Skip to main content

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.
Labels:

Comments

Post a Comment

Popular posts from this blog

Macroeconomics: multiplier and crowding out effects

Multiplier effect: whenever   any of the components of AD increases, the increase in GDP will be greater than the initial increase in expenditures. The impact on GDP of a particular increase in spending depends on the proportion of the new income that is taken out of the system to the proportion that continues to circulate in the economy. The multiplier effect tells us the impact a particular change in one the components of AD will have on the total income (GDP).  Let k denote the spending multiplier, which is a function of MPC and MPS. The larger the marginal propensity to consume, the larger the spending multiplier. Notice that the larger the MPC, the greater the impact a particular change in the spending variables will have on the nation's GDP. The crowding out effect: If government spending increases without an increase in taxes, the government must borrow funds from the private sector to finance its deficit, thereby increasing the interest rate. This increase in interest ...
Post a Comment
Read more

Econometrics: Bivariate population model

Hello I'm finally back from my extended break. I thought that we should start studying Econometrics.  Let's begin by analyzing a simple bivariate regression. Assume that this equation describes the relationship between two variables X and Y. We say that Y is the dependent variable, whereas X is the independent variable. In other words, we assume that Y (the output) depends on X (the input). Epsilon is the error term, it represents other factors that affect Y. The error term must be uncorrelated with the variable X so that we do not need to include them in our regression, and thus the coefficient of X (beta) should not change, even though Epsilon also determines Y.  beta-0 is the constant term. It tells us what would be Y if X=0. beta-1 is the effect on Y if X changes by one unit. To see this, assume X=education is a continuous function, let's take the derivative of Y=wage with respect to X: Thus, if education goes up by one unit, we should expect, on average, wage to go up ...
Post a Comment
Read more

Exercise: short and long run effects of a fiscal policy

  You are in charge of the government budget for the year 2021. You are told that schools and public roads need to be updated, and you estimate an appropriate budget in order to carry out the task. Describe what will happen in the short run to the economy, and what type of inflation do we see? Describe the supply side effect from this policy, explain what happens in the long run. Assume that there is no crowding out effect. First, note that updating public infractures, assuming taxes stay the same, will require an increase in government spending, which will also have an impact on the investment and consumption level in the economy (remember the spending multiplier?). Therefore, the aggregate demand curve will shift to the right. This will cause inflation (i.e positive change in the price level) and a higher output in the short-run.  Note that if we were to assume a large crowding out effect, the short run aggregate supply curve would shift to the left (increase in production c...
Post a Comment
Read more