Chapter 7

Production Theory

Lecture Plan
Objectives Production Types of inputs Factors of production Production function
Production function with one variable input Production function with two variable inputs Isoquants

Producers equilibrium Returns to scale Cobb Douglas and CES production functions Technical progress Summary

Chapter Objectives
To examine the economic analysis of a firms technology, different types of inputs and the process of production. To help develop an understanding of the distinction between short run and long run production functions. To build up a critical appraisal of the law of variable proportions and returns to scale. To introduce the concepts of isoquant, isocost line, marginal rate of technical substitution, elasticity of substitution and expansion path. To develop an understanding of technical progress and its nuances.

Production
The process of transformation of resources (like land, labour, capital and entrepreneurship) into goods and services of utility to consumers and/or producers. The process of creation of value or wealth through the production of goods and services that have economic value. process of adding value may occur
by change in form (input to output, say steel into car), or by change in place (supply chain, say from factory to dealers/retailer), or by changing hands (exchange, say from retailer to consumer).

Goods includes all tangible items such as furniture, house, machine, food, car, television etc Services include all intangible items, like banking, education, management, consultancy, transportation.

Types of Inputs
Technology determines the type, quantity and proportion of inputs. also determines the maximum limit of total output from a given combination of inputs. at any point of time, technology will be given; impact of technology can be seen only over a period of time. Fixed and Variable Inputs Production analysis of a firm uses two distinct time frames:
the short run: refers to a period of time when the firm cannot vary some of its inputs. the long run., refers to a time period sufficient to vary all of its inputs, including technology.

Variable input : that can be made to vary in the short run, e.g. raw material, unskilled/semi skilled labour, etc. Fixed input: that cannot be varied in the short run, e.g. land, machine, technology, skill set, etc.

Factors of Production
5 factors of production Land
Anything which is gift of nature and not the result of human effort, e.g. soil, water, forests, minerals Reward is called as rent Physical or mental effort of human beings that undertakes the production process. Skilled as well as unskilled. Reward is called as wages Wealth which is used for equipment/intermediary good It is outcome of human efforts Reward is called as interest further production as machine /

Labour

Capital

Enterprise
The ability and action to take risk of collecting, coordinating, and utilizing all the factors of production for the purpose of uncertain economic gains Reward is called as profit

Organization

Combination of highly skilled labour capital/managerial aspect of business. Reward is called as salary.

and

specialized

human

Production Function
A technological relationship between physical inputs and physical outputs over a given period of time. shows the maximum quantity of the commodity that can be produced per unit of time for each set of alternative inputs, and with a given level of production technology. Hence it can be said that production function is: Always related to a given time period Always related to a certain level of technology Depends upon relation between inputs. Normally a production function is written as: Q = f (L,K,I,R,E) where Q is the maximum quantity of output of a good being produced, and L=labour; K=capital; l=land; R=raw material; E= efficiency parameter. Technical efficiency is defined as a situation when using more of one input with either the same amount or more of the other input must increase output.

Production Function with One Variable Input

Also termed as variable proportion production function It is the short term production function Shows the maximum output a firm can produce when only one of its inputs can be varied, other inputs remaining fixed:
Q f ( L, K ) where Q = output, L = labour and K = fixed amount of capital

Total product is a function of labour: TPL f ( K ,L)

Average Product (AP) is total product per unit of variable input TP Average product of labour (APL) is: APL L Marginal Product (MP) is the addition in total output per unit change in variable input TP MPL Marginal product of labour (MPL) is: L

Law of Variable Proportions

Labour (00 units) 1 2 3 4 5 6 7 8 Total Product (000 tonnes) MP AP Stages
200 150
Output

20 50 90 120 140 150 150 130

30 40 30 20 10 0 -20

20 25 30 30 28 25 21.5 16.3

Increasing returns
Diminishing returns

100 50 0 1 2 3 4 5 6 7 8 9 -50

Total Product (000 tonnes) Marginal Product Average Product

100

-30

11.1

Negative returns

Labour

As the quantity of the variable factor is increased with other fixed factors, MP and AP of the variable factor will eventually decline. Therefore law of variable proportions is also called as law of diminishing marginal returns.

Law of Variable Proportions

Total Outpu t A
C

First stage
TP
L

Increasing Returns to the Variable Factor

MP>0 and MP>AP

Second stage
Diminishing Returns to a Variable Factor MP>0 and MP<AP

Total Outpu t Stage I A*

Labo ur
Stage II
B*

Third Stage
Negative Returns MP<0 while AP is falling but positive Technically inefficient stage of production A rational firm will never operate in this stage

Stage

III
APL

C*

MP

Labou r

Production Function with Two Variable Inputs

All inputs are variable in long run and only two inputs are used Firm has the opportunity to select that combination of inputs which maximizes returns Curves showing such production function are called isoquants or iso-product curves. An isoquant is the locus of all technically efficient combinations of two inputs for producing a given level of output Represented as: Q f ( L, K )
Capital Labour (Rs. crore) (00 units) 40 6 28 7 18 8 12 9 8 10
45 40 35 30 25 20 15 10 5 0 6 7 8 Labour ('00 units) 9 10

Capital (Rs. Crore)

Characteristics of Isoquants
Downward sloping Convex to the origin A higher isoquant represents a higher output Two Isoquants do not intersect
Capital
C B A

Capital A

Q2 O

Q1 Q2

Q0

Q1 O Labour

Labour

Marginal Rate of Technical Substitution

Measures the reduction in one input, due to unit increase in the other input that is just sufficient to maintain the same level of output.
MRTSLK K L

MRTS of labour for capital is equal to the slope of the isoquant. It is also equal to the ratio of the marginal product of one input to the marginal product of other input

Q MPL L MPK K
0 MPL L MPK K MPL K MRTSLK MPK L

Special Shapes of Isoquants

Capit al Capit al
Q3 Q2 Q1

Q1 Q2 Q

Labo 3 ur

Labo ur
Q min(

Linear isoquants Q f ( L, K ) = K + L
Perfect substitutability between two factors Isoquants are downward sloping straight lines Constant MRTS

Right angled isoquants

L K , )

Leontief production technology Capital is a perfect complement for labour Non existence of any substitutability between the two factors

Elasticity of Substitution
Measures the percentage change in factor proportions due to a change in marginal rate of technical substitution =
d ( K / L) K/L d ( MRTS ) MRTS

is effectively a measure of the curvature of an isoquant More curved or convex is the isoquant, the lower is In Leontief (zero substitution) technology, with L shaped isoquants, there is no substitutability between the inputs =0 In perfect substitution or linear production technology, the MRTS does not change at all along the isoquant. is infinite

Isocost Lines
Capital A2

A
A1 O B1 B B2 Labour

Total Cost is sum of Labour cost (wL) and Capital cost (rK) where wage (w) and interest (r)

C wL rK

The isocost line represents the locus of points of all the different combinations of two inputs that a firm can procure, given the total cost and prices of the inputs
C K w Slope r L C r w

The (absolute) slope of this line is equal to the ratio of the input prices

Producers Equilibrium
Capital A
C

Capita l
A2

A E
D

K*

A1

Q2 Q Q 1
0

Q3

E S

L*

Labou r

Maximization of output subject to a cost constraint

Labou r Minimization of cost for a given level of output

L B1 B

B2

Necessary condition for equilibrium Slope of isoquant = Slope of isocost line

Expansion Path
Capital Expansion Path
E E1 E2

Labour

Line formed by joining the tangency points between various isocost lines and the corresponding highest attainable isoquants is known as Expansion Path.

For homogeneous production function and given factor prices (and hence factor ratio):
expansion path is a straight line through the origin. For non- homogeneous production function:

optimal expansion path is non linear.

Returns to Scale
Returns to Scale show the degree by which the level of output changes in response to a given change in all the inputs in a production system.
Capita l
A

Panel a
B

Capital
B2
A2

Panel b
C2

Capital
400Q B1

Panel c
C1 125Q 90Q

C
200Q 100Q 50Q

Labour

50Q

150Q

A1

Labour

50Q

Labour

Constant Returns to Scale : When a proportional increase in all inputs

yields an equal proportional increase in output (Panel a)

Increasing Returns to Scale : When a proportional increase in all inputs

yields a more than proportional increase in output (Panel b).

Decreasing Returns to Scale : When a proportional increase in all

inputs yields a less than proportional increase in output (Panel c).

Cobb-Douglas Production Function

Proposed by Wicksell and tested against statistical evidence by Charles W. Cobb and Paul H. Douglas in 1928 Q AK L where , are constants. A is the technological parameter, is the elasticity of output with respect to capital, and is the elasticity of output with respect to labour. Properties Homogeneous of degree (+) The returns to scale is immediately revealed by the sum of the two parameters and
( +) = 1 Increasing Returns to Scale: ( +) > 1 Decreasing Returns to Scale: ( +) < 1
Constant Returns to Scale:

Isoquants are negatively sloped and convex to the origin MRTSLK is a function of input ratio Elasticity of substitution is equal to 1

Leontief Production Function

Represents the extreme case of perfect complements L shaped or right angled isoquants. Also known as fixed coefficient production function L K Q min( , )

Production technology always involves inputs labour (L) and capital (K) in fixed proportions to produce a unit of output and and are the fixed coefficients A certain amount of each input is required technologically to produce one unit to output Demand for inputs is uniquely determined Inputs are required in exact quantities per unit of output Any change in MRTS will not lead to any change in the factor proportions: = 0

CES Production Function

Constant Elasticity of Substitution (CES) production function Introduced by Arrow, Chenery, Minhas and Solow (also known as ACMS) Q=A[K - +(1-)L - ] -r/, where:
A(>0) is the efficiency parameter which represents the "size" of the production function is the distribution parameter which will help us explain relative factor shares (so 0<<1); is the substitution parameter, which will help us derive the elasticity of substitution and r is the scale parameter which determines the degree of homogeneity

Homogeneous of degree r

Technical Progress
Refers to research and development and investments made to manage technical know how Technical change may be
Embodied or investment specific, where new capital is used in the production apparatus, which requires investment to take place; or Disembodied or investment neutral, where output increases without any increase in investment but by an innovation through research and knowledge.

Types of Technical Progress (Hicks)

Neutral Technical Progress: changes in the marginal product of labour (MPL) and capital (MPK) are same Labour augmenting Technical Progress: MPL increases faster than the MPK Capital augmenting Technical Progress : MPK increases faster than MPL

Technical Progress
Panel a shows Neutral technical Progress: MRTS is constant and independent of time along the points on the expansion path; isoquants shift parallel downwards. Panel b shows Labour augmenting technical Progress: MRTS LK, being the ratio of the marginal products, decreases. Panel c shows Capital augmenting technical Progress: MRTS LK,, being the ratio of the marginal products, increases.

Capit al
K K1

Panel Q a
Q Q1

Capital

Panel Q Q b
L

Capital QK Q

Panel c

L1 L

Labou r

Q
Labo L ur

QK

Labo ur

Summary
A production function shows the relationship between inputs and outputs given the state of technology. According to the law of variable proportions, as the quantity of the variable factor is increased with other fixed factors, the marginal product and the average product will eventually decline. Isoquants are locus of points of different combinations of labour and capital inputs that produce the same level of output. MRTS is the absolute slope of an isoquant; it is equal to the ratio of the marginal products of factor inputs. The isocost line represents the locus of points of all the different combinations of labour and capital that a firm can purchase, given the total cost and prices of the inputs. The (absolute) slope of the isocost line is equal to the ratio of the input prices; i.e. the relative price of labour to capital. The optimum level of inputs needed for objective of either minimizing cost of producing a given level of output, or maximizing output at a given cost would be at the point of tangency of an isoquant and an isocost line.

Summary
Expansion path is defined as the line formed by joining such tangency points between the isocost lines and the highest attainable isoquants. In increasing returns to scale a proportional increase in all inputs yields a more than proportional increase in output If a proportional increase in all inputs yields an equal proportional increase in output, then there is constant returns to scale. If a proportional increase in all inputs yields a less than proportional increase in output, then there is decreasing returns to scale. In a homogeneous function if each input is multiplied by , then is factored out of the function. The power of is known as the degree of homogeneity and is a measure of returns to scale. Technical progress refers to improvements made in research and development and various investments made to manage technical know how. Technical progress is neutral if changes in marginal products of labour and capital are same; labour augmenting if MPL increases faster than MPK and capital augmenting if MPK increases faster than MPL.