II.  Theory of the Firm

A.  Production

1.  Firms and production

• Firms allow coordination

(a)  Factors of production

• Inputs into the production process

• Labor, capital, raw materials

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(b)  Production function

• Shows the highest output that can be produced by a specific combination of inputs

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(c)  Time frame

• Short run - time period where one or more factors of production are fixed

• Fixed input - factor of production that cannot be varied

• Long run - time period where all factors of production are variable

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2.  One variable input

• Assume capital is fixed, labor can be varied

• Total product - total output produced by different levels of labor

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• Average product - total output per unit of input

• Marginal product - change in output as an input is increased by one unit

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a.  Graphical relationship

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b.  Law of Diminishing Marginal Returns

• When more variable inputs are added to fixed inputs, the marginal product will eventually decline

- MP_L initially increases due to specialization and division of labor

- MP_L eventually decreases due to congestion

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c.  Impact of technological improvement

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3.  All inputs variable

a.  Isoquants

• Shows all combinations of inputs that can be used to produce the same output

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b.  Input substitution

• Marginal rate of technical substitution (MRTS) - slope of isoquant

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c.  Special cases of isoquants

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4.  Returns to scale

a.  Increasing returns to scale - increasing all inputs leads to a more than proportionate increase in output

• Due to specialization and division of labor, technological relationships

• Indivisible inputs - input that cannot be subdivided

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b. Constant returns to scale - increasing all inputs leads to a proportionate increase in output

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c.  Decreasing returns to scale - increasing all inputs leads to a less than proportionate increase in output

• Due to difficulties in organizing and running large-scale operations

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• Cobb-Douglas production function

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