Chapter 6 Read this chapter together with unit five in the study guide. Firms and Production

Chapter 6 Read this chapter together with unit five in the study guide 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. 6-2 Copyright 2012 Pearson Education. All rights reserved.

The Ownership and Management of Firms Firm - an organization that converts inputs such as labor, materials, energy, and capital into outputs, the goods and services that it sells. 6-3 Copyright 2012 Pearson Education. All rights reserved.

Private, Public, and Nonprofit Firms (For-profit) Private sector firms owned by individuals or other nongovernmental entities and whose owners try to earn a profit. Public sector firms and organizations that are owned by governments or government agencies. Nonprofit or not-for-profit sector organizations neither government-owned nor intended to earn a profit. 6-4 Copyright 2012 Pearson Education. All rights reserved.

Ownership of For-Profit Firms Sole proprietorships are firms owned and run by a single individual. General partnerships (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. Owners have limited liability - Personal assets of corporate owners cannot be taken to pay a corporation s debts even if it goes into bankruptcy. 6-5 Copyright 2012 Pearson Education. All rights reserved.

What Owners Want? Main assumption: firm s owners try to maximize profit! Profit (π) - the difference between revenues, R, and costs, C: π = R C 6-6 Copyright 2012 Pearson Education. All rights reserved.

What Owners Want? (cont.) To maximize profit a firm must produce as efficiently as possible. A firm engages in efficient production (achieves technological efficiency) if it cannot produce its current level of output with fewer inputs, given existing knowledge about technology and the organization of production. 6-7 Copyright 2012 Pearson Education. All rights reserved.

6-8 Copyright 2012 Pearson Education. All rights reserved. Production A firm uses a technology or production process to transform inputs or factors of production into outputs. 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).

Production Function 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. 6-9 Copyright 2012 Pearson Education. All rights reserved.

Production Function (cont.) Inputs (L, K) Formally, Production Function q = f(l, K) q = f(l, K) Output q where q units of output are produced using L units of labor services and K units of capital (the number of conveyor belts). 6-10 Copyright 2012 Pearson Education. All rights reserved.

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. 6-11 Copyright 2012 Pearson Education. All rights reserved.

Short-Run Production In the short run, the firm s production function is q = f(l, K) where q is output, L is workers, and K is the fixed number of units of capital. 6-12 Copyright 2012 Pearson Education. All rights reserved.

Table 6.1 Total Product, Marginal Product, and Average Product of Labor with Fixed Capital 6-13 Copyright 2012 Pearson Education. All rights reserved.

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. 6-14 Copyright 2012 Pearson Education. All rights reserved.

Marginal Product of Labor Marginal product of labor (MP L ) - the change in total output, q, resulting from using an extra unit of labor, L, holding other factors constant: MP L = q L 6-15 Copyright 2012 Pearson Education. All rights reserved.

Average Product of Labor Average product of labor (AP L ) - the ratio of output, q, to the number of workers, L, used to produce that output: AP L = q L 6-16 Copyright 2012 Pearson Education. All rights reserved.

Figure 6.1 Production Relationships with Variable Labor (a) Output, q, Units per day 110 90 56 A B C Diminishing Marginal Returns sets in! 0 (b) 20 AP L, MP L 4 a 6 11 L, Workers per day 15 b Average product, AP L Marginal product, MP L c 0 4 6 11 L, Workers per day 6-17 Copyright 2012 Pearson Education. All rights reserved.

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. 6-18 Copyright 2012 Pearson Education. All rights reserved.

Long-Run Production In the long run both labor and capital are variable inputs. It is possible to substitute one input for the other while holding output constant. 6-19 Copyright 2012 Pearson Education. All rights reserved.

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). 6-20 Copyright 2012 Pearson Education. All rights reserved.

Table 6.2 Output Produced with Two Variable Inputs 6-21 Copyright 2012 Pearson Education. All rights reserved.

Figure 6.2 Family of Isoquants K, Units of capital per d a y 6 a 3 b 2 e c f q = 35 1 d q = 24 q = 14 0 1 2 3 6 L, W o r k ers per d a y 6-22 Copyright 2012 Pearson Education. All rights reserved.

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 6-23 Copyright 2012 Pearson Education. All rights reserved.

Figure 6.3(a) and (b) Substitutability of Inputs 6-24 Copyright 2012 Pearson Education. All rights reserved.

Figure 6.3(c) Substitutability of Inputs 6-25 Copyright 2012 Pearson Education. All rights reserved.

Application: A Semiconductor Integrated Circuit Isoquant 6-26 Copyright 2012 Pearson Education. All rights reserved.

Substituting Inputs 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 change in capital K = = change in labor L Slope of Isoquant! 6-27 Copyright 2012 Pearson Education. All rights reserved.

Figure 6.4 How the Marginal Rate of Technical Substitution Varies Along an Isoquant M R TS in a P r inting and Pu b lishing U. S. Fi r m K, Units of capital per d a y 16 10 7 5 4 a K = 6 L = 1 3 b 1 2 c 1 1 d 1 e q = 10 0 1 2 3 4 5 6 7 8 9 10 L, W o r k ers per d a y 6-28 Copyright 2012 Pearson Education. All rights reserved.

Substitutability of Inputs and Marginal Products Along an isoquant q = 0, or: Extra units of labor Extra units of capital or (MP L x ΔL) + (MP K x ΔK) = 0. Increase in q per extra unit of labor - MP L MP K = Increase in q per extra unit of capital - L K = MRTS 6-29 Copyright 2012 Pearson Education. All rights reserved.

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? 6-30 Copyright 2012 Pearson Education. All rights reserved.

Returns to Scale How much does output change if a firm increases all its inputs proportionately? 6-31 Copyright 2012 Pearson Education. All rights reserved.

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). 6-32 Copyright 2012 Pearson Education. All rights reserved.

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). 6-33 Copyright 2012 Pearson Education. All rights reserved.

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). 6-34 Copyright 2012 Pearson Education. All rights reserved.

The Cobb-Douglas Production Function It is one the most widely estimated production functions. q = AL α K β γ=α+β determines the returns to scale. 6-35 Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 6.2 Under what conditions does a Cobb- Douglas production function (Equation 6.4, q = AL α K β ) exhibit decreasing, constant, or increasing returns to scale? 6-36 Copyright 2012 Pearson Education. All rights reserved.

Application: Returns to Scale in U.S. Manufacturing 6-37 Copyright 2012 Pearson Education. All rights reserved.

Application: Returns to Scale in U.S. Manufacturing 6-38 Copyright 2012 Pearson Education. All rights reserved.

Application: Returns to Scale in U.S. Manufacturing 6-39 Copyright 2012 Pearson Education. All rights reserved.

Figure 6.5 Varying Scale Economies 6-40 Copyright 2012 Pearson Education. All rights reserved.

Productivity and Technical Change Productivity may differ across firms produce different amounts of output with a given amount of inputs. After a technical or managerial innovation, a firm can produce more today from a given amount of inputs than it could in the past. 6-41 Copyright 2012 Pearson Education. All rights reserved.

Innovations Technical progress - an advance in knowledge that allows more output to be produced with the same level of inputs. Better management or organization of the production process similarly allows the firm to produce more output from given levels of inputs. 6-42 Copyright 2012 Pearson Education. All rights reserved.

Innovations (cont.) Neutral technical change a firm can produce more output using the same ratio of inputs. 6-43 Copyright 2012 Pearson Education. All rights reserved.

Table 6.3 Annual Percentage Rates of Neutral Productivity Growth for Computer and Related Capital Goods 6-44 Copyright 2012 Pearson Education. All rights reserved.