FINC304

MANAGERIAL ECONOMICS
SESSION 5: PRODUCTION

Lecturer: Dr. Agyapomaa Gyeke-Dako, UGBS

Contact Information: agyeke-dako@ug.edu.gh

College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
 Session Overview
• Having understood demand in detail, it is important to also
understand supply. Firms would usually exist because they want to
maximize profit. It is thus important for us to understand profit.
Profit is made up of two components, cost and revenue. The cost a
firm will incur depends largely on how much output it will produce.
The revenue the firm will receive also depends on the output it will
be able to sell. The act of coming out with an output is production.
Hence to understand cost and revenue which are components of
profit, it is important to understand output/production. We
therefore treat production in this session to give us a good
foundation in cost and revenue. In particular, we look at how
output/ production varies with inputs and also understand the
different measures of productivity.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 2

 Session Outline
The key topics to be covered in the session are as follows:
• Production in the Short Run
• Production in the Long Run

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 3

 Reading List
• Baye Michael and Price Jeffery: Managerial
Economics and Business Strategy, 8th Edition

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 4

 Production Function
• Production function: technological
relationship between inputs and output
• Shows the maximum amount of output that can be
produced with K units of capital and L units of labor.

Q = f (L, K )

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 5

 Production Function
• Two types of inputs: fixed input and variable input.
Fixed input: input does notvary with output
Variable input: input varies with output
• Two periods of production
Short-run vs Long-run production decisions:
• In the short-run at least one input is fixed.
• In the long-run, all inputs are variable.
This means no fixed period for short run or long run. It
depends on the number of years that the firm takes to
change all its factors of production.
• Assume two inputs; capital(K) and labour (L)
• At least one input fixed; assume capital is fixed

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 6

 Productivity Measures
• Total Product: the maximum amount of output that can
be produced
• Marginal Product of Labour: MPL =
change in Q/ c h a n g e i n L
• Measures the output produced by an additional worker.
• Slope of the short-run production function (with respect to labour)
• Average Product of Labour
• APL = Q/ L
• Measures the output per unit of worker. Example: Q = f
(L, K ) = K .5L.5
• If the inputs are K = 16 and L = 16, then the average product of labor
is APL = (16.5 16.5 )/16 = 1

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 7

 Increasing, Diminishing and Negative Marginal Returns
Increasing Diminishing Negative
Q Marginal Marginal Marginal
Retums Retums Returns

Q=F(K,L)

AP
L
Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 8
 Choosing the right amount of input
• Can we increase output indefinitely by increasing
variable input. Definitely not because of diminishing
marginal returns seen in previous diagram.
• How then can we maximise profit?

• Employing the right level of inputs

• When labor or capital vary in the short run, to maximize profit a
manager will hire
• labor until the value of marginal product of labor equals the wage: VMPL
= w , where VMPL = P ∗ MPL
• capital until the value of marginal product of capital equals the rental rate:
VMPk = r , where VMPk = P ∗ MPk

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 9

 Production in the Long Run
• In the Long Run, both inputs will vary; ie. K and L will vary
with output
• The combinations of inputs (K, L) that yield the producer the
same level of output gives an isoquant
• The shape of an isoquant reflects the ease with which a
producer can substitute among inputs while maintaining the
same level of output.
• The rate at which two inputs are substituted while
maintaining the same output level
• MRTS LK = MPL / M P K
• The MRTS is the slope of the isoquants
• Higher isoquants give greater outputs

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 10

 Production in the Long Run
• If firms did not have constraints, they will prefer isoquants high above skies. However,
they have constraints. So they need to consider constraints in their production. Constraint is
given by the cost.

• Isocost: The combinations of inputs that produce a given level of output at the same
cost:
• wL + rK = C
• Rearranging, K = (1/r)C - (w/r)L
• slope of the isocost is -(w/r)
• Isocost gives the limit of the producer

• For given input prices, isocosts farther from the origin are associated with
higher costs.
• Changes in input prices change the slope of the isocost line.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 11

 Right Combination of inputs
• Marginal product per dollar spent should be equal
for all input

• MRTSLK =MPL /MPK =w/r

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 12

 Example
3. Suppose that a firm produces at an output level where the marginal
product of labor (MPL) is 50 units and the wage rate (PL) is $25.
Suppose, further, that the marginal product of capital (MPK) is 100
units and the rental price of capital (PK) is $40.
a. Is this firm producing efficiently?
b. If the firm is not producing efficiently, how might it so?

Solution
The optimal input combination is given by the expression

𝑀𝑃𝐿 𝑀𝑃𝐾
=
𝑃𝐿 𝑃𝐾

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 13

 • Substituting into this expression we get
•
50 2 2.5 100
• = < =
25 1 1 40
•
• That is, the firm is not operating efficiently.
• According to these results, the marginal product of labor
is 2 units of output for every dollar spent on labor. The
marginal product of capital is 2.5 units of output for
every dollar spent on capital. To produce more efficiently,
therefore, this firm should reallocate its budget dollars
away from labor and toward capital.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 14