Microeconomics: firms and factors of production

We have so far introduced the concept of demand, supply, and consumer choice theory. It is time to pay attention to the agents that compose the supply curve.

Firm: a firm is composed of one or more individual that work in order to produce goods or services. A firm's revenue is the total amount of money collected from selling its products. Profit is equal to the revenue minus the cost associated to produce the goods or services.

Firms decide the quantity of goods they will produce based on their available factors of production: land, labor, R&D, and capital. These factors of production form a firm's production function, which is used to determine the quantity to produce.

The production function is the amount of output (total product) a firm can produce given its inputs. It is often assumed that the level of capital (machines) and technology is fixed in the short run. Therefore, in this period the only variable amount of input is labor. As a general rule, by increasing (decreasing) the number of workers employed, a firm increases (decreases) its production.

• As a firm starts to increase its use of labor, the firm's total product is increasing at an increasing rate. In other words, the contribution of each new additional worker to the production is greater than that of the previous worker. As an example, if workers are working on a production line, an additional worker could mean that now each worker can specialize in a specific task, every worker becomes more productive. We say that at this stage the firm experiences increasing marginal returns. The additional contribution of an input is named marginal product.
• Firms reach a point of diminishing marginal returns. At this point, the total product keeps increasing but at a decreasing rate. The contribution (marginal product) of each additional worker is smaller than the previous one.
• A firm experiences a negative marginal returns when the total product decreases as the marginal product becomes negative. For example, this can happen when say a factory owner decides to hire three additional workers to work on one machine. However, if this machine requires exactly two persons to be properly used, the third worker will take up space in the factory, and will not be able to participate in the production. Since the factory becomes overcrowded, the workers achieve their tasks at a slower rate, decreasing the total production.

In the graph, let the y-axis be the total product and the x-axis the amount of workers. You can see that as the number of input increases from 0 to about 1 (blue line) , the firm is experiencing increasing marginal returns. From 1 to about 3.6, the production increases at a diminishing rate (green line), the firm faces diminishing marginal returns. Finally, after 3.6, the firm enters the decreasing marginal returns (red line) as increasing the number of inputs by even a small number will reduce the production.

Average product: total product divided by the total input of labor. In other words:

From the graph above, we can see that when the average product is increasing, the marginal product is greater than the latter. However, the average product is greater than the marginal product when it is decreasing. Note that the marginal product intersects the average product at its maximum.

Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 77-79.