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MGEB02H3 Chapter Notes -Substitute Good, Isoquant, Diminishing Returns

Economics for Management Studies
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Chapter 6 Production Notes
x theory of the firm Æ explanation of how firm makes cost-minimizing production decisions and how its cost varies with its output
The Production Decisions of a Firm
x the production decisions of firms are analogous to the purchasing decisions of consumers, and can be understood in 3 steps:
1) Production Technology: Just as a consumer can reach a level of satisfaction from buying different combinations of goods,
the firm can produce a particular level of output by using different combinations of inputs.
2) Cost Constraints: Just as a consumer is constrained by a limited budget, the firm is concerned about its cost of production.
3) Input Choices: 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.
6.1 The Technology of Production
x factors of production Æ inputs into the production process (e.g., labour, capital, and materials)
x labour inputs include skilled workers and unskilled workers, as well as the entrepreneurial efforts of the firm managers
x materials include steel, plastics, electricity, water, and any other goods that the firm buys and transforms into final products
x capital includes land, buildings, machinery and other equipment, as well as inventories
The Production Function
x production function Æ function showing the highest output that a firm can produce for every specified combination of inputs
x the production function can be written as: q = F(K, L)
x this equation relates the quantity of output to the quantities of the two inputs, capital and labour
x because the production function allows inputs to be combined in varying proportions, output can be produced in many ways
x production functions describe what is technically feasible when the firm operates efficiently—that is, when the firm uses each
combination of inputs as effectively as possible; the presumption that production is always technically efficient need not always
hold, but it is reasonable to expect that profit-seeking firms will not waste resources
The Short Run versus the Long Run
x short run Æ period of time in which quantities of one or more production factors cannot be changed
x fixed input Æ production factor that cannot be varied
x long run Æ amount of time needed to make all production inputs variable
6.2 Production with One Variable Input (Labour)
x when capital is fixed but labour is variable, the only way the firm can produce more output is by increasing its labour input
x beyond a point, total output declines: although initially each unit of labour can take greater and greater advantage of the existing
machinery and plant, after a certain point, additional labour is no longer useful and indeed can be counterproductive
Average and Marginal Products
x average product Æ output per unit of a particular input (APL); calculated by dividing the total output q by total input of labour L
x average product of labour measures productivity of workforce in terms of how much output each worker produces on average
x marginal product Æ additional output produced as an input is increased by one unit (MPL); can be written as ¨q/¨L—in other
words, the change in output ¨q resulting from a 1-unit increase in labour input ¨L
x to summarize:
average product of labour = output/labour input = q/L
marginal product of labour = change in output/change in labour input = ¨q/¨L
The Slopes of the Product Curve
x when the marginal product is greater than the average product, the average product is increasing
x when the marginal product is less than the average product, the average product is decreasing
x average product of labour is given by slope of line drawn from the origin to the corresponding point on the total product curve
x 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
x law of diminishing marginal returns Æ principle that as the use of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease; usually applies to the short run, however, can apply to the long run
x when labour input is small and capital is fixed, extra labour adds considerably to output, however, law of diminishing marginal
returns applies: when there are too many workers, some workers become ineffective and the MPL falls
x the law of diminishing marginal returns describes a declining marginal product but not necessarily a negative one
Labour Productivity
x labour productivity Æ average product of labour for an entire industry or for the economy as a whole
x because the average product measures output per unit of labour input, it is relatively easy to measure
x labour productivity can provide useful comparisons across industries and for one industry over a long period
x labour productivity is especially important because it determines real standard of living that a country can achieve for its citizens
x in any particular year, the aggregate value of goods and services produced by an economy is equal tot eh payments made to all
factors of production, including wages, rental payments to capital, and profits to firms
x consumers ultimately receive these factor payments n the form of wages, salaries, dividends, or interest payments
x as a result, consumers in aggregate can increase their rate of consumption in LR only by increasing the total amount they produce
x stock of capital Æ total amount of capital available for use in production
x technological change Æ development of new technologies allowing factors of production to be used more effectively
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