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Econ Study Guide.docx

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York University
INTL 1200
Theodore Tolias

Econ Study Guide What is the difference between a production function and an isoquant? A production function describes the maximum output that can be achieved with any given combination of inputs. An isoquant identifies all of the different combinations of inputs that can be used to produce one particular level of output. Can an isoquant ever slope upward? Explain No. An upward sloping isoquant would mean that if you increased both inputs output would stay the same; sort of like a bad in consumer theory. As a general rule, if the firm has more of all inputs it can produce more output. Why does production eventually experience diminishing marginal returns to labor in the short run? The marginal product of labour will eventually diminish because there will be at least one fixed factor of production, such as capital. As more and more labour is used along with a fixed amount of capital, there is less and less capital for each worker to use, and the productivity of additional workers necessarily declines. Think for example of an office where there are only three computers. As more and more employees try to share the computers, the marginal product of each additional employee will diminish Faced with constantly changing conditions, why would a firm ever keep any factors fixed? What criteria determine whether a factor is fixed or variable? Whether a factor is fixed or variable depends on the time horizon under consideration: all factors are fixed in the very short run while all factors are variable in the long run. “All fixed inputs in the short run represent outcomes of previous long-run decisions based of estimates of what a firm could profitably produce and sell.” Some factors are fixed in the short run, whether the firm likes it or not, simply because it takes time to adjust the levels of those inputs. For example, a lease on a building may legally bind the firm, some employees may have contracts that must be upheld, or construction of a new facility may take a year or more. Recall that the short run is not defined as a specific number of months or years but as that period of time during which some inputs cannot be changed for reasons such as those given above. In filling a vacant position, you should be concerned with the marginal product of the last worker hired, because the marginal product of the last worker hired, because of the marginal product measures the effect on output, or total product, of hiring another worker. This in turn determines the additional revenue generated by hiring another worker, which should then be compared to the cost of hiring the additional worker. The point at which the average product begins to decline is the point where average product is equal to marginal product. As more workers are used beyond this point, both average product and marginal product decline. However, marginal product is still positive, so total product continues to increase. Thus, it may still be profitable to hire another worker. Is it possible to have diminishing returns to a single factor of production and constant returns to scale at the same time? Discuss. Diminishing returns and returns to scale are completely different concepts, so it is quite possible to have both diminishing returns to, say, labour and constant returns to scale. Diminishing returns to a single factor occurs because all other inputs are fixed. Thus, as more and more of the variable factor is used, the additions to output eventually become smaller and smaller because there are no increases in the other factors. The concept of returns to scale, on the other hand, deals with the increase in output when all factors are increased by the same proportion. While each factor by itself exhibits diminishing returns, output may more than double, less than double, or exactly double when all the factors are doubled. The distinction again is that with returns to scale, all inputs are increased in the same proportion and no inputs are fixed. The production function in Exercise 10 is an example of a function with diminishing returns to each factor and constant returns to scale. Explain the term “marginal rate of technical substitution.” What does MRTS = 4 mean? MRTS is the amount by which the quantity of one input can be reduced when the other input is increased by one unit, while maintaining the same level of output. If the MRTS is 4 then one input can be reduced by 4 units as the other is increased by one unit, and output will remain the same. Explain why the marginal rate of technical substitution is likely to diminish as more and more labour is substituted for capital. As more and more labour is substituted for capital, it becomes increasingly difficult for labour to perform the jobs previously done by capital. Therefore, more units of labour will be required to replace each unit of capital, and the MRTS will diminish. For example, think of employing more and more farm labour while reducing the number of tractor hours used. At first you would stop using tractors for simpler tasks such as driving around the farm to examine and repair fences or to remove rocks and fallen tree limbs from fields. But eventually, as the number or labour hours increased and the number of tractor hours declined, you would have to plant and harvest your crops primarily by hand. This would take huge numbers of additional workers. Can a firm have a production function that exhibits increasing returns to scale, constant returns to scale, and decreasing returns to scale as output increases? Discuss. Many firms have production functions that exhibit first increasing, then constant, and ultimately decreasing returns to scale. At low levels of output, a proportional increase in all inputs may lead to a larger-than-proportional increase in output, because there are many ways to take advantage of greater specialization as the scale of operation increases. As the firm grows, the opportunities for specialization may diminish, and the firm operates at peak efficiency. If the firm wants to double its output, it must duplicate what it is already doing. So it must double all inputs in order to double its production, the firm will be so large that when inputs are doubled, output will less than double, a situation that can arise from management diseconomies. The price of computers has fallen substantial
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