Chapter 6: Production and Business Organization

A. Theory of Production and Marginal Products

Basic Concepts
The Production Function
The production function specifies the maximum output that can be produced with a
given quantity of inputs. It is defined for a given state of engineering and technical
knowledge. These two techniques—one capital-intensive and the other labor-
intensive—are part of the production function for ditchdigging. There are literally
millions of different production functions—one for each and every product or
service.

Total, Average, and Marginal Product

Total product is the total physical product which designates the total amount of
output produced, in physical units such as bushels of wheat or number of
sneakers.
Once we know the total product, it is easy to derive an equally important concept,
the marginal product. Recall that the term “marginal” means “extra.” The marginal
product of an input is the extra output produced by 1 additional unit of that input
while other inputs are held constant. The final concept is the average product,
which equals total output divided by total units of input.

The Law of Diminishing Returns

Under the law of diminishing returns, a firm will get less and less extra output
when it adds additional units of an input while holding other inputs fixed. In other
words, the marginal product of each unit of input will decline as the amount of that
input increases, holding all other inputs constant.
Diminishing returns are a key factor in explaining why many countries in Asia are
so poor. Living standards in crowded Rwanda or Bangladesh are low because
there are so many workers per acre of land and not because farmers are ignorant
or fail to respond to economic incentives. The law of diminishing returns is a widely
observed empirical regularity rather than a universal truth like the law of gravity. It
has been found in numerous empirical studies, but exceptions have also been
uncovered. Moreover, diminishing returns might not hold for all levels of
production.

Returns to Scale
Diminishing returns and marginal products refer to the response of output to an
increase of a single input when all other inputs are held constant.
We saw that increasing labor while holding land constant would increase food
output by ever-smaller increments. But sometimes we are interested in the effect of
increasing all inputs.
What would happen to wheat production if land, labor, water, and other inputs were
increased by the same proportion? Or what would happen to the production of
tractors if the quantities of labor, computers, robots, steel, and factory space were
all doubled? These questions refer to the returns to scale, or the effects of scale
increases of inputs on the quantity produced. Three important cases should be
distinguished:
 Constant returns to scale denote a case where a change in all inputs leads
to a proportional change in output.
 Increasing returns to scale (also called economies of scale) arise when
an increase in all inputs leads to a more-than-proportional increase in the
level of output
 Decreasing returns to scale occur 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.
Production shows increasing, decreasing, or constant returns to scale when a
balanced increase in all inputs leads to a more-than-proportional, less than-
proportional, or just-proportional increase in output.

Short Run and Long Run

Efficient production requires time as well as conventional inputs like labor. We
therefore distinguish between two different time periods in production and cost
analysis. The short run is the period of time in which only some inputs, the
variable inputs, can be adjusted. In the short run, fixed factors, such as plant and
equipment, cannot be fully modified or adjusted. The long run is the period in
which all factors employed by the fi rm, including capital, can be changed.

Technological Change
We distinguish process innovation, which occurs when new engineering knowledge
improves production techniques for existing products, from product innovation,
whereby new or improved products are introduced in the marketplace.
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.
Next, consider product innovations, which involve new and improved products. It is
much more difficult to quantify the importance of product innovations, but they may
be even more important in raising living standards than process innovations.
But 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.

FIGURE 6-4. Value of Networking Increases as Membership Rises

Assume that each person derives a value of $1 for each additional person who is
connected to a telephone or e-mail network. If Ed decides to join, he will get $4 of
value from being connected to Adam, Beth, Carlos, and Dorothy. But there is an
“adoption externality” because each of the four people already in the network gets
$1 of additional value when Ed joins, for a total of $4 of external additional value.
These network effects make it difficult for networks to get started. To see this point,
note that the second or third person who joins the network gets little value from
joining. But when many people are in the network, each new member has a high
value of joining because they are networked with a large number of people. (As an
exercise, calculate the value of joining for the second and for the tenth people who
join the network.)
Productivity and the Aggregate Production Function
Productivity
One of the most important measures of economic performance is productivity.
Productivity is a concept measuring the ratio of total output to a weighted average
of inputs. Two important variants are labor productivity, which calculates the
amount of output per unit of labor, and total factor productivity, which measures
output per unit of total inputs (typically of capital and labor).

Productivity Growth from Economies of Scale and Scope

A central concept in economics is productivity, a term denoting the ratio of output
to inputs. Economists typically look at two measures of productivity. Total factor
productivity is output divided by an index of all inputs (labor, capital, materials, . . .),
while labor productivity measures output per unit of labor (such as hours worked).
When output is growing faster than inputs, this represents productivity growth
Productivity grows because of technological advances such as the process and
product innovations described above. Additionally, productivity grows because of
economies of scale and scope.
A different kind of efficiency arises when there are economies of scope, which
occur when a number of different products can be produced more efficiently
together than apart.

Empirical Estimates of the Aggregate Production Function

Aggregate production functions, which relate total output to the quantity of inputs
(like labor, capital, and land) What have economic studies found? Here are a few
of the important results:
 Total factor productivity has been increasing over the last century because
of technological progress and higher levels of worker education and skill.
 The average rate of total productivity growth was slightly under 1½ percent
per year since 1900.
 Over the twentieth century, labor productivity (output per hour worked) grew
at an average rate of slightly more than 2 percent per year.
 The capital stock has been growing faster than the number of worker-hours.
As a result, labor has a growing quantity of capital goods to work with;
hence, labor productivity and wages have tended to rise even faster than
the 1½ percent per year attributable to total factor productivity growth alone.
B. Business Organization
The Nature of Birth
Firms or business enterprises exist for many reasons, but the most important is
that business firms are specialized organizations devoted to managing the process
of production. Among their important functions are exploiting economies of mass
production, raising funds, and organizing factors of production.
In the first place, production is organized in fi rms because of economies of
specialization. Efficient production requires specialized labor and machinery,
coordinated production, and the division of production into many small operations.
Consider a service such as a college education.
A second function of firms is raising resources for large-scale production.
Developing a new commercial aircraft costs billions of dollars or Euros; the
research and development expenses for a new computer microprocessor are just
as high.
A third reason for the existence of firms is to manage and coordinate the
production process. Once all the factors of production are engaged, someone must
monitor their daily activities to ensure that the job is being done effectively and
honestly. The manager is the person who organizes production, introduces new
ideas, products, or processes, makes the business decisions, and is held
accountable for success or failure.
Business firms are specialized organizations devoted to managing the process of
production. Production is organized in fi rms because efficiency generally requires
large-scale production, the raising of significant financial resources, and careful
management and coordination of ongoing activities.

Big, Small, and Infinitesimal Businesses

There are currently around 30 million different businesses in America. The majority
of these are tiny units owned by a single person—the individual proprietorship.
Others are partnerships, owned by two or perhaps two hundred partners. The
largest businesses tend to be corporations.

The Individual Proprietorship

At one end of the spectrum are the individual proprietorships, the classic small
businesses often called “mom-and-pop” stores. A small store might do a few
hundred dollars of business per day and barely provide a minimum wage for the
owners’ efforts. These businesses are large in number but small in total sales.
For most small businesses, a tremendous amount of personal effort is required.
The self-employed often work 50 or 60 hours per week and take no vacations, yet
the average lifetime of a small business is only a year. Still, some people will
always want to start out on their own. Theirs may be the successful venture that
gets bought out for millions of dollars.

The Partnership
Often a business requires a combination of talents— say, lawyers or doctors
specializing in different areas. Any two or more people can get together and form a
partnership. Each agrees to provide a fraction of the work and capital and to share
a percentage of the profits and losses.
Today, partnerships account for only a small fraction of total economic activity. Up
to recently, partnerships were unattractive because they imposed unlimited liability.
Under unlimited liability, partners are liable without limit for all debts contracted by
the partnership. If you own 1 percent of the partnership and the business fails, you
will be called upon to pay 1 percent of the bills. However, if your partners cannot
pay, you may be called upon to pay all the debts, even if you must sell off your
prized possessions to do so.

The Corporation
The bulk of economic activity in an advanced market economy takes place in
private corporations. Today, a corporation is a form of business organization
chartered in one of the 50 states or abroad and owned by several individual
stockholders.
The corporation has a separate legal identity, and indeed is a legal “person” that
may on its own behalf buy, sell, borrow money, produce goods and services, and
enter contracts. In addition, the corporation enjoys the right of limited liability,
whereby each owner’s investment and financial exposure in the corporation is
strictly limited to a specified amount.
The central features of a modern corporation are the following:
 The ownership of a corporation is determined by the ownership of the
company’s common stock. If you own 10 percent of a corporation’s shares,
you have 10 percent of the ownership.

 In principle, the shareholders control the companies they own. They collect
dividends in proportion to the fraction of the shares they own, and they elect
directors and vote on many important issues.
  The corporation’s managers and directors have the legal power to make
decisions for the corporation. They decide what to produce and how to
produce it. They negotiate with labor unions and decide whether to sell the
firm if another firm wishes to take it over.
Efficient production often requires large-scale enterprises, which need billions of
dollars of invested capital. Corporations, with limited liability and a convenient
management structure, can attract large supplies of private capital, produce a
variety of related products, and pool investor risks.

Ownership, Control, and Executive Compensation

The operation of large corporations raises important issues of public policy. The
first step in understanding large corporations is to realize that most large
corporations are “publicly owned.”
Corporate shares can be bought by anyone, and ownership is spread among many
investors. Because the stock of large companies is so widely dispersed, ownership
is typically divorced from control. Individual owners cannot easily affect the actions
of large corporations. In some situations, there is no conflict of interest between
management and stockholders.
Higher profits benefit everyone. But one important potential conflict between
managers and stockholders has caught people’s attention—the question of
executive compensation. Top managers are able to extract from their board’s large
salaries, stock options, expense accounts, bonuses, free apartments, expensive
artwork, and generous retirement pensions at the stockholders’ expense.
Defenders point to the great importance of managers in efficient capitalism, but this
overlooks the role of marginal productivity in competitive markets. Critics answer
that the most important reason for the trend is the divorce of ownership from
control. This is the symptom of a malady known as the principal-agent problem,
wherein the incentives of the agents (the managers) are not appropriately aligned
with the interests of the principal (the owners).