The Theory of the Producer
Chapter 6
Introduction:
• In the previous chapters, we focused on the
demand side of the market—consumers’
behavior.
• Now we turn to the supply side and examine
the behavior of producers.
• The Egyptian economy’s ability to deliver the
multitude of goods and services in our GDP
depends upon our productive capacity.
• This Productive capacity is determined by:
– Size and quality of the labor force,
– Quantity and quality of the capital stock,
– Natural resources and raw materials,
– Egypt’s technical knowledge.
• So, what tool do we use to describe these
productive capabilities?
The Production Function
• The production function specifies the
maximum output that can be produced with a
given quantity of inputs, for a given state of
technical knowledge.
Given a firm’s production function, we can
calculate three important production concepts:
1. Total Product:
• The total amount of output produced in
physical units; e.g number of laptops.
• TP starts at zero for zero labor and then
increases as additional units of labor are
applied, until it reaches a maximum.
• Once we know the total product, it is easy to
derive the MP; which is changes in the total
product
•
3. Average Product:
• It is equal to total product divided by total
units of input.
•
The following figure illustrates the law of
diminishing returns for labor.
• Here MP curve in (b ) declines as labor inputs increase;
precise meaning of diminishing returns.
• In Figure ( a ), diminishing returns are seen as a concave
(dome-shaped) total product curve.
Applications:
• Disguised unemployment in public sector.
• The law of diminishing returns explains well
why the hours devoted to studying
Microeconomics should be spread out all over
the term rather than crowded into the day
before the exam.
An Exception:
• In few cases, the very first inputs of labor
might actually show increasing marginal
products, where a minimum amount of labor
may be needed.
• Despite these exceptions, diminishing returns
will prevail in most situations.
Returns to Scale
• Diminishing returns and marginal product:
refer to the response of output to an increase
of a single input when all other inputs are held
constant.
• What if we want to examine the effect of
increasing all inputs.
• For example, what would happen to wheat
production if land, labor, water, and other
inputs were all doubled?
Three important cases should be distinguished:
1. Constant returns to scale
• The case where a change in all inputs leads to
a proportional change in output.
• For example, if labor, land, capital, and other
inputs are doubled, then output would also
double.
• Many handicraft industries (such as pottery)
show constant returns.
2. Increasing returns to scale/economies of
scale:
• An increase in all inputs leads to a
more-than-proportional increase in the level
of output.
• Reason: the larger scale of operation allows
workers to specialize in their tasks and make
use of more sophisticated, large-scale
equipment.
• Example: The car assembly line.
3. Decreasing returns to scale
• Occurs when a balanced increase of all inputs leads to
a less-than proportional increase in total output.
• In many processes, scaling up may eventually reach a
point beyond which inefficiencies set in.
• These might arise because the costs of management
or control become large.
– Example: In pursuit of greater profits, a firm may find itself
expanding into more geographic markets than it can
effectively manage.
– With less time to study each market and spend on each
decision, top managers may become insulated from
day-to-day production and begin to make mistakes.
SHORT RUN AND LONG RUN
• Production requires not only labor, capital and
land but also time.
• Pipelines cannot be built overnight, and once
built they last for decades.
• Farmers cannot change crops in midseason.
• It often takes a decade to plan, construct, test,
and commission a large power plant.
The short run:
• The short run is the period of time in which
only the variable inputs, like labor, can be
adjusted.
• In the short run, fixed inputs, such as plant
and equipment, cannot be fully adjusted.
The long run
• The long run is the period in which all factors
employed by the firm, including capital, can be
changed.
Example: “One Million Apartment” Project
• This will lead to an unexpected increase in the
demand for steel.
• In the SR, to adjust to the higher demand for
steel, Ezz Steel can increase production today
by increasing shifts, hiring more workers, and
operating its plants and machinery more
intensively.
• The factors which could be changed in the
short run are called variable factors.
• If demand persisted for several years, Ezz
Steel would decide it should increase its
productive capacity by building a new plant.
• In the long run, a new plant will be built to
accommodate thehigh demand.
TECHNOLOGICAL CHANGE
1. Process innovation:
• Occurs when new engineering knowledge
improves production techniques for existing
products.
• For example, a process innovation allows firms to
produce more output with the same inputs or to
produce the same output with fewer inputs.
• In other words, a process innovation is equivalent
to a shift in the production function.
2. Product innovation:
• Occurs when new/improved products are
introduced in the marketplace.
• Many of today’s goods and services did not
even exist 50 years ago.
• Example: The whole spectrum of Internet
services; WhatsApp, online shopping, e-mail,
FaceBook, Twitter…etc, were not found even in
science fiction movies 30 years ago.
Technological regress…is it a possibility?
1. Case of a well-functioning market economy:
• Technological regress cannot occur.
• Inferior technologies are unprofitable and
tend to be discarded in a market economy,
where more productive technologies, that
increase the profits of the innovating firms,
are introduced.
2. Case of market failures
• Technological regress might occur.
• Example: An unregulated company that dumps
toxic wastes into a stream. This wasteful process
is more profitable for the firm. How?
• Here, the social costs of pollution were not
included in the firm’s calculations of the costs of
production, due to lack of regulation and
penalties.
• If pollution costs were included in a firm’s
decisions, say by pollution taxes, the regressive
process would no longer be profitable.
PRODUCTIVITY
• One of the most important measures of
economic performance is productivity.
• Productivity is a concept measuring the ratio
of output to inputs.
• Labor productivity: measures output per unit
of labor, (such as hours worked).
• Total factor productivity: is output divided by
an index of all inputs (labor, capital, materials)
• When output is growing faster than inputs,
this represents productivity growth
What makes Productivity Grow?
1. Productivity grows because of technological
advances.
2. Higher levels of worker education, health and
skills (Human Capital).
3. Economies of Scale: With no change in
technology, the firm’s inputs increased by 10
percent and that, because of economies of scale,
output increased by 11 percent. Economies of
scale would be responsible for a growth in total
factor productivity of 1 percent.
4. Economies of Scope:
• Occurs when a number of different products
can be produced more efficiently together
than apart.
• Example: Software programs often
incorporate additional features as they evolve
• Economies of scope are like the specialization
and division of labor that increase productivity
as economies become larger and more
diversified.