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Principles of Economics
Session 4
Topics To Be Covered
Factors of Production
Production Function
Productivity
Isoquant
Isocost
Minimum Cost Rule
Returns to Scale
Managing Lock-In
Production
Production is the process that
combines inputs or factors of
production to achieve an output
Factors of Production
Capital
(Physical Capital)
Labor (Human Capital)
Land (Natural Resources)
Technological Knowledge
Physical Capital
Physical capital is the stock of equipment
and structures that are used to produce
goods and services.
 Tools used to build or repair
automobiles.
 Tools used to build furniture.
 Office buildings, schools, etc.
Human Capital
Human capital is the economic term for the
knowledge and skills that workers acquire
through education, training, and
experience.
Like physical capital, human capital
raises a nation’s ability to produce
goods and services.
Natural Resources
Natural resources are inputs used in
production that are provided by nature,
such as land, rivers, and mineral deposits.
 Renewable resources include trees
and forests.
 Nonrenewable resources include
petroleum and coal.
Natural Resources
Natural resources can be important
but are not necessary for an economy
to be highly productive in producing
goods and services.
Technological Knowledge
Technological knowledge is the
understanding of the best ways to
produce goods and services.
The Production Function
The production function shows
the relationship between quantity
of inputs used to make a good and
the quantity of output of that
good.
The Production Function
Q= A F(L, K, N)
Q = quantity of output
A = available production technology
L = quantity of labor
K = quantity of capital
N = quantity of natural resources
Production Function for
Two Inputs
Q = F(K,L)
Q = Output
K = Capital
L = Labor
Production with One Variable Input (Labor)
Amount
Amount
Total
Average
of Labor (L) of Capital (K) Output (Q) Product
Marginal
Product
0
10
0
---
---
1
10
10
10
10
2
10
30
15
20
3
10
60
20
30
4
10
80
20
20
5
10
95
19
15
6
10
108
18
13
7
10
112
16
4
8
10
112
14
0
9
10
108
12
-4
10
10
100
10
-8
Total Product
With additional workers, output or
total product (Q, TP) increases,
reaches a maximum, and then
decreases.
Maximum Product
Output
per
Month
Maximum Product
112
●
Total Product
60
0 1
2 3
4
5 6
7 8
9
10 Labor per Month
Average Product
The average product of labor (AP), or output
per worker, increases and then decreases.
Output
Q
AP 

Labor Input
L
AP = slope of line from origin to a point on TP
AP and TP
Output
per
Month
112
Total Product
A'
●
60
Maximum AP
●
A
Average Product
0 1
2 3
4
5 6
7 8
9
Labor per Month
Marginal Product
The marginal product of labor (MP), or output
of the additional worker, increases rapidly
initially and then decreases and becomes
negative.
Labor Input L
MPL 

Output
Q
MP = slope of tangent to a point on TP
MP and TP
Output
per
Month
B'
112
●
Total Product
A'
●
60
Maximum MP
●
A
●
0 1
2 3
MP=0
4
5 6
7 8
B
9
Labor per Month
Marginal Product
The Law of Diminishing
Marginal Product
The Law of Diminishing Marginal Product states
that the marginal product (MP) of an input
declines as the quantity of the input increases.
When the input is small, MP increases due to
specialization.
When the input is large, MP decreases due to
inefficiencies.
MP and AP
Outpu
t
per
Month
E:
MP = AP and AP is at its maximum
Left of E: MP > AP and AP is increasing
Right of E: MP < AP and AP is decreasing
30
Marginal Product
E
20
Average Product
10
0 1
2 3
4
5 6
7 8
9
10 Labor per Month
TP, AP, and MP
Output
per
Month
C'
112
●
Total Product
B'
When MP = 0, TP is at maximum
When MP > AP, AP is increasing
When MP < AP, AP is decreasing
When MP = AP, AP is at maximum
●
60
A'
●
A
●
●
B
Average Product
●
0 1
2 3
4
5 6
7 C 9
Labor per Month
Marginal Product
The Effect of
Technological Improvement
Output
per
time
period
C
100
B
O3
A
Labor productivity
can increase if there
are improvements in
technology, even though
any given production
process exhibits
diminishing returns to
labor.
O2
50
O1
0 1
2 3
4
5 6
7 8
9
10
Labor per
time period
Productivity
Productivity is the amount of goods
and services produced from each
hour of a worker’s time.
Higher productivity  Higher standard of living
Malthus and the Food Crisis
Malthus predicted mass hunger and
starvation as diminishing returns limited
agricultural output and the population
continued to grow.
Why did Malthus’ prediction fail?
Index of World Food
Consumption Per Capita
Year
Index
1948-1952
100
1960
115
1970
123
1980
128
1990
137
1995
135
1998
140
Malthus and the Food Crisis
The data show that production increases have
exceeded population growth.
Malthus did not take into consideration the
potential impact of technology which has
allowed the supply of food to grow faster than
demand.
Technology has created surpluses and driven
the price down.
Labor Productivity
Total Output
Average Productivity 
Total Labor Input
Isoquants
There is a relationship between
production and productivity.
Long-run production K& L are variable.
Isoquants analyze and compare the
different combinations of K & L and
output.
Isoquants
Isoquants are curves that
show all possible
combinations of inputs
that yield the same output
Isoquants
Capital
Input
1
1
Labor Input
2
3
4
20
40
55
65
75
2
40
60
75
85
90
3
55
75
90
100
105
4
65
85
100
110
115
5
75
90
105
115
120
5
The Isoquant Map
Capital
per year
E
5
The isoquants are derived
from the production
function for output of
of 55, 75, and 90.
4
3
A
B
C
2
Q3 = 90
D
1
Q2 = 75
Q1 = 55
1
2
3
4
5
Labor per year
Isoquants
The isoquants emphasize how different
input combinations can be used to
produce the same output.
This information allows the producer to
respond efficiently to changes in the
markets for inputs.
Substituting among Inputs
Managers want to determine what
combination if inputs to use.
 They must deal with the trade-off
between inputs.
 The slope of each isoquant gives the
trade-off between two inputs while
keeping output constant.
Marginal Rate of
Technical Substitution
MRTS is the rate at which one input is
substituted for another along an isoquant.
K
MRTS 
L
Marginal Rate of
Technical Substitution
Capital 5
per year
4
Isoquants are downward
sloping and convex like
indifference curves.
2
1
3
1
1
2
2/3
Q3 =90
1
1/3
1
Q2 =75
1
Q1 =55
1
2
3
4
5
Labor per month
Diminishing MRTS
Increasing labor in one unit increments
from 1 to 5 results in a decreasing MRTS
from 1 to 1/2.
Diminishing MRTS occurs because of
diminishing returns and implies
isoquants are convex.
MRTS and Marginal Productivity
The change in output from a change in
labor equals:
MPL (L)
 The change in output from a change in
capital equals:
MPK (K )
MRTS and Marginal Productivity
If output is constant and labor
is increased, then:
MPL (L)  MPK (K )
MPL
K

 MRTS
MPK
L
Isoquants When Inputs are
Perfectly Substitutable
Capital
per
month
A
B
C
Q1
Q2
Q3
Labor per month
Perfect Substitutes
When inputs are perfectly substitutable,
the MRTS is constant at all points on the
isoquant.
For a given output, any combination of
inputs an be chosen (A, B, or C) to
generate the same level of output.
Fixed-Proportions
Production Function
Capital
per
month
Q3
C
Q2
B
K1
A
L1
Q1
Labor
per month
Fixed Proportions Production
When inputs must be in a fixed-proportion,
each output requires a specific amount of
each input (e.g. labor and jackhammers).
To increase output requires more labor and
capital proportionately.
Isocost Line
The isocost line is one that
shows all combinations of
inputs that can be purchased
for the same cost.
Isocost Line
Assume inputs are labor (L) and capital
(K) and wage and capital price are w and
r respectively, then:
C  wL  rK
C w
K  L
r r
Isocost Line
Capital
(units)
(C/r) = 40
r = $2
w = $1
C = $80
A
Isocost Line: K= 40 – 0.5L
B
30
D
20
E
C/r
Slope  K / L  
C/w
1
 w / r  
2
10
G
0
20
40
60
80 = (C/w)
Labor (units)
Isocosts and Isoquants
Capital
per
year
For output Q1, point
A is of least cost
K2
A
K1
K3
Q1
C0
L2
L1
C1
L3
C2
Labor per year
Isocosts and Isoquants
Capital
per
year
If the price of labor increases, the
isocost curve becomes steeper due
to the change in the slope: -(w/r).
To maintain Q1, the
minimum cost point shifts
from A to B, which requires
more cost than C1.
B
K2
A
K1
C2
L2
L1
Q1
C1
Labor per year
Minimum Cost Combination
MPL (L)  MPK (K )
MPL
K

 MRTS
MPK
L
K
w

L
r
MPL
w

MPK
r
MPL
MPK

w
r
Minimum Cost Rule
The minimum cost rule states that the cost
of producing a specific level of output is
minimized when the ratio of the marginal
product of each input to the price of that
input is the same for all inputs.
Expansion Path
A firm’s expansion path shows
the minimum cost combinations
of labor and capital at each level
of output.
Expansion Path
Capital
per
year
150 $3000 Isocost Line
Expansion Path
$2000
Isocost Line
100
C
75
B
50
300 Unit Isoquant
A
25
200 Unit
Isoquant
50
100
150
200
300
Labor per year
Returns to Scale
The returns to scale is the rate which
output increases when all inputs are
increased proportionately.
If all the inputs double:
 the
output is exactly doubled, that process is
said to exhibit constant returns to scale.
 the output grows by less than 100 percent,
the press shows decreasing returns to scale.
 the output more than doubles, the process
demonstrates increasing returns to scale.
Constant Returns to Scale
Capital
(machine
hours)
6
30
4
20
2
10
0
5
10
15
Labor (hours)
Decreasing Returns to Scale
Capital
(machine
hours)
18
30
9
20
3
10
0
3
9
18
Labor (hours)
Increasing Returns to Scale
Capital
(machine
hours)
3.6
2.8
30
2
20
10
0
5
7
9
Labor (hours)
Business Organizations
Proprietorship
Partnership
Corporation
Managing Lock-In
Basic Strategy for Sellers
Design products and promotions to attract
customers
Lengthen and strengthen cycle
Sell complementary products to these
consumers
Tension: claim openness, but don’t deliver
 Example:
simple open interface (RTF)
powerful closed interface (DOC)
Look Ahead in Lock-In
Cycle
Calculate present value over whole cycle
Look at type of customer
Special case: Perfect Competition
 Similar
products, many competitors
 Competition forces you to invest in discounts
to get consumers locked in
 Just earn normal rate of return on those
investments;quasiprofits
Extra-normal Returns
Different product
Lower cost
Examples:
 First-mover
advantage (unique product)
 Information
advantage
Influential Buyers
Buyers with high switch costs
Buyer side: convince the seller you are
influential
 May
already be locked in
 Buyer has incentive to exaggerate
Watch out for churn (phone calls, ISPs)
Buyers with growing needs are very
attractive
Multiplayer strategies
Decision maker and payer
Frequent flyer miles
 Infant formulas at hospitals
 Automobile tires

Buyers of complements
Different customers buy razors and blades
 Subsidize the far-sighted group, tax the shortsighted group

• BBS operators
• Netscape suite
Strategic Variables in
Lock-in Cycle
Magnitude of switch costs
Loyalty programs
 Cumulative
volume discounts
 Rely on infotech
 Loyalty programs will become more
widespread
 Convert conventional markets to lock-in
markets
Loyalty Programs
Requirements contracts
Frequent buyer program
Tension with promotions -- offer better deal
to non-customers
Burden of locked-in customers: offer too
high a price to attract new customers

Price discrimination, stripped down product
Consumer switch costs
 Will
go down due to Internet
Assignment
Review Chapter 6
Answer questions on P114
Preview Chapter 7
Thanks