The Theory of Production and Production Theory

Academic Decathlon--Lesson 9

Berryhill Economics

The Theory of Production

The theory of production deals with the relationship between the factors of production and the output of goods and services.

It is based on the short run, a period of production that allows producers to change only the amount of the variable input labor

The Theory of Production

This contrasts with the long run, which is a period of production long enough for producers to adjust the quantities of all their resources, including capital.

Law of Variable Proportions

The law of variable proportions states that, in the short run, output will change as on input is varied while the others are held constant.

How is the output of the final product affected as more units of one variable input or resource are added to a fixed amount of other resources

Adding salt to a meal will make the meal better, to a point, but will eventually ruin the meal.

Production Function

The production function is the concept that describes the relationship between changes in output to different amounts of a single input, ceteris paribus

As you add one more resource (like labor) and you keep everything else the same, how will the final product change?

Production Function

The first column of the production function is the variable input (usually number or workers or hours of labor)

The second column is the total product or total output—the total amount of finished product that is made.

Production Function

The next column is the marginal product—the extra output or change in total product caused by the addition of one or more units of input

In other words, how much the final product changes as you add one unit of input (a worker)

Remember:

Everything else stays the same, the number of factories, the amount of raw materials, equipment, etc.

Only number of workers is changing.

Think about it

As we add workers, at first it will help our production.

Jobs will be split, we’ll see division of labor and specialization.

Production should increase. But at a point, adding another worker

in a full factory will start slowing down production.

Production Functionnumber total marginalof workers product product0 0 01 7 72 20 133 38 184 62 245 90 286 110 207 129 198 138 99 144 610 148 411 145 -312 135 -10

Stages of Production

Stage one is increasing returns (returns being what you get back from putting something in)—as the number of workers increases they make better use of their time, machinery and resources and become increasingly more efficient in their work

There is increasing marginal product with every worker added because that worker can add efficiency and help increase production

Stages of Production

Stage two is diminishing returns—total production keeps growing, but by smaller and smaller amounts.

The rate in increase in total production is starting to slow down.

Each additional worker is making a diminishing, but still positive, contribution to total output

Diminishing returns—output increases at a diminishing (smaller and smaller) rate

Stages of Production

Stage three is when there is too much input.

Total output decreases as input increases.

Marginal product is negative—as input increases, total plant output decreases.

There’s too much salt in the meal and the meal is now ruined.

Production Function with Stagesnumber total marginalof workers product product0 0 0

stage 1 1 7 7increasing 2 20 13marginal3 38 18product 4 62 24

5 90 28stage 2 6 110 20diminishing 7 129 19returns 8 138 9

9 144 610 148 4

stage 3 11 145 -3negative ret. 12 135 -10

Now Graph These Points

It will look like this, increasing, then starting to even out, then decreasing

The Purpose of a Business What is the purpose of a business? If you are a business owner, what do

want? Hopefully you said to make the most

money possible (which is very different than making the most amount of a product possible).

How do we make money? We earn more than we spend. There

are a few fancy terms that economists use to explain this very simple idea.

Costs A business must analyze costs before

making decisions. To simplify decision making, cost is

divided into several different categories.

Fixed cost—cost a business incurs even if the plant is idle and output is zero– -In other words, how much it costs

you to have the company even if you aren’t producing anything

– Examples: salaries, rent, property taxes, car notes

Costs

Variable costs—costs that change when the business rate of operation or output changes– Costs that change according to how

much you produce– Examples: wages (per hour), electricity

bill, freight/shipping charges

Costs

Total cost (or overhead)—the sum of the variable and fixed costs

Marginal Costs—extra cost incurred when a business produces one additional unit of a product– How much do total costs increase if you

produce one more unit of output?– Fixed costs do not change—marginal

cost is the per unit increase in variable costs that stems from using additional factors of production.

Sunk Costs

Costs that have already been invested

Should not be taken into account when making economic decisions

Revenue (Makin’ Money)

We want to make more than we spend. We’ve already looked at what we spend (costs), now we need to look at the amount of money we pull in (revenues).

Total Revenue—total amount of money that comes into the business # of units sold multiplied by average price

per unitOr quantity sold multiplied by price per

unit

Revenue

Marginal revenue—extra revenue associated with the production and sale of one additional unit of outputMR = difference in total revenue / marg. Prod.

Marginal Analysis

Economists use marginal analysis, a type of cost-benefit decision making that compares the extra benefits to the extra costs of an action.

This analysis will show us when we are losing money, when we are making money, and when we are breaking even.

Break-even point—total output or total product the business needs to sell in order to cover its total costs.

Marginal Analysis

A business wants to do more than just cover its costs and break even.

It wants to make money! That’s the goal of a business.

We want to minimize our costs and maximize our revenues to find the point that will make use the most amount of money

Profit-maximizing quantity of output—when marginal cost and marginal revenue are equal.

Profits Profit—your revenue minus your costs

(how much is left over after you pay your bills)

Total profit—Total revenue minus total costs

The total profit is maximized where marginal costs equal marginal revenue. This is were business should operate to make the most possible money.

This is where they are not missing any would be profits and they are not losing any money.

Derived Demand

Because consumers have a desire and willingness to buy goods and services to satisfy their wants and needs, producers have a desire and willingness to buy the factors of production or resources.

This is called derived demand.

Derived Demand

There is a derived demand for autoworkers because there is a demand for automobiles.

There is no demand for buggy-whip braiders because there is no demand for buggy-whips.

Derived Demand

Consumers’ buying decisions make the production of some products profitable, and the production of other products unprofitable, thus restricting the choice of businesses in deciding what to produce.

Businesses must match their production choices with consumer choices or else face losses and eventual bankruptcy.

Growth Through Reinvestment

Businesses can take their revenue and subtract out all costs (wages, interest payments, depreciation, taxes, etc) to get their profit (also known as cash flow)

Businesses then have the power to decide what to do with the profit—some may be paid back to owners or given in the form of bonuses to employees; the rest is usually reinvested

Growth Through Reinvestment

Reinvestment of profits—putting money back into the company to build more factories, hire more workers, buy more capital, etc—allows firm to produce more and grow

Growth Through Mergers

Merger—a combination of two or more businesses to form a single firm

Why? To grow faster to become more efficient, to acquire or deliver a better product, to eliminate a rival, or to change its image

Types of Mergers

Horizontal merger—when two or more firms that produce the same kind of product join forces

Vertical merger—when firms involved in different steps of manufacturing or marketing join together

Growth Through Mergers

A corporation may become so large through mergers and acquisitions that it becomes a conglomerate.

Conglomerate—a firm that has at least four businesses, each making unrelated products, none of which is responsible for a majority of its sales

Growth Through Mergers

Diversification—one of the main reasons for a conglomerate; keeps company from depending on one type of product for its income

Multinationals—corporations that have manufacturing or service operations in a number of different countries