Chapter 6

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University of Toronto Scarborough
Economics for Management Studies

Production 11-10-28 9:21 PM • Theory of the Firm – how a firm makes cost-minimizing production decisions and how the firm’s resulting cost varies with its output The Production Decisions of a Firm • The production decisions of firms are analogous to the purchasing decisions of consumers, and can likewise be understood in three steps: 1. Production Technology (inputs into outputs) 2. Cost Constraints (prices of labour, capital and other inputs with a limited budget) 3. Input Choices (how much of each input to use in producing its output) • The firm’s production technology can be represented in the form of a production function – a compact description of how inputs are turned into outputs 6.1 – THE TECHNOLOGY OF PRODUCTION • Factors of Production - inputs into the production process (e.g. labour, capital, and materials) The Production Function • Production Function – function showing the highest output that a firm can produce for every specified combination of inputs [q=F(K,L)] o The quantity of output to the quantities of the two inputs, capital and labour • Input and outputs are flows – use a certain amount of labour and capital each year • Inputs can be combined in varying proportions, thus outputs can be produced in many ways. • Production function is for a given technology when the firm operates efficiently (uses inputs effectively) The Short Run versus the Long Run • Short Run – period of time in which quantities of one or more production factors cannot be changed (K is fixed) o Fixed Input – production factor that cannot be varied • Long Run - amount of time needed to make all production inputs variables 6.2 – PRODUCTION WITH ONE VARIABLE INPUT (LABOUR) • Capital fixed, labour variables Average and Marginal Products • Average Product – output per unit of a particular input o Total product/total input o Measures productivity of the firm’s workforce in terms of how much output each worker products on average • Marginal Product – additional output produced as an input is increased by one unit o Δq/ΔL (Change in output/change in labour input) The Slopes of the Product • MP max • MP crosses at the point of max total product (adding additional workers, slows down the production) • When MP is greater than AP, then AP is increasing and vice versa • MP = AP when AP reaches its max. The Average Product of Labour Curve • AP of Labour is given by the slope of the line drawn of the origin to the corresponding point on the total product curve The Marginal Product of Labour Curve • The marginal product of labour at a point is given by the slope of the total product at that point The Law of Diminishing Marginal Returns • Law of Diminishing Marginal Returns – principle that as the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease o i.e., when there are too many workers, some workers become ineffective and the marginal product of labour falls • Usually applies to the SR when at lease one input is fixed • Can be applicable in the LR to • Declining marginal product but not necessarily a negative one • Change in technology causes a shift in the TP curve Labour Productivity • Labour Productivity – average product of l
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