Firms and Production

Dr. Mahmoud Shahin

LECON4215 – Principles of
Microeconomics
Lecture 5
Microeconomics
Eighth Edition, Global Edition

Chapter 6
Firms and
Production
Learning Objectives
1. The Ownership and Management of Firms.
2. Production.
3. Short-Run Production.
4. Long-Run Production.
5. Returns to Scale.
6. Productivity and Technical Change.
1. The Ownership and Management of
Firms
• Firm - an organization that converts inputs such as
labor, materials, energy, and capital into outputs, the
goods and services that it sells.
 Private, Public, and Nonprofit Firms
• (For-profit) Private sector – firms owned by
individuals or other nongovernmental entities whose
owners try to earn a profit.
• Public sector – firms and organizations that are
owned by governments or government agencies.
• Nonprofit or not-for-profit sector – organizations
neither government-owned nor intended to earn a
profit.
 Ownership of For-Profit Firms
• Sole proprietorships are firms owned and run by a
single individual.
• Partnerships are businesses jointly owned and
controlled by two or more people operating under a
partnership agreement.
• Corporations are owned by shareholders who own
the firm’s shares (stock).
– Owners have limited liability - Personal assets of
corporate owners cannot be taken to pay a
corporation’s debts even if it goes into bankruptcy.
 What Owners Want
• Main assumption: A firm’s owners try to maximize
profit.
• Profit (p) - the difference between the revenue, R,
and its cost, C:

p  R C

• To maximize profit a firm must produce as efficiently

as possible (achieves technological efficiency).
 2. Production
• A firm uses a technology or production process to transform
inputs or factors of production into outputs. Most of inputs are
grouped in three categories:
– Capital services (K) – use of long-lived inputs such as
land, buildings (factories, stores), and equipment
(machines, trucks).
– Labor services (L) – hours of work provided by
managers, skilled workers (architects, economists,
engineers, plumbers), and less-skilled workers
(custodians, construction laborers, assembly-line workers).
– Materials (M) – natural resources and raw goods (oil,
water, wheat) and processed products (aluminum, plastic,
paper, steel).
 Technology
• A technology is a process by which inputs are
converted into an output (e.g. labor, a computer, a
projector, electricity, and software are combined to
produce this lecture).

• Usually several technologies will produce the same

product
– A blackboard and chalk can be used instead of a computer and a
projector.
• Which technology is the “best”?
• How do we compare technologies?
Production Function

• Formally,
q  f L, K 
– where q units of output are produced using L units of
labor services and K units of capital.
 Varying Inputs Over Time
• Short run - a period of time so brief that at least one
factor of production cannot be varied practically.
– Fixed input - a factor of production that cannot
practically vary in the short run.
– Variable input - a factor of production that the firm can
easily vary during the relevant time period.
• Long run - a lengthy enough period of time that all
factors of production can be varied.
 3. Short-Run Production
• In the short run, the firm’s production function is


q  f L, K 
– where q is output, L is the amount of labor, and K is the
fixed number of units of capital.
Total Product, Marginal Product, and Average
Product of Labor with Fixed Capital
Solved Problem:
• For a linear production function q = f(L, K) = 2L + K,
what is the short-run production function given that
capital is fixed at capital equals to 100? What is the
marginal product of labor?
Solved Problem: Answer
1. Set k  100. The short-run production function is
q  2L  100.
2. Determine the marginal products of labor by
showing how q changes as L is increased by L Units
q   2 L  L   100    2L  100   2L.
q
Thus, the marginal product of labor is MPL   2.
L
 (a)

Output, q, Units per day

C

Production 110

Relationships with
90 B

Variable Labor 56 A

0 4 6 11
Diminishing Marginal (b)
L, Workers per day

Returns sets in! a

APL, MPL
20

b
15
Average product, APL

Marginal product, MPL

c
0 4 6 11

L, Workers per day

Law of Diminishing Marginal Returns
• If a firm keeps increasing an input, holding all other
inputs and technology constant, the corresponding
increases in output will become smaller eventually.
– That is, if only one input is increased, the marginal
product of that input will diminish eventually.
 4. Long-Run Production
• In the long run both labor and capital are variable
inputs.
• It is possible to substitute one input for the other while
continuing to produce the same level of output .
 Isoquants
• Isoquants: curves showing all the combinations of K and
L that yield the same (iso) level of output q  f L, K .

Why does it slope downward?

b
Q=30
Q=20
a
Q=10 Process can be labor intensive: a
L
Process can be capital intensive: b
 Properties of Isoquants
1. The farther an isoquant is from the origin, the
greater the level of output.
2. Isoquants do not cross.
3. Isoquants slope downward.
 Substitutability of Inputs (1)

(a) (b)

Boxes per day

y, Idaho potatoes per day

q= 3
q= 3
q= 2
q= 2

q= 1 q= 1
45° line

, xMaine potatoes Cereal per

per day
day
Substitutability of Inputs (2)
(c)

K, Capital per unit of time

q =1

L , Labor per unit of time

 Substituting Inputs
• Marginal rate of technical substitution (MRTS) – the
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.

change in capital K
MRTS  
change in labor L
Slope of Isoquant!
How the Marginal Rate of Technical Substitution
Varies Along an Isoquant
K, Units of capital

a
16
per day

DK = –6

b
10
DL = 1
–3
1 c
7
–2 1 d
5 e
4 –1
1 q = 10

0 1 2 3 4 5 6 7 8 9 10
L, Work
ers per day
Solved Problem:
• Does the marginal rate of technical substitution vary
along the isoquant for the firm that produced potato
salad using Idaho and Maine potatoes? What is the
MRTS at each point along the isoquant?
Solved Problem: Answer
• The potato salad isoquants are straight lines because
the two types of potatoes are perfect substitutes.
• The slope is the same at every point, so the MRTS is
constant.
• MRTS is −1 at each point along the isoquant.
Because the two inputs are perfect substitutes, 1 lb of
Idaho potatoes can be replaced by 1lb of Maine
potatoes.
 Substitutability of Inputs and
Marginal Products
• Along an isoquant q  0, or:

– or
MPL K
   MRTS
MPK L
 5. Returns to Scale
• How much does output change if a firm increases all
its inputs proportionately?
• The answer helps a firm determine its scale or size in
the long run.
 Constant Returns to Scale (CRS)
• Property of a production function whereby when all
inputs are increased by a certain percentage, output
increases by that same percentage.
f  2L, 2K   2f L, K   2q
 Increasing Returns to Scale (IRS)
• Property of a production function whereby output rises
more than in proportion to an equal increase in all
inputs.

f  2L, 2K   2f L, K   2q
 Decreasing Returns to Scale (DRS)
• Property of a production function whereby output
increases less than in proportion to an equal
percentage increase in all inputs.
f  2L, 2K   2f L, K   2q
Solved Problem:
• Under what conditions does a Cobb-Douglas
 
production function ( q  AL K ) exhibit decreasing,
constant, or increasing returns to scale?
Application: Returns to Scale in
Various Industries (1)
Application: Returns to Scale in
Various Industries (2)
Application: Returns to Scale in
Various Industries (3)
 Marginal returns and returns to scale
• Marginal returns shows how output (y) changes
when one input is changed, holding all other inputs
fixed
• Returns to scale show how output (y) changes when
all inputs are changed (by the same amount)

• Question: can a technology exhibit increasing returns to scale

if all of its marginal products are diminishing?
• Yes. Let’s see an example.
 6. Productivity and Technical Change

• Productivity may differ

across firms – produce
different amounts of
output with a given
amount of inputs.
• After a technical or
managerial innovation,
a firm can produce
more today from a
given amount of inputs
than it could in the past.
 Innovations
• Technical progress - an advance in knowledge that
allows more output to be produced with the same
level of inputs.
• Better management or organization of the production
process similarly allows the firm to produce more
output from given levels of inputs.