Introduction to Economics

(Econ. 101)

By Eyasu kumera

April, 2010
2.3. Theory of Production
- Production and production functions
- Production with one or two variable
inputs
- Production in short-run or long-run
- Stages of production
- Iso cost, Iso quant and producers’
equilibrium
2.3.1. Concept of Production and Production
Functions
Economic activity not only involves consumption
but also production and trade
Production is a process of using the services of
labor, capital and other resources (inputs) to make
goods and services available.
A production function defines the relationship
between inputs and the maximum amount of
output that can be produced within a given time
period with a given technology.
Production Function is the technical
relationship between inputs & output
 Business includes-the different forms of organizations, the financing of firms and the role of giant corporations. It shows how
business firms decide what goods should they produce; what combinations of inputs of land, labor and capital should they employ, how
much does it cost them to produce a given bundle of goods; at what prices should their goods and services be sold; and other questions.

The study of a firm begins with an analysis of production. The essence of a firm is to buy inputs, use these inputs to produce
outputs and then to sell the outputs. This is true of competitive firms as well as monopolies, under capitalism as well as communism.

Business firms function in sole proprietorships, in partnerships or in giant corporations (modern corporations) i.e., they might be
owned by a single person, a small group of persons or by large number of persons and organizations. Their size may be small, medium or
large. The majority of small-scale firms are owned by single persons - the sole proprietor. The bigger ones tend to be corporations.
There are some common questions to be forwarded before the theory of firm or production theory is discussed: Why do we need
large organizations to produce our daily bread rather than producing everything ourselves? Why does business activity generally take
place in firms? Why do people need to gather into small or large organizations to produce goods?

Firms exist for many reasons, but the most important are
1. to exploit economies of scale in production
2. to raise funds
3. to organize the production process

The most compelling factor leading to organization of production firms arises from economies of scale. In production analysis,
economies of scale occur when the cost of production declines with larger and larger volumes of output. If there were no economies of
scale and specialization, then we could each produce our own goods (own food, cloth, car etc.) It is obvious that we gain enormously
because production is organized in large firms.

The second reason is related to the necessity of raising resources for large - scale production. Often, large amount of money is
needed to run large-scale production. Where are the funds to come from? In a private - enterprise economy, most funds for production
must come from company profits or when firms borrow from large number of individual savers.

A third reason for firms is the necessity of management. The manager is the person who organizes production, introduces new
ideas or products or processes, makes the business decisions, and is held accountable for success or failure. Production cannot organize
itself. Managerial decisions are made by firms, or more precisely by people on behalf of firms.

Production is organized in firms because efficiency generally requires large - scale production, the raising of significant external
resources and careful management and monitoring of ongoing activities.

When one for example considers the case of production of food by a farmer, the use of a number of inputs or factors of production
such as land, labor, machinery, fertilizer, etc., is observed. These inputs will be applied over the planting and growing season, and at
harvest time the farmer will reap certain outputs, such as wheat. It is assumed that the farmer always strives to produce efficiently, or at
lowest cost. That is, he will always attempt to produce the maximum level of outputs for a given dose of inputs avoiding waste whenever
possible. Later on, when the farmer decides what crops to produce and sell, it is hoped that he acts to maximize economic profits.
 Hence, in any production activity, there must be inputs that are either transformed or utilized in some way to produce an
output. In economics, inputs are also referred to as resources or factors of production. All the three names apply to the same thing.

Most inputs in developed economy are the product of some other production activity. For example, the still in automobiles is
an output of the steel industry. Even the human input in production has been modified or improved by some past training, whether it
be formal schooling or informal knowledge gained from family, workers, or experience. Knowledge is also the output of a production
activity.

Most production utilizes several inputs at the same time or in some time sequence. In fact, it is difficult to think of an example
where production occurs with just one input. Inputs can be grouped or classified in several ways. One common classification is that
of land, labor and capital. Land can be seen as the resource provided by nature, including the minerals, petroleum, and water
therein.

It is recognized that land is seldom used in its natural state, except perhaps in the production of utility as a wilderness area.
Labor is the services provided by human beings. Capital generally is defined as durable reproducible resources such as buildings,
machines and tools.

However both labor and capital also include capital or man - made improvements. (Education for example, involves the
production of human capital. Land may have to undergo considerable change such as clearing, leveling, or draining before it can be
used as an input. In the production of non-agricultural products, land is often treated as a capital input, resulting in two main types of
inputs: labor and capital.
 Mathematically, the production function
can be expressed as :
Q=f(X1,X2,...,Xk)
Where:
Q is the level of output
X1,X2,...,Xk are the levels of the inputs in the
production process
f( ) represents the production technology
For simplicity, consider a production
function of two inputs:
Q=f(X,Y) ; Q is output
X is Labor
Y is Capital
 Inputs can be classified into Fixed and
Variable inputs :
Fixed inputs = inputs that cannot be increased
or decreased to change the level of output. Ex.
Building in manufacturing.
Variable inputs =can be varied according to the
desired level of output. Ex. labor, materials, fuel,
etc

Three time frames in analyzing

production:
•The Momentary run is a period so short that
production is fixed and that no change in
production can take place.
•Short-run assumes that at least one of the
inputs is fixed.
•Long-run production assumes that all inputs
 2.3.1.1. Production in the Short run
Short-run production function assumes that at
least one of the inputs is fixed.
In the short run, three production measurements
used to help optimize the process.
Total physical product (TPP): the total
amount of output produced.
output
MPP = Marginal Physical Product (MPP) : the
input additional output obtained by adding one
more unit of the input holding constant all
other inputs.
output
 Average Physical product (APP): total
APP =
input output (TPP) divided by the total unit of the
input used up to that point.
 Product Curves
The Case of One Variable Input
• Total Physical Y
Product (TPP) -
– Starts increasing at
an increasing rate.
TPP
– Continues to
increase but at a
decreasing rate
– Reaches the
maximum, then
decreases X
One variable input

– The point where TPP

changes from Y Maximum Point
increasing at an
increasing rate to Y3
C TPP
increasing at a Y2 B
decreasing rate is
called the Inflection
Point. Inflection Point
– Points A, B, and C Y1 A
Indicate total amount
of output produced at X1 X2 X3 X
each level of input use
 Average Physical
Product (APP) -
Example Indicates
X average Y
(input) TPP=Y APP productivity of
0.00 0.00   the inputs being TPP
1.00 10.00 10.00 used.
2.00 25.00 12.50 APP = Y / X
3.00 50.00 16.67
4.00 70.00 17.50 Y X

5.00 85.00 17.00

Drawing a line
6.00 95.00 15.83
from the origin
7.00 100.00 14.29
which is tangent
8.00 101.00 12.63
to the TPP curve
gives APP max. APP
9.00 95.00 10.56
10.00 85.00 8.50 X
 Marginal Physical
Product (MPP) -
 MPP = ΔY / ΔX =
Example ∂Y/∂X
 MPP is the slope of Y
X TPP=Y MPP
the TPP curve. [Thus,
MPP represents the rate of TPP
0.00 0.00   change in output resulting
from adding one more unit of
1.00 10.00 10.00 input]
2.00 25.00 15.00 Since MPP is the
3.00 50.00 25.00
slope of TPP, it X
reaches a maximum Y
4.00 70.00 20.00 at inflection point.
5.00 85.00 15.00 It reaches zero at the
maximum point of
6.00 95.00 10.00 TPP.
7.00 100.00 5.00
APP
8.00 101.00 1.00
9.00 95.00 -6.00 X
10.00 85.00 -10.00 MPP

MPP is Negative
Relationships between Product Curves
 MPP reaches a maximum at
inflection point Y
 MPP = 0 occurs when TPP
is maximum TPP
 MPP is negative beyond TPP
max
 Drawing a line from the origin
which is tangent to the TPP
curve gives APP max Y X
 At point where APP is max,
MPP crosses APP
(MPP=APP)
 When MPP > APP, APP is
increasing
 When MPP = APP, APP is at APP
a max
X
 When MPP < APP, APP is
MPP
decreasing MPP is negative
 Law of Diminishing Marginal Physical Product
 Law of Diminishing Marginal Physical Product: As additional units of one input
are combined with a fixed amount of other inputs, a point is always reached where the
additional product received from the last unit of added input (MPP) will decline.
 Diminishing marginal product of labor, diminishing marginal product of other inputs is
so prevalent that the phrase "the law of diminishing returns” is often used to describe
it.
 The law of diminishing returns is to production while diminishing marginal utility is to
consumption. These two propositions are the bed rock of all micro economics -
diminishing marginal utility on the consumer and demand side, and diminishing
returns on the production and supply side.
– This occurs at the inflection point.
 The law of diminishing returns therefore, can be summarized that
(1) It states that as the use in input increases (with other inputs fixed), a point will
eventually be reached at which the resulting additions to output decrease.
(2) As more of a variable input is added, holding constant the quantity of other inputs,
the additional output forthcoming from each additional units of that input will
lessen beyond some point. The law of diminishing returns is nothing more, than
the phenomenon of decreasing MPP
(3) Diminishing returns and marginal products refer to the response of output to an
increases of a single input when all other inputs held constant.
 Stages of Production : Rational & Irrational
 The levels of input use are classified into three stages: Stage 1 includes the area of
increasing returns and extends to the point where the MPP curve intersects the
APP curve. At this point, APP is at a maximum. Stage 1 includes a portion of the
MPP curve that is declining. The distinguishing characteristic of stage 1 is that
MPP is greater than APP. As long as the marginal unit is greater than the overall
average, the average will always increase.
 The specific characteristic of stage II is that MPP is every where less than APP.
This results in the continual decline of APP. Stage II ends at the point where MPP
becomes zero. Stage III begins where the MPP curve crosses the horizontal axis
and extends to the right indefinitely as the negative MPP continues to pull APP
down, approaching Zero but never reaching it.
 No producer would want to be in stage III. For example, a person would be better
off to go fishing or to stay in bed than to put in a day of work that brings negative
results. No producer either would want to operate in stage I, although the reason
why is less clear than stage III. Consider the regions of increasing returns, each
additional unit of input adds more to output. Thus, the more input that is added, the
more efficient production becomes, and the cheaper it is to produce the added
output. Consequently, it would be foolish to stop adding the variable input when in
the region of increasing returns.
 It is established that a rational, profit maximizing producer would add enough of the
variable input to go past the region of increasing returns but would stop adding
before entering stage III, the region of negative marginal physical product. Thus, a
producer will always produce in the region of diminishing returns. Note that
production always occurs in stage II.
 Stages of Production : Rational & Irrational
Stage I
• The stage I of the Y
production function is I
between 0 and X1 units of TPP
X.
• In stage I:
– TPP is increasing
Y X
– APP is increasing
– MPP increases,
reaches a maximum &
decreases to APP
• Stage I is an irrational APP
stage because APP is still
increasing 0
X1
X
MPP
 Stage II
• The stage II of the Y

production function is I
TPP
between X1 and X2
units of X.
• In Stage II: II
– TPP is increasing Y X
– APP is decreasing
– MPP is decreasing
and less than APP,
but still positive
APP
– RATIONAL STAGE
BECAUSE TPP IS 0 X1 X2
X
STILL INCREASING MPP
 Stage II
• Optimal level of variable input usage occurs in stage II.
• But reaching at the “best” level in stage II depends on:
– how many units of output the firm can sell,
– the price of the product, and
– the monetary costs of employing the variable input (price of the
input).
• A profit-maximizing firm operating in perfectly competitive
output and input markets will be using the optimal
amount of an input at the point at which the monetary
value of the input’s marginal product is equal to the
additional cost of using that input.
– Where P(MP)=MC…>> MR=MC
MP1 MP2 MPk
• When using multiple variable inputs   
w1 w2 wk
Note that for example if we use only one input
(Labor):
 To derive MRP=MLC
 Define the following
– Total Revenue Product (TRP) = Q•P
Marginal Revenue Product (MRP) =
TRP (Q  P ) P  Q
   P  MP
X X X
– Total Labor Cost (TLC) = w•X
Marginal Labor Cost (MLC) = TLC
w
– Multiple variable usage: X
MP1 MP2 MPk
  
w1 w2 wk w represents
variable input cost
 Stage III Y
I
• Stage III of the TPP
II
production function is
beyond X2 level X III

• In Stage III:
– TPP is decreasing Y X

– APP is decreasing
– MPP is decreasing
and negative
– IRRATIONAL STAGE APP
BECAUSE TPP IS
DECREASING 0 X1 X2
X
MPP
A Hypothetical Production Function Schedule
Example
Input TPP APP MPP Total Physical Product Curve

(ΔTPP/
(X) (Y) (Y/X) ΔX)

O u tp u t
0 0 0 Stage I
1 10 10 10 Stage II
2 25 12.5 15 Stage III
Input

3 50 16.67 25
4 70 17.5 20 APP and MPP

5 85 17 15
6 95 15.83 10
A P P /M P P

7 100 14.29 5
0 1 2 3 4 5 6 7 8 9 10
8 101 12.63 1
9 95 10.55 -5 Input

10 85 8.5 -10
 Effects of Technological Change
• We know that the PF
gives the max
amount of output that Y TPP1
can be produced by
a firm using a given
technology. TPP
• The PF can shift over
time as a result of a
technological change
• Technological
change refers to the
introduction of new
technology that X
increases output with
the same amount of
resources.
A Hypothetical Production Function

A Mathematical Example
 Consider a Production Y
Function I

TP (Total Product) = X2 – TPP

II

1/30X3,
III
where TP (Y) is quantity
of output and X is the
quantity of input. Y X
 AP (Average Product) =
TP/X = X – (1/30)X2
 MP (Marginal Product) =
∂TP/∂X APP
= 2X – (3/30)X2
0 X
= 2X – (1/10) X2 MPP
 Marginal Product Maximum

Given
TP = X2 – (1/30)X3,
AP = TP/X = X –
Y
(1/30)X2
MP = ∂TP/∂X = 2X – I
TPP
(1/10)X2 II
At what levels of X does III
the MP reach its
maximum? Y X
oMP reaches its
maximum
where ∂MP/∂X = 0
oThat is, where
2 – (2/10)X = 0 APP
Or, 0.2 X = 2
Or, X = 10 0 10 X
MPP
 Average Product Maximum

Given Y
oTP = X2 – (1/30)X3, I
oAP = TP/X = X – TPP
(1/30)X2 II

oMP = ∂TP/∂X = 2X – III

(1/10)X2

o At what levels of X does Y X

the AP
reach its maximum?
o AP reaches its
maximum
where ∂AP/∂X = 0
That is, where APP
1 – (2/30)X = 0
Or, (1/15) X = 1 0 10 15 X
Or, X = 15 MPP
 Total Product Maximum
Given
TP = X2 – (1/30)X3,
Y
AP = TP/X = X – (1/30)X2
MP = ∂TP/∂X = 2X – I

TPP
(1/10)X2 II

 At what levels of X does III

the TP reach its maximum?

TP reaches its
Y X
maximum where
∂TP/∂X = MP = 0
That is, where
oMP = 2x – (1/10)X2
=0
Using the quadratic
formula of: APP

0
10 15 20 X
oX = 20 MPP
The range of X values for Stage II

Y
Stage II is the stage I

that begins where AP TPP

is at its maximum and II
ends where TP is at III

its maximum.
Y X
 Thus, the range of
X values or Stage II is
15 and 20.
APP

0
10
15 20 X
MPP
 Point where law of diminishing returns set

 At what level of X Y

does the Law of I

TPP
Diminishing Returns II

sets in? III

o It sets in where
X
MP reaches its Y

maximum.

o Thus at X = 10
the law of
APP
Diminishing returns
sets in. X
10
15 20
0
MPP
The elasticity of production
o Given TP = X2 – (1/30)X3,

o At Y = 112.5 and X = 15, what is the

elasticity of production?

o Applying Q X
Ep  
X Q

o Ep = (2X – (1/10) X2) * (X/Q)

o Ep = ((2*15) – (225/10)) * (15/112.5)

o Ep = (30 – 22.5) * (0.133)

o Ep = 7.5 * 0.133 = 0.997

2.3.1.2. Production in the Long Run
Long - run period is a period in which full adjustments in supply response to a change in demand for the
product can be made. How much time would make the period long depends upon the nature of the product
under question. It may be of a few months or a few years depending on the type of the activity.

When the prices of inputs change relative to one another, producers have an incentive to substitute the
cheaper ones for more expensive inputs. The coming part provides a frame work for categorizing substitution
possibilities among inputs.

Firms continually make production decisions in the short run, while simultaneously planning how to alter their
inputs in the long run. Thus, the long - run is the amount of the time sufficient to make all inputs variable. In the
short run, firms vary the intensity with which they utilize a given plant and machinery; In the long-run, they vary
the size of the plant. All fixed inputs in the short run represent the outcomes of previous long-run decisions
based on the firms' estimates of what they could profitably produce and sell. The long run can be as brief as a
day or two for a child's lemonade stand or as long as ten years for a petrochemical producer or an automobile
manufacturer.

The Concept of Isoquant

It is a framework of substitution for categorizing possibilities among inputs. An isoquant is a line showing the
possible combinations of two inputs that can be used to produce a given level of output since is means equal,
a more literal translation of the term is equal quantity. It is referred as the equal product curve or isoquant
curve, which is also product indifference curve. It shows the various combination of two goods that yield the
same amount of input (say labor and capital) yield, the same output of goods. So the producer is indifferent as
to order in which these inputs may be used for they result in an equal quantity of output.

Consider, for example, the possible ways of producing a given level of output, say 500 dozen cookies. At one
extreme, you might utilize a lot of labor and a small amount of labor, as indicated by the ten labor, seven
machine combination. The first situation would be described as a labor - intensive method of production while
the second would be called capital - intensive. There may be other combinations too to make the output more.
Whatever the level of output, each isoquant tells us the possible combinations of the two inputs that can be
used to produce that output.
Production in the Long Run…

In the long run, all inputs are variable.

Isoquant defines combinations of inputs that

yield the same level of product

K5 E

3
A B C
2
Q3 =90
D Q2 =75
1
Q1 =55
1 2 3 4 5 L
 Isoquants & Long Run Production
Functions
 Qt = f(Kt, Lt) ISOQUANT MAP
 Output rate increases
as you move to higher K
isoquants.
 Slope represents
ability to tradeoff Q3
inputs while holding
output constant.
Q2
 Marginal Rate of
Technical
Q1
Substitution.
L
Marginal rate of technical substitution (MRTS)
MRTS: the rate at which a small
amount of one input is replaced for
K
7
A a small amount of another input
without affecting the output level.
6
ΔK=3

5
MRTS  K
B L
4
ΔL=1

3 ΔK=1 C
ΔL=1

2
D
E
1 ΔK=1/3
ΔL=1
0
0 1 2 3 4 5 6 7 L
Substitution Possibilities
A. Perfect Substitutes
Exist when the amount of input required to compensate
for a unit reduction of the other remains constant at all
possible combinations. The ratio does not have to be one for one - just constant. It is
difficult to think of realistic examples of inputs that are perfect substitutes; in practice they would be the same
input. If such inputs could be found, the isoquants would be straight, down ward-sloping lines such as in the
next figure. In this example, natural gas and fuel oil are perfect substitutes as sources of energy for heat in
baking cookies, as long as the equipment for using either or both fuels is in place.

Natural
Gas

Fuel oil
B. Fixed proportion
 Inputs cannot be substituted for each other and the input
must be used together in a fixed ratio or proportion. .
Probably the most common examples of fixed proportions occur in manufacturing, where products require certain materials or
ingredients. For example a cotton shirt of a given size requires a certain amount of material, a certain number of buttons, etc.
More clearly one can visualize substitution between different types of materials, different buttons, and so on. The fixed -
proportion case generally applies to inputs that are narrowly defined or in a relatively short - run situations where it may not be
possible or economically feasible to substitute one input for another. Inputs that must be used in fixed proportions are
represented by isoquants that are rectangular in shape. This means that when more of one input is added, the other input cannot
be decreased if the same level of output is to be maintained. Unless the other input is also increased, the input that is added is
simply not used in the production process. Sugar and salt are examples of two inputs that are used in fixed proportions in cookie
production as shown in the graph below. Perfect substitutes and fixed proportions are the extreme or limiting cases of general
imperfect substitutes. In more general case, isoquants can vary in shape from a gentle curvature to a sharp curve. The less
curvature of the isoquant, the closer it comes to limiting case of perfect substitutes. Thus, an isoquant that exhibits a small
amount of curvature represents the case of two inputs that can be readily substituted for each other. On the other hand, a sharply
curved isoquant comes close to the case of fixed proportions, meaning that the possibility for substitution is limited.

•The substitution effect

could be perfect 1 with 1
complements, perfect 1
with 2 complements, etc
C. Imperfect Substitutes
Exist when the two inputs are, in a sense, more efficient
on their own, rather than when used together.
the particular shape of the isoquant is of intersect at this point. In the next figure each isoquant is drawn convex
to the origin. This implies that the two inputs are imperfect substitutes for one another in the production of cookies.
They are called imperfect substitutes because it takes more of the abundant input to compensate for the loss of
each successive unit reduction of the scarce input. As you move down along the labor axis, more machine days
are required to compensate for the loss of each unit of labor. Moving from 60 to 50 days of labor required only
about one-half extra-machine day to compensate for the loss of 10 days of labor. But moving from 20 to 10 days of
labor requires about two and one-half extra machine days. The same relationship is true for increasing labor and
decreasing machine time. The distinguishing characteristics of inputs that are imperfect substitutes are the
progressively increasing amount of the abundant input required to substitute for the loss of each unit of the scarce
input.
It takes more of the abundant input to compensate for the loss of each successive unit reduction of the scarce
input. It is concave to the origin

Labor (days)
Types of returns to
scale
The long run production process is described by the concept of
returns to scale. Returns to scale describes what happens to total
output as all of the inputs are changed by the same proportion.
If all inputs into the production process are doubled, three things
can happen:
1. Output can more than double
 increasing returns to scale (IRTS)
 For example, an engineer planning a small scales chemical plant would generally find that
increasing the inputs of labor, capital and materials by 10 percent will increase the total output
by more than 10 percent. Engineering studies have determined that many manufacturing
process enjoy modestly increasing returns to scale for plants up to the longest size used today.
2. Output can exactly double
 constant returns to scale (CRTS)
 For example, if inputs of labor, land, capital, and other inputs are doubled, then under constant
returns to scale output would also double. Many handicraft industries (such as handlooms) tend
to show constant returns.
3. Output can less than double
 decreasing returns to scale (DRTS)
 For examples say that a farmer's corn land, seed, labor, machinery, etc., were increased by
50%. If as a result total output increased by only 40%, then this situation is one of the
decreasing returns to scale. Many productive activities involving natural resources, such as
grunting wine grapes or forestry, show decreasing returns to scale.
Elasticity of Production
 One way to measure returns to scale is to use a
coefficient of output elasticity:
 The elasticity of production measures the
degree of responsiveness between output and
input.
 It measures the percentage change in
production in response to a percentage change
in variable input.
E 
Percentage change in Q
Q
Percentage change in all inputs

Q X Q X Q Q MPP
Ep       
Q X X Q X X APP

Q X
Ep   If Ep>1 then IRTS
 Using Calculus: X Q
If Ep=1 then CRTS
If Ep<1 then DRTS
 Production in the Long Run
• Economists
hypothesize that a
firm’s long run
production function
may exhibit at first
increasing returns, then
constant returns, and
finally decreasing
returns to scale.
Various ways of keeping constant returns to
scale for any level of output
Multiply both inputs and output by the
same number
By efficiently redesigning a process,
doubling inputs may lead to a considerably
longer than proportional increase in outputs
Taking advantages of specialization and
division of labor as output increases, firms
may break down production into smaller steps
By using specialized capital equipment,
of automation, even of robots, to perform
simple and repetitive tasks quickly.
The Concept of Isocost

An isocost line shows various combinations of

two inputs that can be purchased for a given
amount of money (inputs, input price, money)

All combinations of inputs that can be

purchased for a fixed amount of money

An isocost line is similar to the budget line. It’s a

set of points with the same cost, C.

It is a down ward sloping curve

 Where:
B  PX X  PY Y • B= total money
• X = input Y (say labor)
• Y = input Y (say capital)
B PX • Px & Py = prices for X & Y
Y  X
PY PY Y (machines rented

12
B Shift
10
PY
B 8 B1 = $1,000
Py B2 = $2,000
6
PX Slope
4
B3 = $3,000

PY 2
B
X (Labor hours used in
Px production)
0 2 4 6
 A Numerical Example
Bundles of: Labor (X) Machine rental (X)
with C = Birr 30 (Birr 6 per labor hour) (Birr 3 per machine hour)

a 0 10
b 1 8
c 2 6
d 3 4
e 4 2
f 5 0

Points a through f lie on the isocost line for C = Birr 30/hour.

43
Capital, Y (machines rented)
The Isocost Line

a
10
b
8
c
6
d
4
e
2
f
0 1 2 3 4 5 6 7 8 9 10
Labor, X (worker-hours employed)
44
Optimal combination of multiple inputs
Isocost = all possible combinations
inputs that will give the producer
Optimal same output level.
combination Units of Y
Isocost = all possible combinations
corresponds to the B3 of inputs that can be purchased at
point of tangency given prices and limited producer
B2 budget
of the isoquant
and isocost.
B1

PX MPX Expansion path

 Y3
PY MPY Y2 C
Y1 B
A
Q3
MPY MPX Q2
 Q1
PY PX
X1 X2 X3
Units of X
Optimal combination of multiple inputs
• Budget Lines
PX MPX – Least-cost production occurs

PY MPY when MPX/PX = MPY/PY and
PX/PY = MPX/MPY
MPY MPX
PY

PX
• Expansion Path
– Shows efficient input
combinations as output grows.
Units of Y
• Illustration of Optimal Input
B3
Proportions
B2
– Input proportions are optimal
B1
when no additional output could
Y3
Expansion path be produced for the same cost.
Y2 B C
Y1 A
Q3 – Optimal input proportions is a
Q1
Q2
necessary but not sufficient
X1 X2 X3
Units of X condition for profit maximization.
Optimal combination of multiple inputs

PX MPX – Profits are maximized


PY MPY when MRPX = PX for all
inputs.
MPY MPX
 – Profit maximization
PY PX
requires optimal input
Units of Y
proportions plus an optimal
B3
level of output.
B2

B1

Expansion path
Y3
Y2
Y1 B C
A
Q3
Q2
Q1
X1 X2 X3
Units of X
References

1.Robert Frank & Ben Bernake Principles of

Economics. Mc Graw-Hill, Irwiv 2001
2.Arhold, Roger Economics USA 1996
Chapter one and two
3.Care, K. Principles of Economics USA
1996
4.Samuelson, Paul. Economics N.Y. 1995
5.Any other text-book on Economics or
Principles of Economics is helpful