Topic 6
Firms and
Production
Hard work never killed anybody,
but why take a chance?
Charlie McCarthy
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Topic 6 Outline
6.1 The Ownership and Management of Firms
6.2 Production
6.3 Short Run Production: One Variable and One Fixed Input
6.4 Long Run Production: Two Variable Inputs
6.5 Returns to Scale
6.6 Productivity and Technical Change
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6.1 What Owners Want
• We focus on for-profit firms in the private sector
• We assume these firms’ owners are profit-maximizers
– Profit is the difference between revenue earnd from
selling output (R), and cost (C) of labor, materials, and
other inputs.
π = R − C where R = pq.
• To maximize profits, a firm must produce efficiently
• It should not be able to produce its current level of output
with fewer inputs, given its existing technology.
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6.2 Production
• A firm uses a technology or production process to
transform inputs into outputs.
• Capital (K): long-lived inputs such as land, buildings (e.g.
factories and stores), and equipment (e.g. machines and
trucks).
• Labour (L): hours of work provided by managers and
workers.
• Materials (M): natural resources and raw goods (such as
oil, water, and wheat) and processed products (such as Al,
plastic, paper, and steel) that are typically consumed in
producing, or incorporated in making, the final product.
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6.2 Production
• The ways that a firm can transform inputs efficiently into
output are summarized in the production function.
– When labor (L) and capital (K) are the only inputs,
the production function is
• A firm can more easily adjust its inputs in the long run than
in the short run.
– The short run is a period of time so brief that at least
one factor of production cannot is fixed.
– The long run is a long enough period of time that all
inputs can be varied.
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6.3 Short Run Production: One Variable
and One Fixed Input
• Assume in the short run (SR) capital is a fixed and labor variable.
– SR Production Function:
– q is output, but also called total product
• The marginal product of labor is the additional output produced by
an additional unit of labor, holding all other factors constant:
• The average product of labor is the ratio of output to the amount of
labor employed:
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6.3 SR Production with Variable Labor
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6.3 Short Run Production with Variable
Input: Labor
• APL = 1+ 30L – L2
• MPL = 1 + 60L – 3L2
• Both first rise and then fall as L increases
• Initial increases due to specialization and
complementarities of activities; more workers are a good
thing
• Eventual declines result when workers begin to get in
each other’s way and use a fixed capital stock
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6.3 Law of Diminishing Marginal
Returns
• The law holds that, further increases in an input, holding all
other inputs and technology constant, correspond to smaller
increases in output
– Occurs at L=10 in previous graph
• Mathematically:
• Note that when MPL begins to fall, TP is still increasing.
• More an empirical regularity more than a law!
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6.4 Long Run Production: Two Variable
Inputs
• In the long run (LR), we assume that both labor and capital
are variable inputs.
• The freedom to vary both inputs provides firms with many
choices of how to produce (labor-intensive v s capital- er
intensive methods).
• Consider a Cobb-Douglas production function where A, a,
and b are constants:
• Hsieh (1995) estimated such a production function for a
U.S. electronics firm:
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6.4 Isoquants
• The isoquant contains all efficient combinations of inputs
that produce a specific level of output for a given
technology.
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6.4 Properties of Isoquants
• The shape of the isoquant is given by the properties
underlying technology
• One key property is again monotonicity
• This implies:
1. The farther an isoquant is from the origin, the greater
the level of output it is associated with.
2. Isoquants do not cross; otherwise the same input
combination produces two different levels of output.
3. Isoquants must slope downward.
4. Isoquants must be thin.
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6.4 Substituting Inputs
• The slope of an isoquant shows the ability of a firm to replace one
input with another holding output constant.
• It is called the Marginal rate of technical substitution (MRTS)
– How many units of K the firm can replace with an extra unit of L
whilst keeping q constant
• Thus,
(MPL = marginal product of labor; MPK = marginal product of capital)
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6.4 Substituting inputs
• Types of isoquants:
1. Convex to the origin
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6.4 Convex isoquants
• MRTS diminishes along a convex isoquant
– The more of L the firm has, the harder it is to replace K
with L.
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6.4 Substituting inputs
• Types of isoquants:
2. Fixed-proportions (e.g. q = min{x,y})
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6.4 Substituting inputs
• Types of isoquants:
3. Perfect substitutes (e.g. q = x + y)
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Your turn
•
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Cobb-Douglas production function
• In a Cobb-Douglas production function, the
powers represent the elasticity of output with
respect to the corresponding input.
• For example, if the power on capital (K) is a = 0.3,
then an increase in the amount of capital used in
production by 1% would result in a 0.3% increase
in output, ceteris paribus (all else held constant).
• Show this!
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6.5 Returns to Scale
• How much does output change if a firm increases all its
inputs proportionately?
• A technology exhibits constant returns to scale when a
scaling up of inputs is followed by the same increase in
output.
– Doubling inputs, doubles output
• More generally, when a production function is
homogeneous of degree
where x is a positive constant.
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6.5 Returns to Scale
• A technology exhibits increasing returns to scale when a
scaling up of inputs is followed by a larger increase in output.
–
– Occurs with greater specialization of L and K; one large
plant more productive than two small plants
• A technology exhibits decreasing returns to scale when a
scaling up of inputs is followed by a smaller increase in output.
–
– Occurs because of difficulty organizing and coordinating
activities as firm size increases.
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Your turn
• Under what conditions does a general Cobb-Douglas
production function, q = ALaKb, exhibit decreasing,
constant, or increasing returns to scale?
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6.5 Returns to Scale Estimates in
Various Industries
Decreasing Returns to Scale
Blank Labor, a Capital, b Scale, g = a + b
U.S. tobacco products a 0.18 0.33 0.51
Bangladesh glass b 0.27 0.45 0.72
Danish food and 0.69 0.18 0.87
beverages c
Chinese high technology 0.28 0.66 0.94
d
Constant Returns to Scale
Blank Labor, a Capital, b Scale, g = a + b
Japanese synthetic 0.50 0.50 1.00
rubber e
Japanese beer e 0.60 0.40a 1.00
New Zealand wholesale 0.60 0.42 1.02
trade f
Danish publishing and 0.89 0.14 1.03
printing c
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6.5 Returns to Scale Estimates in
Various Industries
Increasing Returns to Scale
Blank Labor, a Capital, b Scale, g = a + b
New Zealand mining 0.69 0.45 1.14
f
Bangladesh leather 0.86 0.27 1.13
products b
Bangladesh 0.98 0.28 1.26
fabricated metal b
a
Hsieh (1995); bHossain, Basak, and Majumber (2012); cFox and Smeets (2011); dZhang, Delgado,
and Kumbhakar (2012); eFlath (2011); fDevine, Doan, and Stevens (2012).
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6.5 Japanese Beer Firm: Constant
Returns to Scale
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6.5 U.S. Tobacco Firm: Decreasing
Returns to Scale
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6.5 Bangladesh Fabricated Metal Firm:
Increasing Returns to Scale
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6.5 Varying Returns to Scale
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6.6 Productivity and Technical Change
• Even if all firms are producing efficiently, firms may not be equally
productive.
• Relative productivity of a firm is the firm’s output as a percentage of
the output that the most productive firm in the industry could have
produced with the same inputs.
– Relative productivity depends upon:
1. Management skill/organization
2. Technical innovation
3. Union-mandated work rules
4. Workplace discrimination
5. Government regulations or other industry restrictions
6. Degree of competition in the market
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6.6 Productivity and Technical Change
• An advance in firm knowledge that allows more output to
be produced with the same level of inputs is called
technical progress.
– Example: Robots
– Neutral technical change involves more output using
the same ratio of inputs.
– Biased technical change involves altering the
proportion in which inputs are used to produce more
output.
• Organizational change may also alter the production
function and increase output.
– Example: mass production of Ford automobiles
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Your turn
• The original production function is Q = 10K0.4L0.5. A technological
change occurs that alters the production function to Q = 15K0.4L0.7. Is
this an example of neutral technological change? Why or why not?
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