Microeconomics

Eighth Edition

Chapter 6
Firms and
Production

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Learning Objectives
6.1 The Ownership and Management of Firms.
6.2 Production.
6.3 Short-Run Production.
6.4 Long-Run Production.
6.5 Returns to Scale.
6.6 Productivity and Technical Change.

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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.

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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.

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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.

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What Owners Want (1 of 2)
• 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

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What Owners Want (2 of 2)
• To maximize profit a firm must produce as efficiently
as possible.
• A firm engages in efficient production (achieves
technological efficiency) if it cannot produce its current
level of output with fewer inputs, given existing
knowledge about technology and the organization of
production.

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Production
• A firm uses a technology or production process to transform
inputs or factors of production into outputs.
• 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).
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Production Function (1 of 2)
• Production function - the relationship between the
quantities of inputs used and the maximum quantity
of output that can be produced, given current
knowledge about technology and organization.

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Production Function (2 of 2)

• Formally,
q f L, K 
– where q units of output are produced using L units of
labor services and K units of capital.

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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.

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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.

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Total Product, Marginal Product, and Average
Product of Labor with Fixed Capital
Table 6.1 Total Product, Marginal Product, and Average Product of
Labor with Fixed Capital

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Total Product
• Total product of labor- the amount of output (or total
product) that can be produced by a given amount of
labor.

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Marginal Product of Labor1
• Marginal product of labor (MPL ) - the change in total output,
q, resulting from using an extra unit of labor, L,
holding other factors (capital) constant:

q
MPL 
L

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Solved Problem 6.1
• 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?

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Solved Problem 6.1: 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

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 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

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 (a)
C

Output, q, Units per day

Figure 6.1 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

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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.

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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 .

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Isoquants
• Isoquant - a curve that shows the efficient
combinations of labor and capital that can produce a
single (iso) level of output (quantity).
• Equation for an isoquant:

q f L, K .

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Output Produced with Two Variable
Inputs
Table 6.2 Output Produced with Two Variable Inputs

blank blank blank Labor, L blank blank blank

Capital, K 1 2 3 4 5 6
1 10 14 17 20 22 24
2 14 20 24 28 32 35
3 17 24 30 35 39 42
4 20 28 35 40 45 49
5 22 32 39 45 50 55
6 24 35 42 49 55 60

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Figure 6.2 Family of Isoquants
K, Units of capital per day

6 a
d
e c f
b

b
3

e c f
2
q = 35

d
1 q = 24

q = 14

0 1 2 3 6 L, Workers per day

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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.

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Figure 6.3: Substitutability of
Inputs (1 of 2)

(a) (b)
y, Idaho potatoes per day

Boxes per day

q=3
q=3

q=2
q=2

q=1 q= 1
45 ° line

x, Maine potatoes Cereal per day

per day

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Figure 6.3: Substitutability of
Inputs (2 of 2)
(c)

K, Capital per unit of time

q= 1

L, Labor per unit of time

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Application: A Semiconductor
Integrated Circuit Isoquant

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 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!

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Figure 6.4 How the Marginal Rate of Technical
Substitution Varies Along an Isoquant
K, Units of capital per day

a
16

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, Workers per d ay
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Solved Problem 6.2
• 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?

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Solved Problem 6.2: 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.

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Substitutability of Inputs and
Marginal Products
• Along an isoquant q 0, or:

– or
MPL K
  MRTS
MPK L

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Cobb-Douglas Production Function
• Cobb-Douglas Production function
q  AL K 
• the marginal rate of technical substitution along an
isoquant that holds output fixed is

MPL q / L K
MRTS    .
MPK q / K  L

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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.

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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

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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

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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

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Solved Problem 6.3
• Under what conditions does a Cobb-
 
Douglas production function (Equation 6.4, q  AL K )
exhibit decreasing, constant, or increasing returns to
scale?

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Application: Returns to Scale in
Various Industries (1 of 4)
Table 6.1 Total Product, Marginal Product, and Average Product of
Labor with Fixed Capital

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Application: Returns to Scale in
Various Industries (2 of 4)

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Application: Returns to Scale in
Various Industries (3 of 4)

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Application: Returns to Scale in
Various Industries (4 of 4)

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Figure 6.5 Varying Scale Economies
K, Units of capital per year

d
8

q= 8

c ® :dDecreasing returns to scale

c
4

q= 6
b
2 b ® :cConstant returns to scale
a
1 q= 3
q= 1 a ® :bIncreasing returns to scale
0 1 2 4 8 ,L Work hours per year

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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.

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Innovations (1 of 2)
• 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.

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Innovations (2 of 2)
• Neutral technical change – a firm can produce more
output using the same ratio of inputs.
• Non-neutral technical changes are innovations that
alter the proportion in which inputs are used.
– Technological progress could be capital saving or labor
saving.

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Organizational Change
• Organizational change may also alter the production
function and increase the amount of output produced
by a given amount of inputs.

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