chapter 7 Technology and Production Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-2 Learning Objectives Explain how to identify a firm’s efficient production methods. Calculate average product and marginal product and explain how they measure a firm’s productivity. Discuss input substitution with two variable inputs. Understand the concept of returns to scale and its causes. Discuss the sources of productivity differences across firms and over time. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-3 Overview Among all possible production technologies, firms use the most efficient methods The simplest production function requires one input, but usually we encounter two or more variable inputs As firms grow and increase the use of all inputs, the effect on production may not be proportional – returns to scale Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-4 Production Technologies Outputs: the physical products or services a firm produces Inputs: the materials, labor, land, or equipment that firms use to produce their outputs Production technology: summarizes all possible methods for producing output Efficient: when there is no way for the firm to produce a larger amount of output using the same amounts of inputs Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-5 Production Possibilities Set and Efficient Production Frontier Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-6 Production Possibilities Set and Efficient Production Frontier Production possibilities set: contains all combinations of inputs and outputs that are possible given the firm’s technology Efficient production frontier: contains the combinations of inputs and outputs that the firm can achieve using efficient production methods Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-7 Production Functions Production function: states the amount of output a firm can produce from given amounts of inputs using efficient production methods – Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-8 Production in the Short Run and the Long Run Variable input: can be adjusted over the time period being considered Fixed input: cannot be adjusted over the time period being considered Short run: a period of time over which one or more inputs is fixed Long run: a period of time over which all inputs are variable Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-9 Average Product Average product of labor: the amount of output divided by the number of workers employed – Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-10 Production Function and Average Product Curve Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-11 Marginal Product Marginal product of labor: the extra output produced due to the marginal units of labor, per unit of labor – Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-12 Production Function and Marginal Product Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Law of Diminishing Marginal Returns Law of diminishing marginal returns: states the general tendency for the marginal product of an input to eventually decline as its use is increased holding all other inputs fixed 7-13 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Average and Marginal Product If the marginal worker is more productive than average, she brings the average up. If she is less productive than average, she drives the average down Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Optimal Assignment of Workers between Two Plants 7-15 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-16 Production with Two Variable Inputs Two inputs: labor (L) and capital (K) Production function: Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-17 Input Substitution Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Isoquants Isoquant: identifies all the input combinations a firm can use to efficiently produce a given amount of output Family of isoquants: consists of the isoquants corresponding to all possible output levels 7-18 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-19 Productive Input Principle Increasing the amounts of all inputs strictly increases the amount of output the firm can produce (using efficient production methods). Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-20 Properties of Isoquants Isoquants are thin Output in A > B due to productive input principle ⇒ B and A cannot belong in the same isoquant Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-21 Properties of Isoquants Isoquants are thin Isoquants do not slope upward Output in A > B due to productive input principle ⇒ A and B cannot belong in the same isoquant Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-22 Properties of Isoquants Isoquants are thin Isoquants do not slope upward An isoquant is the boundary between input combinations that produce more than a given amount of output and those that produce less Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-23 Properties of Isoquants Isoquants are thin Isoquants do not slope upward An isoquant is the boundary between input combinations that produce more than a given amount of output and those that produce less Isoquants for the same technology do not cross B C By being on the same isoquant, A and B produce the same output. Similarly, by being on the same isoquant, A and C produce the same output. By transitivity, B and C should produce the same output Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. B C By being on the same isoquant, A and B produce the same output. Similarly, by being on the same isoquant, A and C produce the same output. By transitivity, B and C should produce the same output However, this is impossible since the output in C > B due to the productive input principle

7-24 Properties of Isoquants Isoquants are thin Isoquants do not slope upward An isoquant is the boundary between input combinations that produce more than a given amount of output and those that produce less Isoquants for the same technology do not cross Higher-level isoquants lie farther from the origin Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Substitution between Labor and Capital Along an Isoquant and the MRTS Marginal rate of technical substitution (MRTS) for input X with input Y: the rate at which a firm must replace units of X with units of Y to keep output unchanged starting at a given input combination 7-25 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-26 Declining MRTS Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-27 MRTS and Marginal Products Along the Same Isoquant Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-28 Input Substitution for Three Special Production Technologies Perfect substitutes Perfect complements (fixed proportions) The Cobb-Douglas production function Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Perfect Substitutes If the functions of two inputs are identical, so that a firm can exchange one for another at a fixed rate 7-29 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Perfect Complements (Fixed Proportions) When two inputs must be combined in a fixed ratio 7-30 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

The Cobb-Douglas Production Function 7-31 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-32 Returns to Scale Constant returns to scale Increasing returns to scale Decreasing returns to scale Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Returns to Scale Constant returns to scale: when a proportional change in all inputs produces the same proportional change in output 7-33 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Returns to Scale Increasing returns to scale: when a proportional change in all inputs produces a more than proportional change in output 7-34 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Returns to Scale Decreasing returns to scale: when a proportional change in all inputs produces a less than proportional change in output 7-35 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-36 Implications of Returns to Scale With increasing returns to scale, production is most efficient if there is a single producer However, a single producer may not operate in a manner that would benefit consumers More when we discuss natural monopoly in Chapter 17 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-37 Productivity and Technological Change Technological change: when a firm’s ability to turn inputs into output changes over time Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Productivity Improvement Higher productivity: when a firm can produce more output using the same amounts of inputs Factor-neutral technical change: a productivity improvement that keeps the MRTS unchanged at every input combination 7-38 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-39 Reasons for Productivity Differences Firms may be subject to different regulations or market circumstances Examples: labor laws, union contracts Firms may have different levels of technical, organizational knowledge, research and development; learning by doing Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-40 Review A production method is efficient if there is no way to produce larger amounts of outputs using the same amounts of inputs Production with one variable input: when the marginal product of labor is (larger than/smaller than/equal to) the average product of labor, the average product is (increased by/decreased by/unchanged by) the marginal units of labor. A firm has (constant/increasing/decreasing) returns to scale if a proportional change in all inputs leads to (the same/a greater than/a less than) proportional change in output. A firm is more productive when it can produce more output using the same amount of inputs. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7-41 Looking Forward Next, we will learn how firms put together their production possibilities, with the cost of individual inputs, to determine the optimal combination of inputs for different outputs, and the resulting cost of production for each level of output Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.