Chapter 6: Firms and production

6 main topics:
1. Ownership and management of firms
2. Production  convert inputs into outputs
3. Short-run production
4. Long-run production
5. Return to scale  ratio input to output determines size of firm
6. Productivity and technical change

6.1-The ownership and management of firms

Private, public and non-profit firms:

Firm  organization that converts inputs such as labor, materials, energy, and capital into outputs, the goods and
services that it sells

3 types of firms:
1. Private: “for-profit-firms”  owned by individuals/nongovernmental entities and looking to make profit
2. Public: Firms and organizations that are owned by governments or government agencies
3. Nonprofit: neither owned by governments or looking for profit  social and public interest work

The ownership of for-profit firms:

Firms in the private sector have 3 legal forms of organization:
1. Sole proprietorship  firm owned by a single individual
2. Partnerships  business owned and controlled by 2 or more people under a partnership agreement
3. Cooperation  firm owned by shareholders; elect a board of directors to represent them; corporations benefit of
limited liability (personal assets of the owners of the corporation cannot be taken to pay a corporation’s
debts even if it goes into bankruptcy)

The management of firms:

-Small firms: owner usually manages the firm’s operation
-Large firms: owners, managers, lower-level supervisors are all decision makers; in corporations, board of directors
appoint CEOs and other individuals who run the company and can fire them as they wish if they go against shareholders’
will

What owners want:

𝝅 = 𝑹 − 𝑪 ;where R is revenue and C is cost of production
Firms, to make profit engage in efficient production (current level of output cannot be produced with fewer inputs,
given existing knowledge about technology and the organization of production)  only way to maximize profit
(lower cost of production etc.)

6.2-Production:
3 main factors of production (FDP):
• Capital (K)  all long-lived inputs that help produce goods and services
• Labor (L)  all forms of human effort in the production (intellectual, manual etc.)
• Material (M)  all resources and raw goods necessary for the production of outputs

Production function:
Production function  relationship between the quantities of inputs used and the maximum quantity of outputs
that can be produced, given current knowledge about technology and organization
 𝒒 = 𝒇(𝑳, 𝑲); assumes that production is efficient thus maximizing profit

Varying inputs over time:

Short run  period so brief that at least one FDP cannot be varied practically
Fixed input  FDP that the form cannot practically vary in the short run (machines, high-skilled labor etc.)

Variable input  FDP that the firm can easily vary during the relevant period (low-skilled workers and material)
Long run  lengthy enough period that all FDPs can be varied (machines, high-skilled labor, locals etc.)

6.3-Short-run production:

Short run is a period in which at least one input is fixed  usually L is variable and K is fixed because hiring L is
easier on S-R than building a plant:

̅ ); where 𝑲
𝒒 = 𝒇(𝑳, 𝑲 ̅ is the fixed number of units of K

Total product:
Keeping K fixed, first you’ll observe a rise in the marginal productivity because of the rise in L but the more you add
L but keeping K fixed, the more you’ll observe the marginal productivity to decrease and even become negative 
David Ricardo and Law of Diminishing Marginal Returns
Marginal product of labor:
Marginal product of labor (MPL)  change in total output ∆𝒒, resulting from using an extra unit of labor, ∆𝑳,
∆𝒒 𝝏𝒒
holding other factors constant: 𝑴𝑷𝑳 = or (calculus definition) 𝑴𝑷𝑳 =
∆𝑳 𝝏𝑳

Average product of labor:

Average product of labor (APL)  the ratio of output, q, to the number of workers, L, used to produce that output:
𝑸
𝑨𝑷𝑳 =
𝑳
Graphing the product curve:

-A, the inflexion point means that the variation of the total
product curve is changing (positive to negative)
-B, is the maximum output possible with a constant K (here
110 computers for 11 workers)

-a, represents the average product equalling the slope of the

total product curve
-Average product rises with extra labor if the marginal
product curve is above the average product curve, and
the average product falls if the marginal product is below
the average product curve
Effect of extra labor:
-Having two workers work on a task where one can hold a part and the other bolt it, increases productivity
-Specialization (Taylorism and Fordism) increases productivity
BUT more you increase the number of workers, less marginal productivity you will get because of a fixed K

Relationship of the product curve:

-Average product rises with extra labor if the marginal product curve is above the average product curve, and the average
product falls if the marginal product is below the average product curve
-Total product curve is upward sloping when a firm uses a number of L which increases the output. If they decide to hire
more than the maximum of L capable of increasing the output, then the total product curve is downward sloping

Law of Diminishing Marginal Return:

-Keeping K fixed, first you’ll observe a rise in the marginal productivity because of the rise in L but the more you add
L but keeping K fixed, the more you’ll observe the marginal productivity to decrease and even become negative 
David Ricardo
“Diminishing return” (means that every additional input reduces the marginal output  Thomas Malthus) ≠
“Diminishing marginal return” (even if it diminishes, it is still rising, simply more slowly)
• Through technical progress we can fight diminishing marginal return (today, we can produce more food, on less
land thanks to mechanization etc.)

6.4-Long-run production:
Here both FDP (L &K) are variable  can increase lots of L but little of K, lots of K but little L or a bit of both 
meaning that the firm can substitute one input of a FDP for another (just like for utility)  a firm can thus, produce the
same amount of q through different production functions (=‘combinaison productive’)

Isoquants:
Isoquants: curve that shows the efficient combinations of L & K that can produce the same level of output
̅ = 𝒇(𝑳, 𝑲); where q is the output held constant and the other FDP are variable
𝒒
Properties of isoquants  hold quantity constant:
1. The farther an isoquant is from the origin, the greater level of output
2. Isoquants do not cross
3. Isoquants slope downward and cannot be thick

Shape of isoquants:
-Isoquants can also be perfect substitute, perfect complements (fixed-proportions production function) or imperfect
substitutes

a. Perfect substitutes

b. Perfect complements

c. Imperfect complements
Substituting inputs:
Marginal rate of technical substitution (MRTS)  extra units of one input needed to replace one unit of another
input that enables a firm to keep the amount of output it produces constant
Slope of an isoquant is the MRTS (always negative)  how many fewer K the firm can use if it hires one more worker or
vice-versa

Substitutability of inputs varies along an isoquant:

Decline in the MRTS: diminishing marginal rates of technical substitution  the more L and less K firm has, harder to
replace remaining K with L = flatter isoquant
Substitutability of inputs and marginal products:
MRTS shows by how much a form can increase one input and lower the other while staying on the same isoquant
• Extra L: 𝑴𝑷𝑳 ×∆𝑳  holding other factors constant
• Extra K: 𝑴𝑷𝑲 ×∆𝑲  holding other factors constant

Negative ratio of the marginal products =

MRTS

Cobb-Douglas production function:

𝑞 = 𝐴𝐿𝑎 𝐾 𝑏 ; where A, a, b are all positive constants
Constant a and b = relationship between the marginal and average products of L and K
𝒂𝑲
For a Cobb-Douglas curve: 𝑴𝑹𝑻𝑺 = − 𝒃 𝑳  approaches 0 when going down the isoquants

6.5-Returns to Scale:
How much output changes if a firm increases all its inputs proportionately  determine the scale or size in long-run

Constant, increasing and decreasing returns to scale:

Constant returns to scale  property of a production function whereby when all inputs are increased by a certain
percentage, output rises by that same percentage
𝒇(𝟐𝑳, 𝟐𝑲) = 𝟐𝒇(𝑳, 𝑲) = 𝟐𝒒  when L and K double, the output doubles
Increasing returns to scale  property of a production function whereby output rises more than in proportion to
an equal percentage increase in all inputs
𝒇(𝟐𝑳, 𝟐𝑲) > 𝟐𝒇(𝑳, 𝑲) = 𝟐𝒒  joining 2 small plants into a big one (= multiplying input by 2) (e.g. more specialization)
= increase efficiency = rise in outputs
Decreasing returns to scale  property of a production function whereby output rises less than in proportion to an
equal percentage increase in all inputs
𝒇(𝟐𝑳, 𝟐𝑲) < 𝟐𝒇(𝑳, 𝑲) = 𝟐𝒒  difficulty of organizing, coordinating and integrating activities with firm size = problem
with management of larger plants and larger teams = decrease in efficiency = less output
Cobb-Douglas isoquant often reliable for various large firms and sectors (tobacco, beer & liquors, metal etc.  see
p.168)
Here, 𝑔 = 𝑎 + 𝑏

Constant Increasing Decreasing

g=1 g>1 g<1

Varying returns to scale:

A production function’s returns to scale can vary as the output level changes  often the larger the output, the lower
the returns to scale will be (might even decrease)

6.5-Productivity and technical change:

Technical or managerial innovation = firm increases its productivity = production

Innovations:
Technical progress  advance in knowledge that allows more output to be produced with the same level of inputs
Different forms of innovations:
• Technical innovation (new products)
• Better management or organization of the production process

Technical progress:
Neutral technical change: despite rise in productivity, same ratio of inputs (1 worker for 1 machine)  keeps the same
shape of isoquant unchanged but shifts inward because less inputs are necessary for the same amount of output
Non-neutral technical progress: innovations that alter the proportion in which inputs are used
• Capital saving  Less capital relative to other inputs (more mobile phones = less landlines = less K needed)
• Labor saving  Less labor relative to other inputs (more machines replacing L)

Organizational change:
• Taylorism  vertical and horizontal production
• Fordism  interchangeable parts to cut time on finding the right place for the right part; conveyor belt and
assembly line (specializes in one task while the car moves with the conveyor = limits movements = increases
productivity = increases production with the same number of workers)