Producer Behavior 6

Chapter outline
6.1 The Basics of Production
6.2 Production in the Short
Run
6.3 Production in the Long
Run
6.4 The Firm’s Cost-
Minimization Problem
6.5 Returns to Scale
6.6 Technological Change
6.7 The Firm’s Expansion
Path and the Total Cost
Curve
6.8 Conclusion
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 Introduction 6
We now turn to the supply side of the supply and
demand model
• How do firms decide whether and how much to
produce?
• How do firms choose between inputs such as capital
and labor?
• How does the timeframe of analysis affect firm
decisions?

These questions are fundamental to understanding

how supply responds to changing market conditions

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6.1 The Basics of
6
Production
Production describes the process by which an entity
turns raw inputs into a good or service
• Final goods are purchased by consumers (e.g., bread)
• Intermediate goods are used as inputs in other production
processes (e.g., wheat used to produce bread)
Start with a production function
• Similar to a utility function for consumers, except more
tangible
• Mathematical relationship between amount of output and
various combinations of inputs

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6.1 The Basics of
6
Production
Simplifying Assumptions about Firms’ Production
Behavior
[Link] firm produces a single good
[Link] firm has already chosen which product to produce
[Link] minimize costs associated with every level of
production
• Necessary condition for profit maximization

[Link] two inputs are used in production: capital and labor

• Capital: buildings, equipment, etc.
• Labor: All human resources

[Link] the short run, firms can choose the amount of labor
employed, but capital is assumed to be fixed in total supply
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6.1 The Basics of
6
Production
6. Output increases with inputs
7. Inputs are characterized by diminishing returns
• If the amount of capital is held constant, each additional
worker produces less incremental output than the last, and
vice versa
8. The firm can employ unlimited capital and labor at fixed
prices, and
9. Capital markets are well functioning (the firm is not budget-
constrained)

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6.1 The Basics of
6
Production
Production Functions
• Describe how output is made from different combinations of

Q  f K , L 
inputs

where Q is the quantity of output, K is the quantity of capital,

and L is quantity of labor
A common functional form used in economics is referred
to as the Cobb-Douglas production
  function
Q K L

in which the quantity of each input, each raised to a

power (usually less than one), are multiplied together
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 Application 6
The Environment as an Input to Production
The environment provides many goods and
services that are not exchanged in markets
• Mangroves serve as a key habitat for juvenile grouper
fish, an important commercial species in many parts
of the world
• This ecosystem service (habitat) is difficult to quantify Images: [Link]

• A lack of knowledge of values often means mangroves

and other ecosystems are destroyed to make way for
more salient economic benefits (e.g., beach resort or
shrimp farm)

Barbier (2007) provides an overview and

application of a methodology for valuing the
environment as an input
Citation: Barbier, E.B. 2007. “Valuing ecosystem services as productive inputs” Economic Policy January,
177-229.

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 Application 6
Consider the following production function for a
fishery h  f E ,..., E , S  i k 
where h is fishery-wide harvest, the E ’s are

size of net, etc.) and S is the size of the adjacent

“traditional” inputs (# of boats, hours spent fishing,

wetland Images: [Link]

More wetlands are associated with lower costs and

more aggregate production in an open-access
fishery
• Model is applied to mangrove wetlands in Thailand
• Adjacent to valuable artisanal fisheries

Value of mangroves is found to be $10-12,000 per

hectare
Citation: Barbier, per year
E.B. 2007. “Valuing ecosystem services as productive inputs” Economic Policy January,
177-229. [Link]
• Includes other values (storm protection, forest products)
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•
6.2 Production in the Short
Run 6
The “short run” refers to the case in which the level of
capital is fixed
Q  f K, L  
First, consider how production changes as we vary the
amount of labor
Marginal product refers to the additional output that a
firm can produce using an additional unit of an input
• Similar to marginal utility
• Generally assumed to fall as more of an input is used

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 6.2 Production in the Short
Run 6
The marginal product of labor, MPL , is given as
Q
MPL 
L
Consider the production function
0.5 0.5
Q K L
where capital is fixed at four units

Q 40.5 L0.5 2 L0.5

Table 6.1 calculates the marginal product of labor for this
production function
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6.2
Production in the Short
Run 6

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6.2Production in the Short
Run 6
Figure 6.1 A Short-Run Production Function

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 6.2 Production in the Short
Run 6
Table 6.1 and Figure 6.1 reveal the common assumption
of diminishing marginal product associated with
production inputs
As a firm employs more of one input, while holding all
others fixed, the marginal product of that input will fall
This is seen most easily using a graph

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 6.2 Production in the Short
Run 6
Figure 6.2 Deriving the Marginal Product of Labor

(a) (b)

Output (Q ) MPL
Production (∆ Q /∆ L )
5 function
4.47 1.5
Slope = 0.45
4
Slope = 0.5
3.46
Slope = 0.58 1.0
2.83 Slope = 0.71
2
Slope = 1 Slope = 1
L0.5 0.5 MPL

0 1 2 3 4 5 Labor (L) 0 1 2 3 4 5 Labor (L)

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 6.2 Production in the Short
Run 6
Returning to the mathematical representation of MPL ,

MPL 
Q f K , L  L  f K , L

   
L L
0 .5 0 .5 0 .5
Q 
and using the example production function4 L 2 L
2L  L   2 L0.5
0.5
MPL 
L

the equation for MPL

As L becomes very small, we use calculus to arrive at

MPL 
df K , L 1
 0.5 L 0.5
 
dL L

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 6.2 Production in the Short
Run 6
Another important production metric is average product
• Total output divided by the total amount of an input used
• The average product of labor is give by
Q
APL 
L

 What is the difference between marginal and average

product?

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Production of a Bakery Figure it out

Short-run production function for a local bakery

making loaves of bread 0.75
 
Q  f K , L 20 K L0.25
Q is the number of loaves produced per Khour, is the
number of ovens (fixed at 2), and L is the number of
workers
Answer the following
1. Write an equation for the short-run production
function with output as a function
L of
0, 1labor
, 2, 3, 4only
,5
2. Calculate total output per hour for
3. Calculate MPL and APL for the same labor levels
above

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Production of a Bakery Figure it out

1. SubstituteK 2 into the production function

Q 202 
0.75
L0.25 33.64 L0.25
2. To calculate total output, simply substitute the
different labor quantities into the production
function above
Labor Production
L=0 Q = 33.64(0)0.25 = 0
L=1 Q = 33.64(1)0.25 = 33.64
L=2 Q = 33.64(2)0.25 = 40
L=3 Q = 33.64(3)0.25 = 44.27
L=4 Q = 33.64(4)0.25 = 47.57
L=5 Q = 33.64(5)0.25 = 50.30

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Production of a Bakery Figure it out

3. The marginal product of labor is the additional

amount of bread produced with one more unit of
labor
Average product is simply total output divided by
total labor
Labor Production MPL APL
L=0 Q = 33.64(0)0.25 = 0 — —
L=1 Q = 33.64(1)0.25 = 33.64 33.64 33.64
L=2 Q = 33.64(2)0.25 = 40 6.36 20
L=3 Q = 33.64(3)0.25 = 44.27 4.27 14.76
L=4 Q = 33.64(4)0.25 = 47.57 3.30 11.89
L=5 Q = 33.64(5)0.25 = 50.30 2.73 10.06

 Are there diminishing returns to labor? How do you

know?
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6.3 Production in the Long
Run 6
• For our purposes, the long run is defined as a period
of time long enough to allow firms to adjust the
amount of every input used in production

• Table 6.2 describes a long-run production function in

which two inputs, capital and labor, are used to
produce various quantities of a product
• Columns represent different quantities of labor
• Rows represent different quantities of capital
• Each cell in the table shows the quantity of output
produced with the labor and capital represented by the
column and row values

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6.3
Production in the Long
Run 6

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6.4 The Firm’s Cost-
Minimization Problem 6
The third assumption about production behavior: firms
minimize the cost of production
Cost minimization refers to the firm’s goal of producing
a specific quantity of output at minimum cost
• This is an example of constrained optimization
• The firm will minimize costs subject to a specific amount of
output that must be produced
The cost minimization model requires two concepts, isoquants
and isocost lines

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6.4 The Firm’s Cost-
Minimization Problem 6
An isoquant is a curve representing combinations of
inputs that allow a firm to make a particular quantity of
output
• Similar to indifference curves from consumer theory

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6.4
The Firm’s Cost-
Minimization Problem 6
Figure 6.3 Isoquants

Capital (K )

Output, Q = 4

Output, Q = 2
1
Output, Q = 1
0 1 2 4 Labor (L )

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6.4 The Firm’s Cost-
Minimization Problem 6
An isoquant is a curve representing combinations of
inputs that allow a firm to make a particular quantity of
output
• Similar to indifference curves from consumer theory
The slope of an isoquant describes how inputs may be
substituted to produce a fixed level of output
This relationship is referred to as the marginal rate of

input X for input Y, holding output constant (MRTSXY )

technical substitution: the rate at which the firm can trade

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6.4 The Firm’s Cost-
Minimization Problem 6
Figure 6.4 The Marginal Rate of Technical
Substitution
Capital (K ) The marginal product
of
labor is high relative to
the
A marginal product of
capital . marginal product
The
of
labor is low relative to
the
B marginal product of
Q =2 capital.

Labor (L)

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6.4 The Firm’s Cost-
Minimization Problem 6
Mathematically, MRTSLK can be derived from the
condition that, along an isoquant, quantity of output
produced is held constant
Q MPL L  MPK K 0

Kyields
Rearranging to find the slope of the isoquant MPthe MRTSLK
MPK K  MPL L  MRTS LK  L

L MPK

• MRTSLK describes the rate at which labor must be substituted for

Moving down an isoquant, the amount of capital used declines

capital to hold the quantity produced constant

• As you move down an isoquant, the slope gets smaller, meaning
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the firm has less capital and each unit is relatively more productive
6.4 The Firm’s Cost-
Minimization Problem 6
The Curvature of Isoquants: Substitutes and
Complements
The shape of an isoquant reveals information about the
relationship between inputs to production
• Relatively straight isoquants imply that the inputs are relatively
substitutable
• Relatively curved isoquants imply the inputs are relatively
complementary

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6.4 The Firm’s Cost-
Minimization Problem 6
Figure 6.5 The Shape of Isoquants Indicates the
Substitutability of Inputs

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6.4 The Firm’s Cost-
Minimization Problem 6
The Curvature of Isoquants: Substitutes and
Complements
To illustrate, consider extreme cases
• When inputs are perfect substitutes, they can be traded
off in a constant ratio in a production process (MRTS is
constant)

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 6.4 The Firm’s Cost-
Minimization Problem 6
Perfect substitutes

from either oil or natural gas (Q is

Consider production of electricity
Oil (barrels)
kw-hours)
4
Assume the plant may switch
3
between fuel sources at a relatively
constant rate
2 MRTS is constant

1 **Numbers are examples

Q=1 Q=2 Q=3 Q=4

0 2 4 6 8 Natural gas
(‘000 cubic
feet)
**Numbers are examples

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6.4 The Firm’s Cost-
Minimization Problem 6
The Curvature of Isoquants: Substitutes and
Complements
The shape of an isoquant reveals information about the
relationship between inputs to production
• Relatively straight isoquants imply that the inputs are relatively
substitutable
• Isoquants with significant curvature imply strong complementarity
To illustrate, consider extreme cases
• When inputs are perfect substitutes, they can be traded off at a
constant rate as part of a production process (constant MRTS)
• When inputs are perfect complements, they must be used in a
fixed ratio as part of a production process

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 6.4 The Firm’s Cost-
Minimization Problem 6
Perfect complements
Consider the provision of bus
Buses services
For a bus to operate, it requires
one driver and one bus
C At point A , two buses are in
3 Q=3

A B
service
2 Q=2 Adding another driver (point B )
will not increase the number of
1 Q=1 buses in service

needed (point C )
For this, another bus is also
0 1 2 3 Bus drivers

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6.4 The Firm’s Cost-
Minimization Problem 6
Isoquant maps show how quantities of inputs are related to
output produced
An isocost line shows all of the input combinations that yield
the same cost
• Similar to the budget constraint facing consumers, equation given
by
C RK  WL
where C is total cost, R is the “rental rate” of capital, and W is the
wage rate
• Rearranging yields capital as C
a W of the rental rate, wage rate,
function
and labor
K  L
R R

• Or, graphically
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6.4 The Firm’s Cost-
Minimization Problem 6
Figure 6.7 Isocost Lines
Capital (K )

1
C = $50 C = $80 C = $ 100
0 1 2 3 4 5 6 7 8 9 10 Labor (L )

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6.4 The Firm’s Cost-
Minimization Problem 6
Identifying Minimum Cost: Combining Isoquants and
Isocost Lines
Remember, the firm’s problem is one of constrained
minimization
• Firms minimize costs subject to a given amount of production
• Cost minimization is achieved by adjusting the ratio of capital to
labor
• Similar to expenditure minimization in Chapter 4

Graphically, cost minimization requires tangency between the

isoquant associated with the chosen level of production, and
the lowest cost isocost line

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6.4 The Firm’s Cost-
Minimization Problem 6
Figure 6.10 Cost Minimization

Capital (K )

B (cost-minimizing
combination)

CC cannot
produce Q.
CA can produce Q but
is more expensive.

CA
A
CC CB Q=Q
Labor (L )

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6.4 The Firm’s Cost-
Minimization Problem 6
Identifying Minimum Cost: Combining Isoquants and
Isocost Lines
Mathematically, tangency occurs where the slope of the isocost
line is equal to the W
slope MP MPK MPL or
 of Lthe
 isoquant,

R MPK R W

What does this condition imply?

• Costs are minimized when the marginal product per dollar
spent is equalized across inputs
MPK MPL MPK MPL
 
R W R W
QUESTION: What if or

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Cost minimization figure it out

A firm is employing 25 workers (W = $10/hour) and 5

units of capital (R = $20/hour). At these levels, the
marginal product of labor is 25 and the marginal
product of capital is 30.
Answer the following
1. Is this firm minimizing costs?
2. If not, what changes should they make?
3. How does the answer to (2) depend on the
timeframe of analysis?

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Cost minimization figure it out
MP MPL
1. Cost minimization occurs when K 
R W

For this firm, we haveMP 30

K

1.5
R 20
MPL 25
 2.5
W 10

Since these w ratios

MPL /two MPK / are
r not equal, the firm is not minimizing costs

2. As , changing the mix of capital and labor can

lead to a lower cost of producing the same quantity of output
• The wages to labor and capital are fixed, so to equate these two, the
quantity of labor employed must rise and/or the quantity of capital
employed must fall
• This will shift and/or pivot the isoquant

3. Generally, the short run implies that only the amount of labor
employed can© 2013
Copyright beWorth
altered
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 Application 6
The Cost of Labor and Automation
Stringent labor laws, the threat of labor strikes,
and high payroll taxes in France have made labor
more expensive than in many other western
countries
• 3300 page labor code Images: [Link]

• 39% payroll taxes (in U.S., employers pay <10%)

The response has been a push for automation in

service delivery (i.e., substitution of capital for
labor)
• Self-checkout registers at supermarkets
• Automated ordering at fast food restaurants
• Driverless trains

What is the effect of increasing payroll taxes (a

tax on labor) on the choice between labor and
Citation: “France and automation: Driverless, workless.” The Economist, November 26, 2011.

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capital?
 Application 6
Consider a supermarket deciding between auto checkout
computers and human cashiers

Auto
customers per hour with 8 machines and 8 people (point A )
Before the tax, the supermarket was able to serve 500
checkout
computers
2
0
As the relative price of labor

inward (C′ )
increases, the isocost curve pivots
1
6
1 B
To maintain the same level of

2 new isocost line (C2) is tangent to

production, total costs rise until the
1
0
8
A the old isoquant (point B )
Q = 500
4 C′ C2
C1
0
2 4 8 12 16 20 Cashier
s
Citation: “France and automation: Driverless, workless.” The Economist, November 26, 2011.

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Isocost Lines figure it out

Suppose the wage rate W = $10/hour and the rental

rate of capital R = $20/hour.

1. Write an equation for the isocost line for the firm

2. Draw a graph (with capital on the horizontal axis)
showing the isocost line for C = $400. Indicate the
intercepts and the slope.
3. Suppose the price of labor increases to $20 per
hour. Show what happens to the isocost line on
your graph.

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Isocost Lines figure it out

1. The isocost line has the form:

C RK  WL
For this firm, we have
C 10 L  20 K

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Isocost Lines Figure it out

equal to $400/w ; the

The vertical intercept is

Hours of horizontal to $400/r .

labor
4
is equal to −w/r
The slope of the isocost line
0
3
2 Slope =
An increase in the wage
2 −0.5
paid to labor reduces the
4
2
C1 number of hours of labor
0
1
$400
that can be purchased with
6 C2
Slope =
8 −1

0
2 8 12 16 20 Hours of
capital
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6.5
Scale
Returns to
6
Returns to scale refers to the change in output when all
inputs are increased or decreased in the same proportion
Returning to the Cobb-Douglas production function

Q K  L

If we assume  0.5 , then

Q K 0.5 L0.5
If K = 2 and L = 2, then Q = 2
What happens if the amount of capital and labor used both double?

Q 40.5 40.5 2 2 4

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6.5
Scale
Returns to
6
This relationship, whereby production increases proportionally
with inputs, is called constant returns to scale
Increasing returns to scale describes production for which
changing all inputs by the same proportion changes output
more than proportionally
Decreasing returns to scale describes production for which
changing all inputs by the same proportion changes output less
than proportionally

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6.5
Scale
Returns to
6
QUESTION: Why might a firm experience increasing returns to scale?
• Fixed costs (e.g., webpage management, advertising
contracts) do not vary with output
• Learning by doing may occur, whereby a firm develops more
efficient processes as it expands
Generally, firms should not experience decreasing returns to
scale
• When this phenomenon is observed in data, it often results
from not accounting for all inputs (or attributes); for instance,
second manager may not be as competent as first

QUESTION: Are there any examples of true decreasing returns?

• Regulatory burden: as firms grow larger, often subject to more
regulations; compliance costs may be significant

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 Returns to
6.5Scale 6
Figure 6.12 Returns to Scale
(a) (b) (c)
Constant Returns to Scale Increasing Returns to Scale Decreasing Returns to Scale

Capital Capital Capital

(K) (K) (K)

4 4 4
Q =4 Q =6 Q =3

2 2 2
Q =2 Q = 2.5 Q = 1.8
1 1 1
Q =1 Q =1 Q =1

0 1 2 4 0 1 2 4 0 1 2 4
Labor (L) Labor (L) Labor (L)

Note: labor and capital doubled between

isoquants.
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Returns to Scale figure it out

For each of the following production functions,

determine if they exhibit constant, decreasing, or
increasing returns to scale
a. Q 3K  5 L
b. Q min 6 K , 5 L 
0 .6 0 .3
c. Q 18 K L

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Returns to Scale figure it out

The simplest way to determine returns to scale is to

plug in values for labor and capital, calculate output,
then double the inputs and calculate output again
a. Consider K = L = 2
Q 3K  5 L 6  10 16
Now, double the inputs
Q 3K  5 L 34  54  32
Since output doubled when inputs doubled, we have
constant returns to scale

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Returns to Scale figure it out

b. Consider K = L = 2 again

Q min 6 K , 5 L  10
Now, double the inputs
Q min 64 , 54  20
And once again, we have constant returns to scale

c. K=L=2
Q 18K 0.6 L0.3 33.59
Now, double the inputs
Q 184  40.3 62.68
0.6

Since the new output is less than twice the old output, we
have decreasing returns to scale

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6.6 Technological
6
Change
Examining firm-level production data over time reveals
increasing output, even when input levels are held constant
• The only way to explain this is by assuming some change to the
production function
This change is referred to as total factor productivity
growth
• An improvement in technology that changes the firm’s production
function such that more output is obtained from the same amount of
inputs
Q multiplicatively
Often assumed to enter Af K , L 
with production 

where A is the level of total factor productivity

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6.6 Technological
6
Change

production of Q* requires L1 labor

With old technology, the

Capital and K1 capital

isoquant associated with Q* shifts

When technology improves, the

C1
capital (L2 and K2 )
inward, requiring less labor and

C2
A
K1
K2
B
Q* (old tech)
Q* (new tech)

L2 L1 Labor
0

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 6
The Firm’s Expansion
6.7 Path and Total Cost
Curve
So far, we have only focused on how firms minimize costs,
subject to a fixed quantity of output
• We can use the cost minimization approach to describe how capital
and labor change as output increases
An expansion path is a curve that illustrates how the optimal
mix of inputs varies with total output
This allows construction of the total cost curve, which shows
a firm’s cost of producing particular quantities

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 6
The Firm’s Expansion
6.7 Path and Total Cost
Curve
Figure 6.15 The Expansion Path and the Total Cost
Curve
Capital Total Cost

Total cost (TC)

Expansion path
C
$25
C 0
B
$15
B Q = 30 0 A
A $10
Q = 20 0
Q = 10
0 C = 100 C = 150 C = 250 10 20 30
Labor Output
0

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6.8 Conclusion 6
This chapter looked closely at how firms make decisions
• Firms are assumed to minimize costs at every level of production
• The cost-minimizing combination of inputs occurs where the
marginal rate of technical substitution is equal to the slope of the
isocost line

In Chapter 7 we delve deeper into the different costs facing

firms, and how they change with the level of production

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