If you are a beginner and have just started to study production theories of microeconomics, so then you are on the right place to start from. After studying this article, you will learn the concepts of production, production function, total, average and marginal product and their relationships, and Cobb-Douglas production function in a clear-cut way.
The theory of production is a very crucial subject matter in the field of economics. And, production theories heavily rely on the concept of production and production function. It would be more fruitful to understand the precise concept of the terms production and production function, before we attempt to study the production theories, that are extensively used in the filed of economics . In this scenario, below mentioned sections try to elaborate these concepts one after another.
- What is the meaning of production & production function?
- Concepts of long-run & short-run production function
- Constant vs variable proportion production function
- Meaning of total, average & marginal products of labor
- Introduction to Cobb-Douglas production function
Concept of Production and Production Function
In economic profession, production refers to the creation of utility. The creation of utility is possible through the conversion of factor inputs into the output, and this job is done by production function. Inputs that are used in the production are factors of production or simply, factor inputs. Production function incorporates factor inputs in the production process and yields the output. Hence, production function is the process by which inputs are converted into output. In other words, production function is defined as the technical or engineering relationship between factor inputs and outputs. Mathematically, it is expressed as:
Q = f (K, L, M, N, …, Z) … … … (I),
where, ‘f’ denotes the functional relation between output, Q, and other factors of production like capital, labor, land, raw material, energy, entrepreneur, technology and so on.
However, in modern economics, labor and capital are only two dominant factors of production. Economists overlook other factors of production so as to produce basic economic framework or economic model with ease of exposition. Accordingly, the usable production function shall revert to
Q = f (K, L) … … … (II),
where, notations stand for their usual meaning. Given the values of K and L, they are referred to as exogenous variables i.e. their values are taken as given. Unlikely, Q is called endogenous i.e. whose value depends on other variables and vary over time. In addition, production function also equally represents the technology of production. The basic economic theory of production assumes only the efficient method of production, because inefficient method of production will not be used by a rational producer.
Long-run vs Short-run Production Function
What is that separates long-run from short-run in economic profession? No doubt, the answer is time a variable could take to vary. In this regards, factors of production are classified into long-run and short-run based on the variability i.e time they take to be variable. Doing this is beneficial for us to thoroughly examine and understand the theories of production.
In fact, short-run in economics is a time interval, in which we cannot even change a single factor input. This way a production function is short-run when at least one factor input cannot be changed during the period. In other terms, when not all factors of production is variable then a production function is short-run, and called short run production function. Hence, at least one factor input must be fixed in the short-run production function.
On the other hand, all the factor inputs are variable in long-run production function. Long-run is defined as the time period in which all factor inputs, that are included in production function, can be changed. However, there is no specific law that stipulates the short- and long-run. It is all about the theory, but in practice, it depends on the nature of production activity that determines short- and long-run. That is why, a practical thinking of economists is that long-run is a planning period in which decisions regarding investment in new plant and machinery can be undertaken, whereas short-run involves the operations from existing plant and machinery.
Constant vs Variable Proportion Production Function
Lets us first understand the concept of proportion before starting the topic. Proportion refers to the equality of two ratios, that is, connecting two ratios by equality sign results in proportion. Note that ratio plays key role in proportion, and, this way, proportion equally refers capital-labor ratios.
Also one more thing to consider here is a term called technical coefficients of production, which is the amount of factor inputs required to produce a certain commodity. For example, suppose that it needs 10 units of capital to produce 50 units of particular commodity, then technical coefficient of capital for production is 0.2. If we were to express it in percentage basis, it requires 20 percent capital to produce 50 units of commodity, let alone other 60 percent factor inputs.
Now that we define proportion and technical coefficients of production, it is time to describe constant and variable proportion production functions. Whether production function is variable or fixed proportion depends on the technical coefficients of production. If technical coefficients of factors are constant, then the production function is constant proportion production function, otherwise, variable proportion production function.
In constant proportion production function, capital-labor ratio remains fixed no matter how large the scale of production is, as opposed to variable proportion production function. Likewise, there is zero marginal rate of technical substitution between factor inputs -capital and labor- in constant proportion production function, which means factors are perfect complements. On the other hand, there might be limited factor substitutability or the perfect substitutes in case of variable proportion production function.
Total, Average and Marginal Concepts of Production
We need some preliminary concepts while studying the production theory. They are total products and per unit products. The total product of capital (TPK) and total product of Labor (TPL) are the total product concepts; and marginal product of capital (MPK), marginal product of Labor (MPL), average product of capital (APK) and average product of Labor (APL) are the per unit product concepts. We elaborate these concepts in terms of labor, which equally applies in terms of capital as well.
Total product of labor is the aggregate amount of output produced by the total labor units used in the production. Alternatively, TPL is the sum of marginal products of labor i.e. TPL = MPL (1) + MPL (2) + MPL (3) + … + MPL (n-1) + MPL (n), where MPL (n) is the marginal product of labor from nth unit of labor.
Average Product of Labor
It is the output per unit of labor (APL) and obtained by dividing the total product of labor (TPL) by total number of labor (L) i.e. APL = TPL /L. In figure presented below, average products of labor at point B and C are given by the slopes of line segments OB and OC respectively.
Marginal Product of Labor
It is the extra unit of output produced by employing one additional unit of labor. Put another way, it is the change in TPL due to change in one extra unit of labor i.e.
MPL= ΔTPL / ΔL
where Δ shows the change in the respective variables (ΔL is always 1 because labor unit changes one by one i.e. 1, 2, 3… n-1, n person). This is a per unit production because the marginal refers to the yields from the one additional factor unit. That means we are talking about calculating marginal product from tabular data (also called discrete data), and such calculation of marginal product is called arc marginal product because it measures marginal product between two points. However, the following figure measures point marginal product of labor at points A and C, given by slope of respective tangents, as they measure marginal product at that points.
Relationship between MPL and TPL
hen MPL keeps on increasing, TPL increases at the increasing rate; when MPL remains constant, TPL increases at the constant rate; when MPL decreases, TPL increases at the decreasing rate; when MPL is zero, TPL remains constant; and when MPL is negative, TPL decreases.
Relationship between MPL and TPL
When MPL > APL, APL increases; when MPL = APL , APL remains constant; when MPL < APL , APL decreases.
Cobb-Douglas Production Function
This very famous Cobb-Douglas production function is a long-run production function, and is the result of combined efforts of professor of economics cum U.S. senator Paul Douglas and mathematician Charles Cobb. Douglas observed U.S. data and found that the shares of national income to labor and capital remained almost constant over the long time-period. Put another way, despite continuous growth in national income, proportionate share of labor and capital to national income almost grew at the constant rate. The very fact is depicted in the special case of Cobb-Douglas production function.
Mathematically, the general Cobb-Douglas production function is written as:
Q= F(L,K) = A Kα Lβ where A, α, β > 0 …………………. (III)
where, Q is output, α is output elasticity of capital, β is output elasticity of labor, and A is productivity or total factor productivity measuring productivity of production function or technology or factor inputs in total. And, all of these parameters are positive. If production technique advances, it raises the value of productivity parameter, A. Raising value of total factor productivity, A, equally means that productivity of both labor and capital has increased.
The parameters α and β, which also measure the shares of national income to capital and labor, are distribution parameters. That is parameters α and β measure the contribution of capital and labor to total production or national income. Note that the usage of Cobb-Douglas production function here is in macro sense, that’s why it is often called as aggregate production function. However, it can be used in the micro sense as well.
Characteristics of Cobb-Douglas Production Function
Lets observe the Cobb-Douglas production function Q = A Kα Lβ supposing that we change capital and labor by some constant multiple of λ, which results the right side of function as:
A (λK)α (λL)β = λα+β A Kα Lβ = λα+β . Q
which implies that increasing the factor inputs by multiple of some constant λ, output increase by the multiple of λα+β. That means coefficient λα+β shows the joint contribution of capital and labor to output. More specifically, coefficient α+β is a measure of returns to scale. You can find more information on law of returns to scale.
If α+β = 1, it implies constant returns to scale. In such a case, production function is said to be linearly homogeneous of first order.
If α+β > 1, it implies increasing returns to scale.
If α+β < 1, it implies decreasing returns to scale.
In case of linearly homogeneous production function of first order, the following features holds true:
- Cobb-Douglas production function exhibits constant returns to scale. That means doubling the factor inputs doubles the output by the same proportion.
- It demonstrates diminishing returns i.e. marginal product of factor diminishes. More precisely, marginal product of a factor input decreases as it is used more and more, holding constant the other factor inputs.
- It exhibits the unit elasticity of factor substitution (For more read here).
Initially, the Cobb-Douglas production was used in manufacturing industry. Now, it is widely used in empirical studies as well.
Why an efficient economy produces more output with the same level of capital and labor inputs? Cobb-Douglas production function provides a basic reason that it is because of higher total factor productivity, A. If so, what causes the total factor productivity, A, to change over time? The answer is supply shock, a change in output which an economy can produce with the same level of capital and labor inputs. This means that supply shock causes output to change which equally imply the shift in production function for the same level of factor inputs. The supply shock can be negative, which reduces productivity, and positive , which increases productivity, as well.
There are several forms of supply shocks:
- Technology shocks : Shocks arising from the technological advancement or dis-advancement. Development of faster computer chip, for example, is an example of technological advancement.
- Natural environment shocks : Shocks arising from the natural calamities or a favorable environment. Tsunamis, blizzards, hailstorms, droughts, floods, earthquakes, and so on are factors causing negative supply shocks.
- Energy shocks : Shocks arising from energy crisis or energy gluts. Oil cartel of OPEC is one important factor of negative shock.
Irrespective of types of supply shocks, positive shocks will raise the total factor productivity, A, and shifts production function upwards thereby causing marginal products of labor and capital to increase . Conversely, the negative supply shocks will reduce total factor productivity, A, and shifts production function downwards thereby causing marginal products of labor and capital to decrease.