3a. Firms and Production

Question 1

What does this equation tell us?

Answer 1

A firm’s profit (π), is the difference between its revenue, R, which is what it earns from selling a good, and its cost, C, which is what it pays for labor, materials, and other inputs

Question 2

What are the 3 inputs of a production function?

Answer 2

• 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)

Question 3

Which two inputs do we usually use in the production function?

Answer 3

K and L,

M is rarely ever used

Question 4

What is the definition of “production function”?

Answer 4

“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.”

Question 5

What does “efficient production” really mean?

Answer 5

Efficient production (achieves technological efficiency) if firm cannot produce its current level of output with fewer inputs, given existing knowledge about technology and the organization of production.

Question 6

How is the production function expressed?

Answer 6

q = f(L, K)

so, output is a function of labor and capital

Question 7

How is the production function in the short-run expressed?

Answer 7

K has a bar as it is FIXED in the short run

Question 8

What is specific about short-run production?

Answer 8

Short run - a period of time so brief that at least one factor of production (capital) cannot be varied practically.

whereas quantity of labor (L) can be changed, the line above the K shows that capital is capped and cannot be varied (in the SR)

Question 9

Is there anything specific about long-run production?

Answer 9

No. There are no fixed inputs.

Long run - a lengthy enough period of time that all inputs can be varied. No fixed inputs

Question 10

What is the definition of “total product of labor”?

Answer 10

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

Question 11

What is the definition of “marginal product of labor”?

Answer 11

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

Question 12

What is the definition of “average product of labor”?

Answer 12

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

Question 13

What does point “A” on this curve mean?

Answer 13

diminishing marginal returns sets in - as at this point there is a peak in MPL

Meaning, every additional worker will add less of a marginal product, but MPL > 0, so the total output keeps increasing

Question 14

What does point “C” on this curve mean?

Answer 14

where MPL is 0, at this point each additional worker will start decreasing the total output

Question 15

What is the “law of diminishing marginal return”?

Answer 15

The law of diminishing marginal returns (or diminishing marginal product) holds that 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.

Question 16

Does marginal product have to fall as inputs rise?

Answer 16

That claim is true only if as we add more of an input, we hold technology and other inputs constant. If we increase labor while simultaneously increasing other factors or adopting superior technologies, the marginal product of labor may rise indefinitely.

Question 17

How do we analyse long run production as there are 3 unknowns?

Answer 17

Whilst in the equation there are three unknowns:

q = f(L, K)

We simplify this by fixing q (output) at a set quantity

Following this, we can find the combinations of L and K that can be used to produce that level of output

Question 18

What is the definition of an “isoquant”?

Answer 18

a curve that shows the efficient combinations of labor and capital that can produce a single (iso) level of output (quantity)

Question 19

What is the difference between isoquants and indifference curves?

Answer 19

Isoquant - fix output at a particular quantity

Indifference - fix utility at a particular quantity

Question 20

The farther an isoquant is from the origin ____________

Answer 20

The farther an isoquant is from the origin, the greater the level of output

Question 21

Can isoquants cross?

Answer 21

No. (same reasoning as indifference curves can NOT cross)

Question 22

What does the slope of an isoquant indicate?

Answer 22

how readily a firm can substitute between inputs in the production process.

Question 23

What does an isoquant for perfect substitutes look like?

Answer 23

Question 24

What does an isoquant for perfect complements look like?

Answer 24

example:
production of boxes of cereal
So, you need cereal and a box. If you have 100 boxes, and 50 cereal = you can only make 50 cereal boxes.
-> hence the production output is equal to the SMALLEST value of the two

Question 25

What is the slope of the isoquant?

Answer 25

Marginal rate of technical substitution (MRTS)

–> how many units of capital the firm can replace with an extra unit of labor while holding output constant.

Question 26

What is the equation for MRTS (slope of an isoquant)?

Answer 26

Question 27

How else can the MRTS equation be expressed?

Answer 27

Question 28

What are the 3 possibilities for return to scale?

Answer 28

1. Constant Returns to Scale
2. Increasing Returns to Scale
3. Diminishing Returns to Scale

Question 29

What are “constant returns to scale”?

Answer 29

If, when all inputs are increased by a certain percentage, output rises by that same percentage, the production function is said to exhibit constant returns to scale.

Question 30

What are “increasing returns to scale”?

Answer 30

If output rises more than in proportion to an equal percentage increase in all inputs, the production function is said to exhibit increasing returns to scale.

Question 31

What are “decreasing returns to scale”?

Answer 31

If output rises less than in proportion to an equal percentage increase in all inputs, the production function exhibits decreasing returns to scale.

Question 32

Why would a production function exhibit increasing returns to scale?

Answer 32

example:

although a firm could duplicate a small factory and double its output, the firm might be able to more than double its output by building a single large plant, thereby allowing for greater specialization of labor or capital.

In the two smaller plants, workers have to perform many unrelated tasks such as operating, maintaining, and fixing the machines they use. In the large plant, some workers may specialize in maintaining and fixing machines, thereby increasing efficiency. Similarly, a firm may use specialized equipment in a large plant but not in a small one.

Question 33

What does it mean to exhibit “varying returns to scale”?

Answer 33

This production function exhibits varying returns to scale. Initially, the firm uses one worker and one unit of capital, point a. It repeatedly doubles these inputs to points b, c, and d, which lie along the dashed line. The first time the inputs are doubled, from a to b, output more than doubles from q = 1 to q = 3, so the production function has increasing returns to scale. The next doubling, from b to c, causes a proportionate increase in output, constant returns to scale. At the last doubling, from c to d, the production function exhibits decreasing returns to scale.

Question 34

What are some examples of “economies” which explain the returns to scale?

Answer 34

• Scale of production – large scale may be more efficient
• Indivisibilities – some capital equipment is lumpy
• Learning economies – workers and managers become better at producing over time

Question 35

What are some examples of “diseconomies” which explain the returns to scale?

Answer 35

• Difficulties in managing large enterprises
• Poor industrial relations
• Poor communication