Chapter 6. Production. Introduction. Production Decisions of a Firm. Production Decisions of a Firm

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1 Chapter 6 Production Introduction Our study of consumer behavior was broken down into 3 steps Describing consumer preferences Consumers face budget constraints Consumers choose to maximize utility Production decisions of a firm are similar to consumer decisions Can also be broken down into three steps 005 Pearson Education, Inc. Chapter 6 Production Decisions of a Firm. Describe how inputs can be transformed into outputs Inputs: land, labor, capital & raw materials Outputs: cars, desks, books, etc. Firms can produce different amounts of outputs using different combinations of inputs Production Decisions of a Firm. Firms must consider prices of labor, capital and other inputs s consumers must consider budget constraints, firms must be concerned about costs of production 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6

2 Production Decisions of a Firm 3. Given input prices and production technology, the firm must choose how much of each input to use in producing output Given prices of different inputs, the firm may choose different combinations of inputs to minimize costs Q: Decision Making of Owner- Manager Suppose you are running a small business. 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 6 Chapter 8 6 The Technology of Production Indicates the highest output (q) that a firm can produce for every specified combination of inputs. For simplicity, we will consider only labor (L) and capital (K) The Technology of Production The production function for two inputs: Output (q) is a function of capital (K) and (L) If technology increases, more output can be produced for a given level of inputs Q: Why is raw material not included? 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 8

3 The Technology of Production It takes time for a firm to adjust production from one set of inputs to another Firms must consider not only what inputs can be varied but over what period of time that can occur We must distinguish between long run and short run The Technology of Production Period of time in which quantities of one or more production factors cannot be changed. These inputs are called fixed inputs. mount of time needed to make all production inputs variable. Short-run and long-run are not time specific 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 0 We assume capital is fixed and labor is variable Output can only be increased by increasing labor How does output change as the amount of labor is changed? 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6

4 Observations:. When labor is zero, output is zero as well. With additional workers, output (q) increases up to 8 units of labor. 3. Beyond this point, output declines Increasing labor can make better use of existing capital initially fter a point, more labor is not useful and can be counterproductive verage product of - Output per unit of labor Measures the productivity of a firm s labor in terms of how much, on average, each worker can produce 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 Marginal Product of additional output produced when labor increases by one unit Change in output divided by the change in labor 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 6

5 Output per Month 60 B C Total Product t point D, output is maximized. per Month 005 Pearson Education, Inc. Chapter 6 7 D Output per Worker 0 0 E Left of E: MP > P & P is increasing Right of E: MP < P & P is decreasing t E: MP = P & P is at its maximum t 8 units, MP is zero and output is at max Marginal Product verage Product per Month 005 Pearson Education, Inc. Chapter 6 8 Marginal & verage Product When marginal product is greater than the average product, the average product is increasing When marginal product is less than the average product, the average product is decreasing When marginal product is zero, total product (output) is at its maximum Marginal product crosses average product at its maximum q 60 Product Curves C B q/l 0 0 P is slope of line from origin to point on TP curve Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 0

6 Product Curves Law of Diminishing (Marginal) Returns q 60 D q 5 0 MP is slope of line tangent to corresponding point on TP curve When the labor input is small and capital is fixed, output increases considerably since workers can begin to specialize and MP of labor increases When the labor input is large, some workers become less efficient and MP of labor decreases Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 In the long run, capital and labor are both variable. We can look at the output that can be achieved with different combinations of capital and labor. 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6

7 Isoquant Map The information can be represented graphically using Curves showing all possible combinations of inputs that yield the same output Curves are smooth to allow for use of fractional inputs Curve shows all possible combinations of labor and capital that will produce 55 units of output per year 5 3 E B C 3 5 D Ex: 55 units of output can be produced with 3K & L (pt. ) OR K & 3L (pt. D) q = 55 q = 75 q 3 = 90 per year 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 6 Holding capital at 3 and increasing labor from 0 to to to 3. Output increases at a decreasing rate (0, 55, 0, 5) illustrating diminishing marginal returns from labor in the short-run and longrun. Holding labor constant at 3 increasing capital from 0 to to to 3. Output increases at a decreasing rate (0, 55, 0, 5) due to diminishing returns from capital in short-run and long-run. 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 8

8 Diminishing Returns per year 5 3 B C 3 5 D E Increasing labor holding capital constant (, B, C) OR Increasing capital holding labor constant (E, D, C q = 55 q = 75 q 3 = 90 per year Substituting mong Inputs Slope of the isoquant shows how one input can be substituted for the other and keep the level of output the same. Positive slope is the 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 Marginal Rate of Technical Substitution The Marginal Rate of Technical Substitution equals: per year 5 Slope measures MRTS MRTS decreases as move down the indifference curve 3 /3 Q 3 =90 /3 Q =75 Q = per month 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 3

9 MRTS and Marginal Products If we increase labor and decrease capital to keep output constant, we can see how much the increase in output is due to the increased labor mount of labor increased times the marginal productivity of labor ( MP L )( L) MRTS and Marginal Products Similarly, the decrease in output from the decrease in capital can be calculated Decrease in output from reduction of capital times the marginal produce of capital ( MP K )( K) 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 3 MRTS and Marginal Products If we are holding output constant, the net effect of increasing labor and decreasing capital must be zero Using changes in output from capital and labor we can see MRTS and Marginal Products Rearranging equation, we can see the relationship between MRTS and MPs (MP L)( L) (MPK)( K) 0 (MP )( L) -(MPK)( K) L (MPL ) L MRTS ( MP ) K K 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 36

10 Isoquants: Special Cases. MRTS is constant at all points on isoquant Same output can be produced with a lot of capital or a lot of labor or a balanced mix Perfect Substitutes per month B Same output can be reached with mostly capital or mostly labor ( or C) or with equal amount of both (B) C Q Q Q 3 per month 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 38 Isoquants: Special Cases Fixed-Proportions Production Function. Fixed proportions production function There is no substitution available between inputs The output can be made with only a specific proportion of capital and labor Cannot increase output unless increase both capital and labor in that specific proportion per month K Q B C Q Same output can only be produced with one set of inputs. Q 3 per month 005 Pearson Education, Inc. Chapter 6 39 L 005 Pearson Education, Inc. Chapter 6 0

11 Returns to Scale Increasing Returns to Scale Rate at which output increases as inputs are increased proportionately returns to scale returns to scale returns to scale (machine hours) The isoquants move closer together (hours) 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6 Returns to Scale Returns to Scale (machine hours) 6 (machine hours) 0 0 Constant Returns: Isoquants are equally spaced 0 Decreasing Returns: Isoquants get further apart (hours) 5 0 (hours) 005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 6