Chapter 11

PRODUCTION FUNCTIONS

Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.

MICROECONOMIC THEORYBASIC PRINCIPLES AND EXTENSIONS

EIGHTH EDITION

WALTER NICHOLSON

Production Function

• The firm’s production function for a particular good (q) shows the maximum amount of the good that can be produced using alternative combinations of capital (K) and labor (L)

q = f(K,L)

Marginal Physical Product

• To study variation in a single input, we define marginal physical product as the additional output that can be produced by employing one more unit of that input while holding other inputs constant

KK fK

qMP

capital of product physical marginal

LL fL

qMP

labor of product physical marginal

Diminishing Marginal Productivity

• The marginal physical product of an input depends on how much of that input is used

• In general, we assume diminishing marginal productivity

02

KK

K fK

q

K

MP

02

LL

L fL

q

L

MP

Diminishing Marginal Productivity

• Because of diminishing marginal productivity, 19th century economist Thomas Malthus worried about the effect of population growth on labor productivity

• But changes in the marginal productivity of labor over time also depend on changes in other inputs such as capital– we need to consider fLK which is often > 0

Average Physical Product

• Labor productivity is often measured by average productivity

L

LKf

L

qAPL

),(

input labor

output

• Note that APL also depends on the amount of capital employed

A Two-Input Production Function

• Suppose the production function for flyswatters can be represented by

q = f(K,L) = 600K 2L2 - K 3L3

• To construct MPL and APL, we must assume a value for K – Let K = 10

• The production function becomes

q = 60,000L2 - 1000L3

A Two-Input Production Function

• The marginal productivity function is MPL = q/L = 120,000L - 3000L2

which diminishes as L increases• This implies that q has a maximum value:

120,000L - 3000L2 = 0

40L = L2

L = 40

• Labor input beyond L=40 reduces output

A Two-Input Production Function

• To find average productivity, we hold K=10 and solve

APL = q/L = 60,000L - 1000L2

• APL reaches its maximum where

APL/L = 60,000 - 2000L = 0

L = 30

A Two-Input Production Function

• In fact, when L=30, both APL and MPL are equal to 900,000

• Thus, when APL is at its maximum, APL and MPL are equal

Isoquant Maps

• To illustrate the possible substitution of one input for another, we use an isoquant map

• An isoquant shows those combinations of K and L that can produce a given level of output (q0)

f(K,L) = q0

Isoquant Map

L per period

K per period

• Each isoquant represents a different level of output– output rises as we move northeast

q = 30

q = 20

Marginal Rate of Technical Substitution (RTS)

L per period

K per period

q = 20

- slope = marginal rate of technical substitution (RTS)

• The slope of an isoquant shows the rate at which L can be substituted for K

LA

KA

KB

LB

A

B

RTS > 0 and is diminishing for

increasing inputs of labor

Marginal Rate of Technical Substitution (RTS)

• The marginal rate of technical substitution (RTS) shows the rate at which labor can be substituted for capital while holding output constant along an isoquant

0qqdL

dKKLRTS

) for (

RTS and Marginal Productivities• Take the total differential of the production

function:

dKMPdLMPdKK

fdL

L

fdq KL

• Along an isoquant dq = 0, so

dKMPdLMP KL

K

L

qq MP

MP

dL

dKKLRTS

0

) for (

RTS and Marginal Productivities

• Because MPL and MPK will both be nonnegative, RTS will also be nonnegative

• However, it is not possible to derive a diminishing RTS from the assumption of diminishing marginal productivity alone

RTS and Marginal Productivities

• To show that isoquants are convex, we would like to show that d(RTS)/dL < 0

• Since RTS = fL/fK

dL

ffd

dL

dRTS KL )/(

2)(

)]/()/([

K

KKKLLLKLLK

f

dLdKfffdLdKfff

dL

dRTS

RTS and Marginal Productivities• Using the fact that dK/dL = -fL/fK along an

isoquant and Young’s theorem (fKL = fLK)

3

22 2

)(

)(

K

KKLKLLKLLK

f

fffffff

dL

dRTS

• Because we have assumed fK > 0, the denominator is positive

• Because fLL and fKK are both assumed to be negative, the ratio will be negative if fKL is positive

RTS and Marginal Productivities• Intuitively, it seems reasonable that fKL=fLK

should be positive– if workers have more capital, they will be more

productive

• But some production functions have fKL < 0 over some input ranges– Thus, when we assume diminishing RTS we are

assuming that MPL and MPK diminish quickly enough to compensate for any possible negative cross-productivity effects

A Diminishing RTS

• Suppose the production function isq = f(K,L) = 600K 2L2 - K 3L3

• For this production functionMPL = fL = 1200K 2L - 3K 3L2

MPK = fK = 1200KL2 - 3K 2L3

• These marginal productivities will be positive for values of K and L for which KL < 400

A Diminishing RTS

• Because

fLL = 1200K 2 - 6K 3L

fKK = 1200L2 - 6KL3

this production function exhibits diminishing marginal productivities for sufficiently large values of K and L

– fLL and fKK < 0 if KL > 200

A Diminishing RTS

• Cross differentiation of either of the marginal productivity functions yields

fKL = fLK = 2400KL - 9K 2L2

which is positive only for KL < 266

A Diminishing RTS

• Thus, for this production function, RTS is diminishing throughout the range of K and L where marginal productivities are positive– for higher values of K and L, the diminishing

marginal productivities are sufficient to overcome the influence of a negative value for fKL to ensure convexity of the isoquants

Returns to Scale

• How does output respond to increases in all inputs together?

• Suppose that all inputs are doubled, would output double?

• Returns to scale have been of interest to economists since the days of Adam Smith

Returns to Scale

• Smith identified two forces that come into operation as inputs are doubled– greater division of labor and specialization

of function– loss in efficiency because management

may become more difficult given the larger scale of the firm

Returns to Scale• If the production function is given by q = f(K,L) and all

inputs are multiplied by the same positive constant (m > 1), then

Effect on Output Returns to Scale

f(mK,mL) = mf(K,L) Constant

f(mK,mL) < mf(K,L) Decreasing

f(mK,mL) > mf(K,L) Increasing

Returns to Scale

• It is possible for a production function to exhibit constant returns to scale for some levels of input usage and increasing or decreasing returns for other levels– economists refer to the degree of returns to

scale with the implicit notion that only a fairly narrow range of variation in input usage and the related level of output is being considered

Constant Returns to Scale• Constant returns-to-scale production

functions have the useful theoretical property that that the RTS between K and L depends only on the ratio of K to L, not the scale of operation

• Geometrically, all of the isoquants are “radial blowups” of the unit isoquant

Constant Returns to Scale

L per period

K per period

• Along a ray from the origin (constant K/L), the RTS will be the same on all isoquants

q = 3

q = 2

q = 1

The isoquants are equallyspaced as output expands

Returns to Scale• Returns to scale can be generalized to a

production function with n inputsq = f(X1,X2,…,Xn)

• If all inputs are multiplied by a positive constant m, we have

f(mX1,mX2,…,mXn) = mkf(X1,X2,…,Xn)=mkq

– If k=1, we have constant returns to scale– If k<1, we have decreasing returns to scale– If k>1, we have increasing returns to scale

Elasticity of Substitution• The elasticity of substitution () measures

the proportionate change in K/L relative to the proportionate change in the RTS along an isoquant

RTS

LK

LK

RTS

dRTS

LKd

RTS

LK

ln

)/ln(

/

)/(

%

)/(%

• The value of will always be positive because K/L and RTS move in the same direction

Elasticity of Substitution

L per period

K per period

• Both RTS and K/L will change as we move from point A to point B

A

B q = q0

RTSA

RTSB

(K/L)A

(K/L)B

is the ratio of theseproportional changes

measures thecurvature of theisoquant

Elasticity of Substitution• If is high, the RTS will not change much

relative to K/L– the isoquant will be relatively flat

• If is low, the RTS will change by a substantial amount as K/L changes– the isoquant will be sharply curved

• It is possible for to change along an isoquant or as the scale of production changes

The Linear Production Function

• Suppose that the production function isq = f(K,L) = aK + bL

• This production function exhibits constant returns to scalef(mK,mL) = amK + bmL = m(aK + bL) = mf(K,L)

• All isoquants are straight lines– RTS is constant =

The Linear Production Function

L per period

K per period

q1q2 q3

Capital and labor are perfect substitutes

RTS is constant as K/L changes

slope = -b/a =

Fixed Proportions

• Suppose that the production function isq = min (aK,bL) a,b > 0

• Capital and labor must always be used in a fixed ratio– the firm will always operate along a ray

where K/L is constant

• Because K/L is constant, = 0

Fixed Proportions

L per period

K per period

q1

q2

q3

No substitution between labor and capital is possible

= 0

K/L is fixed at b/a

q3/b

q3/a

Cobb-Douglas Production Function

• Suppose that the production function isq = f(K,L) = AKaLb A,a,b > 0

• This production function can exhibit any returns to scale

f(mK,mL) = A(mK)a(mL) b = Ama+b KaLb = ma+bf(K,L)– if a + b = 1 constant returns to scale– if a + b > 1 increasing returns to scale– if a + b < 1 decreasing returns to scale

Cobb-Douglas Production Function

• Suppose that hamburgers are produced according to the Cobb-Douglas function

q = 10K 0.5 L0.5

• Since a+b=1 constant returns to scale

• The isoquant map can be derivedq = 50 = 10K 0.5 L0.5 KL = 25

q = 100 = 10K 0.5 L0.5 KL = 100– The isoquants are rectangular hyperbolas

Cobb-Douglas Production Function

• The RTS can easily be calculated

L

K

KL

KL

f

fKLRTS

K

L

5050

5050

5

5..

..

) for (

• The RTS declines as L rises and K falls• The RTS depends only on the ratio of K and

L• Because the RTS changes exactly in

proportion to changes in K/L, = 1

Cobb-Douglas Production Function

• The Cobb-Douglas production function is linear in logarithms

ln q = ln A + a ln K + b ln L– a is the elasticity of output with respect to K– b is the elasticity of output with respect to L

CES Production Function• Suppose that the production function is

q = f(K,L) = [K + L] / 1, 0, > 0 > 1 increasing returns to scale < 1 decreasing returns to scale

• For this production function = 1/(1-)

= 1 linear production function = - fixed proportions production function = 0 Cobb-Douglas production function

Technical Progress

• Methods of production change over time

• Following the development of superior production techniques, the same level of output can be produced with fewer inputs– the isoquant shifts in

Technical Progress

• Suppose that the production function isq = A(t)f(K,L)

where A(t) represents all influences that go into determining q other than K and L– changes in A over time represent technical

progress• A is shown as a function of time (t)• dA/dt > 0

Technical Progress

• Differentiating the production function with respect to time we get

dt

LKdfALKf

dt

dA

dt

dq ),(),(

dt

dL

L

f

dt

dK

K

f

LKf

q

A

q

dt

dA

dt

dq

),(

Technical Progress

• Dividing by q gives us

dt

dL

LKf

Lf

dt

dk

LKf

Kf

A

dtdA

q

dtdq

),(

/

),(

///

L

dtdL

LKf

L

L

f

K

dtdK

LKf

K

K

f

A

dtdA

q

dtdq /

),(

/

),(

//

Technical Progress

• For any variable x, [(dx/dt)/x] is the proportional growth rate in x– denote this by Gx

• Then, we can write the equation in terms of growth rates

LKAq GLKf

L

L

fG

LKf

K

K

fGG

),(),(

Technical Progress

• Since

LLqKKqAq GeGeGG ,,

Kqeq

K

K

q

LKf

K

K

f,),(

Lqeq

L

L

q

LKf

L

L

f,),(

Technical Progress in the Cobb-Douglas Function

• Suppose that the production function isq = 10e 0.05t K 0.5 L0.5

• Taking logarithms yieldsln q = ln 10 + 0.05t + 0.5 ln K + 0.5 ln L

• Differentiating with respect to t gives the growth equation

L

dtdL

K

dtdK

q

dtdq /.

/..

/5050050

Technical Progress in the Cobb-Douglas Function

• We can put this in terms of growth ratesGq = 0.05 + 0.5GK + 0.5GL

• When K and L are constant, output grows at 5 percent per period– GK = GL = 0

– Gq = 0.05

Important Points to Note:• If all but one of the inputs are held constant,

a relationship between the single variable input and output can be derived– the marginal physical productivity is the change

in output resulting from a one-unit increase in the use of the input

– the marginal physical productivity of an input is assumed to decline as use of the input increases

Important Points to Note:• The entire production function can be

illustrated by an isoquant map– The slope of an isoquant is the marginal rate of

technical substitution• RTS measures how one input can be substituted for

another while holding output constant• RTS is the ratio of the marginal physical

productivities of the two inputs

– Isoquants are assumed to be convex• they obey the assumption of a diminishing RTS

Important Points to Note:• The returns to scale exhibited by a

production function record how output responds to proportionate increases in all inputs– if output increases proportionately with input

use, there are constant returns to scale– if there are greater than proportionate increases

in output, there are increasing returns to scale– if there are less than proportionate increases in

output, there are decreasing returns to scale

Important Points to Note:• The elasticity of substitution () provides a

measure of how easy it is to substitute on input for another in production– a high implies nearly straight isoquants– a low implies that isoquants are nearly L-

shaped

• Technical progress shifts the entire production function and isoquant map– may arise from the use of more productive

inputs or better economic organization