1. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Production Functions Let q represent output, K represent capital use, L represent labor, and M represent raw materials, the following equation represents a production function.

2. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Marginal Physical Productivity Marginal physical productivity is the additional output produced by adding one more unit of an input while holding all other inputs constant. The marginal product of labor (MP L ) is the extra output obtained by employing one more unit of labor holding capital constant.

3. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Marginal Physical Productivity The marginal product of capital (MP K ) is the extra output obtained by using one more machine while holding the number of workers constant.

4. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Diminishing Marginal Physical Product Marginal physical product of an input will depend upon the level of the input used. It is expected that marginal physical product will eventually diminish as shown in Figure 5.1.

5. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Output per week Labor input per week Total Outpu t L* (a) Total Output MP L L* (b) Marginal Productivity FIGURE 5.1: Relationship between Output and Labor Input Holding Other Inputs Constant Labor input per week

6. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Diminishing Marginal Physical Product The top panel of Figure 5.1 shows the relationship between output per week and labor input during the week as capital is held fixed. Initially, output increases rapidly as new workers are added, but eventually it diminishes as the fixed capital becomes overutilized.

7. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Marginal Physical Productivity Curve The marginal physical product curve is simply the slope of the total product curve. The declining slope, as shown in panel b, shows diminishing marginal productivity.

8. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Average Physical Productivity Average physical product is simply “output per worker” calculated by dividing total output by the number of workers used to produce the output. This corresponds to what many people mean when they discuss productivity, but economists emphasize the change in output reflected in marginal physical product.

9. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Appraising the Marginal Physical Productivity Concept Marginal physical productivity requires the ceteris paribus assumption that other things, such as the level of other inputs and the firm’s technical knowledge, are held constant. An alternative way, that is more realistic, is to study the entire production function for a good.

10. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Isoquant Maps An isoquant is a curve that shows the various combinations of inputs that will produce the same amount of output. The curve labeled q = 10 is an isoquant that shows combinations of labor and capital, such as points A and B, that produce exactly 10 units of output per period

11. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Capital per week KAKA A Bq = 10 KBKB Labor per week LBLB LALA 0 FIGURE 5.2: Isoquant Map q = 20 q = 30

12. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Rate of Technical Substitution Theslope of an isoquant is called the marginal rate of technical substitution (RTS), the amount by which one input can be reduced when one unit of another input is added. It is the rate that capital can be reduced, holding output constant, while using one more unit of labor.

13. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Rate of Technical Substitution

14. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Diminishing RTS Along any isoquant the (negative) slope become flatter and the RTS diminishes. When a relatively large amount of capital is used (as at A in Figure 5.2) a large amount can be replaced by a unit of labor, but when only a small amount of capital is used (as at point B), one more unit of labor replaces very little capital.

15. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Returns to Scale Returns to scale is the rate at which output increases in response to proportional increases in all inputs. In the eighteenth century Adam Smith became aware of this concept when he studied the production of pins.

16. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Returns to Scale Adam Smith identified two forces that come into play when all inputs are increased. –A doubling of inputs permits a greater “division of labor” allowing persons to specialize in the production of specific pin parts. –This specialization may increase efficiency enough to more than double output. However these benefits might be reversed if firms become too large to manage.

17. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Constant Returns to Scale A production function is said to exhibit constant returns to scale if a doubling of all inputs results in a precise doubling of output. –This situation is shown in Panel (a) of Figure 5.3.

18. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Decreasing Returns to Scale If doubling all inputs yields less than a doubling of output, the production function is said to exhibit decreasing returns to scale. –This is shown in Panel (b) of Figure 5.3.

19. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Increasing Returns to Scale If doubling all inputs results in more than a doubling of output, the production function exhibits increasing returns to scale. –This is demonstrated in Panel (c) of Figure 5.3. In the real world, more complicated possibilities may exist such as a production function that changes from increasing to constant to decreasing returns to scale.

20. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Capital per week 4 A q = 10 3 2 1 Labor per week 123 (a) Constant Returns to Scale 40 Capital per week 4 A 3 2 1 Labor per week 123 (c) Increasing Returns to Scale 40 Capital per week 4 A 3 2 1 Labor per week 123 (b) Decreasing Returns to Scale 40 FIGURE 5.3: Isoquant Maps showing Constant, Decreasing, and Increasing Returns to Scale q = 10 q = 20 q = 30 q = 40

21. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 5.3: Returns to Scale in Beer Brewing Economies to scale were achieved through automated control systems in filling beer cans. National markets foster economies of scale in distribution and advertising (especially television). These factors became especially important after World War II and the number of U.S. brewing firms fell by over 90 percent between 1945 and the mid-1980s.

22. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 5.3: Returns to Scale in Beer Brewing The industry consolidated with a few firms operating large breweries in multiple locations to reduce shipping costs. Beginning the 1980s, smaller firms offering premium brands, provided an opening for local microbreweries. A similar event occurred in Britain in the 1980s with the “real ale” movements, but it was followed by small firms being absorbed by national brands. A similar absorption may be starting to take place in the United States.

23. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Input Substitution Another important characteristic of a production function is how easily inputs can be substituted for each other. This characteristic depends upon the slope of a given isoquant, rather than the whole isoquant map.

24. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Fixed-proportions Production Function It may be the case that absolutely no substitution between inputs is possible. This case is shown in Figure 5.4. If K 1 units of capital are used, exactly L 1 units of labor are required to produce q 1 units of output.

25. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Capital per week K2K2 A q2q2 q1q1 q0q0 K1K1 K0K0 Labor per week L0L0 L1L1 L2L2 0 FIGURE 5.4: Isoquant Map with Fixed Proportions

26. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Fixed-proportions Production Function This type of production function is called a fixed-proportion production function because the inputs must be used in a fixed ratio to one another. Many machines require a fixed complement of workers so this type of production function may be relevant in the real world.

27. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. The Relevance of Input Substitutability Over the past century the U.S. economy has shifted away from agricultural production and towards manufacturing and service industries. Economists are interested in the degree to which certain factors of production (notable labor) can be moved from agriculture into the growing industries.

28. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Changes in Technology Technical progress is a shift in the production function that allows a given output level to be produced using fewer inputs. In studying productivity data, especially data on output per worker, it is important to make the distinction between technical improvements and capital substitution.

29. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 5.4: Multifactor Productivity Table 1 shows the rates of change in productivity for three countries measured as output per hour. While the data show declines during the 1974 to 1991 period, they still averaged over 2 percent per year. However, this measure may simply reflect simple capital-labor substitution.

30. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 5.4: Multifactor Productivity A measure that attempts to control for such substitution is called mutifactor productivity. As table 2 shows, the 1974 - 91 period looks much worse using the multifactor productivity measure.

31. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 5.4: Multifactor Productivity Reasons for the decline in post 1973 productivity include rising energy prices, high rates of inflation, increasing environmental regulations, deteriorating education systems, or a general decline in the work ethic. Clearly after 1991, productivity has improved greatly.

32. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 1: Annual Average Change in Output per Hour in Manufacturing

33. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 2: Annual Average Change in Multifactor Productivity Manufacturing

34. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. A Numerical Example Assume a production function for the fast- food chain Hamburger Heaven (HH): - where K represents the number of grills used and L represents the number of workers employed during an hour of production.

35. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 5.1: Hamburger Production Exhibits Constant Returns to Scale

36. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Average and Marginal Productivities Holding capital constant (K = 4), to show labor productivity, we have Table 5.2 shows this relationship and demonstrates that output per worker declines as more labor is employed.

37. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 5.2: Total Output, Average Productivity, and Marginal Productivity with Four Grills

38. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. The Isoquant Map Suppose HH wants to produce 40 hamburgers per hour. Then its production function becomes

39. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 5.3: Construction of the q = 40 Isoquant

40. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Technical Progress Technical advancement can be reflected in the equation Comparing this to the old technology by recalculating the q = 40 isoquant

41. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Grills (K) 4 10 Workers (L) q = 40 before invention 4101 FIGURE 5.6: Technical Progress in Hamburger Production q = 40