7.

FIRMS AND PRODUCTION

7.1. Firms and production

A firm is a unit or organization that convert inputs (raw material, workers,

and machine) into outputs.
7.2. Types of Firms
3 types of firms: sole proprietorship, partnership and cooperation.
1.

Sole

Proprietorship: firms owned and run by a single

individual.
2.

Partnership: firms jointly owned and controlled by two or more

people.
The owners operate under a partnership agreement.

3.

Corporations: firms owned by shareholders in proportion to the

numbers of shares of stock they hold. The shareholders elect a
board of directors who run the firm. In turn, the board of directors
usually hires managers who make short-term decisions and longterm plans.

The owner will make decisions for a firm.

His objective is to maximize

profit ().
= Revenue Cost
Revenue = PQ
A necessary condition for maximizing profit is to have an efficient
production process. An efficient production process is defined that the firm
cannot produce more output with the existing knowledge, or that the firm
cannot produce same output by using less inputs. If a firm is produced
efficiently, then it cannot be maximizing its profit.

There are three major categories of inputs:

Capital (K): building, machine, equipment, etc.

Labor (L): managers, skilled workers, or unskilled workers.

Material (M): oil, water, steel, iron, etc.

For simplicity, we study firms using L and K as inputs

The function of a firm is summarized in its production function.

q = f (L, K)
Where q is the maximum amount of output produced by using L units of
labor services and K units of labor. (Note: Maximum has implied that
production function is an efficient process).
7.3. Time and firms ability to vary inputs
Roughly, we divide a firms time frame into two time periods: long-run and
short-run.

Long-run: all inputs can be changed both labor and capital.

Short-run: some inputs are not changeable capital is fixed, labor

can change.

This is because is generally easier to hire and fire workers instead of

expand or shrink plant sizes.
Equipment is fixed but you can always hire an extra hand.
7.3.1. Short-run production
Lets see a short-run production function (capital is fixed):
q = f(L, K)
Production function with one variable input (L)
A few definitions first:

Marginal product of labor the value of one extra worker

MPL = q/L
Average product of labor the value of team efforts
APL = q/L
The

definition in Table 6.1.

Note that capital is fixed at 8, while labor can be varied.

The graph below shows how Total product, Marginal product, and Average
product curve look like.

Figure 6.1
Facts:
TP (Total Product)
1. Initially, TP increases faster and faster as L increases.
This is because specialization can increase productivity.
2. After the benefit of specialization is fully utilized, the increase in TP
will slow down until an extra worker contributes negatively.
MP (Marginal Product) by definition, it is the slope of TP.
1. MP increases.
2. MP decreases but is still positive
3. MP is negative.
As production increases, it will enter the range of diminishing marginal
returns.

This is called the law of diminishing marginal returns.

This means the extra benefit from an extra worker decreases as the
number of workers increases.
AP is the slope of the line from the origin to (L, q).
Its relationship with MP:
1. MP > AP AP increases
2. MP < AP AP decreases
3. MP = AP (crossing point) AP at maximum
Why?
When L is 4, we have AP=14, which means that in average, each worker
can produce 14 units of output. If we increase 1 more unit of labor, this
extra labor will generate 19 units of output. If he can only generate 14
units of output, then AP will not be changed. But now 19>14, so this extra
unit bids up the average product.
Exercises
1. Suppose a chair manufacturer is producing in the short run when
equipment is fixed. The manufacturer knows that as the number of
laborers used in the production process increases from 1 to 7, the
number of chairs produced changes as follows: 10, 17, 22, 25, 26,
25, and 23.
a. Calculate the marginal and average product of labor for this
production function.
Answer: The average product of labor, APL, is equal to Q/L. The marginal product of
labor, MPL, is equal to DQ/ DL, the change in output divided by the change in labor input.

For this production process we have:

b. Does this production function exhibit diminishing returns to labor?

Explain.
Answer: This production process exhibits diminishing returns to labor. The marginal
product of labor, the extra output produced by each additional worker, diminishes as
workers are added, and is actually negative for the sixth and seventh workers.
c. Explain intuitively what might cause the marginal product of labor to
become
negative.
Answer: Labors negative marginal product for L > 5 may arise from congestion in the
chair manufacturers factory. Since more laborers are using the same, fixed amount of
capital, it is possible that they could get in each others way, decreasing efficiency and
the amount of output.

2. The marginal product of labor is known to be greater than the

average product of labor at a given level of employment. Is the
average product increasing or decreasing? Explain.
Answer: If the marginal product of labor, MPL, is greater than the average product
of labor, APL, then each additional unit of labor is more productive than the average of
the previous units. Therefore, by adding the last unit, the overall average increases. If
MPL is greater than APL, then APL is increasing. If the MPL is lower than the APL,
then the last unit reduces the average. The APL is at a maximum when the productivity
of the last unit is equal to the average of the previous units (i.e., when MPL = APL).