Midterm 2 – Economics 3251
CHAPTER 6: Producers, Consumers, & Competitive Markets
• Theory of the Firm: Describes 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 (Building Blocks of Theory of Firm)
1. Production Technology: A practical way of how inputs are transformed into outputs
a. EX: Electronics firm producing 10,000 TV per month by using a lot of labor and a
little capital. Or vice versa
2. Cost Constraints: Firms must take into account the prices of labor, capital and other inputs;
firm is concerned about its cost of production.
a. EX: Firm that produces 10k TV per month was to minimize total production costs
3. Input Choices: Firm chooses how much of each input to use in producing its output; firm
must take into account the prices of different inputs when deciding how much.
a. EX: If electronics firm operates in country with low wage rates, it may decide to
produce TV using large amounts of labor, little capital
6.1 – Firms & Their Production Decisions
• Prior to mid-1800s, almost all production was done by farmers, craftsmen, merchants and
traders who bought and sold various goods
• Modern Corporations emerged in the latter part of the 19th century
• Ronald Coarse (1937) said, “If markets work so well in allocating resources, why do we need
firms”
• Firms offer a mean of coordination that would be missing if workers operated independently
• Firms exist because they allow goods/services to be produced far more efficiently than would be
possible without them
• Positive Aspects
o Explaining why managers and workers behave the way they do
• Normative Aspects
o Explaining how firms can be best organized so they can operate efficiently as possible
Technology of Production
• Factors of Production: Inputs into the production process
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o EX: labor, capital, and materials
• Production Function: The highest output that a firm can produce for every specified
combination of inputs
o Production Function: q = F (K,L)
• ***Inputs and outputs are flows***
• Given Technology: That is, to a given state of knowledge about the various methods that might
be used to transform inputs into outputs
• Technically Feasible: When a firm operates efficiently – that is, when the firm uses each
combination of inputs as effectively as possible (not waste resources)
Short Run vs. Long Run
• Short Run: A period of time in which the quantities of one or more production factors cannot be
changed
o At least one factor that CANNOT be varied
o Capital is ALWAYS fixed and labor is variable in Short Run
• Long Run: Amount of time needed to make all production inputs variable
• **All fixed inputs in Short Run represent the outcomes of Previous Long-Run Decisions based on
estimates of what firm could profitably produce and sell***
• There is no specific time period that separates LR from SR
6.2 – Production with One variable input (Labor)
• When Labor = 0, then Output = 0
• After a certain point, additional labor is no longer useful and is counterproductive
• Average Product of Labor (APL): Output per unit of labor input (each worker produces on avg.)
o Average Product of Labor: APL = (Q/L)
• Marginal Product of Labor (MPL): Additional output produced as labor is increased by 1 unit
o Marginal Product of Labor: MPL = (
Q/
L)
Amt. of L (L)
Amt. of Cap. (K)
Total Output (q)
Av. Product (q/L)
MP (Q/L)
0
10
0
–
–
1
10
15
15
15
2
10
40
20
25
3
10
69
23
29
4
10
96
24
27
5
10
120
24
24
6
10
138
23
18
7
10
147
21
9
8
10
152
19
5
9
10
153
17
1
10
10
150
15
-3
3
The Slopes of the Product Curve Figure 6.1
• MP is positive (+) as long as output is increasing but becomes negative (-) when output is
decreasing
• When the MP > AP, AP is increasing
• When MP < AP, the average product is decreasing
• ***Marginal Product = Average Product*** @ Maximum point
Average Product of Labor Curve [total product divided by quantity of labor input]
• APL is given by the slope of the line drawn from the origin to the corresponding point on the
Total Product Curve
Marginal Product of Labor Curve [change in total product resulting from increase of 1 unit of labor]
• MPL at a point is given by the slope of the total product at that point
Law of Diminishing Marginal Returns (Figure 6.2)
• Law of Diminishing Marginal Returns: Principle that states as the use of an input increases in
equal increments (with other inputs fixed), a point will eventually be reached at which the
resulting additions to output decrease.
o ***Results from – limitations on the use of other fixed inputs (machinery) not from
declines in worker quality***
o Describes a declining MP but not a negative one
•
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• Thomas Malthus (British Economist): wrongly to predict dire consequences from continued
population growth; failed to account for long-run improvements in technology
Labor Productivity
• Labor Productivity: The average product of labor for an entire industry or for the economy as a
whole
o ***Important because: Determines the Real Standard of Living***
• Important Sources of Growth in Labor Productivity
o (1) Stock of Capital: The total amount of capital available for use in production
o (2) Technological Change: The development of new technologies allowing factors of
production to be used more effectively
• 2 patterns over post-WW2
o U.S. grew on average less rapidly than productivity in other countries until 1990s
o Productivity growth from 1980-2014 was much lower in developed countries
o #1 Japan followed by France & Germany
6.3 – Production with Two Variable Inputs (Figure 6.6)
• Firm can now produce its outputs in a variety of ways by combining different amounts of labor
and capital
• Isoquant: A curve that shows all the possible combination of inputs that yield the same output
o ***Steeper as more Capital (K) is added & Flatter when more Labor (L) is added***
• Isoquant Map: A number of isoquants are combined into a single graph
• Flexibility Example: fast food restaurants have recently faced shortages of young, low-wage
employees. Companies responded by automated self service/recruiting older people to fill it.
• Marginal Rate of Technical Substitution (MRTS): The amount by which the quantity of one
input can be reduced when one extra unit of another input is used, so that output remains
constant
o MRTS = –
K/
L = MPL/MPK (for a fixed level of q)
• Diminishing MRTS: When the MRTS falls (convex) as we move down along isoquant; tells us that
the productivity of any one input is limited. {(MPL)(
L) + (MPK)(
K) = 0}
o Additional output from increased use of labor = (MPL)(L)
o Reduction in output from decreased use of capital = (MP )( K)
• *Tells us that the MRTS between 2 inputs is equal to the ratio of marginal products of the inputs
Production Functions – 2 Special Cases
• (1) Perfect Substitutes: MRTS is constant at all points on isoquant
• (2) Fixed-Proportions Production Function (Leontief Production Function): production function
so that only one combination of labor and capital can be used to produce each level of output
o L-shaped (like perfect complements)
o Each level of output requires a specific combination of labor and capital
o MP of Capital (K) or Labor (L) is 0
Figure 6.9
6.4 – Returns to Scale Figure 6.10
