1Chapter 6Firms and ProductionKey issues1. ownership and management of firms2. production (using existing technologies)3. short-run production: one variable and one fixed input4. long-run production: two variable inputs5. returns to Scale6. productivity and technical changeFirman organization that converts inputs (labor, materials, and capital) into outputs (goods and services)Sources of production: U.S.• firms: 84% of U.S. national production• government: 12%• nonprofit institutions: 4%• private households: 0.2%Government's share of production• United States: 12%• Ghana 37%• Zambia 38%• Sudan 40%• Algeria 90%• Bangladesh, Paraguay, and Nepal 3%Legal forms of for-profit firms• sole proprietorships: owned and run by a single individual• partnerships: jointly owned and controlled by two or more people• corporations: owned by shareholders in proportion to the numbers of shares of stock they hold2Corporations• shareholders elect a board of directors who run the firm• board of directors usually hire managersLiability• sole proprietors and partners liable:• personally liable for debts of their firms • to the extent of all their personal wealth - not just their investments• owners of corporations have limited liability: • cannot lose personal assets• liability limited to their investment (value of stock)<20%90%Corporations7%5%Partnerships75%6%Sole proprietorshipsNumber of FirmsBusiness SalesManagement of Firms• small firm owner usually manages• corporations and larger partnerships use managersObjectives • conflicting objectives between owners, managers, and other employees• employees want to maximize their earnings or utility• owners want to maximize profit:π = R - C• R = revenue = pq = price x quantity• C = costProduction efficiencygiven current knowledge about technology and organization:• current level of output cannot be produced with fewer inputs • given quantity of inputs used, no more output could be produced3Production efficiency and profitproduction efficiency is• a necessary condition to maximize profit• not a sufficient condition to maximize profit (must produce optimal output level)Production• production process: transform inputs or factors of production into outputs• common types of inputs:• capital (K): buildings and equipment• labor services (L)• materials (M): raw goods and processed products Production functionrelationship between quantities of inputs used and maximum quantity of output that can be produced, given current knowledge about technology and organizationProduction function with 2 inputsa production function that uses only labor and capital:q = f (L, K)to produce the maximum amount of output given efficient productionVariability of inputs over time• firm can more easily adjust its inputs in the long run (LR) than in the short run (SR)• short run: a period of time so brief that at least one factor of production is fixed• fixed input: a factor that cannot be varied practically in the SR• variable input: a factor whose quantity can be changed readily during the relevant time period• long run: lengthy enough period of time that all inputs can be variedShort-run production• one variable input: Labor (L)• one fixed input: Capital (K)• thus, firm can increase output only by using more labor4Example• service firm assembles computers for a manufacturing firm • manufacturing firm supplies it with the necessary parts, such as computer chips and disk drives• assembly firm's capital is fixed: eight workbenches fully equipped with tools, electronic probes, and other equipment for testing computers can vary laborMarginal product of labor (MPL)• should firm hire another worker? • want to know marginal product of labor: • change in total output, Dq, resulting from using an extra unit of labor, DL = 1, holding the other factor (K) constant • MPL= Dq/DLAverage product of labor (APL)• does output rise in proportion to this extra labor?• want to know average product of labor: • ratio of output to the number of workers used to produce that output• APL= q/LGraphical relationships• total product: q• marginal product of labor: MPL= Dq/DL• average product of labor: APL= q/L• smooth curves because firm can hire a "fraction of a worker" (works part of a day)Output, q,Units per dayBAC11640L , Workers per dayMarginal product, MPLAverage product, APLAPL, MPL1109056(a)bac11640L , Workers per day2015(b)Figure 6.1 ProductionRelationships with Variable Labor5Effect of extra labor• APL• rises and then falls with labor• slope of line from the origin to point on total product curve • MPL• first rises and then falls • cuts the APLcurve at its peak• is the slope of the total product curveLaw of diminishing marginal returns (product)as a firm increases an input, holding all other inputs and technology constant, • the corresponding increases in output will become smaller eventually• that is, the marginal product of that input will diminish eventually• see Table 6.1 and Figure 6.1bMistake 1• many people overstate this empirical regularity: talk about "diminishing returns" rather than "diminishing marginal returns" • "diminishing returns" extra labor causes output to fall: could produce more output with less labor• "diminishing marginal returns": MPLcurve is falling but may be positive• firms may produce where there are diminishing marginal returns to labor but not diminishing returnsMistake 2 ("Dismal Science")• many people falsely claim that marginal products must fall as an input rises without requiring that technology and other inputs stay constant• attributed to MalthusLong-run production: Two variable inputs• both capital and labor are variable• firm can substitute freely between L and K• many combinations of L and K produce a given level of output:• q = f (L, K)Isoquant• curve that shows efficient combinations of labor and capital that can produce a single (iso) level of output (quantity):• Examples:• 10-unit isoquant for a Norwegian printing firm 10 = 1.52 L0.6 K0.4• Table 6.2 shows four (L, K)pairs that produce q = 24(,)qfLK=6Figure 6.2 Family of IsoquantsK, Units ofcapital per dayebadfc63210L, Workers per day6321q= 14q= 24q= 35Isoquants and indifference curves• have most of the same properties • biggest difference:• isoquant holds something measurable, quantity, constant• indifference curve holds something that is
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