Microeconomics Chapter 6: Production PDF

MICROECONOMICS CHAPTER 6: Production Production The theory of the firm describes how a firm makes cost-minimizing production decisions and how the firm’s resulting cost varies with its output. Production Decisions of a Firm The production decisions of fir...

MICROECONOMICS CHAPTER 6: Production Production The theory of the firm describes how a firm makes cost-minimizing production decisions and how the firm’s resulting cost varies with its output. Production Decisions of a Firm The production decisions of firms are analogous to the purchasing decisions of consumers, and can likewise be understood in three steps: ○ Production Technology ○ Cost Constraints ○ Input Choices Factors of Production ○ Inputs into the production process (e.g., labor, capital, and materials). The Production Function Function showing the highest output that a firm can produce for every specified combination of inputs. ○ Remember the following: Inputs and outputs are flows. In economics and production, a flow refers to a measure of something (such as inputs or outputs) that occurs over a period of time, as opposed to being measured at a single point in time (which would be called a "stock"). Flows help describe dynamic processes, like how much is produced, consumed, or utilized within a specific timeframe. Inputs like labor, raw materials, or energy are considered flows because they are consumed over time to produce goods or services. Outputs, like goods or services, are also flows because they are produced and delivered over time. Inputs and outputs are flows because they are measured over a period of time (e.g., labor hours per week or units produced per day) rather than as static quantities (stock). This equation applies to a given technology. q = F(K,L) ○ Here, q represents the output, K is capital (e.g., machines), L is labor, and F(K,L) is the production function. The equation assumes that the technology available to the firm remains constant.  Example: If technology improves (e.g., better machines), the same inputs may produce more output, changing the production function. Production functions describe what is technically feasible when the firm operates efficiently. The Short Run versus the Long Run Short Run ○ Period of time in which quantities of one or more production factors cannot be changed. Period in which at least one factor of production is fixed and cannot be changed Fixed Input ○ Production factor that cannot be varied. Long Run ○ Amount of time needed to make all production inputs variable. Average and Marginal Products Average Product ○ Output per unit of a particular input. Average product of labor = Output/labor input = q/L Marginal Product ○ Additional output produced as an input is increased by one unit. Marginal product of labor = Change in output/change in labor input = Δq/ΔL The Law of Diminishing Marginal Returns Principle that as the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease. ○ central to the thinking of political economist Thomas Malthus Labor Productivity Average product of labor for an entire industry or for the economy as a whole Productivity and the Standard of Living Stock of Capital ○ Total amount of capital available for use in production. Technological Change ○ Development of new technologies allowing factors of production to be used more effectively. Isoquant Curve showing all possible combinations of inputs that yield the same output. Isoquant Map Graph combining a number of isoquants, used to describe a production function. Substitution Among Inputs Marginal Rate of Technical Substitution (MRTS) ○ 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. MRTS = − Change in capital input/change in labor input = − ΔK/ΔL (for a fixed level of q) ○ When the isoquants are straight lines, the MRTS is constant. Production Functions—Two Special Cases Fixed-Proportions Production Function ○ Production function with L-shaped isoquants, so that only one combination of labor and capital can be used to produce each level of output. The fixed-proportions production function describes situations in which methods of production are limited. Real-World Example: Construction Projects: Building a wall might require a fixed ratio of bricks (capital) and masons (labor). If you have surplus bricks but no masons, the wall cannot be built faster. Electric Cars: Producing an electric vehicle might require a specific number of battery cells and motors. If one component is lacking, production halts. Returns to Scale Returns to Scale ○ Rate at which output increases as inputs are increased proportionately. Returns to Scale refers to how the output of a production process changes when all inputs (like labor and capital) are increased proportionately. It helps in understanding the efficiency and scalability of a firm's production as input levels are scaled up. Increasing Returns to Scale ○ Situation in which output more than doubles when all inputs are doubled. When all inputs are doubled, the output increases by more than double. However, when there are increasing returns to scale, the isoquants move closer together as inputs are increased along the line. Constant Returns to Scale ○ Situation in which output doubles when all inputs are doubled. When all inputs are doubled, the output increases by exactly double. When a firm’s production process exhibits constant returns to scale, the isoquants are equally spaced as output increases proportionally. Decreasing Returns to Scale ○ Situation in which output less than doubles when all inputs are doubled. When all inputs are doubled, the output increases by less than double.