RETURNS TO SCALE

Chapter 6 - Effects of scale increases of inputs on the quantity

produced
PRODUCTION FUNCTION 1. Constant returns to scale
- Relationship between the amount of input required and the • A change in all inputs leads to a PROPORTIONAL
amount of output change in output
- Specifies MAXIMUM output that can be produced with a • Ex. If labor, land and capital are doubled, output would
given quantity of inputs also double
- In areas of the economy where technology is changing 2. Increasing returns to scale
rapidly, production functions may become obsolete soon • Aka economies of scale
after they are used • An increase in all inputs leads to a MORE-THAN-
PROPORTIONAL increase in the level of output
*ASSUMPTION: Firms always strive to produce efficiently; 3. Decreasing returns to scale
they always attempt to produce the maximum level of output • When a balanced increase in all inputs leads to a
for a given dose of inputs LESS-THAN-PROPORTIONAL increase in total output

3 IMPORTANT PRODUCTION CONCEPTS SHORT RUN

1. Total product - Period in which firms CAN adjust production by changing
- Total amount of output produced variable factors such as materials & labor but can’t change
- Starts at 0 for 0 labor and increases as additional fixed factors such as capital
units of labor are applied - Variable factors - factors which are increased/adjusted
2. Marginal product - Fixed factors - factors that can’t be changed in the short run
- “Marginal” - “extra” because of physical conditions/legal contracts
- Marginal product of input is the extra output produced
by 1 additional unit of that input holding other inputs LONG RUN
constant - Period sufficiently long that all factors — fixed & variable —
3. Average product
 including capital can be adjusted
= ______________
Total output
TECHNOLOGICAL CHANGE
Total units of input - Improves productivity and raise living standards
a. Process innovation
• Occurs when new engineering knowledge
improves production techniques for existing
products
• Allows firms to produce output with the same
inputs or to produce the same output with fewer
inputs
• SHIFT in the production function
b. Product innovation
• New or improved products are introduced in the
marketplace
LAW OF DIMINISHING RETURNS
- A firm will get less and less extra output when it adds *Inferior technologies
additional units of an input while holding other inputs fixed - UNPROFITABLE
- Marginal product of each unit of input will decline as the - Tend to be discarded in a market economy
amount of input increases, holding other inputs constant - The economic advantage of inferior technologies comes
only because the social costs of pollution are not
included in the firm’s calculations of the costs of
production
*Productive technologies
- Increase profits of innovating firms

When there are market failures, technological regress might

occur

PRODUCTIVITY
- Measures the RATIO of total output to a weighted average
of inputs
a. Labor productivity
• Amount of output per unit of labor
= __________
Output
Unit of labor
b. Total factor productivity
• Measures output per unit total inputs (typically of
capital & labor)
*Diminishing returns and marginal products refer to the
= _____________
Output
response of output to an increase of a single input when all Index of all inputs
other inputs are held constant. - Productivity growth
• Output is growing faster than inputs
• Because of technological advances, economies of
scale and scope
 • Important elements: economies of scale & mass OWNERSHIP, CONTROL & EXECUTIVE COMPENSATION
production - Operation of large corp raises important issues of public
• If increasing returns to scale prevail, the larger scale of policy
inputs and production would lead to greater productivity • They control much of a market economy yet they are
not controlled by the public
- Most large corps are “publicly owned”
ECONOMIES OF SCOPE - Corp shares can be bought by anyone
- Occurs when a number of diff products can be produced
- Ownership is typically divorced from control
more efficiently together than apart
- Ex. Computer software — different modules can be more • Individual owners can’t easily affect the actions of large
inexpensively produced, packaged, and used together corps
than separately
- Like the specialization and division of labor that increase *Principal-agent problem
- The incentives of the agents (the managers) are not
productivity as economies become larger and more
diversified appropriately aligned with the interests of the principal (the
owners)
EMPIRICAL ESTIMATES OF THE AGGREGATE
PRODUCTION FUNCTION
- Aggregate demand function
• Relate total output to the quantity of inputs (labor,
capital, land)
- Total factor productivity has been increasing over the last
century because of technological progress and higher
levels of worker education and skill
- The capital stock has been growing faster than the number
of worker-hours

NATURE OF THE FIRM

- Firms are specialised organisations devoted to managing
the process of production
- Functions
a. Production is organised in firms because of
economies of specialisation
• Efficient production requires specialized labor and
machinery, coordinated production, and the division
of production into many small operations
b. Raising resources for large-scale production
c. Manage and coordinate the production process
• Once all the factors of production are engaged,
someone has to monitor their daily activities to
ensure that the job is being done effectively and
honestly

BUSINESSES
1. Individual Proprietorship
- Large in number but small in total sales
2. Partnership
- Each partner agrees to provide a fraction of the work
and capital & share a % of profit and losses
- Impose unlimited liability (for debts)
3. Corporation
- “Autocratic” organisations
- Has separate legal entity and indeed is a legal
“person”
- Had limited liability
- Each owner’s investment is strictly limited
- Ownership: company’s common stock
- Shareholders collect dividends
- Managers and directors have legal power to make
decisions for the corp
• Shareholders own the corp; managers run it
- Advantages
• Corp is a legal person that can conduct business
• May have perpetual succession/existence
regardless of how many time the shares of the
stock exchange hands
• Limited liability
• Convenient management structure
- Disadvantages
• Gov’t levies an extra tax on corp profits
• For an unincorporated business, nay income after
expenses is taxed as ordinary personal income
• Corporation income tax — “double taxation”