PRODUCTION

Outline
• The technology of production
• Production with one variable input (labour)
• Production with two variable inputs
• Returns to scale
• Here we study the supply side and examine the behaviour of producers.

• We will see how firms can produce efficiently and how their costs of production change with
changes in both input prices and the level of output.

• The theory of the firm describes how a firm makes cost-minimizing production decisions and
how the firm’s resulting cost varies with its output.
• Consider some of the problems often faced by a company like General Motors.
• General Motors Company is an American multinational automotive manufacturing company
headquartered in Detroit, Michigan, United States. The company is most known for owning and
manufacturing four automobile brands: Chevrolet, GMC, Cadillac, and Buick.
• Questions asked:
• How much assembly-line machinery and how much labour should it use in its new automobile
plants?
• If it wants to increase production, should it hire more workers, construct new plants, or both?
• Does it make more sense for one automobile plant to produce different models, or should each
model be manufactured in a separate plant?

• What should GM expect its costs to be during the coming year?

• How are these costs likely to change over time and be affected by the level of production?

• These questions apply not only to business firms but also to other producers of goods and services,
such as governments and nonprofit agencies.
 The Production Decisions of a Firm
• The production decisions of firms are similar to the purchasing decisions of consumers, and can be
understood in three steps:
1. Production Technology:
We need a practical way of describing how inputs (such as labour, capital, and raw materials) can be
transformed into outputs (such as cars and televisions).
An electronics firm might produce 10,000 televisions per month by using a substantial amount of
labour (e.g., workers assembling the televisions by hand) and very little capital, or by building a
highly automated capital-intensive factory and using very little labour.
2. Cost Constraints:
Firms must take into account the prices of labor, capital, and other inputs.
Just as a consumer is constrained by a limited budget, the firm will be concerned about its cost of
production.
For example, the firm that produces 10,000 televisions per month will want to do so in a way that
minimizes its total production cost, which is determined in part by the prices of the inputs it uses.
Production decisions of a firm
(continuation…)
3. Input Choices:

Given its production technology and the prices of labor, capital, and other inputs, the firm must
choose how much of each input to use in producing its output.

Just as a consumer takes account of the prices of different goods when deciding how much of
each good to buy, the firm must take into account the prices of different inputs when deciding
how much of each input to use.

If an electronics firm operates in a country with low wage rates, it may decide to produce
televisions by using a large amount of labour, thereby using very little capital.

These three steps are the building blocks of the theory of the firm.
 Why do firms exist?
• Firms offer a means of coordination that is extremely important and would be sorely missing if
workers operated independently.

• Firms eliminate the need for every worker to negotiate every task that he or she will perform, and
bargain over the fees that will be paid for those tasks.

• Firms can avoid this kind of bargaining by having managers that direct the production of salaried
workers—they tell workers what to do and when to do it, and the workers (as well as the managers
themselves) are simply paid a weekly or monthly salary.

• There is no guarantee, of course, that a firm will operate efficiently, and there are many examples
of firms that operate very inefficiently.

• Managers cannot always monitor what workers are doing, and managers themselves sometimes
make decisions that are in their interest, but not in the firm’s best interest.

• Firms exist because they allow goods and services to be produced far more efficiently than
would be possible without them.
 The Technology of Production
• At the most fundamental level, firms take inputs and turn them into outputs (or products).

• This production process, turning inputs into outputs, is the essence of what a firm does.

• Inputs, which are also called factors of production, include anything that the firm must use as part of
the production process.

• In a bakery, for example, inputs include the labour of its workers; raw materials, such as flour and
sugar; and the capital invested in its ovens, mixers, and other equipment needed to produce such
outputs as bread, cakes, and pastries.

• We can divide inputs into the broad categories of labor, materials, and capital, each of which might
include more narrow subdivisions.

• Labor inputs include skilled workers (carpenters, engineers) and unskilled workers (agricultural
workers), as well as the entrepreneurial efforts of the firm’s managers.

• Materials include steel, plastics, electricity, water, and any other goods that the firm buys and
transforms into final products. Capital includes land, buildings, machinery and other equipment, as
well as inventories.
 The Production Function
• Firms can turn inputs into outputs in a variety of ways, using various combinations of labour,
materials, and capital.

• The relationship between the inputs into the production process and the resulting output can
be described by a production function.

• A production function indicates the highest output q that a firm can produce for every
specified combination of inputs.

• Although in practice firms use a wide variety of inputs, we will keep our analysis simple by
focusing on only two, labour L and capital K.

• The production function can be written as

• q = F(K, L)

• This equation relates the quantity of output to the quantities of the two inputs, capital and
labour.
• For example, the production function might describe the number of personal computers that can be produced
each year with a 10,000-squarefoot plant and a specific amount of assembly-line labour.

• Or it might describe the crop that a farmer can obtain using specific amounts of machinery and workers.

• Because the production function allows inputs to be combined in varying proportions, output can be
produced in many ways.
• Note that equation applies to a given technology—that is, to a given state of knowledge about the
various methods that might be used to transform inputs into outputs.

• As the technology becomes more advanced and the production function changes, a firm can obtain
more output for a given set of inputs.

• For example, a new, faster assembly line may allow a hardware manufacturer to produce more high-
speed computers in a given period of time.

• Production functions describe what is technically feasible when the firm operates efficiently.
 Short run versus Long run
• It takes time for a firm to adjust its inputs to produce its product with differing amounts of labour and capital.

• A new factory must be planned and built, and machinery and other capital equipment must be
ordered and delivered.

• Because firms must consider whether or not inputs can be varied, and if they can, over what period
of time, it is important to distinguish between the short and long run when analyzing production.

• The short run refers to a period of time in which the quantities of one or more factors of production
cannot be changed.

• In other words, in the short run there is at least one factor that cannot be varied; such a factor is
called a fixed input.

• The long run is the amount of time needed to make all inputs variable.

• The kinds of decisions that firms can make are very different in the short run than those made in the
long run.
• In the short run, firms vary the intensity with which they utilize a given plant and machinery;

• In the long run, they vary the size of the plant. All fixed inputs in the short run represent the
outcomes of previous long-run decisions based on estimates of what a firm could profitably
produce and sell.

• There is no specific time period, such as one year, that separates the short run from the long run.
Rather, one must distinguish them on a case-by-case basis.

• For example, the long run can be as brief as a day or two for a child’s lemonade stand or as
long as five or ten years for a petrochemical producer or an automobile manufacturer.

• In the long run firms can vary the amounts of all their inputs to minimize the cost of production.
Production with one variable input
• When capital is fixed but labor is variable, the only way the firm can produce more
output is by increasing its labor input.

• Imagine, for example, that you are managing a clothing factory.

• Although you have a fixed amount of equipment, you can hire more or less labor to sew
and to run the machines.

• You must decide how much labor to hire and how much clothing to produce.

• To make the decision, you will need to know how the amount of output q increases (if at
all) as the input of labor L increases.
Production with one variable input (labour)
 Average and Marginal Products
• The contribution that labor makes to the production process can be described n both an average and
a marginal (i.e., incremental) basis.
• Average Product: Output per unit of a particular input.
• In our example, the average product increases initially but falls when the labor input becomes
greater than four.
• Marginal product: Additional output produced as an input is increased by one unit.
• The marginal product of labor depends on the amount of capital used.
• If the capital input increased from 10 to 20, the marginal product of labor most likely would
increase. Why?
• Because additional workers are likely to be more productive if they have more capital to use.
• Like the average product, the marginal product first increases then falls—in this case, after the
third unit of labor.
PRODUCTION WITH ONE VARIABLE INPUT
• The total product curve in (a) shows the output
produced for different amounts of labor input.
• The average and marginal products in (b) can be
obtained from the total product curve.
• At point A in (a), the marginal product is 20
because the tangent to the total product curve has
a slope of 20.
• At point B in (a) the average product of labor is
20, which is the slope of the line from the origin
to B.
• The average product of labor at point C in (a) is
given by the slope of the line 0C.
• To the left of point E in (b), the marginal product
is above the average product and the average is
increasing;
• To the right of E, the marginal product is below
the average product and the average is
decreasing.
• As a result, E represents the point at which the
average and marginal products are equal, when
the average product reaches its maximum.
THE GRAPH EXPLAINED
• Note that the marginal product is positive as long as output is increasing, but becomes
negative when output is decreasing.
• It is no coincidence that the marginal product curve crosses the horizontal axis of the
graph at the point of maximum total product.
• This happens because adding a worker in a manner that slows production and decreases
total output implies a negative marginal product for that worker.
• The average product and marginal product curves are closely related.
• When the marginal product is greater than the average product, the average product is increasing.
• Similarly, when the marginal product is less than the average product, the average product is
decreasing.