1. Principles of Economics
Session 4

2. Topics To Be Covered Factors of Production Production Function
Productivity
Isoquant
Isocost
Minimum Cost Rule
Returns to Scale
Managing Lock-In

3. Production
Production is the process that combines inputs or factors of production to achieve an output 4

4. Factors of Production Capital (Physical Capital) Labor (Human Capital)
Land (Natural Resources)
Technological Knowledge

5. Physical Capital
Physical capital is the stock of equipment and structures that are used to produce goods and services.
Tools used to build or repair automobiles.
Tools used to build furniture.
Office buildings, schools, etc.

6. Human Capital
Human capital is the economic term for the knowledge and skills that workers acquire through education, training, and experience.
Like physical capital, human capital raises a nation’s ability to produce goods and services.

7. Natural Resources
Natural resources are inputs used in production that are provided by nature, such as land, rivers, and mineral deposits.
Renewable resources include trees and forests.
Nonrenewable resources include petroleum and coal.

8. Natural Resources
Natural resources can be important but are not necessary for an economy to be highly productive in producing goods and services.

9. Technological Knowledge
Technological knowledge is the understanding of the best ways to produce goods and services.

10. The Production Function
The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

11. The Production Function
Q= A F(L, K, N)
Q = quantity of output
A = available production technology
L = quantity of labor
K = quantity of capital
N = quantity of natural resources

12. Production Function for Two Inputs
Q = F(K,L)
Q = Output K = Capital L = Labor 6

13. Production with One Variable Input (Labor)
Amount Amount Total Average Marginal
of Labor (L) of Capital (K) Output (Q) Product Product 17

14. Total Product
With additional workers, output or total product (Q, TP) increases, reaches a maximum, and then decreases. 18

15. Maximum Product Maximum Product 112 Total Product 60 1 2 3 4 5 6 7 8 9
Output
per
Month ●
Maximum Product
112
Total Product 60 1 2 3 4 5 6 7 8 9 10
Labor per Month 23

16. AP = slope of line from origin to a point on TP
Average Product
The average product of labor (AP), or output per worker, increases and then decreases.
AP = slope of line from origin to a point on TP 19

17. AP and TP A' A 112 Total Product Maximum AP 60 Average Product 1 2 3 4
Output
per
Month
112
Total Product ●
Maximum AP A A' 60
Average Product
Labor per Month 1 2 3 4 5 6 7 8 9 23

18. MP = slope of tangent to a point on TP
Marginal Product
The marginal product of labor (MP), or output of the additional worker, increases rapidly initially and then decreases and becomes negative.
MP = slope of tangent to a point on TP 20

19. MP and TP B' A' A B MP=0 112 Total Product Maximum MP 60
Output
per
Month ● B' B
MP=0
112
Total Product ●
Maximum MP A A' 60
Marginal Product
Labor per Month 1 2 3 4 5 6 7 8 9 23

20. The Law of Diminishing Marginal Product
The Law of Diminishing Marginal Product states that the marginal product (MP) of an input declines as the quantity of the input increases.
When the input is small, MP increases due to specialization.
When the input is large, MP decreases due to inefficiencies. 31

21. MP and AP E E: MP = AP and AP is at its maximum
Output
per
Month
E: MP = AP and AP is at its maximum
Left of E: MP > AP and AP is increasing
Right of E: MP < AP and AP is decreasing 30 E
Marginal Product 20
Average Product 10 1 2 3 4 5 6 7 8 9 10
Labor per Month 27

22. TP, AP, and MP C' B' A' A B C Total Product 112
Output
per
Month
Total Product ● C C'
112 ● B B'
When MP = 0, TP is at maximum
When MP > AP, AP is increasing
When MP < AP, AP is decreasing
When MP = AP, AP is at maximum ● A' A 60
Marginal Product
Average Product
Labor per Month 1 2 3 4 5 6 7 9 23

23. The Effect of Technological Improvement
Output
per
time
period C O3 O2 B
Labor productivity
can increase if there
are improvements in
technology, even though
any given production
process exhibits
diminishing returns to
labor.
100 A O1 50
Labor per
time period 1 2 3 4 5 6 7 8 9 10 37

24. Higher productivity ð Higher standard of living
Productivity is the amount of goods and services produced from each hour of a worker’s time.
Higher productivity ð Higher standard of living 22

25. Malthus and the Food Crisis
Malthus predicted mass hunger and starvation as diminishing returns limited agricultural output and the population continued to grow.
Why did Malthus’ prediction fail? 38

26. Index of World Food Consumption Per Capita
Year Index 39

27. Malthus and the Food Crisis
The data show that production increases have exceeded population growth.
Malthus did not take into consideration the potential impact of technology which has allowed the supply of food to grow faster than demand.
Technology has created surpluses and driven the price down. 40

28. Labor Productivity 42

29. Isoquants There is a relationship between production and productivity.
Long-run production K& L are variable.
Isoquants analyze and compare the different combinations of K & L and output. 53

30. Isoquants
Isoquants are curves that show all possible combinations of inputs that yield the same output 8

31. Isoquants Labor Input Capital 1 2 3 4 5 Input 1 20 40 55 65 75 9

32. The isoquants are derived
The Isoquant Map
Capital
per year E 5
The isoquants are derived
from the production
function for output of
of 55, 75, and 90. 4 3 A B C 2
Q3 = 90 D
Q2 = 75 1
Q1 = 55 1 2 3 4 5
Labor per year 14

33. Isoquants
The isoquants emphasize how different input combinations can be used to produce the same output.
This information allows the producer to respond efficiently to changes in the markets for inputs. 15

34. Substituting among Inputs
Managers want to determine what combination if inputs to use.
They must deal with the trade-off between inputs.
The slope of each isoquant gives the trade-off between two inputs while keeping output constant. 57

35. Marginal Rate of Technical Substitution
MRTS is the rate at which one input is substituted for another along an isoquant. 59

36. Marginal Rate of Technical Substitution
Q1 =55
Q2 =75
Q3 =90
Capital
per year 5 1 2
2/3
1/3
Isoquants are downward
sloping and convex like indifference curves. 4 3 2 1 1 2 3 4 5
Labor per month 60

37. Diminishing MRTS
Increasing labor in one unit increments from 1 to 5 results in a decreasing MRTS from 1 to 1/2.
Diminishing MRTS occurs because of diminishing returns and implies isoquants are convex. 61

38. MRTS and Marginal Productivity
The change in output from a change in labor equals:
The change in output from a change in capital equals: 62

39. MRTS and Marginal Productivity
If output is constant and labor is increased, then: 62

40. Isoquants When Inputs are Perfectly Substitutable
Capital
per
month Q1 Q2 Q3 A B C
Labor per month 64

41. Perfect Substitutes
When inputs are perfectly substitutable, the MRTS is constant at all points on the isoquant.
For a given output, any combination of inputs an be chosen (A, B, or C) to generate the same level of output. 65

42. Fixed-Proportions Production FunctionL1 K1 Q1 Q2 Q3 A B C
Capital
per
month
Labor
per month 66

43. Fixed Proportions Production
When inputs must be in a fixed-proportion, each output requires a specific amount of each input (e.g. labor and jackhammers).
To increase output requires more labor and capital proportionately. 67

44. Isocost Line
The isocost line is one that shows all combinations of inputs that can be purchased for the same cost. 43

45. Isocost Line
Assume inputs are labor (L) and capital (K) and wage and capital price are w and r respectively, then: 44

46. Isocost Line r = $2 w = $1 C = $80 Isocost Line: K= 40 – 0.5L A
Capital
(units)
r = $ w = $ C = $80 A B D E G
(C/r) = 40
Isocost Line: K= 40 – 0.5L 30 20 10
Labor (units) 20 40 60
80 = (C/w) 42 54

47. Isocosts and Isoquants
Capital
per
year C0 C1 C2
For output Q1, point A is of least cost Q1 A K1 L1 K3 L3 K2 L2
Labor per year 52

48. Isocosts and Isoquants
Capital
per
year
If the price of labor increases, the isocost curve becomes steeper due to the change in the slope: -(w/r). C2 K2 L2 B
To maintain Q1, the minimum cost point shifts from A to B, which requires more cost than C1. A K1 Q1 C1 L1
Labor per year 55

49. Minimum Cost Combination56

50. Minimum Cost Rule
The minimum cost rule states that the cost of producing a specific level of output is minimized when the ratio of the marginal product of each input to the price of that input is the same for all inputs. 56

51. Expansion Path
A firm’s expansion path shows the minimum cost combinations of labor and capital at each level of output. 65

52. Expansion Path Expansion Path Capital per year Labor per year 150 C B
$3000 Isocost Line
300 Unit Isoquant C
Expansion Path
$2000
Isocost Line
200 Unit
Isoquant B
100 75 50 A 25
Labor per year 50
100
150
200
300 72

53. Returns to Scale
The returns to scale is the rate which output increases when all inputs are increased proportionately.
If all the inputs double:
the output is exactly doubled, that process is said to exhibit constant returns to scale.
the output grows by less than 100 percent, the press shows decreasing returns to scale.
the output more than doubles, the process demonstrates increasing returns to scale. 76

54. Constant Returns to Scale10 20 30
Capital
(machine
hours) 15 5 10 2 4 6
Labor (hours) 75

55. Decreasing Returns to Scale10 20 30
Capital
(machine
hours) 18 3 9
Labor (hours) 75

56. Increasing Returns to Scale
Capital
(machine
hours) 9 5 7 2
2.8
3.6 10 20 30
Labor (hours) 75

57. Business Organizations
Proprietorship
Partnership
Corporation 67

58. Managing Lock-In

59. Basic Strategy for Sellers
Design products and promotions to attract customers
Lengthen and strengthen cycle
Sell complementary products to these consumers
Tension: claim openness, but don’t deliver
Example: simple open interface (RTF) powerful closed interface (DOC)

60. Look Ahead in Lock-In Cycle
Calculate present value over whole cycle
Look at type of customer
Special case: Perfect Competition
Similar products, many competitors
Competition forces you to invest in discounts to get consumers locked in
Just earn normal rate of return on those investments;quasiprofits

61. Extra-normal Returns Different product Lower cost Examples:
First-mover advantage (unique product)
Information advantage

62. Influential Buyers Buyers with high switch costs
Buyer side: convince the seller you are influential
May already be locked in
Buyer has incentive to exaggerate
Watch out for churn (phone calls, ISPs)
Buyers with growing needs are very attractive

63. Multiplayer strategies
Decision maker and payer
Frequent flyer miles
Infant formulas at hospitals
Automobile tires
Buyers of complements
Different customers buy razors and blades
Subsidize the far-sighted group, tax the short-sighted group
BBS operators
Netscape suite

64. Strategic Variables in Lock-in Cycle
Magnitude of switch costs
Loyalty programs
Cumulative volume discounts
Rely on infotech
Loyalty programs will become more widespread
Convert conventional markets to lock-in markets

65. Loyalty Programs Requirements contracts Frequent buyer program
Tension with promotions -- offer better deal to non-customers
Burden of locked-in customers: offer too high a price to attract new customers
Price discrimination, stripped down product
Consumer switch costs
Will go down due to Internet

66. Assignment
Review Chapter 6
Answer questions on P114
Preview Chapter 7

67. Thanks