Production Theory 2

1. Production Theory 2

2. Returns-to-Scale • Marginal product describe the change in output level as a single input level changes. (Short-run) • Returns-to-scale describes how the output level changes as all input levels change, e.g. all input levels doubled. (Long-run)

3. Returns-to-Scale If, for any input bundle (x1,…,xn), then the technology described by theproduction function f exhibits constantreturns-to-scale, e.g. doubling all input levels doubles the output level (t=2). Note: Books often (confusingly) replace t with k.

4. Returns-to-Scale One input Output Level y = f(x) 2y’ Constantreturns-to-scale y’ x’ 2x’ x Input Level

5. Returns-to-Scale If, for any input bundle (x1,…,xn), then the technology exhibits decreasing returns-to-scale, e.g. doubling all input levels less than doubles the output level (t=2).

6. Returns-to-Scale One input Output Level 2f(x’) y = f(x) f(2x’) Decreasingreturns-to-scale f(x’) x’ 2x’ x Input Level

7. Returns-to-Scale If, for any input bundle (x1,…,xn), then the technology exhibits increasingreturns-to-scale, e.g. doubling all input levels more than doubles the output level (t=2).

8. Returns-to-Scale One input Output Level Increasingreturns-to-scale y = f(x) f(2x’) 2f(x’) f(x’) x’ 2x’ x Input Level

9. Returns-to-Scale: Example The Cobb-Douglas production function is The Cobb-Douglas technology’s returns-to-scale isconstant if a1+ … + an = 1increasing if a1+ … + an > 1decreasing if a1+ … + an < 1.

10. Short-Run: Marginal Product • A marginal product is the rate-of-change of output as one input level increases, holding all other input levels fixed. • Marginal product diminishes because the other input levels are fixed, so the increasing input’s units each have less and less of other inputs with which to work.

11. Long-Run: Returns-to-Scale • When all input levels are increased proportionately, there need be no such “crowding out” as each input will always have the same amount of other inputs with which to work. Input productivities need not fall and so returns-to-scale can be constant or even increasing.

12. Homogenous Production Function A production function is homogeneous of degree  if F(tK, tL) = t F(K,L) for all t. If= 1CRS If  > 1 IRS If <1DRS Note: Not all production functions are homogeneous. (Y = 1 + L + K)

13. Perfect Substitutes Constant Returns to Scale: Show K Y=aK + bL MRTS= (-) b/a L

14. Perfect Complements Constant Returns to Scale: Show Y = Min {L, K} K Y=Y1 Y=Yo L

15. Cobb-Douglas Homogeneous of degree ( + ) Y=AKL K Y=Y1 Y=Yo L

16. Properties of Cobb-Douglas Production Function Y=AKL The Cobb-Douglas is homogeneous of degree  = (+ ).

17. Properties of Cobb-Douglas Production Function Proof: Given Y=KL now introduce t Y=(tK)(tL) Y= t  K  t  L  Y=t + K  L  Y= t + Y Y=tY as =+ If  =1 (+=1) then CRS If  >1 (+>1) then IRS If  <1 (+<1) then DRS

18. Properties of Cobb-Douglas Production Function Output Elasticity Y=AKL For Capital (show) For Labour (show)

19. Properties of Cobb-Douglas Production Function Y=AKL Marginal Product of Capital (show) Marginal Product of Labour (show)

20. Properties of Cobb-Douglas Production Function Y=AKL Marginal Rate of Technical Substitution (MRTS = TRS) Show

21. Properties of Cobb-Douglas Production Function Y=AKL Euler’s theorem: Where  is the degree of homogeneity (show)

22. Elasticity of Substitution • The Elasticity of Substitution is the ratio of the proportionate change in factor proportions to the proportionate change in the slope of the isoquant. • Intuition: If a small change in the slope of the isoquant leads to a large change in the K/L ratio then capital and labour are highly substitutable.

23. Elasticity of Substitution •  = % Change in K/L % Change in Slope of Isoquant •  = % Change in K/L % Change in MRTS

24. Elasticity of Substitution A small change in the MRTS Large change in K/L High  K and L are highly substitutable for each other K L

25. Elasticity of Substitution A large change in the MRTS Small change in K/L Low  K and L are not highly substitutable for each other K L

26. Elasticity of Substitution

27. Properties of Cobb-Douglas Production Function Y=AKL The elasticity of substitution = 1 Show

28. Properties of Cobb-Douglas Production Function • In equilibrium,MRTS = w/r and so the formula for  reduces to, Useful for Revision Purposes: Not Obvious Now

29. Properties of Cobb-Douglas Production Function • For the Cobb-Douglas, =1 means that a 10% change in the factor price ratio leads to a 10% change in the opposite direction in the factor input ratio. Useful For Revision Purposes: Not Obvious Now

30. Well-Behaved Technologies • A well-behaved technology is • monotonic, and • convex.

31. Well-Behaved Technologies - Monotonicity • Monotonicity: More of any input generates more output. y y monotonic notmonotonic x x

32. Well-Behaved Technologies - Convexity • Convexity: If the input bundles x’ and x” both provide y units of output then the mixture tx’ + (1-t)x” provides at least y units of output, for any 0 < t < 1.

33. Well-Behaved Technologies - Convexity x2 yº100 x1

34. Well-Behaved Technologies - Convexity x2 yº100 x1

35. Well-Behaved Technologies - Convexity x2 Convexity implies that the MRTS/TRS decreases as x1 increases. x1