ACC 806 – Economic

Theory
Production Theory 2
Production Theory
1.0 Introduction
• As earlier highlighted, Production function is purely a technical relationship between inputs
and output.
• A product can be produced through various processes each process containing a certain
combination of factors. The choice of any particular process is in most cases based on the
available technology and other economic consideration.
• Analysis of production in our earlier lecture was based on the use of one variable input.
• We will build on this assumption by considering a production function with two variable
inputs
• The production function with two variable inputs will look at combinations of two factor
inputs required for the efficient production of an output.
• We will also examine the choice of the optimal combination of factors by the producer.
• It is important to note that all the variables in the production function are flow that is they
are measured per unit of time. For instance, agricultural production function can be
estimated per cropping season while production of industrial products can be estimated
even daily.
Production Theory Contd.
Isoquant
• A production function with two variable inputs can be depicted by the formula: Q = f (L, k)
• Where Q is the output and Land k are factor inputs, say, labor and capital respectively.
• We will use this function to illustrate a very important physical relationship between inputs
and output i. e. isoquant.
• An isoquant shows the different combinations of inputs say labor and capital, which can be
used to produce a specific quantity of output.
• It is a locus of points each of which represents a combination of inputs capable of producing
stipulated quantity of output.
• The graph of an isoquant may assume various shapes depending on the degree of
substitutability of inputs.
• We will limit ourselves to a smooth curve isoquant, which is negatively sloped and convex to
the origin. This shape of isoquant assumes continuous substitutability of the two variables
over a certain range, beyond which the factors cannot substitute for each other.
• Figure 11.1 shows the isoquant of combinations of labor and capital to produce a specified
quantity of an output.
Production Theory Contd.
Production Theory Contd.
• At points A and B of the isoquant in Figure 11.1, the same quantity of output could be
produced using the various combinations of labor and capital in the ratio of L1: K1 and L2 : K2
respectively.
• Other combinations of labor and capital along the isoquant curve will yield the same level of
output.
• The slope of the isoquant decreases as we move downwards along its length. In other words,
one factor could be substituted for another along a particular range on the isoquant to
produce the same level of output.
• A Production function with more than one variable input describes a whole array of Isoquants
relating output to different combinations of factor inputs. It shows how output varies as the
factor inputs varies.
• For a production function involving labor and capital, we could have an array of isoquant
showing the various trade-off between capital and labor at specified levels of output.
• A higher isoquant refers to a greater quantity of output and a lower one, to smaller quantity
of output.
• Let us consider three different combinations of capital and labor to produce three levels of
output using the same set of axes as indicated in Figure 11.1
Production Theory Contd.
• If you plot all the points on the same graph and connects
all the different combinations by a smooth curve, we get
an array of isoquants (isoquant map) each representing a
combination of inputs that will produce different
quantities of output.
• An isoquant map relating output to different
combinations of labor and capital is shown in Figure
11.2.
Production Theory Contd.
Production Theory Contd.
• The more to the right an isoquant lies, the higher the level of output
it represents, thus you will observe, from Figure 11.2 that isoquant
represented by III depicts a higher level of output than that given by
I.
• This implies, that a rational producer will always prefer to operate
on a higher isoquant with greater quantity of output.
• Note that Isoquants relating output to different combination of
inputs cannot intersect or cross each other. This is expected because
if a set of isoquant were allowed to cross, the point of intersection
would be imply that the firm could produce two different levels of
output using the same combination of factor inputs. This is not
possible based on our assumption that each isoquant represent the
most efficient techniques of production.
Production Theory Contd.
Marginal rate of technical substitution
• The points on an isoquant represent different combinations of factor inputs that
will yield the same level of output. This implies that, to operate on a given
isoquant, one factor input would have to be substituted for another to produce
the same level of output.
• The rate of substitution, which equally expresses the slope of the isoquant, is
called the marginal rate of technical substitution. The rate of technical substitution
of one input for another is the amounts of one input that must be given up by
increasing the amount of the second input used by one unit and still remain on the
same isoquant. It is referred to as Marginal Rate of Technical Substitution (MRTS)
• As the producer moves along an isoquant, the MRTS LK Diminishes. The declining
value of marginal rate of technical substitution along the curve is a reflection of
the convex nature of an isoquant.
• We will use figure 11.3 to illustrate the declining nature of the slope of an
isoquant.
Production Theory Contd.
Production Theory Contd.
At point A on the isoquant in Figure 11.3, the combination of
capital and labor is (9, 2) while at point B, the combination is (5,
4.2)-respectively. Thus moving from point A to B, the firm gives
up 4 units of capital (MPk) for additional 2.2 units of labor
(MPL1' Thus the MRTSkL = 4/2.2 = 1.8. Similarly, moving from
point B to C, the combination of capital and labor change from
(5, 4.1) at point B, to (2, 6.4) at point C. Thus, the firm gives up 3
units of capital (MPk) for additional 2.3 units of labor (MPL). Thus
the MRTSkL = 3/2.1 = 1.4. As you move down the isoquant, the
marginal rates of technical substitution continue to diminish.
This is so because the less capital and the more labor the firm is
Production Theory Contd.
Isocosts
• An isoquant map allows us to compare points representing combinations of
factor inputs, which will give the same quantity of outputs.
• You will also recall that isoquant located to the right and above other isoquants
represents higher quantity of outputs.
• A rational producer will naturally want to operate on a higher isoquant.
• However, the relative prices of factor inputs and the total cost outlay of the firm
will determine the optimum input combination, which a firm will use.
• Let us assume that the total cost outlay of a firm is C, and the two inputs the firm
uses in production are labor (L) and capital (k).
• Assuming the labor wage rate is w and the price of capital service is r and if the
firm spent all of its total cost outlay on labor, it could purchase C/Pw_ units of
labor., which is the total cost outlay divided by the unit price of labor.
Production Theory Contd.
• On the other hand, if the firm spends all its cost outlay on
capital, it could purchase C/Pr units of capital, that is total cost
outlay divided by unit price of capital.
• If you join these two points by a straight line as shown in Figure
11.4, we get the isocost of the firm.
• Points on the isocost line represent different combinations of
labor and capital that can be purchased with a given cost outlay.
• An isocost line can be defined as the combination of factor
inputs the firm can purchase with a given monetary cost outlay.
• Note that any combination of input outside the isocost line is
unattainable at the given total cost outlay.
Production Theory Contd.
Production Theory Contd.
• The slope of the isocost line is equal to the ratio of the input prices.
• With the wage rate of labor (w) and the price of capital service (r), the slope of the isocost line
illustrated in Figure 11.4 is represented by - Pw / Pr.
• An isocost line is negatively sloped because increasing the expenditure on one input implies that less
will be left to spend on the other input.
Producer equilibrium
• The goal of a firm is how to combine factor inputs to produce the largest quantity of output for a given
cost outlay.
• Let's assume the price of capital service is N10 per unit and the wage rate is N8 and the firm's total
cost outlay is N500 per day.
• Subject to this input prices, the firm will maximize output attainable by selecting the proper input
combination. That is, among all input combination he can purchase for the available total cost outlay,
he must select the one that results in the greatest level of output.
• Given a set of isoquants representing different levels of output, a firm will operate on the highest
isoquant subject to the total cost outlay. Thus, a producer will maximize his level of output at the point
where the isocost line is tangent to an isoquant as shown in Figure 11.5.
• A producer is said to be in equilibrium when the highest isoquant is reached, given the particular
Production Theory Contd.
Production Theory Contd.
• If you consider the isoquants in figure 11.5, you will observe that the firm can operate
either on isoquant I, or II because both are within the level of the total cost outlay.
• However, at point b1 and b2, on isoquant I, the firm will be operating at a lower
isoquant with smaller quantity of output.
• At point b, the isoquant I is tangent to the isocost line, thus the producer is at
equilibrium at this point. At this point of equilibrium, the slope of the isoquant is equal
to the slope of the isocost.
• The slope of the isoquant is the ratio of the marginal products of the inputs, that is
MPL/MPK, while the slope of the isocost line is the ratio of the input prices, PL/PK. Thus at
equilibrium,
MPL/MPK = PL/Pk. Or MPL/PL = MPk/PK

• This means that a producer will maximize output when the marginal product of the last
amount of money spent on labor is the same as the marginal product of the last amount
spent on capital.
Production Theory Contd.
Expansion Path.
An isocost line is the line showing all the different combinations of factor
inputs that a firm can purchase, given the total cost outlay of the firm and
input prices.
If the firm changes its total outlay while the prices of input remained
constant the isocost line also shifts.
An isocost line will shift to the right if there is an increase in total outlay
while the line will shift to the left with decrease in total cost outlay.
The series of isocost line resulting from changes in cost outlay will be
tangent to different isoquants thus defining different equilibrium points for
the producer.
If you join all the points of equilibrium of a producer (points a, b and c), we
will get what is referred to as the expansion path as indicated in Figure 12.6.
Production Theory Contd.
Production Theory Contd.
• Points a, band c are the path along which output will
expand when factor prices remained unchanged.
• The expansion path shows the optimum combination of
the inputs used to produce different levels of output as
illustrated in fig. 11.6.
• At every point of the expansion path, the slope of the
isocost line is equal to the slope of the isoquant.
Production Theory Contd.
Summary
• This lecture focuses on the production function involving two variable inputs.
• We defined an isoquant as a locus of points each of which represents a combination of inputs
capable of producing a stipulated quantity of output.
• We derived an isoquant map from a set of isoquants each representing different combinations of
input that will give the same quantity of output.
• The slope of an isoquant is defined in terms of marginal rate of technical substitution. The rate of
technical substitution of one input for another is the amounts of one input that must be given up
by increasing the amount of the second input used by one unit and still remain on the same
isoquant.
• An isoquant on its own is not a useful decision tool except it is combined with an isocost line.
• We defined an isocost line as the combination of factor inputs the firm can purchase with a given
monetary cost outlay.
• A firm is said to be at equilibrium if the slope of the isoquant is equal to the slope of the isocost
line.
• Finally, we considered effect of changes in the total cost outlay on the producer equilibrium.
• We derived expansion path from the points of tangency of different isoquants and isocost lines
resulting from changes in the total cost outlay with input prices remaining constant.
• We defined expansion path as the optimum combination of the inputs to use to produce different
Production Theory Contd.
Conclusion
• Understanding the production situation requiring more
than one variable input enable firms make decision
regarding the choice of least input combination to
produce the desired level of output. This choice, in most
cases is based on economic consideration, as a
technically efficient method may not necessarily be
economically efficient. Economic efficiency has to do
with variables like prices of factor inputs which also
depend on the input market situation.