Production Function with two variable inputs

Rachita Gulati

Production in the Long-Run

All inputs are now considered to be variable (both L and K

in our case) How to determine the optimal combination of inputs? To illustrate this case we will use production isoquants.

An isoquant is a curve showing all possible combinations of inputs physically capable of producing a same level of output. Isoquant are also known as equal-product curves.

Isoquants
160

Factor combination A B C

Labour 10 20 30

Capital 100 60 50

An isoquant shows the combinations of capital and labour that produce the same level of output

140 120 Capital 100 80 60 40 20 0 0 10 20 Labour 30 40

240 358

These Are Called Isoquants

They slope down and to the right
Due to Marginal Rate of Technical Substitution

Higher isoquant represent higher output level They are convex to the origin They do not cross, although they are not necessarily

parallel

Marginal Rate of Technical Substitution (MRTS)

MRTSLK would be the amount of capital that the firm would be willing to give up for an additional unit of labour.
MRTSLK = - K/ L = MPL/MPK MRTSKL would be the amount of labour that the firm would be willing to give up for an additional unit of capital. MRTSKL = - L/ K = MPK/MPL

Law of Diminishing Marginal Rate of Technical Substitution:

for Isoquant Q C ombination A B C D E = 52 K 12 8 5 3 2 L 1 2 3 4 5

Downward sloping isoquant

A
K=- 4 L= 1 K = -3 L=1 K= -2 L=1

B C D E

MRTS = K/ L = - MPL/MPK
U its of K n E p e m loy d 1 8 1 2 8 5 3 2 1 3 7 52 2 5 3 7 3 1 2 4 1 7 8 1 6 0 6 4 52 5 2 4 7 3 9 2 9 1 8 2 8 3 7 8 6 4 52 5 2 4 7 4 1 2 9 3 O tp t Q a tity (Q u u un ) 9 6 17 17 0 1 9 0 11 10 0 1 7 3 8 2 9 0 6 7 7 5 8 2 52 5 2 6 7 7 3 52 4 7 5 52 6 2 4 3 9 4 7 5 2 4 5 6 U its of L E p e n m loy d 17 2 19 1 9 7 8 9 7 9 6 9 5 6 7 18 2 10 2 14 0 9 5 8 5 7 3 5 2 8

Higher isoquant represents higher output

U nits of K Em ploy d e 8 7 6 5 4 3 2 1

Isoquant
3 7 4 2 3 7 3 1 2 4 1 7 8 4 1 60 64 52 47 39 29 18 8 2 O utput Q ntity (Q ua ) 83 96 107 117 78 90 101 110 64 73 82 90 58 67 75 82 52 60 67 73 41 52 58 64 29 39 47 52 14 29 27 24 3 4 5 6 Units of L Em ploy d e 12 7 11 9 97 89 79 69 56 21 7 12 8 12 0 10 4 95 85 73 52 17 8

Economic region of production

Isoquants

Economic Region of Production

Ridge Line

Substituting inputs
There exists some degree of substitutability between inputs.
Different degrees of substitution:
Corn syrup Natural flavoring Capital
K1 K2 K3 K4
Q

Sugar a) Perfect substitution

All other ingredients b) Perfect complementarity

L1 L2 L3

L4

Labor

c) Imperfect substitution

Isocost lines
Isocost line is the locus of points of all the different

combinations of labour and capital that a firm can employ, given the total cost and prices. Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost. If the price of labour is wage (w), the price of capital is interest (r), then total cost incurred by the firm is summarized as

C = wL + rK
(M=Px. X+ Py. Y)

Isocost line Budget line

Isocost curves

Isocost Lines AB AB AB AB* C = $100, w = r = $10 C = $140, w = r = $10 C = $80, w = r = $10 C = $100, w = $5, r = $10

C w K= L r r
intercept slope

The intercept of isocost line on the capital axis is the

maximum amount of capital employed, when labour is not used in production process and is given by C/r. The intercept on the labour axis is the maximum amount of labour used in the production process and is given by C/w. Slope of the isocost line
Slope= Price of labour/Price of capital= w/r

Changes in the Isocost Line

Changes in total cost
Decrease lead to a parallel,
L

inward shift in the isocost line. Increases lead to a parallel, outward shift.
Rs. 300

Rs. 500 Rs. 400

Changes in Price of labour

A decreases in the price of K

labour L rotates the isocost line counter-clockwise. An increases rotates the budget line clockwise.

60

If price of labour falls from Rs. 4 to Rs. 3, isocost line shifts outwards.

50

100

Producers Equilibrium:
Optimal Combination of Inputs MRTSLK = - K/ L=w/r (slope of isoquant=slope of isocost line)

Producers equilibrium
Producers equilibrium shows lowest cost producing a given

level of output, where the isoquant corresponding to this output is tangent to the isocost line. Thus, optimal combination of factor inputs depends on the relative prices of factor inputs and on the degree to which they can be substituted for one another. This relationship can be stated as follows: MRTS=- K/ L=MPL/MPK = PL/PK = w/r (or MPL/PL= MPK/PK) MPL/w= MPK/r

Optimal level of inputs

The optimality conditions given in the previous slides ensure

that a firm will be producing in the least costly way, regardless of the level of output. But how much output should the firm be producing? Answer to this depends on the demand for the product (like in the one input case as well).

Expansion path
The locus of equilibrium points of isoquant with the

lowest possible isocost line It shows all the cost minimising input combinations for various levels of output the firm could produce in the long run.

Units of capital (K)

The long-run situation: both factors are variable

Expansion path

300 TC = Rs. 40 000 TC = Rs. 60 000 200 100

TC = Rs. 20 000

Units of labor (L)

Producers equilibrium vs. Consumers equilibrium

Producers equilibrium
Producers theory Maximization of output Isoquant and isocost line Expansion path Equilibrium condition

Consumers equilibrium
Consumers theory Maximization of satisfaction Indifference curve and

MRTS= - K/ L=w/r

budget line Income consumption curve or price consumption curve Equilibrium condition
MRS= - Y/ X=Px/Py

Returns to Scale
Let us now consider the effect of proportional increase in

all inputs on the level of output produced. To explain how much the output will increase, we will use the concept of 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 the factor inputs used in production.

Returns to Scale
What happens to output when all inputs are increased by a given percentage? Three will be three situations: Increasing Returns output increases by a larger percentage

Increase in factors by 10%, output increase by 20%

Constant Returns output increases by the same percentage Increase in factors by 10%, output increase by 10% Decreasing Returns output increases by a smaller percentage Increase in factors by 10%, output increase by 5%

Returns to Scale
U its o L n f E p yd m lo e 8 7 6 5 4 3 2 1 O tp t Q a tity (Q u u un ) 9 6 17 17 0 1 9 0 11 10 0 1 7 3 8 2 9 0 6 7 7 5 8 2 6 0 6 7 7 3 5 2 5 8 6 4 3 9 4 7 5 2 2 0 2 7 2 4 4 5 6 U its o K E p y d n f m lo e

3 7 4 2 3 7 3 1 2 4 1 7 8 4 1

6 0 6 4 5 2 4 7 3 9 2 9 1 8 8 2

8 3 7 8 6 4 5 8 5 2 4 1 2 9 1 4 3

17 2 19 1 9 7 8 9 7 9 6 9 5 6 2 1 7

18 2 10 2 14 0 9 5 8 5 7 3 5 2 1 7 8

In the previous table we are experiencing increasing

returns to scale
Similarly, constant returns to scale and decreasing

returns to scale are possible.

Measurement of Returns to Scale

Coefficient of output elasticity: EQ= percentage change in output percentage change in all inputs

So if, EQ>1, increasing returns (proportionate increase in output is more

than proportionate increase in inputs)

EQ=1, constant returns (proportionate increase in output is in same

proportion to that of increase in inputs)

EQ<1, decreasing returns (proportionate increase in output is less than

proportionate increase in inputs)

Constant Returns to Scale

1K+1L (100) 2K+2L (200) 3K+3L (300)

R c 500

Units of capital (K)

400

300 200 100

fig

Units of labor (L)

Increasing Returns to Scale (beyond point b)

1K+1L (100) 1.7K+1.7L (200) 2.2K+2.2L (300)

R c 600 500 b 400 300 200 100

Units of capital (K)

fig

Units of labor (L)

Decreasing Returns to Scale (beyond point b)

1K+1L (100) 2.5K+2.5L (200) 4.5K+4.5L (300)

R c 500

Units of capital (K)

400 300 200

fig

Units of labor (L)

Reasons for Increasing Returns to Scale:

Division of labor (specialization) Indivisibility of machinery or more sophisticated machinery

justified Economies of scale

Decreasing returns to scale can result from certain managerial inefficiencies: problems in communication increased bureaucracy Increased use of fixed factor

Production function as power function

Power function is the most frequently used type of production function in empirical work, even though it cannot exhibit two directions for marginal product on the same function. One reason for its popularity is that it can be readily transformed into a function with two or more independent variables:

Q = aV1bV2cV3d ...Vnm

Production Function as Power Function

Production function with one variable input Q = aLb if b > 1, b = 1, b < 1, Q increasing at increasing rate: MPL Q increasing at constant rate: MPL Q increasing at decreasing rate: MPL increasing constant decreasing

Major advantage of the power function is the fact that it can be transformed in a log-linear function log Q = log a + b log L

The Cobb-Douglas Production Function

A special case of power functions is Cobb-Douglas Production Function Q = AKaLb Estimated using natural logarithms ln Q = ln A + a ln K + b ln L Original version with constant returns to scale ( b + 1 - b = 1) introduced by Cobb in 1928. Q = aLbK1-b,

Reformulation by Cobb and Douglas:

Q = aLbKc b + c = 1, constant returns b + c > 1, increasing returns b + c < 1, decreasing returns

Properties of the Cobb-Douglas function that have kept it so popular for 80 years
1. 2. 3.

Both inputs have to be used simultaneously to get an output Can exhibit different returns to scale Allows to investigate MP for any factor while holding all others constant. So it is useful both in short-run and long-run analysis.
Q Q =b L L Q Q MPK = =c K K MPL =

4.

Elasticities are equal to the exponents b and c (constant in this formulation)

Assignment problems
1.

If an estimated Cobb-Douglas production function is Q = 10L0.8K0.6 (a) what are the output elasticities of capital and labour? If the firm increases only the quantity of capital or only the labour used by 10%, by how much would output increase? (c) What type of returns to scale does this production function indicate? If the firm increases at the same time both the quantity of capital and labour used by 10%, by how much would output increase?

2. Suppose that the production function for a commodity is given by Q = 10L0.5K0.5 , where Q is the quantity of output, L is the labour units, and K is the capital units. (a)Indicate whether this production function exhibits constant, increasing or decreasing returns to scale? (b)Does the production function exhibits diminishing returns? If so, when does the law of diminishing returns begin to operate?

3. The Royal furnishing manufacturers office furniture with the following production function: Q = 20L0.1K0.9 the firm currently is producing with maximum efficiency and using 20 units of capital and 50 units of labour. (a)What is the rate of output? (b)What are the relative prices of capital and labour? What will be the actual price of labour and capital? Explain