose w and optimal Q stays same (i.e., Q1) Rotate budget line out, and then shift back inward!

Q1

K1

L1

L
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Decrease in wage leads to substitution

Firms substitute away from capital (K1 to K2). Firms substitute toward labor (L1 to L2 ) Pure substitution effect: a to b Maps out demand for labor curve

a
K1 K2

b Q1
L1 L2

L
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Derivation of Labor Demand from Substitution Effect

Wage falls w

K
w1

a
K1 K2

b Q1
L1 L2

w2 DL1

L1

L2

L
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There is also a scale effect

Scale effect is increase in output that results from lower costs Scale effect: b-c

Q1

Q2 a b c

K1

L1

L
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Scale Effect Shifts Demand

Wage falls

K
w1 K1 K2

a b

c
w2

Q1
L1 L2 L3

DL1

DL2

L1

L2 L3

L
49

Recall the Isocost Line TC=w*L + r*K

Thus, TC=TVC+TFC  Lets relate the cost relationships to the production relationships.  Recall the Law of Diminishing Returns.


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Law of Diminishing Marginal Returns

As you add more and more variable inputs (L) to your fixed inputs (K), marginal additions to output eventually fall (i.e., MPL= (Q/(L falls) What does this say about the shape of cost curves?

51

Marginal Productivity (MPL) and Marginal Cost (MC)

Look at how TC changes when output changes. Assume w and r are fixed. Since TC=w*L+r*K then (TC = w*(L + r*(K How does K change in SR?

52

Changes in TC in SR must come from changes in Labor.

(TC = w* (L Divide through by change in Q (ie. (Q) (TC/(Q = w* ((L/(Q) (TC/(Q = Marginal Cost = MC What is MPL? MPL=((Q/(L) Thus: (TC/(Q = w* 1/((Q/(L) This gives: MC=w/MPL

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MC=w/MPL

Look at where Diminishing Returns sets in.

MPL MC

MPL L1 L Q

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MC=w/MPL

Substitute L1 into SR Production Function Q1=f(KFIXED,L1)

MPL MC MC

MPL L1 L Q1 Q
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Alternatively: TC and TP

Substitute L1 into SR Production Function Q1=f(KFIXED,L1)

Q TC TC

MPL L1 L Q1 Q
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Relationship between APL and AVC

TC=TVC + TFC TC = w*L + r*K Divide equation by Q to get average cost formula. TC/Q = w*L/Q + r*K/Q ATC = AVC + AFC Thus, AVC=w*L/Q

57

AVC and APL

AVC=w*L/Q Rearranging: AVC=w/(Q/L) Since Q/L=APL AVC=w/APL Diagram is similar.

58

AVC=w/APL

Substitute L2 into SR Production Function Q2=f(KFIXED,L2)

APL AVC AVC

APL L2 L Q2 Q
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Put SR Cost Curves Together

Average Cost Curves

ATC

AVC

AFC Q
61

Short Run Average Costs and Marginal Cost

$ ATC MC AVC

Q
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Cost Curve Shifters

(Variable Cost Increases)

A change in the wage shifts the AVC and MC curves. Thus, the ATC curve also shifts upward.

MC ATC $ AVC ATC AVC

MC Q
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Cost Curve Shifters

(Fixed Cost Increases)

An increase in price of capital increases fixed costs, but not variable costs. Thus, AVC and MC are fixed, but ATC increases.

$ ATC MC ATC AVC

Q
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Costs in the LR

Why did SR cost curves have the shape they did? Why do LR cost curves have the shape they do?

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LR Total Costs Graphically

TC Cost IRS CRS DRS

Q
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Why are there Economies of Scale?

Specialization in use of inputs. Less than proportionate materials use as plant size increase. Some technologies are not feasible at small scales.

67

Why do Diseconomies of Scale Set In? Eventually, large scale operations become more costly to operate (i.e., they use more resources) due to problems of coordination and control. e.g., red tape in the bureaucracy. Graphical Representation

68

Economies and Diseconomies of Scale

Assume Q increases 10 units for each isoquant

IRS
L
69

Economies and Diseconomies of Scale

Assume Q increases 10 units for each isoquant

DRS

IRS
L
70

Economies and Diseconomies of Scale

LRAC curve
Assume Q increases 10 units for each isoquant

DRS

IRS CRS CRS

DRS

IRS
L QMES Q
71

LRMC and LRAC Curves

LRAC and LRMC

$ LRMC

LRMC is (TC/(Q (i.e., change in TC from a change in Q) when all inputs are variable inputs. When LRMC is above LRAC, it pulls the average up, and viceversa.

LRAC

Q
73

Relating SR to LR curves

Relationship between SR ATC and LRAC curves. curves.

At Q1, the SR plant size which gives ATC1 is least costly.

$ ATC1 LRAC

Q Q1
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Relationship between SR ATC and LRAC curves.

$ ATC1 LRAC

At Q1, the SR plant size which gives ATC1 is least costly. SR ATC is tangent to LRAC at one point.

Q Q1
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Relationship between SR ATC and LRAC curves.

$ ATC1 LRAC

At Q1, the SR plant size which gives ATC1 is least costly. SR ATC is tangent to LRAC at one point. Tangency is not at minimum point of ATC1.

Q Q1
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Adjustments in SR are still more costly than LR

At Q2, the SR plant size which gives ATC1 is no longer least costly.

$ ATC1 atc1 lrac1 Q Q2

78

LRAC

Adjustments in SR are still more costly than LR

$ ATC1 atc1 lrac1 Q Q2 LRAC

At Q2, the SR plant size which gives ATC1 is no longer least costly. Optimal move would be to larger plant size!

79

LRAC is lower envelope of family of SRATC curves

$ ATC1 ATC2 ATC3 LRAC

Q Q1 Q2=QMES Q3
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SRMC and LRMC

$
SRMC1 SRMC2 SRATC1 SRATC2

LRMC
SRMC3

LRAC

SRATC3

q1

q2

q3

q
81