Lecture 10
PRODUCTION

• Production function
• Marginal product
• Marginal revenue product
• Law of diminishing marginal returns
• Optimal level of inputs

1. Basic Production Concepts

1. Inputs (or Factors of production): Labor (L), capital (K), energy, land
2. Output (Q): Amount of good produced by a firm using various inputs
3. Production function: Maximum output that can be produced with different levels of inputs
4. Total physical product: Total output produced using different amounts of one input, keeping other inputs fixed
5. Average physical product
   • Also called Average Product
   • AP = Output per unit of input
   • Question: Average physical product of labor = 10. What does it mean?
6. Marginal physical product
   • Also called Marginal Product
   • Additional output produced by using 1 more unit of an input, keeping the levels of other inputs fixed
   • Question: Marginal product of labor = 5. What does it mean?
   • Question: Why is MP_L = Slope of the production function?
7. Slope of the MP_L curve:
   • May be positive for very small values of output: Increasing marginal returns
   • But typically, slope is negative, for higher values of output: Diminishing marginal returns
8. Law of diminishing marginal returns
   • Holding other inputs fixed, increases in the amount of an input will yield progressively smaller increases in output
   • Relate this to the shape of the production function

2. Optimal level of inputs

1. Marginal revenue product of labor (MRP_L)
   • Additional revenue earned by the firm by selling the output produced by the use of 1 more input
   • MRP_L = Price of output x MP_L
   • Question: A firm is currently using 11 workers. The marginal revenue product of the 12th worker is $30. What does it mean?
2. Optimal rule
   • If MRP < Price of input, firm should reduce level of input
   • If MRP > Price of input, firm should increase level of input
   • The optimal level of an input satisfies the condition:
     MRP of input = Price of input
3. Demand for inputs
   • Derive negatively-sloped labor demand curve
   • Question: How does an increase in the price of output affect the optimal level of an input?