Micro Economics I 3.

1 The Production Function

Econ 111 Instructor: Mr. Chandra Sekhar

3. THEORY OF PRODUCTION
I. The Production Function

i. The Production Function for a single product:

The production function is a purely technical relation which connects factor-inputs
and outputs. It describes the laws of proportion, which is the transformation of factor
inputs into products (outputs) at any particular time period. The production function
represents the technology of a firm of an industry, of the economy as a whole. The
production function includes all the technically efficient methods of production.

The production function in traditional economic theory assumes the form

X  f ( L, K , ,  ) . The factor ν, returns to scale, refer to the long run analysis of the
laws of production. The efficiency parameter γ refers to the entrepreneurial-
organizational aspects of production.

Graphically, the production function is usually presented as a curve on two

dimensional graphs. Changes of the relevant variables are shown either by
movements along the curve that depicts the production function, or by shifts of this
curve. The most commonly used diagrams of a single product are shown in figures 1a
and 1b.

X=f(L) k3, ν3, γ3

X X X=f(K) L3, ν3, γ3

X=f(L) k1, ν1, γ1 X=f(K) L3, ν3, γ3

0 L 0 K
Fig. 1a. Fig. 1b.

Each curve shows the relation between X and L for given K, ν, and γ . As labor
increases, we move along the curve depicting the production function. If capital
increase, the production function X= f(L) moves upwards.

The marginal product of a factor is defined as the change in output resulting from
a very small change of this factor, keeping all other factors constant.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

Mathematically the marginal product of each factor is the partial derivative of

X X
production function with respect to this factor. MPL  and MPK 
L K

Graphically the marginal product of labor is shown by the slope of the production
function. X=f1(L) K, ν, γ and the marginal product of capital is shown by the slope of
the production function X = f2 (K) L, ν, γ.

The theory of production concentrates on levels of employment of the factors over

which their marginal products are positive but decrease: in fig.2 the range of
employment of L examined by the theory of production is AB over that range MPL>0
 ( MP ) L
but  0.
L
Similarly in fig.3 the range of employment of capital examined by the theory of
 ( MP) L
production is CD over that range MPK>0 but  0.
K
X|

0 Fig. 2 A| B| L
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

A method of production is a combination of factor inputs required for the production

of one unit of output. Usually a commodity may be produced by various methods of
production. For example, a unit of commodity x may be produced by the following
process:
Process P1 Process P2 Process P3
Labor units 2 3 1

Capital Units 3 2 4

Activities may be presented graphically by the length of lines from the origin to the
point determined by the labor and capital inputs. The three processes above are
shown in Fig. 3.1. A method of production A is technically efficient relative to any
other method B, if A uses less of at least one factor and no more from the other factors
compared with B.

0 1 2 3 4 L
Fig 1

Method B is technically inefficient as compared with A. The basic theory of

production concentrates only on efficient methods. Inefficient methods will not be
used by rational entrepreneurs.
Process A uses less of some factor(s) and more of some other(s) as compared with any
other process B, then A and B cannot be directly compared on the criterion of
technical efficiency. For example, the activities
A B
Labor units 2 1

Capital Units 3 4 are not directly comparable. Both process

are considered as technically efficient and are included in the production function (the
technology). When one of them will be chosen at any particular time depends on the
prices of factors. The theory of production describes the laws of production. The
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

choice of any particular technique is economic one, based on prices, and not a
technical one. To note that a technically efficient method is not necessarily
economically efficient. There is difference between technical and economic
efficiency.

An isoquant includes all the technically efficient methods (or all the combinations of
factors of production) for producing a given level of output.

The production isoquant may assume various shapes depending on the degree of
substitutability of factors. They are broadly classified as linear isoquant, Input-output
isoquant, Kinked Isoquant and Convex Isoquant.

Linear isoquant. This type assumes perfect substitutability of factors of production: a

given commodity may be produced by using only capital, or only labor, or by an
infinite combination of K and L. See figure. 2

0 L

Fig.2 Linear Isoquant

Input-output isoquant. This assumes strict complimentarity (that is zero substitution)
of the factors of production. There is only one method of production for any one
commodity. The isoquant takes the shape of right angle (fig. 3). This type of isoquant
is also called’Leontief isoquant’ after Leontief, who invented the input output
analysis.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

0 L

Fig.3 Input-Output Isoquant

Kinked isoquant. This assumes limited substitutability of K and L. There are only a
few processes for producing any one commodity. Substitutability of the factors is
possible only at the kinks. This form is also called ‘activity analysis-isoquant’ or
“linear programming isoquant”, because it is basically used in linear programming.
K
K P1
P2 A
P3

X
P4
B

0 L 0 L

Fig 4. Linear Programming Isoquant

Fig. 5 Convex Isoquant

Smooth, convex Isoquant. This form assumes continuous substitutability of K and L

only over a certain range, beyond which factors cannot substitute each other. The
isoquant appears as a smooth curve, convex to the origin. See fig 5.

The production function describes not only a single isoquant, but the whole array of
isoquants, each of which shows a different level of output. It shows how output
varies as the factor inputs change.

Cobb-Douglas Production Function

 Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

The Cobb-Douglas Production function is the most popular in applied research,

because it is easiest to handle mathematically.

The Cobb-Douglas function is of the form

X  b0 .Lb1 .K b2
To indicate magnitude of production function we allow parameters to take arbitrary
values. The parameter b measures, the scale of production: how much out put we
would get if we used one unit of each input. The parameter b 1 and b2 measure how
the amount of output responds to the changes in the input.

1. The Marginal Product of factors

a. The MPL
X b 1
MPL   b1.b0 .L 1 , K b1
L

b b A
= b1 (b0 L 1 K 2 ) L

X
= b1.  b1 ( APL )
L
Where APL = the average product of labor

b. Similarly
X
MPK  b2 .  b2 ( APK )
K

TECHNOLOGY
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

Inputs to production are called factors of production. Factors of production are often
classified into broad categories such as land, labor, capital, and raw materials. Capital
goods are those inputs to production that are themselves produced goods. Capital
goods are machines of one sort or another: tractors, buildings, computers, or whatever.

Sometimes capital is used to describe the money used to start up or maintain a

business. Financial capital is the term that used to describe this concept of capital
goods, or physical capital, for produced factors of production.

Inputs and outputs as being measured in flow units: a certain amount of labor per
week and a certain number of machine hours per week will produce a certain amount
of output a week.

Technology changes as knowledge of new and more efficient methods of production

becomes available. In addition, new inventions may result in the increase of the
efficiency of all methods of production. At the same time some techniques may
become inefficient and drop out from the production function. These changes in
technology constitute technological progress.

Graphically the effect of innovation in processes is shown with an upward shift of the
production function (fig. 1), or down ward movement of production isoquant (fig. 2).
This shift shows that the same output may be produced by less factor inputs, or more
output may be obtained with the same inputs.
X X0
X1=f(L) K

X1
X
X=f(L)

X0

0 L 0 L

Fig. 1 Fig. 2

Technical progress may also change the shape of isoquant. Hicks has distinguished
three types of technical progress, depending on effect on the rate of substitution of the
factors of production.

Capital-deepening technical progress

Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

Technical progress is capital-deepening or capital using, along a line on which K/L

ratio is constant, the MRSL,K increases. This implies that technical progress increases
the marginal product of capital by more than the marginal product of the labor. The
ratio of marginal products (which is the MRS L,K) decreases in absolute value. But
taking into account that the slope of the isoquant is negative, this sort of technical
progress increases the MRSL,K . The slope of the shifting isoquant becomes less steep
along any given radius. The capital-deepening technical progress is shown in fig.3.

Labor-deepening technical progress

Technical progress is labour deepening, if along a radius through the origin with
constant K/L ratio), the MRSL,K increases. This implies that the technical progress
increases the MPL faster than the MPK. Accordingly the MRSL,K, being the ratio of the
marginal products  (X / L) /  (X / K ) , increases in absolute value. The
downwards-shifting isoquant becomes steeper along any given radius through the
origin. This is show in the figure 4.

Neutral – technical progress

Technical progress is neutral if it increases the marginal product of both factors by the
same percentage, so that the MRS L,K (along any radius) remains constant. The
isoquant shifts downwards parallel to itself. This is shown in the fig. 5.

A
A1
A 11

O L

Fig3. Capital-deepening technical progress.

Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

B
B1
B11

O L

Fig. 4 Labour-deepening technical progress

C1

C11

0 L

Fig. 5 Neutral Technical progress

Properties of Technology

Firs, technologies are monotonic. If you increase the amount of at least one of the
inputs, it should be possible to produce at least as much out put as you were
producing originally. This is sometimes referred to as the property of free disposal: if
the firm can dispose costlessly any of inputs, having extra inputs around can not
disturb it.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

Second, the technology is Convex. This means that if you have two ways to produce y
units of output, (x1, x2) and (z1, z2) when their weighted average will produce at least y
units of output.

One argument for convex technologies goes as follows. Suppose that you have a way
to produce 1 unit of output using L 1 units of factor (Labour) 1 and K 2 units of factor
(capital) 2 and that you have another way to produce 1 unit of output using L 2 units of
factor 1 and K2 units of factor2. These two ways are called as production techniques.

Furthermore, let us suppose that you are free to scale the output up to arbitrary
amounts so that (100a1, 100b2) will produce 100 units of output. But now note that if
you have (Technique A) 25L1+75L2, units of factor 1 (Labor) and (Technique B)
25K1+75K2 units of factor 2 (Capital) you can still produce 100 units of output: just
produce 25 units of the output using the “a” technique and 75 units of the output using
“b” technique.

This is depicted in the fig.6 by choosing the level at which you operate each of the
two activities, you can produce a given amount of output in a variety of different
ways. In particular, every input combination along the line connecting (100b1.
100b2) will be a feasible way to produce 100 units of output.

X2

100a2 (25a1+75b1, 25a2+75b2)

100b2

100 a1 100 b2 X1
Fig. 6 Convexity: If you can operate production activities
independently, then weighted averages of production plans will also be
feasible. Thus the isoquants will have a convex shape..

In this kind of technology, where you can scale the production process up and down
easily and where separate production processes do not interface with each other,
convexity is a very natural measure.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

LAWS OF PRODUCTION

Introduction

The laws of production describe the technically possible ways of increasing the level
of production. Output may increase in various ways.
Output can be increased by changing all factors of production. Clearly this is possible
only in the long run. Thus the laws of returns to scale refer to the long run analysis of
production.

In the short run output may be increased by using more of the variable factor(s), while
capital (and possibly other factors as well) are kept constant. The marginal product of
the variable factor(s) will decline eventually as more and more quantities of this factor
are combined with the other constant factors. The expansion of output with one factor
(at least) constant is described by the law of diminishing returns of the variable factor,
which is often referred to as the law of variable proportions.

Product Lines
To analyze the expansion of output we need a third dimension, since along the two
dimensional diagram we can depict only the isoquant along which the level of output
is constant. Instead of introducing a third dimension it is easier to show the change of
output by shifts of the isoquant and use the concept of product lines to describe the
expansion of output.
Product Line shows the (physical) movement from one isoquant to another as we
change both factors or a single factor. A product curve is drawn independent of the
prices of factors of production. It does not imply any actual choice of expansion,
which is based on the prices of factors and is shown by the expansion path.
The product line describes the technically possible alternative paths of expanding
output. What path will actually be chosen by the line will depend on the prices of
factors.
The product curve passes through the origin if all factors are variable. If only one
factor is variable (the other being kept constant) the product line is straight line
parallel to the axis of the variable factor (Fig. 1). The K/L ratio diminishes the
product line.

Product Linews
N

Fig.1 Product line for K given L

Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

Among all possible product lines of particular interest are the so called isoclines. An
isocline is the locus of points of different isoquants at which the marginal rate of
substitution (MRS) of factors is constant. If the production function is homogeneous
the isoclines are straight lines through the origin. Along any of one isocline the K/L
ratio is constant (as the MRS of the factors). Of course the K/L ratio (and the MRS is
different technologies (Fig.2).

LAWS OF RETURNS TO SCALE: Long-run Analysis of Production.

The long run expansion of output may be achieved by varying all factors. In the long
run all factors are variable. The laws of returns to scale refer to the effects of scale
relationships.

In the long run output may be increased by changing all factors by the same
proportion, or by different proportions. Traditional theory production concentrates on
the first case that is the study of output as all inputs change by the same proportion.
The term returns to scale refers to the changes in output as all factors change by the
same proportion.

Suppose we start from an initial level of inputs and output.

X 0  f ( L, K )

and we increase all the factors by the same proportion k, we will clearly obtain a new
level of output X*, higher than the original level X0,

X *  f (kL, kK )

If X* increases by the same proportion k as the inputs, we say that there are constant
returns to scale.
If X* increases less than proportionally with the increase in the factors we have
decreasing returns to scale.
If X* increases more than proportionally with the increase in the factors, we have
increasing returns to scale.

Returns to scale and Homogeneity of the Production Function

Suppose we increase both factors of the function

X0 = f(L,K)

by the same proportion k, and we observe the resulting new level of outputx.

X* = f(kL,kK)
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

If k can be factored out (that is may be taken out of the brackets as a common factor),
then the new level of output X* can be expressed as a function of k and the initial
level of output

X* = kvf(L,K) or X* = kv.X0

and the production function is called homogeneous. If k cannot be factored out, the
production is non-homogeneous. Thus a homogeneous function is a function such that
if each of the inputs is multiplied by k, then k can be completely factored out of the
function. The power v of k is called the degree of homogeneity of the function and is
a measure of the returns to scale.

if v = 1 we have constant returns to scale. This production function some times

called linear homogeneous.

if v < 1 We have decreasing returns to scale.

if v > 1 We have increasing returns to scale.

Graphical Representation of the Returns to scale for a homogeneous Pro. Fun.

The returns to scale may be shown graphically by the distance (on an isocline)
between successive multiple level of output isoquants, that is isoquants that show
levels of output which are multiples of some base level of output, e.g., X, 2X, 3X,..
etc.

Constant Returns to Scale: Along any isocline the distance between successive
multiple isoquants is constant. Doubling the factor inputs achieve double the level of
the initial output; trebling inputs achieves treble output, and so on (fig. 2)

3K

2K

K 3X
2X

0 L 2L 3L L
Fig.2 Constant Returns to Scale: Oa = Ob = Oc

Decreasing Returns to Scale: The distance between consecutive multiple isoquants

increases. By doubling the inputs, output increases by less than twice its original
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

level in fig. 3 the point a defined by 2K and 2L, lies on an isoquant below the one
showing 2x.

2K
3X
K
2X
x

0 L 2L L
Fig.3 Decreasing Returns to Scale: Oa < Ob < Oc

Increasing returns to scale. The distance between consecutive multiple-isoquants

decreases. By doubling the inputs, output is more than doubled. In fig. 4 doubling K
and L leads to point b which lies on an isoquant above the one denoting 2x.

2K

3X
K
2X
x

0 L 2L L
Fig.4 Increasing Returns to Scale: Oa > Ob>< Oc

Returns to scale are usually assumed to be the same everywhere on the production
surface, that is the same along all the expansion product line. All processes are
assumed to show the same returns over all ranges of output: either constant returns
everywhere, decreasing returns everywhere, or increasing returns everywhere.
However, the technological conditions of production may be such that returns to scale
may vary over different ranges of output. Over some range we may have constant
returns to scale may vary over different ranges output.

With a non-homogeneous production function returns to scale may be increasing,

constant, or decreasing, but their measurement and graphical presentation is not as
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

straight forward as in the case of the homogeneous production function. The isoclines
will be curves over the production surface and along each one of them the K/L ratio to
simplify the statistical work. Homogeneity however is a special assumption. In some
cases a very restrictive one. When the technology shows increasing or decreasing
returns to scale it may or may not imply a homogeneous production function.

THE LAW OF VARIABLE PROPORTIONS: Short-run Analysis.

If one of the factors of the production (usually capital K) is kept constant. The
marginal product of the variable factor (Labour L) will diminish after a certain range
of production. The traditional theory of production concentrates on the ranges of
output over which the marginal products of the factors are positive but diminishing.
The ranges of increasing returns (to a factor) and the range of negative productivity
are not equilibrium ranges of output.

If production function is homogeneous with constant or decreasing returns to scale

everywhere on the production surface, the productivity of the variable factor will
necessarily be diminishing. If, however, the production function exhibits increasing
returns to scale, the diminishing returns arising from the decreasing marginal product
of the variable factor (labor) may be offset, if the returns to scale are considerable.
This however, is rare. In general the productivity of single-variable factor is
diminishing.

Let us examine the law of variable proportions or the law of diminishing productivity
(returns) in some detail.

K
A
2x

2K

Product Line

0 L 2L L* L
Fig. 5

If the production function is homogeneous with constant returns to scale everywhere,

the returns to a single-variable factor will be diminishing. This is implied by the
negative slope and the convexity of the isoquants. With constant returns to scale
everywhere on the production surface, doubling both factors (2K, 2L) leads to a
doubling of output. In fig.5 point b on the isocline OA lays on the isoquant 2x.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

However, if we keep K constant (at the level K ) and we double only the amount of
L, we reach point c, which clearly lies on a lower isoquant than 2X. If we wanted to
double output with the initial capital K , we would require L* units of labour. Clearly
L* > 2L. Hence doubling L, with K constant, less than doubles output. The variable
factor L exhibits diminishing productivity (diminishing returns).

If the production function is homogeneous with decreasing returns to scale, the

returns to a single – variable factor will be, a fortiori, diminishing. Since returns to
scale are decreasing, doubling both factors will less than double output. In fig.6 we
see that with 2L and 2K output reaches the level d which is on a lower isoquant than
2x. If we double only labor while keeping capital constant, output reaches the level c,
which lies on a still lower isoquant.

2K
2X
Product Line
X

0 L 2L L
Fig.6

K K

0 L 2L L 0 L 2L L
Fig. 7 Fig. 8
If the production function shows increasing returns to scale, the returns to the single
variable factor L will in general be diminishing (Fig.7), unless the positive returns to
scale are so strong as to offset the diminishing marginal productivity of the single
variable factor. Fig. 8 shows the rare case strong returns to scale which offset the
diminishing productivity of L.

CHOICE OF OPTIMAL COMBINATION OF FACTORS OF PRODUCTION

Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

In this section we shall show the use of the production function in the choice of the
optimal combination of factors by the firm. In part A we will examine two cases in
which the firm is faced with a single decision, namely maximizing output for a given
cost and minimizing cost subject to a given output. Both these decisions comprise
cases of constrained profit maximization in a single period.

In above cases it is assumed that the firm can choose the optimal combination of
factors, that it can employ any amount of any factor in order to maximize its profits.
This assumption is valid if the firm is new, or if the firm is in the long-run. However,
an existing firm may be pressurized, due to pressure of demand, to expand its output
in the short-run, when at least one factor, usually capital, is constant.

Assumptions:

1. The goal of the firm is profit maximization – that is, the maximization of the
difference   R  C where П = profits, R = revenue, and C = cost.

2. The price of output is given, Px.

 
3. The prices of factors are given: w is the given wage rate, r is the given price
of capital services (rental price of machinery).

A. Single Decision of the Firm

The problem facing the firm is that of constrained profit maximization, which may
take one of the following forms:

(a) maximize profit П, subject to a cost constraint. In this case total cost and
 
prices are given (C, w , r , Px), and the problem may be stated as follows.

max   R  C
  Px X  C
Clearly maximization of П is achieved in this case if cost C is minimized,
given that X and Px are given constants by the assumption.
(b) Maximise profit П, for a given level of output. For example, a contractor
wants to build a bridge (X is given) with the maximum profit. In this we have
max   R  C
 
  Px X  C
Clearly maximization of П is achieved in this case is cost C is minimized, given that
X and Px are given constants by assumption.

For a graphical presentation of the equilibrium of the firm (its profit maximizing
position) we will use the isoquant map (fig. 1) and the isocost-line(s) fig.2.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar


K K
C
A r

B L
L
Fig. 1 Fig. 2

The slope of an isoquant is

K MPL X / L
-  MRSL , K  
L MPK X / K
The isocost line is defined by the cost equation
C  (r )( K )  ( w)( L)
Where w = wage rate, and r = price of capital services

The isocost line is the locus of all combinations of factors the firm can purchase
with a given monetary cost outlay.
The slope of the isocost line is equal to the ratio of the price of the factors of
production. Slope of isocost line = w/r

Case 1: Maximisation of output subject to a cost constraint (Financial constraint)

Assume (a) A given production function X = f(L,K,v,γ)

and (b) given factor prices w, r, for labor and capital respectively.

The firm is in equilibrium when it maximizes its output given its total cost outlay and
the prices of the factors, w and r.

In fig.3 the maximum level of output the firm can produce, given the cost constraint,
is X2 defined by the tangency of the isocost line, and the highest isoquant. The
optimal combination factors of production is K2 and L2, for prices w and r. Higher
levels of output (to the right of e) are desirable but not attainable due to the cost
constraint.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

X3
K
X2

K2 e

0 L2 B L
Fig. 3

Other points on ABO , below it lie on a lower isoquant than X2. Hence X2 is the
maximum output possible under the above assumptions (of given cost outlay, given
production function, and given factor prices). At the point of tangency (e) the slope of
the isocost line (w/r) is equal to the slope of the isoquant (MPL/MPK). This constitutes
the first condition for equilibrium. The second condition is that the isoquants be
convex to the origin. In summary: the conditions for equilibrium of the firm are:

(a) slope of isoquant = Slope of isocost

w MPL X / L
   MRS L , K
r MPK X / K

(b) The isoquants must be convex to the origin, if the isoquant is concave the point of
tangency of the isocost curves does not define an equilibrium position Fig.3

e1 e

Isoquant X2

0 e2 L Fig. 4
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

Output X2 (depicted by the concave isoquant) can be produced with lower cost at e2
which lies on a lower isocost curve than e. (with concave isoquant we have a cornel
solution).

Formal derivation of the equilibrium conditions

The equilibrium conditions may be obtained by applying calculus and solving a

constraint maximum problem which may be stated as follows. The rational
entrepreneur seeks the maximization of his output, given his total-cost outlay and the
prices of factors, formally:

Maximize X = f ( L, K )

subject to C = wL + rK (cost constraint)

This is a problem of constrained maximum and the above conditions for the
equilibrium of firm may be obtained from its solution.

we can solve this problem by using Lagrangian multipliers. The solution involves the
following steps:

Rewrite the constraint in the form C  wL  rK  0

Multiply the constraint by a constant λ which is the lagrangian multiplier:

The Lagrangian multipliers are undefined constraints which are used for solving
constraint maxima or minima. Their value is determined simultaneously with the
values of the other unknown (L and K in our example). There will be as many
Langrangian multipliers as there are constraints in the problem.

From the composite function   X   (C  wL  rK )

It can be shown that maximization of the  function implies maximization of the
output.

The first condition for the maximization of a function is that its partial derivatives be
equal to zero. The partial derivatives of the above function with respect to L,K, and λ
are:
 X
   (  w)  0
L L (1)

 X
   ( r )  0 (2)
k K
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar


 C  wL  rK  0 (3)

solving the first two equations for λ we obtain

X X / L MPL
 w or  
L w w

X X / L MPK
 r or  
K r r
The two equations must be equal then
X / L X / K MPL X / L w
 or  
w r MPK X / K r

This firm is in equilibrium when it equates the ratio of the marginal productivities of
factors to the ratio of their prices.

It can be shown that the second-order conditions for equilibrium of the firm require
that the marginal product curves of the two factors have a negative slope.
The slope of the marginal product curve of labor is the second derivative of the
production function:
2 X
Slope of MPL curve =
L2
Similarly for capital
2 X
Slope of MLK curve =
K 2
The second order conditions are
2 X 2 X
 0 and 0
L2 K 2
and
2
 2 X   2 X   2 X 
     
 L  K   LK 
2 2

These conditions are sufficient for establishing the convexity of the isoquants.

Case 2: Minimization of cost for a given level of output

The conditions for equilibrium of the firm are formally the same as in case 1. That is
there must be tangency of the (given) isoquant and the lowest possible isocost curve,
and the isoquant must be convex. However, the problem is conceptually different in
the case of cost minimization. The entrepreneur wants to produce a given output for
example, a bridge, a building, or X tons of a commodity with the minimum cost
outlay.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

In this case we have a single isoquant (fig.5) which denotes the desired level of
output, but we have a set of isocost curves (fig. 6). curves closer to the origin show a
lower total-cost outlay. The isocost lines are parallel because they arre drawn on the
assumption of constant prices of factors: since w and r do not change, all the isocost
curves have the same slope w/r.

K
K
K

_
X K

0 L 0 L 0 L L
Fig. 5 Fig.6 Fig.7

The firm minimizes its costs by employing the combination of K and L determined by
_
the point of tangency of the X isoquant with the lowest isocost line (fig.7). Points
below e are desirable because they show lower cost but are not attainable for output
_
X . Points above e shows higher costs. Hence point e is the least – cost point, the
point denoting the least-cost combination of the factors K and L for producing X.

Clearly the conditions for equilibrium (least cost) are the same as in case 1, that is
equality of the slopes of the isoquant and the isocost curves, and convexity of the
isoquant.

Formally:
Minimise C  f ( X )  wL  rK

subject to X  f ( L, K )

Rewrite the constraint in the form X  f ( L, K )  0

Premultiply the constraint by the Langrangian multiplier λ.

  X  f ( L, K )   0
From the composite function
  C    X  f ( L, K ) 
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

or
   wL  rK     X  f ( L, K )

Take the partial derivatives of  with respect to L, K and λ and equal to zero.

  /( L, K ) X
 w  0  w
L L L

  /( L, K ) X
 r   0  r 
K K K


   X  f ( L, K )   0

from the first two equations we obtain

X
w
L

X
r
K
Dividing through these expressions we find

w X / L
  MRS LK
r X / K

This condition is the same as in case 1 above. The second sufficient conditions,
concerning the convexity of the isoquants, is fulfilled by the assumption of negative
slopes of the marginal product of factors as in case 1, that is
2
2 X 2 X  2 X   2 X   2 X 
 0, 0 and  2     
 L  K   LK 
2
L2 K 2

CHOICE OF OPTIMAL EXPANSION PATH

We distinguish two cases: expansion of output with all factors variable (the long run),
and expansion of output with some factor(s) constant (short run).

Optimal expansion path in the long run

In the long run all factors of production are variable. There is no limitation (technical
or financial) to the expansion of output. The firm’s objective is the choice of the
optimal way of expanding its output, so as to maximize profits. With given factor
prices (w,r) and given production function, the optimal expansion path is determined
by the points of tangency of successive isocost lines and successive isoquants.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

If he production function is homogeneous the expansion path will be straight line

through the origin whose slope (which determines the optimal K/L ratio) depends on
the ratio of the factor prices.

K A
K
w/r, w’/r’
B

0 L 0 L
Fig. 8 Fig. 9

In fig. 8 the optimal expansion will be OA defined by the locus of points of tangency
of the isoquants with successive parallel isocost lines with a slope of w/r. If prices
increases the isocost lines become flatter (for example, with slope of w’/r’), and the
optimal expansion path will be the straight line OB. Of course, if the ratio of prices of
factors was initially w/r and subsequently changes to w’/r’, the expansion path
changes: initially the firm moves along OA, but after the change in the factor prices it
moves along OB.

If the production function is non-homogeneous the optimal expansion path will not be
a straight line, even if the ratio of prices of factors remains constant. This is shown
w/r ratio with MRSL,K, which the same on a curved isocline.

Optimal Expansion path in the short run

In the short run, capital is constant and the firm is coerced to expand along a straight
line parallel to the axis on which we measure the variable factor L. With prices …..
factors constant the firm does not maximize its profits in the short run, due to the
constraint of the given capital. This situation is shown in fi.10. The optimal
expansion path would be OA were it possible to increase K. Given the capital
equipment, the firm can expand only along KK in the short run.
Micro Economics I 3.1 The Production Function
Econ 111 Instructor: Mr. Chandra Sekhar

K
A

_ _
K K
O L
Fig. 10