Chapter 6: Production and Business Organization

Economics, 18th Edition (Samuel Nordhaus)

Theory of Production and Marginal Products

BASIC CONCEPTS
The Production Function
 Input – land , labor
 Output – wheat, toothpaste

If you have a fixed amount of inputs, how much outputs can you get?
In practice, the answer depends on the state of technology and engineering knowledge.

 Production Function
o The relationship between the amount of input required and the amount of output that
can be obtained
o Specifies the maximum output that can be produced with a given quantity of inputs
o Defined for a given state of engineering and technical knowledge
o There are literally millions of different production functions--- one for each and every
product or service. Most of them are not written down but are in people’s minds.
o In areas of the economy where technology is changing rapidly, production functions
may become obsolete soon after they are used. And some (like the blueprints of a
medical laboratory) are specifically designed for a specific location or purpose and
would be useless anywhere else. Nevertheless, the concept of a production function is a
useful way of describing the productive capabilities of a firm

Total, Average and Marginal Product

 Total Product – total amount of outputs produced
 Marginal Product – (of an input) the extra output produced by one additional unit of that input
while other factors are held constant
 Average Product – total output divided by total units of input

The Law of Diminishing Returns: holds that we will get less and less extra output when we add additional
doses of an input while holding other inputs fixed.
 The marginal product of each unit of input will decline as the amount of that input increases,
holding all other inputs constant.
 A widely observed empirical regularity rather than a universal truth

Note: Diminishing returns and Marginal Products refer to the response of output to an increase of a single
input when all other inputs are held constant.

Returns to Scale – the effects of scale increases of inputs on the quantity produced.
 Three Important Cases:
1. Constant Returns to Scale
o denote a case where a change in all inputs leads to a proportional change in
output.
o Example: if labor, land, capital and other inputs are doubled, then under
constant returns to scale output would also double.
2. Increasing Returns to Scale
o also called economics of scale
o arise when an increase in all inputs leads to a more-than-proportional increase
in the level of output.
o Example: an engineer planning a small-scale chemical plant will generally find
that increasing the inputs of labor, capital and materials by 10% will increase
the total output by more than 10%.
3. Decreasing Returns to Scale
o Occur when a balanced increase of all inputs leads to a less-than-proportional
increase in total output.

1
 Chapter 6: Production and Business Organization
Economics, 18th Edition (Samuel Nordhaus)

SHORT RUN AND LONG RUN

• Production requires not only labor and land but also time.
• To account for the role of time in production and costs, we distinguished between two different
time periods:
 Short Run – period in which a firm can adjust production by changing variable factors
(i.e., materials & labor) but cannot change fixed factors (i.e., capital)
 Long Run – period sufficiently long that all factors including capital can be adjusted.
• Two different time periods in production and cost analysis:
 Short Run – period of time in which some inputs (the variable inputs) can be adjusted
 Long Run – period in which all factors employed by the firm (including the capital) can
be changed

TECHNOLOGICAL CHANGE
• Much of the increase in output has come from technological change, which improves
productivity and raises living standards.
o Process Innovation – occurs when new engineering knowledge improves production
techniques for existing products
o Product Innovation – new or improved products are introduced in the market place

PRODUCTIVITY AND THE AGGREGATE PRODUCTION FUNCTION

• Productivity – a concept measuring the ratio of total output to a weighted average of inputs.
o Labor Productivity – calculates the amount of output per unit of labor
o Total factor productivity – measures output per unit of total inputs (typically of capital
and labor)
• Productivity grows because of economies of scale and because of technological change.
o While technology might ideally allow constant or increasing returns to scale, the need
for management and supervision may eventually lead to decreasing returns to scale in
giant firms.
• Aggregate Production Function – relate total output to the quantity of inputs (like labor, capital,
and land) and to total productivity

Business Organizations
THE NATURE OF THE FIRM
• Business firms are specialized organizations devoted to managing the production of production.
Among their important functions are exploiting economies of mass production, raising funds,
and organizing factors of production.

BIG, SMALL AND INFINIRESIMAL BUSINESSES

• The Individual Proprietorship: classic small businesses often called “mom-and-pop stores”;
might do a few hundred dollars of business per day and barely provide a minimum wage for the
owner’s efforts.
• The Partnership: combination of talents. Partnerships pose disadvantages that make them
impractical for large businesses.
o The major disadvantage is unlimited liability. General partners are liable without limit for
all debts contracted by the partnership.
• The Corporation: a separate legal entity that may on its own behalf buy, sell, borrow money,
produce goods and services, and enter into contracts.