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Institute of Lifelong Learning, University of Delhi
Typology: Study notes
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are combine to produce output. The decisions related to production have a definite
implication for the profits and the viability of the firm. Figure 1 illustrates the circular flow
diagram, which shows the demand and supply of the inputs as well as the output. It shows
the demand and supply decision of firms and households. It is very important to understand
the questions that are faced by the firms and how are they answered. The chapter aims at
solving all these puzzles.
Figure 1 : Decisions of the firms and households
Production can be defined as a process whereby, inputs are combined, processed and converted into output. Production is a vital function of a firm be it of any size and internal structure. There are a set of assumptions on which the analysis in this chapter is based. The assumptions are listed below:
Production is not confined only to firms: The function of production is not confined only to the firms in the market. Households can also process and convert inputs like land, labor, capital etc. into output. A household that has a kitchen garden, combines land, labor, manure, fertilizers, seeds and other tools to grow vegetables. Government utilizes various factors of production to provide various services of public utility.
Firms are different from households and government in the sense that they produce goods or services to meet the demand for those goods or services to make profits.
Firms differ from each other on the basis of their size, type of organization and the market structure that they function in. We analyze the case of perfect competition here.
Perfect Competition: There are characteristics particular to a perfectly competitive industry. The industry comprises of a large number of relatively small firms that produce homogeneous goods. No specific firm can control market price of either the output it produces or the inputs that it uses for production. Hence, two features specific to the perfectly competitive industry are that each firm is very small compared to the size of the industry and all the firms in a perfectly competitive industry produce identical goods.
Resultantly, each firm in the industry takes the market price, which is determined by the supply and demand, as given. These firms can be described as “price-takers”. At the given price, the firms can decide how much output to supply, quantity of inputs to purchase and how to produce the output.
Since the products produced by the firms are homogeneous, no firm can charge a price above the market price as the consumers, in this case will easily shift to the other sellers in the market and the firm who fixed a price above the market price will incur losses. Also, it is very clear, that no firm would want to charge a price below the market price, since it can sell any quantity of output at the given market price. The demand for output produced by such a firm is also perfectly elastic. For instance, let’s consider the case of Ram who sells pens in a perfectly competitive market. Part a in figure 2 depicts the supply and demand conditions in the market. Say the price set by the market is Rs.5 per pen. Part b in figure 2 represents the demand curve being faced by a perfectly competitive firm for its output. It would not be beneficial for Ram to raise the price of pen above Rs.5, since the consumers will shift their demand to the other sellers and he will not be able to sell any pen. On the other hand, he would not want to fix a price below Rs.5, because he can sell as many number of pens at this price as he wants.
Figure 2 : A perfectly competitive market structure and the demand faced by a single firm
Profits and Costs
We have already discussed, that any firm functions in the market, primarily to make profits. Since, profits are so vital for any firm, it is important to understand what profit is. Profit can be defined as the difference between the total revenue and the total cost of the firm.
Total revenue is the amount of money that a firm receives out of selling its output; it’s the quantity of output sold (q) multiplied by the per unit price of that good (p). Total cost or the total economic cost includes three elements. First being the explicit/accounting or out of pocket costs, which is the cost of raw materials and other inputs used in the production. The normal rate of return on capital and the opportunity cost of each factor of production are the other two elements of the total economic cost. The normal rate of return on capital and the opportunity cost of each factor of production can be categorized as implicit costs. Opportunity costs are implicit and need to be included in the total cost incurred by the firm. For example, a person who owns a business also contributes his labor services to it, but does not get any wage in return, instead of running his own business, he could have worked as an employee and would have got a wage for his labor. The wage that this person loses out is the opportunity cost of his labor which needs to be added to the total economic cost. The opportunity cost of capital, in a similar fashion is equally important. The opportunity cost of capital can be accounted for by including the normal rate of return to capital in the total economic costs.
Normal Rate of Return
Capital is required to establish a firm or to start a business. Money is required purchase and set up machinery, equipment, furniture etc. This implies that this capital will stay tied up with the business for a long period. Fresh investments also need to be made, even when the firm or the business has been in place for a long time. There is an opportunity attached with this invested capital. The investor or the proprietor, instead of investing his funds in the business, could have invested them in some financial security, which would have given him returns. This rate of return is the opportunity cost of using or investing one’s capital in the business.
The concept of rate of return needs to be understood. A person who has invested his funds in a business, will get a stream of returns. The rate of return can be described as the annual flow of net returns on investment, expressed as a proportion of the total investment. A normal rate of return, on the other hand, can be defined as the rate of return that keeps the investors and owners satisfied. If the rate of return falls below the normal rate of return, the owners will get a lower return if they invest in the business, they could earn a higher returns by putting the funds in the financial securities, bonds or anywhere else. Under normal conditions, i.e. when there is a consistent stream of revenue, there is no uncertainty about the future, the firm earns a steady stream of revenues, the normal rate of return will be quite close to the rate of return on risk-free government securities.
Let’s define economic profit now. Economic profit is the difference between the total revenue and the total economic costs.
With this definition, it is easy to see that when the firm earns a rate of return equal to the normal rate of return, firms don’t earn any profits. On the other hand, if the firm is earning a positive sum of profit, it implies that the rate of return is above the normal rate of return to capital. A positive level of profit will keep the investors happy and motivate new firms to enter the industry. A negative profit, means that the rate of return is below the normal rate of return to capital. In such a case the firms might shut down the business and move out of the industry, a few might contract and the fresh investments will be hard to come by.
A Numerical Example
Table 1: Calculating Profits for Ravi’s Venture Total Revenue (30000 radios x Rs.100) Rs. Economic Costs Amount Paid to the supplier (30000 radios x Rs.50)
Rs.
Wage paid to the worker Rs. 400000 Opportunity cost of Capital (Rs.1000000 x 0.10)
Rs.1 00000
Total Economic Costs Rs. Economic Profit = Total Revenue – Total Economic Costs
Rs.
A profit of Rs.
Ravi earns a revenue of Rs.3000000, out of his venture. The total economic costs have been calculated by including the opportunity cost of capital or the normal return to the capital. The economic profit generated by this venture is Rs.1000000.
Production is any process through which the inputs are processed and converted into output. Production technology is a functional relationship between the inputs and the output. For example producing a cotton shirt requires cotton, threads, buttons, dyes, machinery, electricity, laborers and other inputs. It is possible that a good can be produced through a number of different production techniques. The technology can be labor intensive or capital intensive. A production technique that uses more of labor relative to capital, is called a labor intensive production technology. On the other hand, a production technique that uses more of capital relative to labor, is a capital-intensive technology. For example, to make a swimming pool in a resort 50 laborers can be employed, with necessary tools and equipment. This is a labor intensive technique. On the other hand, the swimming pool can also be made with the help of 15 laborers, a crane and other machinery. This is a capital- intensive technique. Since, the firm tries to choose the method of production which minimizes the cost, a firm in an economy with abundant supply of cheap labor will use labor-intensive techniques of production. However, in the economy where, the labor is short in supply and the wages are high, the firms will have a tendency to use more of capital relative to labor in the production process.
Production Functions and Concepts of Total Product, Marginal Product and Average Product
A production function can be describe as the mathematical relationship between the inputs and the output. The total product function shows the total number of units of output that will result on using different units of inputs.
For example, in a bakery one worker, working alone can produce 12 cookies in an hour. If another worker is added, both the workers produce a total of 27 cookies in an hour, which means that the second worker can produce 15 cookies in an hour. With the third worker the total number of cookies produced rises to 37, i.e. the third worker adds only 10 cookies. This could be because with three workers, the kitchen gets crowded and workers come in each other’s way. Also the number of ovens is fixed, so three workers get to work on with a fixed number of ovens, so there is a capital constraint. Note that we assume that all the workers are equally efficient, it is the constraint of space and capital which leads to fall in the number of cookies added to the total production by the third worker. With the addition of the fourth and the fifth worker, these constraints are felt more strongly and the addition made to the total production of cookies by each worker falls. With the fourth worker, the total production of cookies rises to 40 and with the fifth worker it rises to 41 cookies. With the sixth worker there is no further rise in the total production.
Tale 2: Production Function Laborers Total Product (Cookies Per Hour)
Marginal Product of Labor
Average Product of Labor 0 0 - - 1 12 12 12 2 27 15 13. 3 37 10 12. 4 40 3 10 5 41 1 8. 6 41 0 6.
Law of Diminishing Returns: Marginal Product Function
Marginal product can be defined as the additional units of output that can be produced by employing an additional unit of a particular input, holding the quantity of other inputs fixed. Table 2 above shows the marginal product of labor. The first unit of labor in the bakery produces 12 cookies, the second unit of labor adds 15 cookies to the total production, the marginal product of the third worker is 10 cookies, fourth worker adds 3 cookies, fifth worker produces 1 cookie, while the marginal product of the sixth unit of labor is 0. Part b of figure 5 shows the curve for marginal product of labor.
Figure 5 : Production function for cookies
It is the short run where the firm or a factory or a farmer faces the constraint of fixed inputs. Hence law of diminish returns always applies in the short run.
Marginal Product and Average Product
Average product is the amount of output produced on an average by each unit of the variable input employed. Table 2 also shows the average product of labor. The average product of labor is calculated by dividing the total output the total number of units of labor used. For instance the average product of the first two units of labor is 13.5 (27/2), while the average product of 6 units of labor is 6.83 (41/6).
The average product and marginal product are related to each other, however the average product is not very quick to change, as compared to the marginal product. If the marginal product exceeds the average product, the average product increases. For instance, Sam participates in a competition that has five rounds and he has already completed two rounds. Suppose he gets points for each round and his average for the first two rounds is 10, if he scores 8 in the third round, his average for three rounds will fall but not all the way to 8, the average will be 9.33. If he gets 12 points his average will rise but not all the way up to 12, the average will be 10.66. Table 2 shows that the marginal product has been falling after
employing the third worker. Though the average product also falls with the marginal product, it has been falling slowly, when compared with the marginal product. Figure 6 shows the graph of the Total product and the graph of marginal and average product. The marginal product curve is nothing but a depiction of the slope of the total product function. As figure 6 shows, the marginal and average product curves start out together. While the marginal product is rising and is above the average product curve, the average product rises with it but at a slower pace. The marginal product curve reaches its maximum at point A with number of workers, before the average product reaches its maximum at point B with number of workers. At point A, the marginal product curve begins to fall since at this point the additional u nits of output that an extra worker generates, begins to fall due to fixed inputs or capacity constraints. At point B, the average product and marginal product of labor are equal. The average product of labor continues to rise till point B, while the marginal product has already begun to fall at point A. Average product is equal to the marginal product of labor, when it reaches its highest point B. Beyond point B and till the point C, the marginal product continues to decline and it is less than the average product of labor. The average product also follows this decline in the marginal product. At the point where units of labor are employed, the marginal product falls to 0, i.e. an additional unit of labor cannot add to the output. This is point C and this is where the firm reaches its capacity and the total product is at its maximum.
Figure 6 : Total product, average product and marginal product
Table 3: Production Technologies Available to Produce 150 Toys Technology Units of Capital (K) Units of Labor/Hours of Labor (L) A 3 10 B 4 7 C 5 6 D 6 3 E 7 1
Analyzing, different production technologies, it is easy to see that out of all the options, technology A is the most labor intensive while technology E is the most capital intensive. Since, the firm chooses the production technique which minimizes the cost, its ultimate decision will depend on the market prices of the inputs. Let’s assume that the wage rate (W) is Rs.1 and the cost of capital per hour (R) is Rs.5. The total cost corresponding to each production technique can be calculate given the input prices.
Given the input prices, technology A is the one that will produce 150 toys at the least cost, which is Rs.25, as shown in table 4. All the other technologies cost more than this amount. Hence, the firm will choose technology which is the most labor-intensive technique. Now, if the wage rate rises to Rs.7 and the cost of using capital per hour stays fixed at Rs.5, the cost minimizing production technique after the rise in wage rate is option E. The cost of production with technology E is Rs.42 after the rise in wages, as shown in table 4. So, the firm will choose option E which is the most capital intensive technique out of all the options.
Hence, the cost of production depends on the available production techniques and the input prices decided by the input markets.
Table 4: Alternative Production Techniques and corresponding Cost [Cost = (LxW) + (KxR)] Technology Units of Capital (K)
Units of Labor/ Hours of Labor (L)
Cost when W=Rs. And R=Rs.
Cost when W=Rs. And R=Rs. A 3 10 25 85 B 4 7 27 69 C 5 6 31 67 D 6 3 33 51 E 7 1 36 42
The lesson throws light on important elements that go into the decision making process of a firm. The ultimate goal of any firm is to generate profits for itself. Decisions taken by the firm effect its profit. These decisions are regarding the quantity of output to be produced, choice of production technique and the quantity of inputs to purchase. Hence, it is important to understand the market structure in which a firm operates, the types of production techniques that are available for production and what does the cost of production depend on. The decisions made are such that, the profits should be maximized while the cost should be minimized.
The chapter focuses on how the production decisions are taken at the firm level. Case of the firm functioning in a perfectly competitive set up has been discussed. Following points summarize the chapter.
Firms differ in size and structure. For instance a firm functioning in a perfectly competitive industry is a price-taker. Perfect competition is a market structure where there are several firms that are small in size relative to the industry, each firm produces identical goods and there is no restriction on entry and exit of the firms. The demand curve facing a firm in a perfectly competitive industry is perfectly elastic, i.e. at this price the firm can sell any amount of output, but it will not be able to sell anything if it fixes a price above this price. Also the firm will not want to reduce the price it charges below the market price. Profit maximizing firms have to take three basic decisions. The first being the quantity of output to produce, second, the choice of production technique and the third, the quantity of inputs to purchase. The ultimate aim of the firm is to make profit. Profit is the difference between total revenue and total cost of the firm. The total economic costs include out of pocket costs that are explicit in nature, the opportunity cost of each input and the normal rate of return to capital which are implicit in nature. The normal rate of return to capital is the rate of return which is sufficient to keep the investors and owners satisfied. In normal conditions, it is quite close to the rate of interest on risk-free government securities. If the firm makes positive profit, it implies that the rate of return that it earns is greater than the normal rate of return to capital. Decisions made by the firm also take into consideration the time period. Short run differs from the long-run since it involves fixed inputs and the entry and exit of the firms from the industry is constrained. Decisions to be taken by the firm depend on market price of the good it produces, the production technologies available and the input prices. A production function entails how the inputs are related to output. It is a mathematical relationship between inputs and output. Marginal product is the additional units of output produced by employing an additional unit of variable input. The law of diminishing returns states that beyond a particular point, if additional units of a variable input are employed along with fixed inputs, the marginal product of the variable input falls. Average product is the average amount of output produce by each unit of variable input employed. It is related to the marginal product. It rises when the marginal is above the average product, it is equal to the marginal product at its highest level and falls when the marginal product falls below it. Capital and labor are inputs, complementary in nature, but they can also act as substitutes. A profit maximizing firm uses the technology that minimizes the cost of production, given the prices of inputs and various production techniques.
b. When additional units of a variable input are used with fixed inputs, the marginal product of that variable input rises. c. When additional units of a variable input are used with fixed inputs, the marginal product of that variable input becomes constant. d. None of the above.
Q.5 While choosing the production technology, the profit-maximizing firm should keep in mind:
a. Input-prices. b. Available production techniques. c. Market price of output. d. All of the above.
Correct Answers/Options for the Multiple Choice Questions Question Number Option Q.1 d Q.2 d Q.3 d Q.4 a Q.5 d
Answer 1. The characteristics of a perfectly competitive industry include a large number of firms, these firms sell identical products and there is no restriction on the entry and exit of firms.
Answer 2. The opportunity cost of capital are accounted for by including the normal rate of return to capital in the total economic costs.
Answer 3. Short-run is the time period where one or more of the inputs are fixed.
Answer 4. The law of diminishing returns state that when additional units of a variable input are used with fixed inputs, the marginal product of that variable input declines.
Answer 5. The choice of production technology by a profit-maximizing firm depends on input prices, available production technology and the market price of output.
Answer 1. All the options for question 1 are correct hence the answer is option d.
Answer 2. Option a is incorrect, revenue is not included in the total economic costs. Option b is also not correct, profit is calculated by deducting costs from revenue. Option c is incorrect since price of the output is used in calculating the revenue earned by a firm.
Answer 3. Option a and b are incorrect, short-run is not earmarked by months or years. Option c defines the long-run.
Answer 4. Option b is incorrect, the law states that as more and more units of variable input are used with fixed inputs, the marginal product of the variable input declines. Option c is incorrect for the same reason. Option d is ruled out.
Answer 5. All the options for question 5 are correct.
Average Product: average product is the ratio of total product to the total units of the variable input. It is the average product produced by each unit of variable input.
Capital-Intensive Technology: The production technology that uses greater number of units of capital relative to the units of labor.
Labor-Intensive Technology: The production technology that uses greater number of units of labor relative to the units of capital.
Marginal Product: The additional units of output produced by an additional unit of variable input employed.
Homogeneous Products: The goods that are identical to each other in terms of quality and characteristics.
Case, Karl E. and Fair, Ray C. (2007), “Principles of Economics”, Ch.7, 8th^ edition, Pearson Education Inc.
http://www.econlib.org/library/Enc/bios/Ricardo.html
