Chapter 5 The Firm Chapter 5 The Firm SHORT-RUN THEORY OF PRODUCTION Profits and the aims of the...

Chapter 5The Firm

Chapter 5The Firm

SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION

• Profits and the aims of the firm

• Profit maximisation

• Manager/Shareholder separation

• Manager/Worker Capture

• Capital Market => Profit maximisation

• Profits and the aims of the firm

• Profit maximisation

• Manager/Shareholder separation

• Manager/Worker Capture

• Capital Market => Profit maximisation

SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION

• So first objective:

• Produce as efficiently as possible

• What is maximum output per worker

• So first objective:

• Produce as efficiently as possible

• What is maximum output per worker

Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)

Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Number of farm workers

To

nne

s o

f wh

eat

pro

du

ced

pe

r ye

ar

Number of workers

012345678

TPP 0 310243640424240

Wheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Number of farm workers

To

nne

s o

f wh

eat

pro

du

ced

pe

r ye

ar TPP

TPP=Total Physical Product

• Next, we are interested in the Next, we are interested in the Marginal Marginal Physical ProductPhysical Product::

• This is the additional output gained as a This is the additional output gained as a result of employing one more worker (or result of employing one more worker (or unit of unit of LLabour or other inputs)abour or other inputs)

01

01

LL

TPPTPP

L

TPPMPP

Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)

Wheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Number of farm workers

To

nne

s o

f wh

eat

pro

du

ced

pe

r ye

ar TPP

MPP= TPP/ L = 7/1

TPP = 7

L = 1

And MPP = Slope of the TPP curve

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Number offarm workers (L)

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

Number offarm workers (L)

TPP = 7

L = 1

MPP = TPP / L = 7

0

10

20

30

40

0 1 2 3 4 5 6 7 8Number of

farm workers (L)

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

Number offarm workers (L)

TPP = 7

L = 1

MPP = TPP / L = 7

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

MPP

MPP = TPP / L

Number offarm workers (L)

Number offarm workers (L)

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

Diminishing returnsset in here

Number offarm workers (L)

Number offarm workers (L)

b

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

Maximum output occurs here

Number offarm workers (L)

Number offarm workers (L)

b

SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION

• Long-run and short-run production: – Here changing only one factor of production at a

time

• The law of diminishing returns

• Long-run and short-run production: – Here changing only one factor of production at a

time

• The law of diminishing returns

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

MPP

MPP = TPP / L

Number offarm workers (L)

Number offarm workers (L)

SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION

• Long-run and short-run production: – Here changing only one factor of production at a time

• The law of diminishing returns

• Fixed and variable factors

• Fixed Factors:– Factory

– Equipment

• Variable Factors:– Labour

– Raw materials, electricity etc

• Long-run and short-run production: – Here changing only one factor of production at a time

• The law of diminishing returns

• Fixed and variable factors

• Fixed Factors:– Factory

– Equipment

• Variable Factors:– Labour

– Raw materials, electricity etc

Average Physical ProductAverage Physical Product

• The next concept we are interested in is The next concept we are interested in is Average ProductAverage Product

• That is, the average output per worker That is, the average output per worker

• (per year)(per year)

L

TPPAPP

Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)

• How would we represent the average on a How would we represent the average on a diagram?diagram?

L

TPPAPP

Average= Height of TPP/Length of L

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Slope = TPP / L= APP

c

c

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Slope = TPP / L= APP

c

c

Average rises and then falls

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Slope = TPP / L= APP

c

c

How does the average

compare with the marginal?

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Slope = TPP / L= APP

c

c

At point c the Marginal = Average

What about below c?

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Slope = TPP / L= APP

c

c

What about above c?

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Slope = TPP / L= APP

c

c

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farm

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

APP = TPP / L

Number offarm workers (L)

Number offarm workers (L)

Relationship between average and marginalRelationship between average and marginal

• If the If the marginalmarginal is is aboveabove the average, the average,

• The The average risesaverage rises

• If the If the marginalmarginal is is belowbelow the average, the average,

• The The average fallsaverage falls

• If the If the marginalmarginal is the is the samesame as the average, as the average,

• The The averageaverage stays the stays the samesame

Judge 1Score 9.3Average

Relationship between average and marginalRelationship between average and marginal

e.g. Ballroom Dancing Scores

Judge 1 2Score 9.3 9.1Average 9.2

Relationship between average and marginalRelationship between average and marginal

Ballroom Dancing Scores

Judge 1 2 3Score 9.3 9.1 9.4Average 9.2 9.266667

Relationship between average and marginalRelationship between average and marginal

Ballroom Dancing Scores

Judge 1 2 3 4Score 9.3 9.1 9.4 9.6Average 9.2 9.266667 9.35

Relationship between average and marginalRelationship between average and marginal

Ballroom Dancing Scores

Judge 1 2 3 4 5Score 9.3 9.1 9.4 9.6 9.1Average 9.2 9.266667 9.35 9.3

Relationship between average and marginalRelationship between average and marginal

Ballroom Dancing Scores

Game 1 2 3 4 5Score 25 14 6 28 44Average 19.5 15 18.25 23.4

Relationship between average and marginalRelationship between average and marginal

Cricket Averages

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Can see these rules in operation, here M> A, A UP Can see these rules in operation, here M> A, A UP etcetc

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

APP = TPP / L

Number offarm workers (L)

Number offarm workers (L)

• TPP tells us about Production PossibilitiesTPP tells us about Production Possibilities

• And MPP tells us the effect of hiring more And MPP tells us the effect of hiring more workersworkers

• But need to translate production But need to translate production information into costs per unit of information into costs per unit of production.production.

• That way can compare cost of producing That way can compare cost of producing with revenue (price) from selling.with revenue (price) from selling.