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CHAPTER 5

Production Theory

Chapter Review

* The production function defines the relationship among various inputs and the maximum quantity of a good that can be produced. Managers study production functions to gain insights into the firm's cost structure.

* An isoquant is a curve showing all possible (efficient) combinations of inputs capable of producing a particular quantity of output. The marginal rate of technical substitution shows the rate at which one input can be substituted for another input if output were held constant. No profit-maximizing manager will operate at a point where the isoquant is positively sloped.

* To minimize the cost of producing a particular output, a manager should allocate expenditures among various inputs so that the ratio of the marginal product to the input price is the same for all inputs used. Graphically, this amounts to choosing the input combination where the relevant isoquant is tangent to an isocost curve.

If a manager increases all inputs by the same proportion and output increases by more (less) than this proportion, there are increasing (decreasing) returns to scale. Increasing returns to scale may occur because of indivisibility of inputs, various geometrical relations, or specialization. Decreasing returns to scale can also occur; the most frequently cited reason is the difficulty of managing a huge enterprise. Whether there are constant, increasing, or decreasing returns to scale is an empirical question that must be settled case by case. Managers have estimated production functions in many firms and industries. Many studies show that a Cobb-Douglas function is the best fit for the data.