Economic principles chapter 6

What are the three building blocks of the theory of the firms ?

1. Production technology 2. Cost constraints 3. Input choices

Theory of the firm

Explanation of how a firm makes cost-minimizing production decisions and how its cost varies with its output

Production function

Function showing the highest output that a firm can produce for every specified combination of inputs.

Factors of Production

Inputs into the production process (e.g., labor, capital, and materials

What do firms really do

they take inputs and turn them into outputs or products

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. For example: When the labor input is small (and capital is fixed), extra labor adds considerably to output, often because workers are allowed to devote themselves to specialized tasks. Eventually, however, the law of diminishing marginal returns applies: When there are too many workers, some workers become ineffective and the marginal product of labor falls. Law of diminishing returns usually applies in the short run when at least one input is fixed. It can also happen in the long-run a manager may still want to analyze production choices for which one or more inputs are unchanged

Long-run

The long run is the amount of time needed to make all inputs variable Both labor and capital are variable

Cost constraints

The price of labor, capital and other inputs

what happens when capital is fixed and labor is variable?

When capital is fixed but labor is variable, the only way the firm can produce more output is by increasing its labor input

what happens to average product when marginal product is greater that average product

When the marginal product is greater than the average product, the average product is increasing. Similarly, when the marginal product is less than the average product, the average product is decreasing

Deminishing marginal returns

a level of production in which the marginal product of labor decreases as the number of workers increases

marginal rate of substitution

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. = - change in capital input/change in labor input

Deminishing MRTS

falls as we move down along the isoquant

Input choices

firm must choose how much of each input to use in producing its output

Average product of labor

output per unit of labor = Total output/amount of labor the average product increases initially but falls when the labor input becomes greater

Production function formula

q=f(K,L) q= output k=capital l= labor

productivity and standard of living

the aggregate value of goods and services produced by an economy is equal to the payments made to all factors of production, including wages, rental payments to capital, and profit to firms Consumers ultimately receive these factor payments in the form of wages, salaries, dividends, or interest payments. As a result, consumers in the aggregate can increase their rate of consumption in the long run only by increasing the total amount they produce.

Labor Productivity

the average product of labor for an entire industry or for the economy as a whole Labor productivity can provide useful comparisons across industries and for one industry over a long period. But labor productivity is especially important because it determines the real standard of living that a country can achieve for its citizens.

Why do firms exist?

1. they offer a means of coordination that is extremely important 2. eliminate the need for every worker to negotiate every task he /she will perform and bargain over the fees that will be paid for those tasks 3.

marginal product of labor

Additional output produced as an labor input is increased by one unit = change in quantity produced/change in labor marginal product of labor depends on the amount of capital used.If the capital input increased from 10 to 20, the marginal product of labor most likely would increase because additional workers are likely to be more productive if they have more capital to use Like the average product, the marginal product first increases then falls

shortrun

The short run refers to a period of time in which the quantities of one or more factors of production cannot be changed. only one input to the production process can be varied Capital is fixed and labor is variable

Is there a specific time for the long and short run period?

There is no specific time period, such as one year, that separates the short run from the long run. Rather, one must distinguish them on a case-by-case basis

Isoquants

curve showing all possible combinations of inputs that yield the same output are downward slopping just like indifference curves the slope of an isoquant measures the marginal rate of technical substitution/ the ability of a firm to replace capital with labor while maintaining the same level of output

what do isoquants show?

flexibility that firms have when making production decisions: sometimes they usually make substitutions to inputs.e.g where there are a fewer servers in restaurants they have automated the systems

isoquant map

graph combining a number of isoquants, used to describe a production function

Production technology

how inputs such as labor, capital and raw materials can be transformed into outputs