Chapter Six

Firms and Production

Topics
The Ownership and Management of Firms. Production. Short-Run Production: One Variable and One Fixed Input. Long-Run Production: Two Variable Inputs. Returns to Scale. Productivity and Technical Change.
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What is a firm?
Firm - an organization that converts inputs such as labor, materials, energy, and capital into outputs, the goods and services that it sells.
Sole proprietorships are firms owned and run by a single individual. Partnerships are businesses jointly owned and controlled by two or more people. Corporations are owned by shareholders in proportion to the numbers of shares of stock they hold.
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What Owners Want?

Main assumption: firms owners try to maximize profit! Profit () - the difference between revenues, R, and costs, C:

=RC
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What are the categories of inputs?

Capital (K) - long-lived inputs.
land, buildings (factories, stores), and equipment (machines, trucks)

Labor (L) - human services

managers, skilled workers (architects, economists, engineers, plumbers), and less-skilled workers (custodians, construction laborers, assembly-line workers)

Materials (M) - raw goods (oil, water, wheat) and processed products (aluminum, plastic, paper, steel)
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How firms combine the inputs?

Production function - the relationship between the quantities of inputs used and the maximum quantity of output that can be produced, given current knowledge about technology and organization

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Production Function
Production Function q = f(L, K)

Inputs (L, K)

Output q

Formally, q = f(L, K)
where q units of output are produced using L units of labor services and K units of capital (the number of conveyor belts).
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Time and the Variability of Inputs

Short run - a period of time so brief that at least one factor of production cannot be varied practically
Fixed input - a factor of production that cannot be varied practically in the short run. Variable input - a factor of production whose quantity can be changed readily by the firm during the relevant time period

Long run - a lengthy enough period of time that all inputs can be varied
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Short-Run Production
In the short run, the firms production function is q = f(L, K)
where q is output, L is workers, and K is the fixed number of units of capital.

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Table 6.1 Total Product, Marginal Product, and Average Product of Labor with Fixed Capital

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Marginal Product of Labor

Marginal product of labor (MPL ) - the change in total output, q, resulting from using an extra unit of labor, L, holding other factors constant:

MPL =

q L
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Average Product of Labor

Average product of labor (APL ) - the ratio of output, q, to the number of workers, L, used to produce that output:

APL =

q L
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Total Product of Labor

Total product of labor- the amount of output (or total product) that can be produced by a given amount of labor

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Figure 6.1 Production Relationships with Variable Labor

Diminishing Marginal Returns sets in!

(a) Output, q, Units per day 110 C

90

56

0 (b) APL, MPL 20

11 L, Workers per day

15

b Average product, APL

Marginal product, MPL c 0 4 6 11 L, Workers per day

Law of Diminishing Marginal Returns If a firm keeps increasing an input, holding all other inputs and technology constant, the corresponding increases in output will become smaller eventually.
That is, if only one input is increased, the marginal product of that input will diminish eventually.

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Isoquants
Isoquant - a curve that shows the efficient combinations of labor and capital that can produce a single (iso) level of output (quantity). Equation for an Isoquant: q = f (L, K).

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Table 6.2 Output Produced with Two Variable Inputs

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Figure 6.2 Family of Isoquants

K, Units of capital per day 6 a

3 e

f q = 35

d q = 24 q = 14

L, Workers per day

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Properties of Isoquants.
1. The farther an isoquant is from the origin, the greater the level of output. 2. Isoquants do not cross. 3. Isoquants slope downward

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Figure 6.3a,b Substitutability of Inputs

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Figure 6.3c Substitutability of Inputs

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Application A Semiconductor Integrated Circuit Isoquant

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Marginal Rate of Technical Substitution

marginal rate of technical substitution (MRTS) - the number of extra units of one input needed to replace one unit of another input that enables a firm to keep the amount of output it produces constant
MRTS = changein capital K = changein labor L
Slope of Isoquant!

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Figure 6.4 How the Marginal Rate of Technical Substitution Varies Along an Isoquant
MRTS in a Printing and Pu blishing U.S. Firm K, Units of capital per d ay

16 K = 6 10 7 5 4

b L = 1 3 c 1 2 1 1 1

d e q = 10

10

L, Workers per d ay
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Substitutability of Inputs and Marginal Products. Along an Isoquant q = 0, or:

Extra units of labor Extra units of capital

(MPL x L) + (MPK x K) = 0.
Increase in q per extra unit of labor Increase in q per extra unit of capital

or
-

MPL L =MPK K

= MRTS

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Solved Problem 6.1

Does the marginal rate of technical substitution vary along the isoquant for the firm that produced potato salad using Idaho and Maine potatoes? What is the MRTS at each point along the isoquant?

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Returns to Scale
Constant returns to scale (CRS) property of a production function whereby when all inputs are increased by a certain percentage, output increases by that same percentage. f(2L, 2K) = 2f(L, K).

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Returns to Scale (cont).

Increasing returns to scale (IRS) property of a production function whereby output rises more than in proportion to an equal increase in all inputs f(2L, 2K) > 2f(L, K).

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Returns to Scale (cont).

Decreasing returns to scale (DRS) property of a production function whereby output increases less than in proportion to an equal percentage increase in all inputs f(2L, 2K) < 2f(L, K).

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The Cobb-Douglas Production Function It one is the most popular estimated functions.

q = ALK

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Solved Problem 6.2

Under what conditions does a CobbDouglas production function exhibit decreasing, constant, or increasing returns to scale?

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Application:Returns to Scale in U.S. Manufacturing

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Application: Returns to Scale in U.S. Manufacturing

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Application: Returns to Scale in U.S. Manufacturing

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Figure 6.5 Varying Scale Economies

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Table 6.3 Annual Percentage Rates

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Innovations
Technical progress - an advance in knowledge that allows more output to be produced with the same level of inputs

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