Production

Technology
Chapter 7

Slides by Pamela L. Hall

Western Washington University
2005, Southwestern
 Introduction
Aim in this chapter
Investigate purely technical relationship of combining inputs to produce
outputs
Presents a physical constraint on societys ability to satisfy wants
Classify factors going into production process
Derive a production function that establishes a relationship between
production factors and a firms output
Discuss Law of Diminishing Marginal Returns and stages of production
Develop concept of isoquants
When two production factors are allowed to vary
Can substitute one factor for another
Measure of this ability is elasticity of substitution
Effect of proportional changes in all inputs is called returns to scale
Can classify production functions in terms of their elasticity of substitution
and returns to scale attributes

2
 Factors of Production
For economic modeling, factors of production are
generally classified as
Capital
Durable manmade inputs
Are themselves produced goods
Labor
Time or service individuals put into production
Land
All natural resources (for example, water, oil, and climate)
Classification allows us to conceptualize simple
cases first
Then extend analysis to higher dimensions that are more
general (realistic) 3
 Factors of Production
Time also enters into production process
Economists generally divide time into three periods, based on ability to vary
inputs
Market period
All inputs are fixed
Short-run period
Some inputs are fixed and some are variable
Long-run period
All inputs are variable
In terms of actual time, market-period, short-run, and long-run intervals
can vary considerably from one firm to another,
Depends on nature of a particular firm
Division of time into three periods is a simplification
With intertemporal substitution among stages
More general models incorporating numerous time stages are less
restrictive in their assumptions
Called dynamic models 4
 Production Functions
Firms are interested in turning inputs into outputs with the
objective of maximizing profit
Formalized by a production function
q = (K, L, M)
Where q is output of a particular commodity
K is capital
L is labor
M is land or natural resources
For any possible combination of inputs, production function
records maximum level of output that can be produced from
that combination
In market period all inputs are fixed, so level of output
cannot be varied
5
 Production Functions
Denote K, L, and M as the fixed level of capital, labor,
and land
Production from these fixed inputs is fixed at q, so
q = (K, L, M)
If capital and labor could be varied with only land fixed, then
a short-run production function would be
q = (K, L, M)
Now possible to vary output by changing either K or L
Or both K and L
In long run, all inputs could be varied, so only restriction on
output is technology
Production function represents set of technically efficient production
processes
Yields highest level of output for a given set of inputs
6
 Production Functions
Generally, technical aspects of production do impose
restrictions on profit
Assumptions (axioms) concerning these aspects are required for
developing economic models
Two axioms generally underlie a production function
Monotonicity
Implies that if a firm can produce q with a certain level of inputs
Should be able to produce at least q if there exists more of every input
Assumes free disposal of inputs
Implies that all marginal products of the variable inputs are positive at
their profit-maximizing level
Strict convexity
Analogous to Strict Convexity Axiom in consumer theory

7
 Variations in One Input (Short
Run) Marginal Product
Marginal product (MP) of variable input
Change in output, q, resulting from a unit change of the variable
input
Holding all other inputs constant
If capital is variable input, then marginal product of capital is

Alternatively, if labor is variable input, then marginal product

of labor is

MP is analogous to concept of marginal utility except that MP

is a cardinal number measured on the ratio scale
Not an ordinal number
8
 Variations in One Input (Short
Run) Marginal Product
Distances between any levels of MP are of a
known size measured in physical quantities
Bushels, crates, pounds, etc.
Consider following cubic production function
with labor as variable input
q = 6L2 L3
Marginal product of labor is
MPL = 12L L2
Graph of production function and MPL is provided in Figure
7.1

9
Figure 7.1 Stages of production
and MPL and APL

10
 Variations in One Input (Short
Run) Marginal Product
At first, for low levels of labor, total product (TP) is increasing at an
increasing rate
Slope of TP or MPL is rising
At point of inflection, slope is at its maximum
MPL is also at a maximum
To right of maximum MPL, TP is still increasing
But at a decreasing rate
MPL is positive, but falling
At maximum TP, slope of TP curve is zero
Corresponding to MPL = 0
When TP is falling, MPL is negative
According to Monotonicity Axiom, given free disposal, a firm will not
operate in negative range of MPL
Generally assumed that MPL 0

11
 Average Product
According to U.S. Department of Labor, output per hour of labor for nonfarm
business increased at an annual rate of 2.1% from 1991 to 2000
Measure of productivity is measured in physical quantities
Called average product (AP) of an input
Defined, for labor, as
APL = q/L
In general, average product (AP) is output (TP) divided by input
In Figure 7.1, APL at first increases, reaches a maximum, then declines
Productivity of labor, as measured by APL, changes as additional workers are
employed
Results from short-run condition that all other inputs remain fixed
At first, with a relatively small number of workers for a large amount of other inputs
Adding an additional worker increases productivity of all workers
APL increases
However, a point is reached where labor is no longer relatively limited compared with
fixed inputs
An additional worker will result in APL declining

12
 Average Product
Graphically, we can determine APL from TP curve
by considering a line (cord) through origin
Slope of a cord through origin is TP divided by labor
Since APL is defined as TP divided by labor
Slope of a cord through origin is APL at a level of labor where cord
intersects TP
As number of workers increases, at first cord shifts
upward and slope of the cord increases
Resulting in increased APL
Can continue to shift cord upward and it will continue to
intersect TP curve until it finally is tangent to TP curve
At this point, APL is at its maximum

13
Law of Diminishing Marginal Returns
and Stages of Production
A firms costs will depend on
Prices it pays for inputs
Technology of combining inputs into output
In short run firm can change its output by adding variable inputs to fixed
inputs
Output may at first increase at an increasing rate
However, given a constant amount of fixed inputs, output will at some point
increase at a decreasing rate
Occurs because at first variable input is limited compared with fixed input
As additional workers are added, productivity remains very high
Output, or TP, increases at an increasing rate
However, as more of variable input is added, it is no longer as limited
Eventually, TP will still be increasing, but at a decreasing rate
MPL will still be positive, but declining
Called Law of Diminishing Marginal Returns (or just diminishing returns)

14
Law of Diminishing Marginal Returns
and Stages of Production
As indicated in Figure 7.1, diminishing marginal returns starts at point A
MPL is at a maximum
To the left of point A there are increasing returns and at point A constant
returns exist
Between points A and B, where MPL is declining, diminishing marginal
returns exist
To the right of point B, marginal productivity is both diminishing and
negative (MPL < 0), which violates Monotonicity Axiom
TP curve will at some point increase only at a decreasing rate (concave)
due to Law of Diminishing Marginal Returns
Some production functions may not exhibit increasing returns at first
In fact no firm with a profit-maximizing objective will operate in area of
increasing returns or negative returns
Production functions generally will only be concave
With diminishing marginal returns throughout production process
Depicted in Figure 7.2
15
 Figure 7.2 Production function with
diminishing marginal returns throughout

16
Law of Diminishing Marginal Returns
and Stages of Production
In Figure 7.2 MPL and APL decline throughout
Cobb-Douglas production function can also only
exhibit diminishing marginal returns throughout
production process
Can characterize production where all marginal products
are positive
Useful for representing firms technology constraints
Given that profit-maximizing firms will only operate in area of
diminishing marginal returns where all marginal products are
positive
Illustrated in Figure 7.3 for a variable level of labor

17
Figure 7.3 Cobb- Douglas production function
with labor as the only variable input

18
Relationship of Marginal Product
to Average Product
In area of diminishing marginal returns, marginal product can intersect
with average product
As indicated in Figure 7.1, this intersection of MPL and APL occurs where
APL is at a maximum
If addition to total, marginal unit, is greater (less) [equal to] than overall
average
Average will rise (fall) [neither rise nor fall]
Taking derivative of average results in relationship between marginal
product and average product
Marginal product is average product plus an adjustment factor
(APL/L)L
If slope of APL is zero (rising) [falling]
Adjustment factor is zero (> 0) [< 0]
MPL = APL (MPL > APL) [MPL < APL]

19
 Output Elasticity
Another important relation between an average and
marginal product is output elasticity
Measures how responsive output is to a change in an input
For example, output elasticity of labor, denoted L, is
defined as proportionate rate of change in q with respect to
L
Given production function
q = (K, L)
Output elasticity of labor is
L = (ln q)/ (ln L) = (q/L)(L/q) = MPL/APL
When MPL > APL, L > 1; when 0 < MPL < APL, 0 < L < 1;
and when MPL < 0, L < 1
Illustrated in Figure 7.1
20
Table 7.1 Estimated output
elasticities for milk

21
 Stages of Production
Firm must determine profit-maximizing
amount of an available input it should employ
Use technology of production to determine at
what stage of production to add a variable input,
say, labor
Exact profit-maximizing level of labor within this
stage depends on
Cost of labor
Price received for the firms output
Specifically, we divide short-run production
function into three stages of production 22
 Stages of Production
Stage I includes area of increasing returns and extends up to point
where average product reaches a maximum
Illustrated in Figure 7.1
Includes a portion of marginal product curve that is declining
Marginal product is greater than average product, so average product is rising
As long as average product is rising, firm will add variable inputs
Fixed inputs are present in uneconomically large proportion relative to variable input
Variable input is limited relative to fixed inputs
Rational profit-maximizing producer would never operate in Stage I of production
Firm would not produce in short run
Would produce by using fewer units of fixed inputs in long run
Fixed inputs become variable
Reduction of fixed inputs would result in entire set of product curves shifting
leftward
Results in Stage I ending at a lower level of output
Illustrated in Figure 7.4

23
Figure 7.4 Shifts in stages of production with
a reduction in the level of fixed inputs

24
 Stages of Production
Rational producer will also not operate in Stage III of production
Range of negative marginal product for variable input
In Stage III, TP is actually declining as more of the variable input is added
Figures 7.1, 7.2, and 7.4 illustrate Stage III
Additional units of the variable input Stage III actually cause a decline in total
output
Even if units of variable input were free, a rational producer would not employ them
beyond the point of zero marginal product
In Stage III, variable input is combined with fixed input in uneconomically large
proportions
Indeed, point of zero MP, for variable input, is called intensive margin
Point of maximum AP of variable input is called extensive margin
A firm will operate between extensive and intensive margins
Stage II of production
Both AP and MP of variable input are positive but declining
Output elasticity is between 0 and 1
In contrast, output elasticity for variable input is < 0 in Stage III and > 1 in Stage I

25
 Two Variable Inputs
Assumed a different combination of, say two, inputs will produce same
level of output
For example, in manufacturing microwave ovens, greater use of plastics
may be substituted for a reduction in metal use
Indifference curves represent a consumers preferences for different
combinations of two goods with utility remaining constant
In production theory isoquants represent different input combinations that
may be used to produce a specified level of output
Iso means equal and quant stands for quantity
An isoquant is a locus of points representing same level of output or equal quantity
For movements along an isoquant
Level of output remains constant
Input ratio changes continuously
Isoquants are the same concept as indifference mapping
Equal utility along same indifference curve replaced by equal output level
along same isoquant
Figure 7.5 represents a possible production function for two inputs
26
Figure 7.5 Isoquant map for two variable
inputs, capital, K, and labor, L

27
 Marginal Rate of Technical
Substitution (MRTS)
In Figure 7.5, isoquants are drawn with a negative slope
Based on assumption that substituting one input for another can result
in output not changing
A measure for this substitution is marginal rate of technical
substitution (MRTS)
Defined as negative of slope of an isoquant

Measures how easy it is to substitute one input for another holding

output constant
Similar to concept of MRS in consumer theory
MRTS measures reduction in one input per unit increase in
the other that is just sufficient to maintain a constant level of
output 28
 Convex and Negatively Sloping
Isoquants
Can establish underlying assumptions of negatively sloped and convex-to-the-
origin isoquant by developing relationship between MRTS and MPs
MRTS (K for L) = MPL MPK
Take total derivative of production function, q = (K, L)
dq = MPLdL + MPKdK
Along an isoquant dq = 0, output is constant
Thus MPLdL = -MPKdK
Solving for the negative of the slope of the isoquant yields

Along an isoquant, gain in output from increasing L slightly is exactly balanced by loss
in output from a suitable decrease in K
For isoquants to be negatively sloped, both MPL and MPK must be positive
Ridgelines trace out boundary in isoquant map where marginal products are positive
See Figure 7.6
Ridgelines are isoclines (equal slopes) where MRTS is either zero or undefined for
different levels of output
29
Figure 7.6 Ridgelines in the
isoquant map

30
 Convex and Negatively Sloping
Isoquants
MRTS results in isoquants drawn strictly convex to origin
Result is analogous to relationship between MRS and strictly convex
indifference curves
For high ratios of K to L MRTS is large
Indicating that a great deal of capital can be given up if one more unit of labor becomes
available
Assumption of strictly convex isoquants is related to Law of Diminishing Marginal
Returns
Given MRTS(K for L) = MPL/MPK
Movement from A to B in Figure 7.6 results in an increase in labor
Corresponding decrease in MPL
Decrease in capital with a corresponding increase in MPK
A firm will always operate in Stage II of production
Characterized by diminishing marginal returns
Stage II of production, for both the variable inputs, is represented by strictly convex
isoquants
In Figure 7.6, a rational producer will only operate somewhere between points D
and C
31
 Stages of Production in the
Isoquant Map
Can illustrate stages of production in isoquant map by fixing
one of the inputs
A situation where capital is fixed at some level is indicated
by horizontal line at A in Figure 7.7
In short run, firm must operate somewhere on this line
At Stage I, labor input is small relative to fixed level of capital
Marginal product of capital and MRTS are negative
Isoquants have positive slopes
At point B, MRTS is undefined, MPK is zero, and APL equals MPL
This is demarcation between Stages I and II of production
In Stage II of production, all isoquants are strictly convex and have
negative slopes
At point C, marginal product of labor is zero
Corresponds to line of demarcation between Stages II and III
32
Figure 7.7 Stages of production
in the isoquant map

33
Classifying Production Functions
Production functions represent tangible
(measurable) productive processes
Economists pay more attention to actual form of
these functions than to form of utility functions
Resulted in classification of production functions in
terms of returns to scale and substitution possibilities
Empirical estimates of actual production functions

For some production processes it may be

extremely difficult if not impossible to
substitute one input for another
34
 Returns to Scale
Measure how output responds to increases or decreases in all inputs
together
Long-run concept since all inputs can vary
For example, if all inputs are doubled, returns to scale determine
whether output will double, less than double, or more than double
In many cases, it is difficult to change some inputs at will and increase
inputs proportionally
Firms do attempt to control as much of environmental conditions as feasible
Examples in agriculture include greenhouses or pesticides
Assuming it is possible to proportionally change all inputs, a production
function can exhibit constant, decreasing, or increasing returns to scale
across different output ranges
However, it is generally assumed, for simplicity, production functions only
exhibit either constant, decreasing, or increasing returns to scale

35
 Returns to Scale
Specifically, given production function
q= (K, L)
A explicit definition of constant returns to scale is
(K, L) = (K, L) = q, for any > 0
If all inputs are multiplied by some positive constant
, output is multiplied by that constant also
If production function is homogeneous
Constant returns to scale production function is
homogeneous of degree 1 or linear homogeneous in all
inputs
Isoquants are radial blowups and equally spaced as output
expands (Figure 7.8)
36
Figure 7.8 Returns to scale

37
 Returns to Scale
Decreasing returns to scale exists if output
is increased proportionally less than all
inputs
(K, L) < (K, L) = q
Increasing returns to scale exists if output
increases more than proportional increase in
inputs
(K, L) > (K, L) = q

38
Determinants of Returns to Scale
Adam Smith established that returns to scale is result of two forces
Division of labor
An increase in all inputs increases division of labor and results in increased
efficiency
Production might more than double
Managerial difficulties
Result in decreased efficiency
Production might not double
Early 20th century concept of assembly-line mass production is based on
division of labor
Each worker has a specialized task to perform for each product being
assembled
Worker becomes very skilled at this task
Increases productivity
Example: Henry Ford experienced increasing returns to scale in automobile
manufacturing

39
Determinants of Returns to Scale
One cause of managerial difficulties in mass
production is required stockpiling of parts and
supplies
Inventory control must be maintained, where an
accounting of parts is required
Results in a significant amount of inputs allocated to storage and
accounting of inventories
Results in decreasing returns to scale
Just-in-time delivery systems are helping to mitigate
these factors
One problem with just-in-time production
Increased vulnerability of firms to supply disruptions
Without a stockpile of parts, such disruptions could shut down
production fairly quickly
40
Determinants of Returns to Scale
Postindustrial manufacturing is shifting away
from mass production of a standardized
product and evolving toward mass
customization
Called agile manufacturing
Results in increasing returns to scale

41
Determinants of Returns to Scale
As a firm increases in size by increasing all
inputs, another possible cause of decreasing
returns to scale is
Allocation of inputs for environmental and local
service projects
As a firm employs more inputs and increases output, it
becomes increasingly more exposed to public
concerns associated with its production practices
To enhance and maintain goodwill within its community, firm
will allocate additional inputs for environmental and local
service projects
Contributes to decreasing returns to scale
42
 Returns to Scale and Stages of
Production
Determine relationship between returns to scale
and stages of production by assuming a linear
homogeneous production function (homogeneous
of degree 1)
Implies a constant returns to scale production function
Applying Eulers Theorem to production function q
= (K, L) we obtain
q = L(MPL) + K(MPK)
Dividing by L gives
APL = MPL + (K/L)MPK
Solving for MPK yields
MPK = (L/K)(APL MPL)
43
 Returns to Scale and Stages of
Production
Assuming constant returns to scale, we define
stages of production as
Stage I
MPL > APL > 0, MPK < 0
Stage II
APL > MPL > 0, APK > MPK > 0
Stage III
MPL < 0, MPK > APK > 0
Stages I and III are symmetric for a constant
returns to scale production function
Given Monotonicity Axiom, only relevant region for
production is Stage II
44
 Elasticity of Substitution
A firm may compensate for a decrease in use of one input by an
increase in use of another
Heinrich von Thunen collected evidence from his farm in Germany that
suggested ability of one input to compensate for another was significant
Postulated principle of substitutability
Possible to produce a constant output level with a variety of input combinations
Principle of substitutability is not an economic law
There are production functions for which inputs are not substitutable
However, for those functions where inputs are substitutable
Degree that inputs can be substituted for one another is an important technical
relationship for producers
Production functions may also be classified in terms of elasticity of
substitution
Measures how easy it is to substitute one input for another
Determines shape of a single isoquant

45
 Elasticity of Substitution
In Figure 7.9 consider a movement from A to B
Results in capital/labor ratio (K/L) decreasing
Profit-maximizing firm is interested in determining a
measure of ease in which it can substitute K for L
If MRTS does not change at all for changes in K/L, the two inputs are
perfect substitutes
If MRTS changes rapidly for small changes in K/L, substitution is
difficult
If there is an infinite change in the MRTS for small changes in K/L
(called fixed proportions), substitution is not possible
A scale-free measure of this responsiveness is elasticity of substitution

46
Figure 7.9 Capital/labor ratio and
MRTS, K/L > K'/L'

47
 Elasticity of Substitution
Defined as percentage change in K/L divided by percentage change in
MRTS

Along a strictly convex isoquant, K/L and MRTS move in same

direction
Elasticity of substitution is positive
In Figure 7.9, a movement from A to B results in both K/L and MRTS
declining
Relative magnitude of this change is measured by elasticity of substitution
If it is high, MRTS will not change much relative to K/L and the isoquant will be
less curved (less strictly convex)
A low elasticity of substitution gives rather sharply curved isoquants
Possible for the elasticity of substitution to vary for movements along
an isoquant and as the scale of production changes
However, frequently elasticity of substitution is assumed constant
48
 Elasticity of Substitution:
Perfect-Substitute
= , a perfect-substitute technology
Analogous to perfect substitutes in consumer
theory
A production function representing this
technology exhibits constant returns to scale
(K, L) = aK + bL = (aK + bL) = (K, L)
All isoquants for this production function are parallel
straight lines with slopes = -b/a
See Figure 7.10

49
Figure 7.10 Elasticity of substitution
for perfect-substitute technologies

50
 Elasticity of Substitution:
Leontief
= 0, a fixed-proportions (or Leontief ) technology
Analogous to perfect complements in consumer theory
Characterized by zero substitution
A production technology that exhibits fixed proportions is

This production function also exhibits constant

returns to scale

51
 Elasticity of Substitution:
Leontief
Figure 7.11 illustrates a fixed proportions function
Capital and labor must always be used in a fixed
ratio
Marginal products are constant and zero
Violates Monotonicity Axiom and Law of Diminishing
Marginal Returns
Isoquants for this technology are right angles
Are not smooth curves, but are kinked
At kink, MRTS is not uniquecan take on an infinite number of
positive values
K/L is a constant, d(K/L) = 0, which results in = 0

52
Figure 7.11 Elasticity of substitution
for fixed-proportions technologies

53
Elasticity of Substitution; Cobb-
Douglas
= 1, Cobb-Douglas technology
Isoquants are strictly convex
Assumes diminishing MRTS (Figure 7.12)
An example of a Cobb-Douglas production
function is
q = (K, L) = aKbLd
a, b, and d are all positive constants
Useful in many applications because it is
linear in logs

54
Figure 7.12 Isoquants for a Cobb-
Douglas production function

55
Elasticity of Substitution; Cobb-
Douglas
= some positive constant
Constant elasticity of substitution (CES) production
function can be specified
q = [K- + (1 - )L-]-1/
> 0, 0 1, -1
is efficiency parameter
is a distribution parameter
is substitution parameter
Elasticity of substitution is
= 1/(1 + )
Useful in empirical studies

56