ECON 356 - Outline Ten

The Theory of the Firm:  Production - The Mainstream Theory

Production:   Transforming inputs into outputs.  Or, creating value.

Factors of Production:

The Production Function:  The relationship that describes how inputs are transformed into output.

The standard function:

Intermediate Products and Value Creation:  Transform the intermediate products into something of greater value.

Fixed vs. Variable Inputs

Fixed Input:

Variable Input:

Long Run:

Short Run:

Short Run Production Function - The Total Product Curve (the level of output that is associated with alternative amounts of labor, holding capital constant)

                GRAPH (also see handout - Figure 6.2)

The shape?

Division and Specialization of Labor:

Law of Diminishing Marginal Returns:

What happens with an increase in technology?  How would the curve change?

GRAPH:

 Marginal Product (MP):

Relationship Between Total and Marginal Product: (see handout Figure 6.3)

                GRAPHS

Average Product (AP):

Relationship between Average and Marginal Product:

                GRAPH (see handout Figure 6.4)

Production in the Long Run

The Isoquant Map -  the set of all (L and K) pairs that provides a given level of output.  (Very similar idea as the indifference curve).

                GRAPH: (see handout Figure 6.6)

The higher the isoquant – the higher the output.

Marginal Rate of Technical Substitution:  the rate at which one input can be exchanged for another without altering the total level of output.  (Absolute value of the slope of the isoquant that passes through that point = ∆K/∆L.  Change in K units of capital are removed and change in L units of labor are added, output will remain the same at that given output level.)

Why the shape?  For most production functions, holding output constant, the less we have of one input, the more we must add of the other input to compensate for a one-unit reduction in the first input.   This is due to diminishing marginal rate of technical substitution..

Perfect Substitutes In Production:

                GRAPH: (see handout Figure 6.7)

Perfect Complements in Production:

                GRAPH:  (see handout Figure 6.7)

Changing the size of the firm – scale

                Which is better?  Large scale production or small scale production?  It depends upon the production process.  This is why some industries have small firms and others have large firms.

Increasing Returns to Scale:  the property of a production process whereby a proportional increase in every input yields a more than proportional increase in output.  Due to division and specialization mostly.

Constant Returns to Scale:  a proportional increase in every input yields an equal proportional increase in output.

Decreasing Returns to Scale:  a proportional increase in every input yields a less than proportional increase in output.  Due to management problems, information problems.

 GRAPH:

Don’t Confuse Diminishing Marginal Returns with Decreasing Returns to Scale!!  They are completely different.