No Such as a Free Lunch: Principles of Economics (Part 33)

The secret to the movie business, or any business, is to get a good education in a subject besides film - whether it's history, psychology, economics, or architecture - so you have something to make a movie about. All the skill in the world isn't going to help you unless you have something to say.

George Lucas

The Production Process: The Behavior of Profit-Making Firms

(Part D)

by

Charles Lamson

The Production Process

Production is the process through which inputs are combined and transformed into outputs. Production technology relates inputs to outputs. Specific quantities of inputs are needed to produce any given service or good. A loaf of bread requires certain amounts of water, flour, and yeast, some needing and patting, as well as an oven and gas or electricity. A trip from downtown New York to Newark, New Jersey, can be produced with a taxi cab, 45 minutes of a driver's labor, some gasoline, and so forth.

Most output can be produced by a number of different techniques. You can tear down an old building and clear a lot to create a park in several ways, for example. Five hundred men and women could descend on it with sledgehammers and carry the pieces away by hand; this would be a labor-intensive technology. The same park could be produced by two people with a wrecking crane, a steam shovel, a backhoe, and a dump truck; this would be a capital-intensive technology. Similarly, different inputs can be combined to transport people from Oakland to San Francisco. The Bay Area Rapid Transit carries thousands of people simultaneously under San Francisco Bay and uses a massive amount of capital relative to labor. Cab rides to San Francisco require much more labor relative to capital; a driver is needed for every few passengers.

In choosing the most appropriate technology, firms choose the one that minimizes the cost of production. For a firm in an economy with a plentiful supply of inexpensive labor but not much capital, the optimal method of production will involve labor intensive techniques. For example, assembly of items like running shoes is done most efficiently by hand. That is why Nike produces virtually all its shoes in developing countries where labor costs are very low. In contrast, firms in an economy with high wages and high labor costs have an incentive to substitute away from labor and to use more capital-intensive, or labor-saving, techniques. Suburban office parks use more land and have more open space in part because land in the suburbs is more plentiful and less expensive than land in the middle of a big city.

Production Functions: Total Product, Marginal Product, and Average Product

The relationship between inputs and outputs---that is, the production technology expressed numerically or mathematically is called a production function (or total product function). A production function shows units of total product as a function of the units of inputs.

Imagine, for example, a small sandwich shop. All the sandwiches made in the shop are grilled, and the shop owns only one grill, which can accommodate only two people comfortably. As columns 1 and 2 of the production function in Table 2 show, one person working alone can produce only 10 sandwiches per hour, in addition to answering the phone, waiting on customers, keeping the tables clean, and so on. The second worker can stay at the grill full time and not worry about anything except making sandwiches. Because the two workers together can produce 25 sandwiches, the second worker can produce 25 - 10 = 15 sandwiches per hour. A third person trying to use the grill produces crowding, but, with careful use of space, more sandwiches can be produced. The third worker adds 10 sandwiches per hour. Note that the added output from hiring a third worker is less because of the capital constraint, not because the third worker is somehow less efficient or hard-working. We assume that all workers are equally capable.

The fourth and fifth workers can work at the grill only while the first three are putting the pickles, onions, and rapping on the sandwiches they have made. Then the first three must wait to get back to the grill. Worker four adds five sandwiches per hour to the total, and worker five adds just two. Adding a sixth worker adds no output at all: the current maximum capacity of the shop is 42 sandwiches per hour.

Figure 5 (a) graphs the total product data from table two.

Diminishing returns, or diminishing marginal product, begin to show up when more and more units of a variable input are added to a fixed input, such as scale of a plant. Recall that we defined the short run as that period in which some fixed factor of production constrains the firm. It then follows that diminishing returns always apply in the short run, and in the short run every firm will face diminishing returns. This means that every firm finds it progressively more difficult to increase its output as it approaches capacity production.

Marginal Product versus Average Product Average product is the average amount produced by each unit of a variable factor of production. At our sandwich shop with one grill, that variable factor is labor. In Table 2, you saw that the first two workers together produce 25 sandwiches per hour. Their average product is therefore 12.5 (25/2). The third worker adds only 10 sandwiches per hour to the total. These 10 sandwiches are the marginal product of labor. The average product of the first three units of labor, however, is 11.7 (the average of 10, 15, and 10). Stated in equation form, the average product of labor is the total product divided by total units of labor:

Average product "follows" marginal product, but it does not change as quickly. If marginal product is above average product, the average rises; if marginal product is below average product, the average falls. Suppose, for example, that you have had six exams and that your average is 86. If you score 75 on the next exam, your average score will fall, but not all the way to 75. In fact, it will fall only to 84.4. If you score a 95 instead, your average will rise to 87.3. As columns 3 and 4 of table 2 show, marginal product at the sandwich shop declines continuously after the third worker is hired. Average product also decreases, but more slowly.

Production of Functions with Two Variable Factors of Production

So far we have considered production functions with only one variable factor of production. However, inputs work together in production. In general, additional capital increases the productivity of labor. Because capital---buildings, machines, and so on---is of no use without people to operate it, we say that capital and labor are complementary inputs.

A simple example will clarify this point. Consider again the sandwich shop. If the demand for sandwiches began to exceed the capacity of the shop to produce them, the shop's owner might decide to expand capacity. This would mean purchasing more capital in the form of a new grill.

A second grill would essentially double the shop's productive capacity. The new higher capacity would mean that the sandwich shop would not run into diminishing returns as quickly. With only one grill, the third and fourth workers are less productive because the single grill gets crowded. With two grills, however, the third and fourth workers could produce 15 sandwiches per hour using the second grill. In essence, the added capital raises the productivity of labor---that is, the amount of output produced per worker per hour.

Just as the new grill enhances the productivity of workers in the sandwich shop, new businesses and the capital that they put in place raise the productivity of workers in countries like Malaysia, India, and Kenya.

This simple relationship lies at the heart of worries about productivity at the national and international levels. Building new, modern plants and equipment enhance a nation's productivity. Since the 1950s, for example, Japan has accumulated capital (i.e., built plant and equipment) faster than any other country in the world. The result is a very high average quantity of output per worker in Japan. 

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 136-140*

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