Chapter 6

Production Theory and Estimation

Managerial Economics
Instructor: Maharouf Oyolola
 Introduction
• Managers are required to make decisions about
the employment of the various types of
resources within the firm.
• Production decisions include the determination
of the type and amount of resources or inputs-
such as land, labor, raw and processed
materials, factories, machinery, equipment, and
managerial talent- to be used in the production
of a desired quantity of output.
 Introduction
• The objective of the private sector
manager is to combine the resources of
the firm in the most efficient manner to
contribute to the goal of maximizing
shareholder wealth.
• This chapter discusses the use of the
theory of production in making wealth-
maximizing production decisions
 Production
• It refers to the transformation of inputs or
resources into outputs of goods and
services.
 Example 1
• IBM hires workers to use machinery,
parts, and raw materials in factories to
produce personal computers.

• The final output in this example is the IBM

computer.
 Inputs
• These are resources used in the
production of goods and services.

• There are four types of inputs

- Labor
- Capital
- Land
- Entrepreneurship
 Production
• The creation of any good or service that
has value to either consumers or other
producers.
• This definition includes production of
transportation services, legal advice,
education (teaching students), and
invention
 The Production Function
• A mathematical model, schedule, or graph that
relates the maximum quantity of output that can
be produced from given amounts of various
inputs.
• Letting X and Y represent the quantities of inputs
used in producing a quantity Q of output, a
production function can be represented in the
form of a mathematical model as:
• Q= f( X, Y)
 Input
• A resource or factor of production, such as
a raw material, labor skill, or piece of
equipment, that is employed in a
production process
 Example
• The production of a house requires the
use of many different labor skills
(carpenters, plumbers, and electricians),
raw materials (bricks, lumber), and types
of equipment (bulldozers, saws, and
cement mixers)
 The Cobb-Douglas production
function
• One commonly used function is the Cobb-
Douglas production function:
β1 β2
Q = αL K
Where L is the amount of labor and K is the amount of capital used in
the production process (α,, β1 and β2 are constants )
 Short-Run
• The period of time in which one (or more)
of the resources employed in a production
process is fixed or incapable of being
varied.
• For example, for a production plant of
fixed size and capacity, the firm can
increase output only by employing more
labor, such as by paying workers overtime
or by scheduling additional shifts.
 Long-run
• The period of time in which all the
resources employed in a production
process can be varied.
 The production function with one
variable input
• In this section, we present the theory of
production when only one input is variable.
Thus, we are in the short-run.
• We assume, for instance, that capital input
does not vary in the short-run. Only labor
changes
 Total, Average and Marginal
Product
• Total Product (TP) of the variable input

• ∆ TP
MPL =
∆ L
TP
APL =
L
Production or output elasticity

%∆ Q
EL =
%∆ L
∆Q
Q ∆ Q L MPL
EL = = • =
∆L ∆ L Q APL
L
 Production or output elasticity
• EL measures the percentage change in
output divided by the percentage change
in the quantity of labor used.
 Total, Marginal, and Average Product
of Labor, and Output Elasticity
Labor Output or total Marginal Average Output
(number of product product of Product of Elasticity of
Workers) Labor Labor Labor

0 0 - - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1
 Total product

16
14
Total output (TP)

12
10
8 TP
6
4
2
0
0 2 4 6 8
Labor (L)
 Marginal Product and Average product

6
5
4
MPL and APL

3
2 MPL
1 APL
0
-1 0 2 4 6 8
-2
-3
Labor
 Interpretation of the graphs
• Law of Diminishing Marginal Returns:
Given that the amount of all other
productive factors remains unchanged,
the use of increasing amount of a variable
factor in the production process beyond
some point will eventually result in
diminishing marginal increases in total
output.
 Interpretation of the graphs
• In analyzing the production function, economists have
identified three different stages of production.
• Stage I: the range of X over which average product is
increasing.
• Stage II: corresponds to the range of X from the point at
which the average product is a maximum to the point
where the marginal product declines to zero. The
endpoint of stage II thus corresponds to the point of
maximum output on the TP curve.
• Stage III: encompasses the range of X over which the
total output is declining, or equivalently, the marginal
product negative.
Optimal use of the variable input
• How much labor (the variable in our
previous section) should the firm use in
order to maximize profits?
• The answer is that the firm should employ
an additional unit of labor as long as the
extra revenue generated from the sale of
the output exceeds the extra cost of hiring
the unit of labor (i.e., until the extra
revenue equals the extra cost).
 Example
• If an additional unit of labor generates $30
in extra revenue and costs an extra $20 to
hire, it pays for the firm to hire this unit of
labor. Therefore, its total profit will
increase by $10.
• However, it does not pay for the firm to
hire an additional unit of labor if the extra
revenue it generates falls short of the
extra cost incurred.
Marginal Revenue Product of Labor
• This equals the marginal product of labor (MPL) times
the marginal revenue (MR) from the sale of the extra
output produced.
• This is the extra revenue generated by the use of an
additional unit of labor

MRPL = ( MPL )( MR )
 Marginal Resource cost of Labor
• The extra cost of hiring an additional unit
of labor (MRCL) is equal to the increase in
the total cost to the firm resulting from
hiring the additional unit of labor. That is,

∆TC
MRC L =
∆L
• A firm should continue to hire labor as
long as MRPL>MRCL and until
MRPL=MRCL.
 Marginal Revenue product and Marginal
Factor cost- Deep Creek Mining Company
Labor TP Marginal Total Marginal Marginal Marginal
(Number of revenue of revenue revenue revenue factor cost
workers)
labor (tons TP=P.Q ($) ($/ton) product ($/worker)
per worker) MRPx=MPx*
MRQ

0 0 - 0 - - -
1 6 6 60 10 60 50
2 16 10 160 10 100 50
3 29 13 290 10 130 50
4 44 15 440 10 150 50
5 55 11 550 10 110 50
6 60 5 600 10 50 50
7 62 2 620 10 20 50
8 62 0 620 10 0 50
 Comments
• As it can be seen in the table above, the
optimal input is X*=6 workers because
MRP=MFC=$50 at this point
 The Production Function with two
variable inputs
• We now examine the production function when
there are two variable inputs.

• An Isoquant shows the various combinations of

inputs (labor and capital) that the firm can use to
produce a specific level of output.
• A higher isoquant refers to a larger output, while
a lower isoquant refers to a smaller output.
 Marginal Rate of Technical
Substitution
• The rate at which one input may be
substituted for another input in producing
a given quantity of output.
 Optimal use of labor

160
140
120
MRP and MFC

100
MRP
80
MFC
60
40
20
0
0 2 4 6 8 10
Labor
 Optimal combination of inputs
• Suppose that a firm uses only labor and capital in
production. The total costs or expenditures of the firm
can then be represented by
• C=wL + rK where
• C=total costs
• W=wage rate of labor
• L=quantity of labor
• R=rental price capital
• K=quantity of capital used
 Optimization problem
• One can solve for the combination of
inputs that either
• (1) minimizes total cost subject to a given
constraint on output
• (2) maximizes output subject to a given
total cost constraint
 Returns to scale
• Returns to scale refers to the degree by
which output changes as a result of a
given change in the quantity of all inputs
used in the production.
• There are 3 types of returns to scale:
constant, increasing, and decreasing.
 Example
• If the quantity of all inputs used in the
production is increased by a given
proportion, We have Constant returns to
scale if output increases in the same
proportion; increasing returns to scale if
output increases by a greater proportion;
and decreasing returns to scale if output
increases by a smaller proportion.
• (see figure 6-14 page 252)
 Constant Returns to Scale
capital

6 B

200Q

3 A

100Q

labor
3 6
 Increasing returns to scale

capital

6 C

300Q

3 A

100Q

Labor
3 6
 Decreasing Returns to Scale

capital

6
D

150Q

3 A

100Q

labor
3 6