Chapter 6

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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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.

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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.
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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.

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What Owners Want?

• Main assumption: firm’s owners try to

maximize profit!

• Profit (p) - the difference between

revenues, R, and costs, C:

p=R–C

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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.

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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).
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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.

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Production Function (cont.)

Production
Inputs Function Output
(L, K) q = f(L, K) 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 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.

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

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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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Marginal Product of Labor

• Marginal product of labor (MPL ) - the

change in total output, Dq, resulting from using
an extra unit of labor, DL, holding other factors
constant:

Dq
MPL =
DL

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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:

q
APL =
L

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Figure 6.1 (a)

Output, q, Units per day

C

Production 110

90 B
Relationships
with Variable 56 A

Labor
Diminishing Marginal 0 4 6 11
L, Workers per day
Returns sets in! (b)
a

AP L , MP L
20

b
15
Average product, APL

Marginal product, MPL

c
0 4 6 11

L, Workers per day

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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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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.

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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

b
3

e c f
2
q = 35

d
1 q = 24

q = 14

0 1 2 3 6 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 6.3(a) and (b)
Substitutability of Inputs
(a) If the inputs are perfect (b) If the inputs cannot be
substitutes, each isoquant is substituted at all, the isoquants
a straight line. are right angles

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Figure 6.3(c) Substitutability of
Inputs
(c) Typical isoquants lie between
the extreme cases of straight lines and right
angles. Along a curved isoquant, the ability
to substitute one input for another varies.

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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.

change in capital DK
MRTS = =
change in labor DL
Slope of Isoquant!

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Figure 6.4 How the Marginal Rate of Technical
Substitution Varies Along an Isoquant

MR TS in a Printing and Pu blishing U.S. Firm

K , Units of capital per d ay

a
16

DK = –6

b
10
DL = 1
–3
1 c
7
–2 1 d
5 e
4 –1
1 q = 10

0 1 2 3 4 5 6 7 8 9 10
L , Workers per d ay

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Substitutability of Inputs and Marginal
Products

• Along an isoquant Dq = 0, or:

Extra units Extra units
of labor of capital

(MPL x ΔL) + (MPK x ΔK) = 0.

Increase in Increase in
q per extra q per extra
unit of labor unit of
capital
 or
MPL DK
=- = MRTS
MPK DL

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Returns to Scale

• How much does output change if a firm

increases all its inputs proportionately?

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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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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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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 is one the most widely estimated

production functions.

q = ALaKb

g=a+b determines the returns to scale.

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Figure 6.5 Varying Scale Economies
• The firm uses 1
worker and 1 unit of
capital at point a.
• When 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.
• Doubling inputs, from
b to c, causes a
proportionate
increase in output,
implying constant
returns to scale.

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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.

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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.

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