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Chap 06

Chap 06

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Published by: Syed Hamdan on Dec 11, 2010
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CHAPTER 6PRODUCTION AND BUSINESS ORGANIZATION
I.  CHAPTER OVERVIEW
This chapter begins a discussion of the concepts economists use to investigate the purpose of forming anybusiness:  production and subsequent supply of goods and/or services to consumers.  Remember the supplycurve that you generated back in Chapter 3 of this Study Guide.  It defined a relationship between the price of aproduct and the quantity of that same product that producers are willing and able to produce in a given timeperiod.  You will add to the definition of this relationship by exploring first the fundamental relationships thatdescribe a production process, and second the most common organizational structures of firms in the U.S.economy.  You will be answering two basic questions:  What characteristics are common to most productionprocesses?  How are firms defined and organized?
II.  LEARNING OBJECTIVES
After you have read Chapter 6 in your text and completed the exercises in this Study Guide chapter, you shouldbe able to:1. Define a
production function
and relate it to the notions of (a) total product, (b) marginal product, and(c) average product.2. Explain the
law of diminishing marginal returns
.  Define
constant
,
increasing
and
decreasingreturns
 
to
 
scale
, and relate each to the law of diminishing marginal returns.3. Compare and contrast the measures of total productivity and the productivity of a particular input.Relate both to technological change and the law of diminishing marginal returns.4. Distinguish between the short run and the long run in the context of production.5. State and explain the stylized facts that describe the growth of the aggregate U.S. economy since theturn of the century.  Describe why it can be said that the experience of the United States over the past twodecades has not been as profitable as its experience over the century taken as a whole.6. Explain the differences between the three major forms of business organization:  proprietorship,partnership, and corporation.7. Describe three reasons why firms exist in a modern economy.8. Define the term
unlimited liability
as it applies to business organization, and explain the propensity of large businesses to be incorporated.9. List the advantages and/or disadvantages of each of the three business forms.
III.  REVIEW OF KEY CONCEPTS
Match the following terms from column A with their definitions in column B.
A B
__ Production 1. Holds that we will get less and less extra output when we add additional unitsfunction of an input, all other inputs held fixed.__ Total product 2. Occurs when a balanced increase in all inputs leads to a less-than-proportionalincrease in total product.__ Average product 3. A period of time in which firms can adjust production by changing variablefactors but not fixed factors such as capital.__ Marginal 4. Tells you how much output you will get from a given amount of inputs.product__ Law of diminishing 5. Occurs when new engineering knowledge improves production techniques for marginal existing products.__ Constant returns 6. The extra product or output added by 1 extra unit of input while other inputs areto scale held constant.__ Increasing 7. Arise when an increase in all inputs leads to a more-than-proportional increasereturns to scale in the level of output.__ Decreasing 8. Different people are linked together through a particular medium.returns to scale__ Short run 9. Occurs when new or improved products are introduced in the marketplace.__ Long run 10. Designates the total amount of output produced, in physical units.
 
104
__ Network 11. Denotes a case where doubling the use of all inputs leads to a doubling of output.__ Fixed cost 12. A period sufficiently long so that all factors, including capital, can be adjusted.__ Adoption 13. Measures the ratio of total.externality__ Process 14.  Measures total output divided by total units of an input.innovation.__ Product 15.  Consumers derive benefits from a number of other consumers who adopt theinnovation good.__ Productivity 16. Cost associated with an input that is fixed in the short run.
IV.  SUMMARY AND CHAPTER OUTLINE
Chapter 6 is divided into two related parts.  Section A describes the theory of production; this will provide abasis for your understanding of production costs, as well as firm output decisions.  Section B discusses businessorganization in the United States, helping to explain how and why firms do business.
A.  Theory of Production and Marginal Products
1. A production function describes a relationship between total product or output of a firm and theemployment of inputs.2. The average product of an input is total output divided by the level of employment of that input.  Themarginal product of an input is the rate at which total output changes as employment changes by one unit—allother inputs held constant.3. Marginal product declines in the short run due to the law of diminishing returns.  This law states that as youcontinue to add variable inputs to a fixed capital base, eventually marginal product will fall.4. Returns to scale is a long-run concept that reflects the response of total output to proportionate changes inall inputs.  Diminishing marginal productivity (which is a short-run concept) can be consistent with increasing,decreasing, or constant returns to scale.5. Time period is critical in defining the sort of adjustments available to firms.  In the short run, the firm hastime to manipulate the employment of some inputs (e.g., labor), but the capital stock is usually assumed to befixed.  Use of all inputs, including the capital stocks and embodied technology, can be altered only in the longrun.6. When technological change occurs, the production function of the firm may shift.  Process innovation leadsto changes in production methods, while product innovation leads to the development of new products for themarketplace.7. Productivity measures the amount of output produced per unit of input; productivity growth measures therate of growth in the level of productivity.
B. Business Organization
1. Business establishments can be organized as individual proprietorships, as partnerships, or as corporations.2. Businesses exist for three important reasons.  First, firms exist to exploit economies of mass production,i.e., to take advantage of specialized equipment, assembly lines, and division of labor.  Second, entrepreneurscan raise capital more effectively when businesses are carefully structured.  Third, the production process isorganized more efficiently when managers direct the activities of all inputs within a firm.3. Corporations allow owners to limit their potential liability to the amount they have invested, but thisstructure usually requires owners to release the reigns of control to a management team.
V.  HELPFUL HINTS
1. Make sure that you take time to carefully plot a production function, along with its related average andmarginal cost curves.  Practicing this exercise will help you to understand the relationships between inputs andoutput that characterize most production functions.2. Remember that the law of diminishing returns is a short-run concept, because you are adding variableinputs to a fixed capital base.  This differs from decreasing returns to scale, which involves the changes inoutput associated with increasing the use of all inputs, including capital.  A change in a capital base alwaysinvolves a long-run decision.3. The law of diminishing returns is compatible with increasing, decreasing, and constant returns to scale; thiscan be difficult to understand.  Returns to scale and marginal productivity refer to two distinct things:  returns to
 
105
scale reflect what happens when there is a proportional change in all inputs; marginal productivity reflects whathappens when there is a one-unit change in only one input (all the others are held fixed).4. When referring to the products that a firm produces, economists use the terms “total product” and “output”synonymously.
VI.  MULTIPLE CHOICE QUESTIONS
These questions are organized by topic from the chapter outline.  Choose the best answer from the optionsavailable.
A. Theory of Production and Marginal Products
1. A production function describes:a. how input prices change as the firm changes its output level.b. how much output you will get from a given amount of inputs.c. the level of output that firms should optimally produce at each price level.d. a relationship between prices and quantity demanded.e. all the above.2. The average product of an input is given by the following ratio:a. change in total product/total product.b. change in the employment of one input/change in the employment of all inputs.c. total employment of all inputs/total employment of one input.d. total product/total employment of one input.e. change in total product/change in the employment of one input.The following data describe a short-run production function for ABC, Inc., which hires workers to producewidgets.  Use Table 6-1 to complete questions 3 through 7.
TABLE 6-1
 Quantity of TotaLabor (Workers)  Product (Daily)
 0 010 5020 15030 35040 50050 60060 65070 65080 64090                      6203. The marginal product of the first 10 workers is:a. 0.b. 5.c. 10.d. 50.e. 500.4. When ABC, Inc. changes its utilization of labor from 40 to 50 workers, the marginal product is:a. 0.b. 5.c. 10.d. 50.e. 500.5. The average product of 50 workers is:a. 12.b. 50.c. 100.d. 600.e. cannot be determined without more information.6. Diminishing returns set in sometime between:

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