Production Theory 1

Short-Run v. Long-Run
◆ Fixed input/factor of production: quantity
of input is fixed regardless of required
output level, e.g. capital or specialized
labour
◆ Variable input/factor of production:
quantity of input used depends on the
level of output
◆ Short run: at least one input/factor is fixed
◆ Long run: all inputs/factors are variable
 Production Function
◆ A technology is a process by which
inputs (e.g. labour and capital) are
converted into output.
◆ The output level is denoted by y.
◆ The technology’s production function
states the maximum amount of output
possible from an input bundle.
y = f ( x1 ,  , xn )
 Production Function
One input
Output Level y = f(x) is the
production
y’ function
y’ = f(x’) is the maximum
output level obtainable
from x’ input units.

x’ x
Input Level
 Technology Set
◆ The collection of all feasible
production plans is the technology set.
 Technology Set
One input
Output Level y = f(x) is the
production
y’ function.

y” y” = f(x’) is an output level

that is feasible from x’
input units.
x’ x
Input Level
 Technology Set
One input
Output Level

y’

The technology
set
y”

x’ x
Input Level
 Technology Set
One input
Output Level

Technically
y’ efficient plans
The technology
y” Technically set
inefficient
plans
x’ x
Input Level
 Technology: Multiple Inputs
◆ What does a technology look like
when there is more than one input?
◆ The two input case: Input levels are
x1 and x2. Output level is y.
◆ Example of production function is

y = f ( x1 , x2 ) = 2 x x
1/ 3 1/ 3
1 2
 PREVIEW: ISOQUANT
◆ An isoquant is the set of all combinations
of inputs 1 and 2 that are just sufficient to
produce a given amount of output.
◆ The slope of the isoquant = the marginal
rate of technical substitution (MRTS) = the
technical rate of substitution (TRS)
◆ MRTS (TRS): The number of units of K that
we can dispose of if one more unit of L
becomes available while remaining on the
original isoquant.
 Technologies with Multiple
Inputs
◆ The complete collection of isoquants
is the isoquant map.
◆ The isoquant map is equivalent to
the production function.
◆ Example
1/ 3 1/ 3
y = f ( x1 , x2 ) = 2 x1 x2
 Isoquants with Two Inputs

Y=40
Y=20

L
 Isoquants with Two Inputs
◆ Properties

δY/δK>0, δY/δL>0

δ 2Y/δK2<0, δ 2Y/δL2<0
Diminishing marginal product
(Diminishing marginal utility)
 Cobb-Douglas Technology
x2
All isoquants are hyperbolic,
asymptoting to, but never
touching any axis.

a1 a 2
y = x1 x 2

x1
 Marginal (Physical) Product
y = f ( x 1 ,  , xn )
◆ The marginal product of input i is the
rate-of-change of the output level as
the level of input i changes, holding
all other input levels fixed.

∂y
MP i =
∂ xi
 Marginal (Physical) Product
1/ 3 2 / 3
y = f ( x1 , x 2 ) = x1 x 2
then the marginal product of input 1 is
 Marginal (Physical) Product
1/ 3 2 / 3
y = f ( x1 , x 2 ) = x1 x 2
then the marginal product of input 1 is
∂ y 1 − 2/ 3 2/ 3
MP1 = = x1 x 2
∂ x1 3
 Marginal (Physical) Product
1/ 3 2 / 3
y = f ( x1 , x 2 ) = x1 x 2
then the marginal product of input 1 is
∂ y 1 − 2/ 3 2/ 3
MP1 = = x1 x 2
∂ x1 3
and the marginal product of input 2 is
 Marginal (Physical) Product
1/ 3 2 / 3
y = f ( x1 , x 2 ) = x1 x 2
then the marginal product of input 1 is
∂ y 1 − 2/ 3 2/ 3
MP1 = = x1 x 2
∂ x1 3
and the marginal product of input 2 is
∂ y 2 1/ 3 −1/ 3
MP2 = = x1 x 2 .
∂ x2 3
 Marginal (Physical) Product
◆ The marginal product of input i is
diminishing if it becomes smaller as
the level of input i increases. That is,
if
∂ MPi ∂ ∂ y ∂ y 2
=   = 2 < 0
∂ xi ∂ xi  ∂ xi  ∂ xi
 Technical Rate-of-Substitution
The slope is the rate at which
x2 input 2 must be given up as
input 1’s level is increased so as
not to change the output level.
The slope of an isoquant is its
x'2 technical rate-of-substitution.

y≡100

x'1 x1
 Technical Rate-of-Substitution
◆ How is a technical rate-of-substitution
computed?
 Technical Rate-of-Substitution
◆ How is a technical rate-of-substitution
computed?
◆ The production function is y = f ( x1 , x 2 ).

◆ A small change (dx1, dx2) in the input

bundle causes a change to the output
level of
∂y ∂y
dy = dx1 + dx 2 .
∂ x1 ∂ x2
 Technical Rate-of-Substitution
∂y ∂y
dy = dx1 + dx 2 .
∂ x1 ∂ x2

Along an individual isoquant, dy = 0,

therefore the changes dx1 and dx2 must
satisfy the following,

∂y ∂y
0= dx1 + dx 2 .
∂ x1 ∂ x2
Technical Rate-of-Substitution
∂y ∂y
0= dx1 + dx 2
∂ x1 ∂ x2
which rearranges to
∂y ∂y
dx 2 = − dx1
∂ x2 ∂ x1
or dx 2 ∂ y / ∂ x1
=− .
dx1 ∂ y / ∂ x2
 Technical Rate-of-Substitution
dx 2 ∂ y / ∂ x1
=−
dx1 ∂ y / ∂ x2

is the rate at which input 2 must be given

up as input 1 increases so as to keep
the output level constant. It is the slope
of the isoquant = MRTS = TRS.