1. Economic Analysis for Managers (ECO 501) Fall:2012 Semester
Khurrum S. Mughal

2. Theme of the Lecture Production Theory Introduction
The Production Function
Production with One Variable Input
Production with Two Variable Input
Returns to Scale

3. Production
Production refers to the transformation of inputs or resources into outputs of goods and services

4. Production INPUTS CAPITAL LABOR Land & Natural Entrepreneur Structures
Resources
Entrepreneur
Workers
Machinery
plant &
equipment

5. Short Run- At least one input is fixed
Factors of Production
Short Run- At least one input is fixed
Long Run - All inputs are variable
The length of long run depends on industry.

6. Output = Total inputs(variable inputs)
Level and Scale of Production
Level of production can be altered changing the proportion of variable inputs Output = Fixed inputs + Variable inputs
Scale of production can be altered by changing the supply of all the inputs (only in the long run)
Output = Total inputs(variable inputs)

7. Production Function General equation for Production Function:
Q = f (K,L), where
L = Labour
K = Capital
Maximum rate of output per unit of time obtainable from given rate of Capital and Labour
An engineering concept: Relates out puts and inputs

8. Production Function with Two Inputs
Devoid of economics 6 10 24 31 36 40 39 5 12 28 42 4 3 23 33 2 7 18 30 1 8 14
Q = f(L, K)
Capital (K)
Labor (L)
Substitutability between factors of production
Returns to Scale vs Returns to Factor

9. Theme of the Lecture Production Theory Introduction
The Production Function
Production with One Variable Input
Production with Two Variable Input
Returns to Scale

10. Production or Output Elasticity
Production With One Variable Input
Q = f (K,L), where K is fixed
Total Product
TP = Q = f(L)
Marginal Product
MPL =
TP L
Average Product
APL =
TP L
Production or Output Elasticity
Q/Q
L/L
Q/ L
Q/L = EL
MPL
APL

11. Total, Marginal, and Average Product of Labor, and Output Elasticity
Production With One Variable Input
Total, Marginal, and Average Product of Labor, and Output Elasticity

12. Total, Marginal, and Average Product of Labor, and Output Elasticity
Production With One Variable Input
Total, Marginal, and Average Product of Labor, and Output Elasticity L Q MP AP E - 1 3 2 8 5 4
1.25 12 14
3.5
0.57
2.8 6 -2 -1

13. Law of Diminishing Returns and Stages of Production
Stage II of Labor
Stage III of Labor
Stage I of Labor
Total
Product 16 D E 14 C F TP 12 I 10 B 8 G 6 A 4 2
Marginal
& Average
Product 1 2 3 4 5 6
Labor 7 6 5 B’ C’ A’ D’ E’ F’ 4 3 AP 2 1 1 2 3 4 5 6 7 -1 MP
Labor -2 -3

14. Relationship Among Production Functions1:
Marginal product reaches a maximum at L1 (Point of Inflection G). The total product function changes from increasing at a increasing rate to increasing at a decreasing rate. 2:
MP intersects AP at its maximum at L2. 3:
MP becomes negative at labor rate L3 and TP reaches its maximum.

15. Marginal Revenue Product of Labor
Optimal use of the Variable Input
Marginal Revenue Product of Labor
MRPL = (MPL)(MR)
Optimal Use of Labor
MRPL = w

16. Optimal use of the Variable InputMP
MR = P L
2.50 4
$10
3.00 3 10
3.50 2 10
4.00 1 10
4.50 10
Assumption : Firm hires additional units of labor at constant
wage rate = $20

17. Use of Labor is Optimal When L = 3.50
Optimal use of the Variable Input L MP
MR = P
MRP w L L
2.50 4
$10
$40
$20
3.00 3 10 30 20
3.50 2 10 20 20
4.00 1 10 10 20
4.50 10 20
Assumption : Firm hires additional units of labor at constant
wage rate
Use of Labor is Optimal When L = 3.50

18. Optimal use of the Variable Input$ 40 30 20 10
w = $20
dL = MRPL
Units of Labor Used

19. Optimal use of the Variable Input
Production function of global electronics:
Q=2k0.5L0.5
Compute Optimal use of labor when
K is fixed at 9,
Price is Rs. 6 per unit
and wage rate is Rs. 2 per unit

20. Theme of the Lecture Production Theory Introduction
The Production Function
Production with One Variable Input
Production with Two Variable Input
Returns to Scale

21. Production with Two Variable Input
Isoquants show combinations of two inputs that can produce the same level of output. K Q 6 10 24 31 36 40 39 5 12 28 42 4 3 23 33 2 7 18 30 1 8 14 L

22. Marginal Rate of Technical SubstitutionK

23. _ (MPL) = MRTS (MPK) Marginal Rate of Technical Substitution
A movement down an Isoquant the
gain in out put from using more labor equals loss in output from using less capital
MRTS: Slope of the Isoquant
_ (MPL) = MRTS
(MPK)

24. ISOCOST
Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost.

25. Isocost Line AB C = $100, w = r = $10 slope = -w/r = -1
Capital
AB C = $100, w = r = $10 10 8 6 4 2 A
slope = -w/r = -1
vertical intercept = 10 1K 1L B
Labor

26. Isocost Line Capital Labor A’ 14 10 8 4 Isocost Lines
AB C = $100, w = r = $10
A’B’ C = $140, w = r = $10
AB* C = $100, w = $5, r = $10 A B B’ B*
Labor

27. MRTS = w/r Optimal Combination of Inputs Isocost Lines
AB C = $100, w = r = $10
A’B’ C = $140, w = r = $10
A’’B’’ C = $80, w = r = $10
MRTS = w/r

28. Optimal Employment of Two Inputs
Optimal combination is where slope of Iso Cost and that of Isoquant are equal:
MPL = w
MPK r
MPL = MPK
w r

29. Profit Maximization MPL = w MPL = MPK w r MPK r
To maximize Profits, each input must be hired at the efficient input rate
MRPL = w = (MPL)(MR)
MRPK = r = (MPK)(MR)
Profit Maximizing follows that the firm must be operating efficiently
MPL = MPK
w r
MPL = w
MPK r

30. Expansion Path

31. Theme of the Lecture Production Theory Introduction
The Production Function
Production with One Variable Input
Production with Two Variable Input
Returns to Scale

32. Production Function Q = f(L, K)
Economies of Scale Returns to Scale
Production Function Q = f(L, K)
Q = f(hL, hK)
If  = h, constant returns to scale.
If  > h, increasing returns to scale.
If  < h, decreasing returns to scale.

33. Constant Returns to Scale Increasing Returns to Scale
Decreasing Returns to Scale

34. Cobb-Douglas Production Function
Returns to Scale in An Empirical Production Function
Cobb-Douglas Production Function
Q = AKaLb
If a + b = 1, constant returns to scale.
If a + b > 1, increasing returns to scale.
If a + b <1, decreasing returns to scale.

35. Sources of Increasing Returns to Scale
Technologies that are effective at larger scale of production generally have higher unit costs at lower level of production
Labor Specialization
Labor may specialize in their specific tasks and perform it efficiently
Inventory economies
Larger firms have lesser need for machine inventory backup

36. Sources of Decreasing Returns to Scale
Managerial Issues due to large size of the firm
Increased Transportation costs
Larger labor costs due to requirement of increased wages to attract labor from farther areas

37. Economies of Scope Using facility for producing additional products
E.g. Daewoo Bus Service for passenger and cargo movement
Using unique skills or comparative advantage
Proctor & Gamble using its existing sales staff and production capabilities for marketing various products as substitutes and complements

38. Measuring Productivity
Total Factor Productivity