Beattie, Taylor, and Watts Sections: 2.1-2.2, 5.1-5.2b Technology Beattie, Taylor, and Watts Sections: 2.1-2.2, 5.1-5.2b

Agenda The Production Function with One Input Understand APP and MPP Diminishing Marginal Returns and the Stages of Production The Production Function with Two Input Isoquants

Agenda Cont. Marginal Rate of Technical Substitution Returns to Scale Production Possibility Frontier Marginal Rate of Product Transformation

Production Function A production function maps a set of inputs into a set of outputs. The production function tells you how to achieve the highest level of outputs given a certain set of inputs. Inputs to the production function are also called the factors of production. The general production function can be represented as y = f(x1, x2, …, xn).

Production Function Cont. The general production function can be represented as y = f(x1, x2, …, xn). Where y is the output produced and is a positive number. Where xi is the quantity of input i for i = 1, 2, …, n and each is a positive number.

Production Function with One Input In many situations, we want to examine what happens to output when we only change one input. This is equivalent to investigating the general production function previously given holding all but one of the variables constant.

Production Function with One Input Cont. Mathematically we can represent the production function with one input as the following: y = f(x) = f(x1) = f(x1|x2,x3,…,xn) Suppose y = f(x1, x2, x3) = x1*x2*x3 Suppose that x2 = 3 and x3 = 4, which are fixed inputs, then y = f(x) = f(x1) = f(x1|3,4) = 12x1 =12x

Example of Production Function y = f(x) = -x3 + 60x2

APP and MPP There are two major tools for examining a production function: Average Physical Product (APP) Marginal Physical Product (MPP)

APP The average physical product tells you the average amount of output you are getting for an input. We define APP as output (y) divided by input (x). APP = y/x = f(x)/x

Example of Finding APP Assume you have the following production function: y = f(x) = -x3 + 60x2

Example of Finding Maximum APP To find the maximum APP, you take the derivative of APP and solve for the x that gives you zero. From the previous example: APP = -x2 + 60x

MPP The marginal physical product tells you what effect a change of the input will do to the output. In essence, it is the change in the output divided by the change in the input. MPP is defined as:

Example of Finding MPP Assume you have the following production function: y = f(x) = -x3 + 60x2

Interpreting MPP When MPP > 0, then the production function is said to have positive returns to the use of the input. This occurs on the convex and the beginning of the concave portion of the production function. In the previous example, this implies that MPP > 0 when input is less than 40 (x<40).

Interpreting MPP Cont. When MPP = 0, then we know that the production function is at a maximum. Setting MPP = 0 is just the first order condition to find the maximum of the production function. In the example above, MPP = 0 when the input was at 40.

Interpreting MPP Cont. When MPP < 0, then the production function is said to have decreasing returns to the use of the input. This occurs on the concave portion of the production function. In the previous example, this implies that MPP < 0 when input is greater than 40 (x>40).

Example of APP and MPP y = f(x) = -x3 + 60x2

Law of Diminishing Marginal Returns (LDMR) The Law of Diminishing Marginal Returns states that as you add successive units of an input while holding all other inputs constant, then the marginal physical product must eventually decrease. This is equivalent to saying that the derivative of MPP is negative.

Finding Where LDMR Exists Suppose y = f(x) = -x3 + 60x2 To find where the LDMR exists is equivalent to finding what input levels give a second order condition that is negative.

Relationship of APP and MPP When MPP > APP, then APP is rising When MPP = APP, then APP is at a maximum When MPP < APP, then APP is declining

Relationship of APP and MPP Cont.

Stages of Production Stage I of production is where the MPP is above the APP, i.e., it starts where the input level is 0 and goes all the way up to the input level where MPP=APP. To find the transition point from stage I to Stage II you need to set the APP function equal to the MPP function and solve for x.

Stages of Production Cont. Stage II of production is where MPP is less than APP but greater than zero, i.e., it starts at the input level where MPP=APP and ends at the input level where MPP=0. To find the transition point from Stage II to Stage III, you want to set MPP = 0 and solve for x. Stage III is where the MPP<0, i.e., it starts at the input level where MPP=0.

Finding the Transition From Stage I to Stage II Suppose y = f(x) = -x3 + 60x2

Finding the Transition From Stage II to Stage III Suppose y = f(x) = -x3 + 60x2

Production Function with Two Inputs While one input production functions provide much intuitive information about production, there are times when we want to examine what is the relationship of output to two inputs. This is equivalent to investigating the general production function holding all but two of the variables constant.

Production Function with Two Inputs Cont. Mathematically we can represent the production function with one input as the following: y = f(x1,x2) = f(x1, x2|x3,…,xn)

Example of a Production Function with Two Variables: y=f(x1,x2)=-x13+25x12-x23+25x22

Example 2 of a Production Function with Two Variables: y=f(x1,x2)=8x11/4x23/4

Three Important Concepts for Examining Production Function with Two Inputs There are three important concepts to understand with a production function with two or more inputs. Marginal Physical Product (MPP) Isoquant Marginal Rate Of Technical Substitution (MRTS)

MPP for Two Input Production Function MPP for a production function with multiple inputs can be viewed much like MPP for a production function with one input. The only difference is that the MPP for the multiple input production function must be calculated while holding all other inputs constant, i.e., instead of taking the derivative of the function, you take the partial derivative.

MPP for Two Input Production Function Cont. Hence, with two inputs, you need to calculate the MPP for both inputs. MPP for input xi is defined mathematically as the following:

Example of Calculating MPP Suppose y = f(x1,x2) = -x13+25x12-x23+25x22

Example 2 of Calculating MPP Suppose y = f(x1,x2) = 8x11/4 x23/4

Note on MPP for Multiple Inputs When the MPP for a particular input is zero, you have found a relative extrema point for the production function. In general, the MPP w.r.t. input 1 does not have to equal MPP w.r.t. input 2.

The Isoquant An isoquant is the set of inputs that give you the same level of output. To find the isoquant, you need to set the dependent variable y equal to some number and examine all the combinations of inputs that give you that level of output. An isoquant map shows you all the isoquants for a given set of inputs.

Example of An Isoquant Map: y = -x12+24x1-x22+26x2

Example 2 of An Isoquant Map: y = 8x11/4 x23/4

Finding the Set of Inputs for a General Output Given y = -x12+24x1-x22+26x2 Suppose y = -x12+24x1-x22+26x2 We can solve the above equation for x2 in terms of y and x1.

Question From the previous example, does it make economic sense to have both the positive and negative sign in front of the radical? No, only one makes economic sense; but which one. You should expect that you will have an inverse relationship between x1 and x2. This implies that for this particular function, you would prefer to use the negative sign.

Finding the Set of Inputs for a General Output Given y = 8x11/4 x23/4 Suppose y = 8x11/4 x23/4 We can solve the above equation for x2 in terms of y and x1.

Marginal Rate of Technical Substitution (MRTS) The Marginal Rate of Technical Substitution tells you the trade-off of one input for another that will leave you with the same level of output. In essence, it is the slope of the isoquant.

Finding the MRTS There are two methods you can find MRTS. The first method is to derive the isoquant from the production function and then calculate the slope of the isoquant. The second method is to derive the MPP for each input and then take the negative of the ratio of these MPP.

Equivalency Between Slope of the Isoquant and the Ratio of MPP’s

Finding the MRTS Using the ratio of the MPP’s Given y = -x12+24x1-x22+26x2 Suppose y = -x12+24x1-x22+26x2

Finding the MRTS Using the Slope of the Isoquant Given y = -x12+24x1-x22+26x2 Suppose y = -x12+24x1-x22+26x2

Finding the MRTS Using the Slope of the Isoquant Given y = -x12+24x1-x22+26x2 Cont.

Finding the MRTS Using the ratio of the MPP’s Given y = Kx1x2 Suppose y = Kx1x2

Finding the MRTS Using the Slope of the Isoquant Given y = Kx1x2 Suppose y = Kx1x2

Finding the MRTS Using the Slope of the Isoquant Given y = Kx1x2 Cont.

Returns to Scale Returns to Scale examines what happens to output when you change all inputs by the same proportion, i.e., f(tx1,tx2). There are three types of Returns to Scale: Increasing Constant Decreasing

Increasing Returns to Scale Increasing Returns to Scale are said to exist when f(tx1,tx2)>tf(x1,x2) for t > 1. Suppose y = f(x1,x2) = x1x2 This implies that f(tx1,tx2) = tx1tx2 =t2x1x2 Comparing f(tx1,tx2) and tf(x1,x2) implies f(tx1,tx2) = t2x1x2 >t f(x1,x2) = tx1x2, because when t >1, t2 > t.

Example Increasing Returns to Scale: y = 10x1 x2

Constant Returns to Scale Constant Returns to Scale are said to exist when f(tx1,tx2)=tf(x1,x2) for t > 1. Suppose y = f(x1,x2) = x1½ x2½ This implies that f(tx1,tx2) = (tx1)½ (tx2)½ =tx1x2 Comparing f(tx1,tx2) and tf(x1,x2) implies f(tx1,tx2) = tx1x2 = t f(x1,x2) = tx1x2, because when t >1, t = t.

Example Constant Returns to Scale: y = 10x1½ x2½

Return to Scale Cont. Decreasing Returns to Scale are said to exist when f(tx1,tx2)<tf(x1,x2) for t > 1. Suppose y = f(x1,x2) = x1 ¼ x2¼ This implies that f(tx1,tx2) = (tx1)¼ (tx2)¼ =t½x1¼x2¼ Comparing f(tx1,tx2) and tf(x1,x2) implies f(tx1,tx2) = t½x1x2 < t f(x1,x2) = tx1¼x2¼, because when t >1, t½ < t.

Example Decreasing Returns to Scale: y = 10x1 ¼ x2¼

The Multiple Product Firm Many producers have a tendency to produce more than one product. This allows them to minimize risk by diversifying their production. Personal choice. The question arises: What type of trade-off exists for enterprises that use the same inputs?

Two Major Types of Multiple Production Multiple products coming from one production function. E.g., wool and lamb chops Mathematically: Y1, Y2, …, Yn = f(x1, x2, …, xn) Where Yi is output of good i Where xi is input i

Two Major Types of Multiple Production Cont. Multiple products coming from multiple production functions where the production functions are competing for the same inputs. E.g., strawberries and lettuce

Two Major Types of Multiple Production Cont. Mathematically: Y1= f1(x11, x12, …, x1m) Y2= f2(x21, x22, …, x2m) Yn= fn(xn1, xn2, …, xnm) Where Yi is output of good i Where xij is input j allocated to output Yi Where Xj  x1j + x2j + … + xnj and is the maximum amount of input j available.

Production Possibility Frontier A production possibility frontier (PPF) tells you the maximum amount of each product that can be produced given a fixed level of inputs. The emphasis of the production possibility function is on the fixed level of inputs. These fixed inputs could be labor, capital, land, etc.

PPF Cont. All points along the edge of the production possibility frontier are the most efficient use of resources that can be achieved given its resource constraints. Anything inside the PPF is achievable but is not fully utilizing all the resources, while everything outside is not feasible.

Deriving the PPF Mathematically To derive the production possibility frontier, you want to use the resource constraint on the inputs as a way of solving for one output as a function of the other.

PPF Example Suppose you produce two goods, strawberries (Y1) and lettuce (Y2). Also suppose your limiting factor is land (X1) at 100 acres. For strawberries you know that you have the following production relationship: Y1 = x1½

PPF Example Cont. For lettuce you know that you have the following production relationship: Y2 = x2½ We know that 100 = x1 + x2.

Solving PPF Example Mathematically

PPF Graphical Example

Marginal Rate of Product Transformation (MRPT) MRPT can be defined as the amount of one product you must give up to get another product. This is equivalent to saying that the MRPT is equal to the slope of the production possibility frontier. MRPT = dY2/dY1 Also known as Marginal Rate of Product Substitution.

Find MRPT of the Following PPF: Y2 = (100-Y12)½ Suppose Y2 = (100-Y12)½