Economic Theory:

Business Economics
(Understanding Supply - Production)
Readings
• Salvatore: Principles of Microeconomics, Oxford University
Press – Chapter 7
• Hirschey: Economics for Managers, (Indian Reprint), South-
Western Cengage Learning – Chapter 8
• Hubbard & O’Brian: Microeconomics (latest Edition), Pearson
Education India – Chapter 10
• Mansfield, Allen, Doherty and Weigelt: Managerial Economics:
Theory, Applications and Cases (latest Edition), Viva-Norton
Student Edition – Chapter 4
• Thomas, Maurice and Sarkar: Managerial Economics: Concepts
and Applications (latest Edition), Tata McGraw-Hill – Chapters 8
&9
• McConnel, Brue, Flynn and Ray Chaudhuri: Economics - McGraw-
Hill – Chapter 9

2
Session Objectives
• Features of a production function.
• How is the economic short run distinguished from long
run?
• What are average and marginal products? How are they
related?
• What are “economies of scale” and how are they
different from returns to factors of production?

3
What is a Firm’s Objective?
• The economic goal of the firm is to maximize profits.
• Profit = Total revenue – Total cost
• Profit = Price X Quantity – (Fixed Cost + Variable Cost)

The amount a firm The market value of

receives from the the inputs a firm
sale of its output uses in production

• Profit maximization therefore involves either:

1. Revenue maximization, or
2. Output maximization, if price is fixed, or
3. Cost minimization or
4. A mixture of the above policies

• The explicit and implicit costs discussed earlier

4
• Cost in this context will only focus on explicit ones
Profit Considerations

What influences Profit considerations?

The Production Function
• Production is the process of transforming inputs into output.
• The production function indicates that maximum level of output
the firm can produce for any combination of inputs.
• For simplicity, we assume that all inputs or factors of production
can be grouped into two broad categories, labour (L) and capital
(K).
• The general equation:

Q = f (K, L)

• This function defines the maximum rate of output (Q) per unit of
time obtainable from a given rate of capital and labour inputs.
• Output may be physical units such as automobiles or washing
machines, or it may be intangible, as in the case of medical care,
transportation and education services.

6
Why stress on Maximum?
• For instance, in perfectly competitive framework, all firms are
price-takers, i.e., can only change their output, but not price.
• Suppose a firm fails to organize or manage resources efficiently
and produce less than the maximum output for given input
combinations.
• In a competitive environment, such firms are not likely to survive
because competitors using efficient production techniques will be
able to produce at lower cost, sell at lower prices, and ultimately
drive inefficient producers out of market.
• Scale advantages from undertaking higher production will be
discussed in the next lecture on Costs.
• Is it realistic in today’s context?

• Academic Perspective: Melitz Model (2003) predictions

• What if a firm cannot set price? 7
Can Increased Output Lower Competition?

Drawn from various

Internet resources
Short Run vs. Long Run

The short run refers to the

period of time in which one
or more of the firm’s inputs
• Inputs that cannot be is fixed — that is, cannot
varied in the short run be varied. Only ONE input
may vary.
are called fixed inputs.
• Inputs that can vary in
the short run are called
variable inputs The long run is the period of
time sufficiently long to allow
the firm to vary all inputs—
e.g., plant size, number of
trucks, or number of apple
trees.

Managerial thought: Will duration of short run be same for all industries? 9
Production Function: Important Concepts
Production Definition
Input Type
Variable An input for which the level of usage may be changed quite
input readily, e.g., substitution between L and K in low-tech
products
Fixed input An input for which the level of usage cannot readily be
changed and which must be paid even if no output is
produced, e.g., one oven and one cook in roadside eateries
Quasi-fixed An input employed in a fixed amount for any positive level
input of output that need not be paid if output is zero

Managerial Thought: Any example of Quasi-fixed inputs?

Example: Production Function for Auto Parts
Number of Plant Size (000s) (K)
Workers (L) • Consider a multi-product firm that
10 20 30 40 supplies parts to major US auto
10 93 120 145 165 manufacturers.

20 135 190 235 264 • Its production function is given by

the following relationship:
30 180 255 300 337
• Q = F(L, K)
40 230 315 365 410 • where Q is the quantity of
50 263 360 425 460 specialty parts produced per day, L
is the number of workers employed
60 293 395 478 510 per day, and K is plant size (say,
70 321 430 520 555 measured in thousands of square
feet).
80 346 460 552 600
• This table shows the hypothetical
90 368 485 580 645 quantity of output that can be
obtained from various combinations
100 388 508 605 680
of plant size and labour.

11
Short Run Path: Hypothetical Example
Number of Workers Plant Size (000s)

10 20 30 40

10 93 120 145 165

20 135 190 235 264

30 180 255 300 337

40 230 315 365 410

50 263 360 425 460

60 293 395 478 510

70 321 430 520 555

80 346 460 552 600

90 368 485 580 645

100 388 508 605 680

12
Moving to Long Run: Hypothetical Example
Number of Workers Plant Size (000s)

10 20 30 40

10 93 120 145 165

20 135 190 235 264

30 180 255 300 337

40 230 315 365 410

50 263 360 425 460

60 293 395 478 510

70 321 430 520 555

80 346 460 552 600

90 368 485 580 645

100 388 508 605 680

Managerial thought: Any logic behind the sharp increase in output in LR? 13
What is the relationship between
Total, Average and Marginal Products?
Total, Average and Marginal Product
• Let’s start with Short-Run production using Single variable
input.
• Total product of labour is the maximum rate of output
forthcoming from combining varying rates of labour input with
a fixed capital input.
• Denoting the fixed capital input as Ko, the total product of
labour function is TPL = f (Ko, L) = f ( L).
• Average product is the total product per unit of the variable
input and is found by dividing the rate of output by the rate of
the variable input.
• The average product of labour function is: APL = TPL/L
• Marginal product of any input is the increase in output arising
from employment of an additional unit of that input, holding all
other inputs constant.
• Marginal product of labor MPL = ∆Q / ∆L.

Graphical Interpretation: The marginal product is the slope of

the total product curve. 15
Total, Average and Marginal Product: Example 1
Production of specialty parts, assuming a • What Inference can be drawn?
plant size of 10,000 square feet
• In this example, the marginal
Number of Total Marginal Product product of labor (MPL) is the
Workers Product of Labour extra output of auto parts
10 93 realized by employing one
additional worker, holding plant
20 135 4.2
size constant.
30 180 4.5
• Law of Diminishing Returns
40 230 5.0
• As units of a variable input are
50 263 3.3 added (with all other inputs held
60 293 3.0 constant), a point is reached
where additional units will add
70 321 2.8
successively decreasing
80 346 2.5 increments to total output—that
90 368 2.2 is, marginal product will begin to
decline.
100 388 2.0
• Notice that, after 40 workers
110 400 1.2
are employed, marginal product
120 403 0.3 begins to decline.
130 391 -1.2 • Managerial Perspective: Any
140 380 -1.1 possible reason?
16
Total, Average and Marginal Product: Example 2
• A farmer grows wheat.
• He has 5 acres of land.
• He can hire as many workers as he wants and the
output (say in Kg.) has the following pattern:

Labour Input (L) TPL APL MPL

0 0 - -

Key Question: 1 20 20 20
Employ workers 2 50 25 30
upto which level?
3 90 30 40
4 120 30 30
5 140 28 20
6 150 25 10
7 155 22 5
8 150 19 -5
17
Total, Average and Marginal Product: Example 2
1. When intput usage is zero, TP is also zero; so that TP curve starts
from the origin and AP and MP curve have the same vertical
intercept (for all practical purposes!!!).
• TP increases at an increasing rate over the range of L = (0, 3), and
then increases at a decreasing rate.
• Initially the input proportions are inefficient – there is too much of
fixed factor, capital. As the labour input is increased from 0 to 3,
output rises more than in proportion to the increase in labour input
and as a result MP of labour rises.
2. As labour input is increased beyond 3 units, diminishing marginal
returns set in and marginal product declines; the additional units of
labour still result in an increase in output, but each increment to
output is smaller.
3. When labour has increased to 7, TP reaches a maximum. Then, at 8
units, the amount of labour become excessive and slows the
production process, with the result that total product actually
declines.

Manager’s Perspective: Nationalization drive in late 60s and

early 70s and Government policy towards consolidation and
downsizing (or, right-sizing) in the Banks in recent period. 18
Total, Average and Marginal Product
• MP at first increases, reaches a maximum at L = 3, which
corresponds to a point of inflection on the total
production curve.
• At the inflection point, total product function changes
from increasing at an increasing rate to increasing at a
decreasing rate.
• MP intersects AP at the maximum point on the AP curve.
This occurs at L = 4.
• Whenever MP is above the AP product, the AP is rising.
• When the MP is below the AP, the AP is falling.
• The intersection occurs at the maximum point of AP.
• MP becomes negative at L = 8, when TP starts diminishing.

19
Relationship Between APL and MPL
• APL = Q/L, by definition. That is, Q = APL x L. .. (1)

• Differentiating both sides of eqn (1) w.r.t. to L, we get

dQ/dL = (dAPL /dL)*L + APL .. (2)

• The expression on the LHS is nothing but MPL . So:

MPL = (dAPL /dL)*L + APL .. (3)

• Hence, rearranging terms, we get,

(dAPL /dL) = (MPL - APL)/L .. (4)

• This means that:

(a) MPL > APL implies (dAPL /dL) > 0 (Rising APL)
(b) MPL = APL implies (dAPL /dL) = 0 (Constant APL)
(c) MPL < APL implies (dAPL /dL) < 0 (Falling APL)
20
Illustration of the Law of Diminishing Returns to a Factor

Variable
Input (X)

21
Illustration of the Law of Diminishing Returns to a Factor

Desirable zone Normal operation Not ideal for a Firm with

for a Firm for a Firm profit-making objective
22
Production Relations
Upto which point a factor should be
engaged for production?

Objective: Profit Maximization

Optimal Employment of a Factor of Production
• To maximize profit, a firm should hire labour as long as the
additional revenue associated with hiring of another unit of
labour exceeds the cost of employing that unit.
• Suppose that the marginal product of an additional worker is 2
units of output and each unit of output is worth Rs. 2000.
• Thus, the additional revenue to the firm will be Rs. 4000 if the
worker is hired.
• If the additional cost of employing a worker (i.e., wage rate) is
Rs. 3000, the worker will be hired because Rs. 1000, the
difference between additional revenue and additional cost, will be
added to profit.
• If however, the wage rate is Rs. 4500, the worker should not be
hired because profit would be reduced by Rs. 500.

25
Optimal Employment of a Factor of Production
• The principle is that additional units of the variable input
should be hired until the marginal revenue product (MRP) of
the last unit employed is equal to the cost of the input.
• The MRP is defined as marginal revenue times marginal product
and represents the value created by the extra unit of labour,
i.e., MRP = MR x MPL.
• Thus labour is hired until MRPL equals wage rate (w), i.e.:
• MRPL = w, or, MR x MPL = w.
• For a price-taker firm, MR = P (given), so that we get:
• P x MPL = w.
• The term P x MPL is the value of MP of labour and is denoted
as VMPL .
• Thus for a price taker firm, labour will be hired until:
• VMPL =w

26
A Hypothetical Example: W = 100
• Suppose, Price = P = MR remains constant at Rs. 20
• Labour Cost = w =100 (say, government determined minimum wage)

• P = 20 and MPL = 5
• Then, MR . MPL = MRPL = 100 = w,
• What should the firm do?

• Now, suppose, P = 20 and MPL = 4.5

• MR . MPL = MRPL = 90 < w = 100
• What should the firm do?

• Now, P = 20 and MPL = 5.5

• MR . MPL = MRPL = 110 > w = 100
• What should the firm do?
A Hypothetical Example: W = 90
• Suppose, Price = P = MR remains constant at Rs. 20
• Labour Cost = w =90 (say, government changed minimum wage)

• P = 20 and MPL = 5
• Then, MR . MPL = MRPL = 100 > 90 = w,
• What should the firm do?

• Now, suppose, P = 20 and MPL = 4.5

• MR . MPL = MRPL = 90 = w = 90
• What should the firm do?

• Now, P = 20 and MPL = 5.5

• MR . MPL = MRPL = 110 > w = 90
• What should the firm do?
The Equilibrium

W, MRPL

MRPL = VMPL = P.MPL

L1
L
What Happens if Productivity Rises?

W, MRPL

MRPL1 = VMPL1 = P.MPL1

MRPL = VMPL = P.MPL

W

L1 L2
L

Managerial Perspective: What happens, if Minimum wage rises?

The Example of Firm Dealing with Auto Parts
Number of Total
• Example: Workers Product
• The firm has estimated that the 10 93
cost of hiring 10 additional workers
is equal to $160 per day, that is, 20 135
MCL = $160. 30 180
• Assume the firm can sell all the 40 230
parts it wants at a price of $40. 50 263
Hence, MR = $40
60 293
• We know, the MRPL = (MR)(MPL) =
70 321
($40)(MPL)
80 346
90 368

Manager’s Perspective: Upto which 100 388

point will the firm operate? 110 400
120 403
130 391
140 380
31
The Example of Firm Dealing with Auto Parts
Number of Total Marginal Product Marginal Marginal Value
Workers Product of Labour Revenue Product Cost Creation
10 93 160

20 135 4.2 168 160 8

30 180 4.5 180 160 20
40 230 5.0 200 160 40
50 263 3.3 132 160 -28
60 293 3.0 120 160 -40
70 321 2.8 112 160 -48
80 346 2.5 100 160 -60
90 368 2.2 88 160 -72
100 388 2.0 80 160 -80
110 400 1.2 48 160 -112
120 403 0.3 12 160 -108
130 391 -1.2 -48 160 -208
140 380 -1.1 -44 160 -204

Manager’s Perspective: Upto which point will the firm operate? 32

How can the Market Signals
influence Production Decision?

Estimation of Demand – Adjustment in Supply –

Implications for Factor Market.
Automobile Market
P

S2
S1

E3 E1
E2
D1
D2
Q

Labour Market
W

E4 S
W0 E5

D1
D2
L
How can the Government Policies
Influence Production decision?
Recent Steel Sector Interventions
Learning Assessment
No. Question Answer

1 The short run is:

A Less than a year

B Less than a month

C However long it takes to produce the planned output

D A time period in which at least one input is fixed

2 For many firms, capital is the production input that is typically fixed in the short
run. Which of the following firms would face the longest time to adjust its capital
inputs?
A Firm that makes DVD players

B Computer chip fabricator

C Flat-screen TV manufacturer

D Nuclear power plant

3 Maruti manufactures automobiles given the production function q = 5KL, where

q is the number of autos assembled per eight-hour shift, K is the number of robots
used on the assembly line (K) and L is the number of workers hired per hour (L). If
we use K = 10 robots and L = 10 workers in order to produce q = 450 autos per shift,
then we know that production is:
A Technologically efficient

B Technologically inefficient

C Maximized

D Optimal
Learning Assessment
No. Question Answer

4 At a given level of labor employment, knowing the difference between the average
product of labor and the marginal product of labor most importantly tells you:
A Whether increasing labor use raises output

B Whether economies of scale exist

C How increasing labor use alters the average product of labor

D Whether production technique is efficinet

5 The law of diminishing returns applies to:

A The short run only

B The long run only

C Both the short and the long run

D All inputs, with no reference to the time period

6 Marginal product crosses the horizontal axis (is equal to zero) at the point where:

A Average product is maximized

B Total product is maximized

C Diminishing returns set in

D Output per worker reaches a maximum

Answers
No. Answer
1 D
2 D
3 B
4 C
5 A
6 B
Practical Application - 2
• Ronaldʹs Outboard Motor Manufacturing plant production function is:
• Q = f(K, L) = 25√(KL).

• Ronald is investigating a new outboard motor manufacturing technique. It

believes that if it adopts the new technique, his production function for
outboard motors will become:
• Q = f(K, L) = 36√(KL)

• Given that Ronald uses 4 units of machine hours, sketch his production
function with the old technique and the new technique as he increases
labor hours.

• With the new technique, do labor hours contribute more to production?

The Old (Q1) and New (Q2) Outputs
300

Q1 Q2 MQ1 MQ2
250

200

150

100

50

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

The slope of the new production function is steeper for all labor uses. This
implies the MPL is higher for the new technique, i.e., L contribute at a
higher rate.
What happens when a firm employs two
variable inputs?
Demand as a Driver of Long-Run Dynamics
Maruti Thought on Newer Products: Profit
or Expected Profit as Driver of Change?

• Rise in cost of production

• Rise in variable cost for the consumer
• Government regulations on net-zero emissions
• Government regulations on Crude import reduction
• Anticipated Trade Policy change in other countries?
Production Function With Two Variable Inputs
• Up to this point, we have been concerned with the case where
there is only one variable input.
• Now take up the general case where there are two variable
inputs.
• For simplicity, we assume that there are only two inputs, in
which case the situation is the long run, since all the inputs are
now variable.
• If X1 is the amount of the first input and X2 is the amount of
the second input, the production function is:
Q = f (X1, X2) …………. (i)
• where Q is the firm’s output rate. The marginal product of the
first input is δQ/δ X1; the marginal product of the second input
is δQ/δ X2.

45
Production Function With Two Variable Inputs
• The production function, represented by equation (i), does not
include many of the different ways in which a given output can
be produced, because it includes only efficient combinations of
inputs.
• For example, if 2 units of labour and 3 units of capital can
produce 1 unit of output, this combination of inputs and output
will not be included in the production function if it is also
possible to produce 1 unit of output with 2 units of labour and
2 units of capital.
• The former input-output combination is clearly inefficient,
since it is possible to obtain the result with the same amount
of labour and less capital.
• So, production function has to be consistent and efficient.

Manager’s Perspective: Production functions represent the

efficient combinations that represents maximum outputs
with a fixed set of inputs. 46
How can the outputs of the Production
Function be represented?
Isoquants
An isoquant is a curve showing all possible (efficient) combinations
of inputs that are capable of producing a certain quantity of output.

• Several isoquants, each pertaining to

a different output rate is shown in
the figure.
• The two axes measure the quantities
of inputs that are used.
• Let labour and capital be the relevant
inputs in this case.
• The curves show the various
combinations of inputs that can
produce 5000, 10000 and 30000
units of output.

The concept is analogous to the Indifferences Curves

discussed under Welfare and Utility. 48
Isoquants
dK / dL = - MPL/MPK
• For example, consider the isoquant
pertaining to 5000 units of output
per period of time.
• According to this isoquant, it is P
possible to attain this output rate
if 10 workers are hired and 2
machines rented / purchased per
period of time.
• Alternatively, this output rate can
be attained if 6 workers are hired Q
and 3 machines are rented per
period of time.

Manager’s Perspective: The firm will employ more labour or

more capital for producing a particular level of output?
49
Marginal Rate of Technical Substitution
• The production function is:
• Q = f(X1, X2) …(1)
• By totally differentiating, we get:
• dQ = (δf/δX1) dX1 + (δf/δX2) dX2 …(2)
• By definition, on an isoquant, the output remains unchanged. So,
dQ = 0.
• (δf/δX1) dX1 + (δf/δX2) dX2 = 0 …(3)
• dX2 / dX1 = - (δf/δX1) / (δf/δX2) …(4)
• dX2 / dX1 = - MP1/MP2 …(5)
• If we have K on the vertical axis (X2) and L (X1) on the horizontal
axis:
• dK / dL = - MPL/MPK

Slope of Isoquant: The marginal rate of technical substitution (MRTS)

shows the rate at which one input can be substituted for another input so as
to keep the level of output constant.
Isoquants: Various Shapes
1. Consider the output of a electric power plant run by
combinations of gas and oil
2. Consider the production of bicycles by joining wheels and
frames
3. Consider the production of a dress with cloth and labour

Manager’s Perspective: How MRTS will shape the isoquants?

Input Factor Substitution Pattern
Input Factor Substitution
1. Figure (a) shows isoquants for an electric power plant with boilers
equipped to burn either oil or gas. Power can be produced by burning:
(1) gas only, (2) oil only, or (3) varying amounts of each. In this
instance, gas and oil are perfect substitutes and the electricity
isoquants are straight lines.
• At the other extreme of substitutability lie production systems in
which inputs are perfect complements: exact amount of each input
are required to produce a given quantity of output.
2. Figure (b) illustrates isoquants for bicycles in which exactly two
wheels and one frame are required to produce a bicycle. Wheels
cannot be substituted for frames, nor vice versa.
• Pants and coats for men’s suits, engines and bodies for trucks, and
chemicals in specific compounds for prescription drugs are further
examples of complimentary inputs.
• Production isoquants for perfect complements take the shape of
right angles or L- shaped.
Input Factor Substitution
3. Figure (c) shows a production process in which inputs can be
substituted for each other within limits.
• A dress can be made with a relatively small amount of labour (L1) and a
large amount of cloth (C1).
• The same dress can also be made with less cloth (C2) if more labour
(L2) is used, because the dressmakers can cut the material more
carefully and reduce waste.
• Finally, the dress can be made with still less cloth (C3), but work
schedule now must be so extremely painstaking that the labour input
requirement rises to L3.
• Although a relatively small addition of labour, from L1 to L2, reduces
the input of cloth from C1 to C2, a very large increase in labour, from
L2 to L3, is required to obtain a similar reduction in cloth from C2 to C3.
The substitutability of labour for cloth diminishes from L1 to L2 to L3
(movement to right and movement downwards).

• Manager’s Perspective: Most labour-capital substitutions in

production systems exhibits this diminishing substitutability.
• Any Example? 54
Learning Assessment
No. Question Answer

1 Which would not increase the productivity of labor?

A An increase in the size of the labor force

B An increase in the quality of capital

C An increase in the quantity of capital

D Adoption on modern technology

2 One of the factors contributing to the fact that labor productivity is higher in the
US than in the Peopleʹs Republic of China is:

A Chinaʹs larger stock of capital

B The higher capital / labor ratio in China

C The higher capital / labor ratio in the U.S.

D Chinaʹs smaller stock of fossil fuels

3 Two isoquants, which represent different output levels but are derived from the
same production function, cannot cross because:

A Isoquants represent different production levels

B This would violate a technical efficiency condition

C Isoquants are downward sloping

D Output represented by isoquants are fixed

Learning Assessment
No. Question Answer

4 As we move downward along a typical isoquant, the slope of the isoquant:

A Becomes flatter

B Becomes steeper

C Remains constant

D Becomes linear

5 If capital is measured on the vertical axis and labor is measured on the horizontal
axis, the slope of an isoquant can be interpreted as the:

A Rate at which the firm can replace capital with labor without changing the output
rate
B Average rate at which the firm can replace capital with labor without changing the
output rate
C Marginal product of labor

D Efficiency of capital

6 A firmʹs marginal product of labor is 4 and its marginal product of capital is 5. If

the firm adds one unit of labor, but does not want its output quantity to change, the
firm should:
A Use five fewer units of capital

B Use 0.8 fewer units of capital

C Use 1.25 fewer units of capital

D Add 1.25 units of capital

Answers
No. Answer
1 A
2 C
3 B
4 A
5 A
6 B
How to arrive at the Optimum Input
Combinations?

Note: A firm is going to set an output target for the next quarter (based
on projected demand), which they will try to produce at the lowest cost.
The Optimal Combination of Inputs
• If a firm wants to maximize profit, it will try to minimize the
cost of producing a given output or maximize the output derived
from a given level of cost.
Assumptions:
• There are two inputs labour and capital, that are variable in
the relevant time period.
• The firm takes input prices as given.
Question:
• What combination of capital and labour should the firm choose if
it wants to maximize the quantity of output derived from the
given level of cost?

• Manager’s Perspective: Is the assumption of given cost logical?

The Optimal Combination of Inputs
• To answer this question, let’s determine the various combinations of
inputs that the firm can obtain for a given expenditure.
• For example, if capital and labour are the inputs and the price of
labour is w per unit and the price of capital is r per unit, the input
combinations that can be obtained for a total outlay C are such that:
wL + rK = C.
• where L is the amount of labour input and K is the amount of capital
input.
• Thus, the various combinations of capital and labour that can be
purchased, given w, r and C, can be represented by a straight line –
capital is plotted on the vertical axis and labour on the horizontal
axis.
• The line, which has an intercept on the vertical axis equal to C/r, an
intercept on the horizontal axis equal to C/w and a slope –w/r, is
called an Isocost line.

The concept is analogous to the Budget Line discussed under

Welfare and Utility.
The Optimal Combination of Inputs
Slope = - w/r = - Rs. 1,500 / Rs. 2,500 = - 0.6
C/r

• Each isocost line:

Units of capital per month

• Combinations of labor and capital

10 that can be purchased for a given
amount of total cost
• Slope is negative of wage divided
by the rental cost of capital
5

0 C/w
5 10 15
Units of labor per month

Higher costs: Isocost lines farther from origin

61
The Slope of Cost Line
• The cost constraint is:
• C = wL + rK .. (1)
• Let’s assume, w and r are given by the Ministry of Labour (minimum
wage) and RBI (prime lending rate) respectively.
• By totally differentiating, we get:
• dC = wdL + rdK .. (2)
• By definition, on an isocost, the amount spent by the firm of
production-related activities remains unchanged. So, dC = 0.
• wdL + rdK = 0 .. (3)
• dK / dL = - w / r .. (4)
• So, the slope of the Isocost line represents the factor price ratio?
• What happens if the wage rate increases?
The Cost Lines
• Suppose, the factor prices are given in the economy: r = 2, w
= 5.
• Let’s say, a firm’s ability of spend is determined by the Bank
Loan received = 100 = C
• Now, how can the firm produce by employing different input
combinations and: (a) remain on the same Isocost, (b) reach
a higher Isocost, (c) reach a lower Isocost?

K r L w C1 C2 C3
50 2 0 5 100
25 2 10 5 100
10 2 16 5 100
0 2 20 5 100
25 2 20 5 150
10 2 10 5 70
The Optimal Combination of Inputs
• Super-imposing the relevant Isocost curve on the firm’s Isoquant map,
we can determine graphically which combinations of inputs will maximize
the output.
• The firm should pick the point on the Isocost curve that is on the
highest Isoquant, for example, R in the figure (next slide).
• This is a point where the Isocost curve is tangent to the Isoquant.
• Thus, since the slope of the Isocost curve is the negative of w/r and the
slope of the Isoquant is the negative of MPL/MPK, it follows that the
optimal combination of inputs is one where MPL/MPK = w/r.
• Put differently, the firm should choose an input combination where
MPL/w= MPK/r.
• Thus, the firm will maximize output by distributing its expenditures
among various inputs in such a way that the marginal product of a rupee’s
worth of any one input is equal to the marginal product of a rupee’s
worth of the other input used.

Manager’s Perspective: Importance of capital and labour units

used and costs
The Optimal Combination of Inputs

• R: isoquant Q2 is tangent to the

Isocost curve Isocost line.
Units of capital per month

• MPL / MPK = w/r … (1)

• MPL /w = MPK /r … (2)

a f • MPL /Price of L = MPK / Price of

K K

R Q3
• Consider Point a.
Q2 • MPL / MPK > w/r … (3)
S • MPL/w > MPK/r … (4)
Q1

Units of labor per month

Manager’s Perspective: How should a firm choose the optimal

combination of inputs if its objective is to minimize cost subject
to a given level of output? 65
Practical Application - 3
• Consider a production function for agricultural crops
• Crops can be produced using different methods. Food grown on
large farms in the United States is usually produced with a capital
intensive technology, which involves substantial investments in
capital, such as equipment and farm machineries, and relatively
little input of labour. However, food can also be produced using very
little capital equipment (a hoe) and a lot of labour.
• One way to describe the agricultural production process is to show
one isoquant that describes the combination of inputs that
generates a given level of output.
• Consider an isoquant (associated with a production function for
wheat) corresponding to an output of 13,800 bushels of wheat per
year.
• The manager of the firm can use this isoquant to decide whether it
is profitable to hire more labour or use more machinery.

Manager’s Perspective: Which considerations will determine

the factor intensity of production?
66
Practical Application - 3
• Suppose the farm is operating at a point on the isoquant, with labour input
(L) of 500 hours and a capital input (K) of 100 machine-hours.
• The manager decides to experiment by using fewer hours of machine time.
• To produce the same crop per year, he finds that he needs to replace the
machine time of 10 machine-hours by adding 250 hours of labour.
• Thus, the manager finds that the marginal rate of technical substitution
(MRTS) is equal to 0.04.
• The MRTS tells the manager the nature of the trade-off between adding
labour and reducing the use of farm machinery (and vice versa).
• Because the MRTS is substantially less than 1 in value, the manager knows
that when the wage of labour is equal to the cost of running the machine, he
ought to use more capital. (At his current level of production, he needs 250
units of labour to substitute for 10 units of capital).
• In addition, he knows that unless labour is substantially less expensive than
the use of machine, his production process ought to become more capital-
intensive.

MRTS LK = - MPL / MPK = dK / dL = 10/250 = 0.04 = w/r (in equilibrium)

67
Practical Application - 3
• This example illustrates how knowledge about production
isoquants and the marginal rate of technical substitution can help
a manager.
• The decision about how many labourers to hire and machines to
use cannot be fully resolved until we know the costs of inputs.
• It also suggests why most firms in United States and Canada,
where labour is relatively expensive, operate in the range of
production in which MRTS is relatively high (with a high capital to
labour ratio), while firms in developing countries like India, in
which labour is cheap, operate with a lower MRTS (and a lower
capital to labour ratio).

• Manager’s Perspective: Under ‘Atmanirbhar Bharat Abhiyan’, we

are expecting Apple to relocate its production unit in India.
• Can you think the problem from Apple perspective in terms of
MRTS? 68
Some Considerations
What Happens if Demand is stable
but Competition is steep and One
Input is getting Costlier?

• Managerial Perspective: Why are many corporates

investing on Farming activities in Africa?
• Sino-Cam Iko Ltd., Olam, Daewoo Logistics
Foxconn: Looking for Newer Pastures

• “Foxconn 1.0” - Existing business optimization - Further development of precision molds

Hon Hai
Corporate Social • “Foxconn 2.0” - Digital transformation - embracing innovation
Responsibility • “Foxconn 3.0” - Transformation to new industries focusing on electric vehicles, digital
Report 2020 health, and robotics.
What Happens if a Core Input is
now Costlier?
What happens to the Output?

Manager’s
Perspective:
How will we
display the new
equilibrium in
diagrammatic
representation?
Understanding Returns to Scale
Returns to Scale
• In the short run, one input is fixed, while the other is
variable.
• If more of the other input is applied, production increases
and after an initial productivity rise, the law of
diminishing marginal returns set in.
• In the long run, all inputs are variable.
Question:
If all the inputs are increased in the same proportion,
does output increase in the same proportion?
• The relationship between proportionate changes in both
inputs and output change is referred to as returns to
scale.

75
Returns to Scale: Summary
• Assume that the usage of all inputs are increased by 25 percent.
• If output increases by exactly 25%, the production function
exhibits constant returns to scale.
• If, however, output increases by more than 25%, the production
function exhibits increasing returns to scale.
• Alternatively, if output increases less than 25%, the production
function is characterized by decreasing returns to scale.
• Important: Many production systems exhibit increasing, then
constant, then decreasing returns to scale.
• The region of increasing returns is attributable to specialization.

Manager’s Perspective: How specialization enables firms to

enhance output in proportional sense?
76
Returns to Scale

77
Output Elasticity and Returns to Scale
• To measure whether there are increasing, decreasing, or constant
returns to scale, the output elasticity can be computed.
• The output elasticity is defined as the percentage change in
output from a one–percent change in all inputs.
a. If the output elasticity exceeds one, there are increasing returns
to scale;
b. If it equals one, there are constant returns to scale;
c. If it is less than one, there are decreasing returns to scale.
• Thus, returns to scale can be analyzed by examining the
relationship between the rate of increase in inputs and the
quantity of output produced.

78
Returns to Scale and Homogenous Production Functions
• Certain production functions are called homogenous production
functions when, if each factor is multiplied by a constant t, the
constant can be completely factored out of the production
function expression.

• A production function is homogenous of degree k if:

f (tK, tL) = tkf (K, L) … (1)

f (2K, 2L) = 2f (K, L) … (2)
f (2K, 2L) = 4f (K, L) … (3)

where k is a constant and t is any positive real number.

• If both inputs are increased by the same factor t, output is

increased by the factor tk.

• Returns to scale are increasing if k > 1,

• Returns to scale are constant if k = 1, and
• Returns to scale are decreasing if 0 < k < 1. 79
Application From Cobb-Douglas Function
• Consider the Cobb-Douglas production function:
Q0 = AKaLb
Now, suppose after doubling the inputs:
Q1 = A(2K)a(2L)b
Q1 = A2a Ka2b Lb
Q1 = 2a2bA Ka Lb
Q1 = 2a2bQ0 = 2a+b Q0
where A > 0, 0 < a, b < 1.
Questions:
• Comment on the returns to scale for this production function.
• Role of (a + b)
• a + b = 1.3, what is the type of Return to Scale?
• a + b = 1, what is the type of Return to Scale?
• a + b = 0.9, what is the type of Return to Scale?

• Manager’s Perspective: How to know about a and b?

80
How can a Production Function be Estimated?

Q = AKaLbPc
Log Q = Log A + a Log K + b Log L + c Log P
Regress, LogQ Constant Log K Log L Log P, robust

Q K L P
10 2 10 3
12 3 15 5
15 4 19 7

Proposed functional form or non-parametric

• Manager’s Perspective: Which type of industries are

more likely to have IRS?
• Link with Cost part
Sources of Increasing Returns to Scale
1. Specialization of plant and equipment / Services
• As output increases, specialized labour and efficient large-scale
machinery can be assigned in the production process.
• As more workers and machines are used, it is possible to subdivide
tasks and allow various inputs to specialize.
• Example:
a. Large scale production in furniture manufacturing allows for
application of specialized equipment in metal fabrication, painting,
upholstery, and materials handling.

b. The English editors in a publishing house become more efficient

with repeated operations.

c. The IT programmers in TCS / Infosys becoming more aware of

their functions / possible innovations with experience.
d. McKinsey, BCG in business consultancy services

e. Instead of Manual processing, automated processing of credit cards

Manager’s Perspective: Any other benefits

of specialization leading to scale efficiency?
Sources of Increasing Returns to Scale
2. Economies of massed reserves
• Any business that has a substantial fixed cost component that now
gets spread across the wider range of output.
a. A factory with one stamping machine needs to have 100 spare
parts in inventory to be prepared for breakdown—does a factory
with 20 machines need to have 2,000 spare parts on hand?
b. The cost of preparing the computer code for a software package
is fixed.
c. The cost for a distributor for laying the gas pipelines in a housing
society is fixed - after that providing connections to new
subscribers come at incremental cost.

Manager’s Perspective: Any other benefits of massed

reserves leading to scale efficiency?
Sources of Decreasing Returns to Scale
• Bigger is not always better; managers can experience decreasing
returns to scale.
• The most cited reason is the difficulty of coordinating a large
enterprise. Beyond some scale of operation further gains from
specialization are limited and coordination problems emerge.
• It can be difficult even in a small firm to obtain the information
required to make important decisions; in a large firm, difficulties
tend to be greater.
• It can be difficult even in a small firm to be certain that
management’s wishes are being carried out; in a large firm, these
difficulties too tend to be greater.
• When coordination expenses more than offset additional benefits
of specialization, decreasing returns to scale set in.

Manager’s Perspective: Any other flaws of specialization

leading to scale inefficiency?
84
Learning Assessment
No. Question Answer

1 With increasing returns to scale, isoquants for unit increases in output become:

A Farther and farther apart

B Closer and closer together

C The same distance apart

D None of these

2 A farmer uses M units of machinery and L hours of labor to produce C tons of corn,
with the following production function C = L0.5M0.75. This production function
exhibits:
A Decreasing returns to scale for all output levels

B Constant returns to scale for all output levels

C Increasing returns to scale for all output levels

D No clear pattern of returns to scale

3 Does it make sense to consider the returns to scale of a production function in the
short run?

A Yes, this is an important short-run characteristic of production functions

B Yes, returns to scale determine the diminishing marginal returns of the inputs

C No, returns to scale depends on the consumer's utility function

D No, we cannot change all of the production inputs in the short run
Answers
No. Answer
1 B
2 C
3 D
How do we see Production Efficiencies
in Real World?
Practical Application - 4
Should two Punjab wheat farms merge?
• Agricultural economists have estimated the production function for many
types of farms, here and abroad. Suppose that a study came up with the
following production relationship for a particular type of Punjab wheat farm:

Q = ZA0.1L0.1E0.1S0.7R0.1,
where Q is the output per period, A is the amount of land used, L is the
amount of labour used, E is the amount of equipment used, S is the amount of
fertilizers and chemicals used, R is the amount of other resources used, and Z
is constant.
• The owner of a Punjab wheat farm of this type is concerned that his farm may
be too small to compete effectively with larger wheat farms. His farm is of
below-average size, and he is troubled by the possibility that larger farms may
be more efficient than his.
• He is considering the merger of his farm with a neighboring farm that is
essentially the same (in size and other characteristics) as his own, and he
hires you to advise him on this deliberation.

• Manager’s Perspective: Should a firm acquire a loss-making unit?

• Policymaker’s Perspective: Should two loss-making PSUs merge? 88