Managerial Economics

1. Module: 4Module: 4
ProductionProduction

2. IntroductionIntroduction
 Consumer behavior:Consumer behavior:
– Describing consumer preferencesDescribing consumer preferences
– Consumers face budget constraintsConsumers face budget constraints
– Consumers choose to maximize utilityConsumers choose to maximize utility
 Production decision of a firm isProduction decision of a firm is
similar to consumer decisionsimilar to consumer decision
– Involves three stepsInvolves three steps

3. Production Decisions of a FirmProduction Decisions of a Firm
1.1. Production TechnologyProduction Technology
 Describe howDescribe how inputsinputs can be transformedcan be transformed
intointo outputsoutputs
 Inputs: land, labor, capital and rawInputs: land, labor, capital and raw
materialsmaterials
 Outputs: cars, desks, books, etc.Outputs: cars, desks, books, etc.
 Firms can produce different amounts ofFirms can produce different amounts of
outputs using different combinations ofoutputs using different combinations of
inputsinputs

4. Production Decisions of a FirmProduction Decisions of a Firm
2.2. Cost ConstraintsCost Constraints
 Firms must considerFirms must consider pricesprices of labor,of labor,
capital and other inputscapital and other inputs
 Firms want to minimize totalFirms want to minimize total
production costs determined by inputproduction costs determined by input
pricesprices
 As consumers must consider budgetAs consumers must consider budget
constraints, firms must be concernedconstraints, firms must be concerned
about costs of productionabout costs of production

5. Production Decisions of a FirmProduction Decisions of a Firm
3.3. Input ChoicesInput Choices
– Given input prices and productionGiven input prices and production
technology, the firm must choosetechnology, the firm must choose howhow
much of each inputmuch of each input to use in producingto use in producing
outputoutput
– Given prices of different inputs, theGiven prices of different inputs, the
firm may choose different combinationsfirm may choose different combinations
of inputs to minimize costsof inputs to minimize costs
 If labor is cheap, firm may choose toIf labor is cheap, firm may choose to
produce with more labor and less capitalproduce with more labor and less capital

6. Production Decisions of a FirmProduction Decisions of a Firm
 Firm is aFirm is a
– cost minimizercost minimizer
– output maximiseroutput maximiser
– profit maximiserprofit maximiser
 We can represent the firm’sWe can represent the firm’s
production technology in the form ofproduction technology in the form of
aa productionproduction functionfunction

7. The Technology of ProductionThe Technology of Production
 Production Function:Production Function:
– Indicates the highest output (Indicates the highest output (qq) that a) that a
firm can produce for every specifiedfirm can produce for every specified
combination of inputscombination of inputs
– For simplicity, we will consider onlyFor simplicity, we will consider only
labor (L) and capital (K)labor (L) and capital (K)
– Shows what is technically feasible whenShows what is technically feasible when
the firm operates efficientlythe firm operates efficiently

8. The Technology of ProductionThe Technology of Production
 The production function for twoThe production function for two
inputs:inputs:
qq = F(K,L)= F(K,L)
– Output (Output (qq) is a function of capital (K)) is a function of capital (K)
and labor (L)and labor (L)
– The production function is true for aThe production function is true for a
given technologygiven technology
If technology improves, more output couldIf technology improves, more output could
be produced for a given level of inputsbe produced for a given level of inputs

9. The Technology of ProductionThe Technology of Production
 Short Run versus Long RunShort Run versus Long Run
– It takes time for a firm to adjustIt takes time for a firm to adjust
production from one set of inputs toproduction from one set of inputs to
anotheranother
– Firms must consider not only whatFirms must consider not only what
inputs can be varied but over whatinputs can be varied but over what
period of time that can occurperiod of time that can occur
– We must distinguish between long runWe must distinguish between long run
and short runand short run

10. The Technology of ProductionThe Technology of Production
 Short RunShort Run
– Period of time in which quantities of onePeriod of time in which quantities of one
or more production factors cannot beor more production factors cannot be
changedchanged
– These inputs are called fixed inputsThese inputs are called fixed inputs
 Long RunLong Run
– Amount of time needed to make allAmount of time needed to make all
production inputs variableproduction inputs variable

11. Production: One Variable InputProduction: One Variable Input
 We will begin looking at the short runWe will begin looking at the short run
when only one input can be variedwhen only one input can be varied
 We assume capital is fixed and laborWe assume capital is fixed and labor
is variableis variable
– Output can only be increased byOutput can only be increased by
increasing laborincreasing labor
– Must know how output changes as theMust know how output changes as the
amount of labor is changedamount of labor is changed

12. Production: One Variable InputProduction: One Variable Input

13. Production: One Variable InputProduction: One Variable Input
 Observations:Observations:
1.1. When labor is zero, output is zero asWhen labor is zero, output is zero as
wellwell
2.2. With additional workers, output (With additional workers, output (qq))
increases up to 8 units of laborincreases up to 8 units of labor
3.3. Beyond this point, output declinesBeyond this point, output declines
 Increasing labor can make better use ofIncreasing labor can make better use of
existing capital initiallyexisting capital initially
 After a point, more labor is not useful andAfter a point, more labor is not useful and
can be counterproductivecan be counterproductive

14. Production: One Variable InputProduction: One Variable Input
 Firms make decisions based on theFirms make decisions based on the
benefits and costs of productionbenefits and costs of production
 Sometimes useful to look at benefitsSometimes useful to look at benefits
and costs on anand costs on an incremental basisincremental basis
– How much more can be produced whenHow much more can be produced when
at incremental units of an input?at incremental units of an input?
 Sometimes useful to makeSometimes useful to make
comparison on ancomparison on an average basisaverage basis

15. Production: One Variable InputProduction: One Variable Input
 Average product of Labor - OutputAverage product of Labor - Output
per unit of a particular productper unit of a particular product
 Measures the productivity of a firm’sMeasures the productivity of a firm’s
labor in terms of how much, onlabor in terms of how much, on
average, each worker can produceaverage, each worker can produce
L
q
==
InputLabor
Output
APL

16. Production: One Variable InputProduction: One Variable Input
 Marginal Product of Labor –Marginal Product of Labor –
additional output produced whenadditional output produced when
labor increases by one unitlabor increases by one unit
 Change in output divided by theChange in output divided by the
change in laborchange in labor
L
q
∆
∆
=
∆
∆
=
InputLabor
Output
MPL

17. Production: One Variable InputProduction: One Variable Input

18. Production: One Variable InputProduction: One Variable Input
 We can graph the information in theWe can graph the information in the
Table to showTable to show
– How output varies with changes in laborHow output varies with changes in labor
Output is maximized at 112 unitsOutput is maximized at 112 units
– Average and Marginal ProductsAverage and Marginal Products
Marginal Product is positive as long as totalMarginal Product is positive as long as total
output is increasingoutput is increasing
Marginal Product crosses Average Product atMarginal Product crosses Average Product at
its maximumits maximum

19. At point D, output is
maximized.
Labor
Output
0 2 3 4 5 6 7 8 9 101
Total Product
60
112
A
B
C
D
Production: One Variable InputProduction: One Variable Input

20. Average Product
Production: One Variable InputProduction: One Variable Input
10
20
Output
per
Worker
30
80 2 3 4 5 6 7 9 101 Labor per Month
E
Marginal Product
•Left of E: MP > AP & AP is increasing
•Right of E: MP < AP & AP is decreasing
•At E: MP = AP & AP is at its maximum
•At 8 units, MP is zero and output is at max

21. Marginal and Average ProductMarginal and Average Product
 When marginal product is greater than theWhen marginal product is greater than the
average product, the average product isaverage product, the average product is
increasingincreasing
 When marginal product is less than theWhen marginal product is less than the
average product, the average product isaverage product, the average product is
decreasingdecreasing
 When marginal product is zero, totalWhen marginal product is zero, total
product (output) is at its maximumproduct (output) is at its maximum
 Marginal product crosses average productMarginal product crosses average product
at its maximumat its maximum

22. Production: One Variable InputProduction: One Variable Input
 We can see that as we increase laborWe can see that as we increase labor
the additional output producedthe additional output produced
declinesdeclines
 Law of Diminishing MarginalLaw of Diminishing Marginal
ReturnsReturns:: As the use of an inputAs the use of an input
increases with other inputs fixed, theincreases with other inputs fixed, the
resulting additions to output willresulting additions to output will
eventually decreaseeventually decrease

23. Law of Diminishing Marginal ReturnsLaw of Diminishing Marginal Returns
 When the use of labor input is smallWhen the use of labor input is small
and capital is fixed, output increasesand capital is fixed, output increases
considerably since workers can beginconsiderably since workers can begin
to specialize and MP of laborto specialize and MP of labor
increasesincreases
 When the use of labor input is large,When the use of labor input is large,
some workers become less efficientsome workers become less efficient
and MP of labor decreasesand MP of labor decreases

24. Production: Two Variable InputsProduction: Two Variable Inputs
 Firm can produce output byFirm can produce output by
combining different amounts of laborcombining different amounts of labor
and capitaland capital
 In the long run, capital and labor areIn the long run, capital and labor are
both variableboth variable
 We can look at the output we canWe can look at the output we can
achieve with different combinationsachieve with different combinations
of capital and laborof capital and labor

25. Production: Two Variable InputsProduction: Two Variable Inputs

26. Production: Two Variable InputsProduction: Two Variable Inputs
 The information can be representedThe information can be represented
graphically usinggraphically using isoquantsisoquants
– Curves showing all possible combinations ofCurves showing all possible combinations of
inputs that yield the same outputinputs that yield the same output
 Curve 1 shows all possible combinations ofCurve 1 shows all possible combinations of
labor and capital that will produce 55 unitslabor and capital that will produce 55 units
of outputof output

27. Isoquant MapIsoquant Map
Labor per year1 2 3 4 5
Ex: 55 units of output
can be produced with
3K & 1L (pt. A)
OR
1K & 3L (pt. D)
q1 = 55
q2 = 75
q3 = 90
1
2
3
4
5Capital
per year
D
E
A B C

28. Production: Two Variable InputsProduction: Two Variable Inputs
 Diminishing Returns to Labor withDiminishing Returns to Labor with
IsoquantsIsoquants
 Holding capital at 3 and increasingHolding capital at 3 and increasing
labor from 0 to 1 to 2 to 3labor from 0 to 1 to 2 to 3
– Output increases at a decreasing rateOutput increases at a decreasing rate
(0, 55, 20, 15) illustrating diminishing(0, 55, 20, 15) illustrating diminishing
marginal returns from labor in the shortmarginal returns from labor in the short
run and long runrun and long run

29. Production: Two Variable InputsProduction: Two Variable Inputs
 Substituting Among InputsSubstituting Among Inputs
– Companies must decide whatCompanies must decide what
combination of inputs to use to producecombination of inputs to use to produce
a certain quantity of outputa certain quantity of output
– There is a trade-off between inputs,There is a trade-off between inputs,
allowing them to use more of one inputallowing them to use more of one input
and less of another for the same level ofand less of another for the same level of
outputoutput

30. Production: Two Variable InputsProduction: Two Variable Inputs
 Marginal rate of technicalMarginal rate of technical
substitution (MRTS)substitution (MRTS)
- Amount by which the quantity of- Amount by which the quantity of
one input can be reduced whenone input can be reduced when
one extra unit of another input isone extra unit of another input is
used, so that output remainsused, so that output remains
constantconstant

31. Production: Two Variable InputsProduction: Two Variable Inputs
 The marginal rate of technicalThe marginal rate of technical
substitution equals:substitution equals:
)( q
L
KMRTS
InputLaborinChange
InputCapitalinChange
MRTS
oflevelfixedafor
∆
∆−=
−=
MRTS = Slope of the Isoquant

32. Marginal Rate ofMarginal Rate of
Technical SubstitutionTechnical Substitution
Labor per month
1
2
3
4
1 2 3 4 5
5Capital
per year
Negative Slope measures MRTS;
MRTS decreases as move down
the isoquant
1
1
1
1
2
1
2/3
1/3
Q1 =55
Q2 =75
Q3 =90

33. Returns to ScaleReturns to Scale
 In addition to discussing the tradeoffIn addition to discussing the tradeoff
between inputs to keep productionbetween inputs to keep production
the samethe same
 How does a firm decide, in the longHow does a firm decide, in the long
run, the best way to increase output?run, the best way to increase output?
– Can change the scale of production byCan change the scale of production by
increasing all inputs in proportionincreasing all inputs in proportion
– If double inputs, output will most likelyIf double inputs, output will most likely
increase but by how much?increase but by how much?

34. Returns to ScaleReturns to Scale
 Rate at which output increases asRate at which output increases as
inputs are increased proportionatelyinputs are increased proportionately
and simultaneouslyand simultaneously
– Increasing returns to scaleIncreasing returns to scale
– Constant returns to scaleConstant returns to scale
– Decreasing returns to scaleDecreasing returns to scale

35. Returns to ScaleReturns to Scale
 Increasing returns to scaleIncreasing returns to scale::
output more than doubles when alloutput more than doubles when all
inputs are doubledinputs are doubled
– The isoquants get closer togetherThe isoquants get closer together

36. Increasing Returns to ScaleIncreasing Returns to Scale
10
20
30
The isoquants
move closer
together
Labor (hours)
5 10
Capital
(machine
hours)
2
4
A

37. Returns to ScaleReturns to Scale
 Constant returns to scaleConstant returns to scale: output: output
doubles when all inputs are doubleddoubles when all inputs are doubled
– Isoquants are equidistant apartIsoquants are equidistant apart

38. Returns to ScaleReturns to Scale
Constant
Returns:
Isoquants are
equally spaced
2
0
30
Labor (hours)
155 10
A
10
Capital
(machine
hours)
2
4
6

39. Returns to ScaleReturns to Scale
 Decreasing returns to scaleDecreasing returns to scale::
output less than doubles when alloutput less than doubles when all
inputs are doubledinputs are doubled
– Isoquants become farther apartIsoquants become farther apart

40. Returns to ScaleReturns to Scale
Labor (hours)
Capital
(machine
hours)
Decreasing Returns:
Isoquants get further
apart10
20
10
4
A
15
5
2

41. RecapRecap
 Technology of ProductionTechnology of Production
 Production with One Variable InputProduction with One Variable Input
(Labor)(Labor)
 Production with Two Variable InputsProduction with Two Variable Inputs
- Isoquants- Isoquants
 Returns to ScaleReturns to Scale