Fakultas Rekayasa Industri: Pengantar Ilmu Ekonomi (Iei2C2)

27/09/2020
FAKULTAS REKAYASA INDUSTRI

PENGANTAR ILMU EKONOMI (IEI2C2)
by : BYG, FRD, SIN, RMK
Lecture Note #5
FIRMS AND PRODUCTION
IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI
Course Content
In this section, we examine five main topics:
 The Ownership and Management of Firms Production
 Short Run Production : One Variable and One Fixed Input
 Long Run Production: Two Variable Inputs
 Returns to Scale
 Productivity and Technical Change
Firms and Production 2 of 36
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The Ownership and Management of A Firm

 Firm : an organization that converts inputs (labor, materials, and
capital) into outputs (goods and services) that it sells. Most firms
exist to make a profit.
 Categories :
1. the private sector,
2. the public sector,
3. the nonprofit sector

Private, Public and Nonprofit Sector
 Private sector (for-profit private sector): profit oriented firms owned by individuals or
other non-governmental entities
 Public sector: firms and organizations that are owned by governments or
government agencies. Examples: PT. KAI, PT. PLN, PDAM, the armed forces and the
court system, public school, colleges, and universities.
 The nonprofit or not-for-profit sector: organizations that are neither
government-owned nor intended to earn a profit. Typically pursue social or public
interest objectives. Examples: Greenpeace, Wahli, KPK, Komnas HAM
 U.S. Census Bureau’s 2009 U.S. Statistical Abstract, the private sector created 77% of
the U.S. GDP, the government sector was responsible for 11%, and nonprofits and
households 12%.
 Public sector contribution is different between countries. Nigeria (4%), Eritrea (94%)
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Ownership for Profit Firms
 Sole proprietorships: firms owned by a single individual who is personally
liable for the firm’s debts.
 General partnerships (partnerships) : businesses jointly owned and
controlled by two or more people who are personally liable for the firm’s
debts.
 Corporations are owned by shareholders in proportion to the number of
shares or amount of stock they hold.
• In corporations, the owners have limited liability  personal assets
of corporate owners cannot be taken to pay a corporation’s debts,
even if it goes into bankruptcy
• Shareholders elect board of directors to run the companies
What Owners Want ?

Objective of A Company
 We focus on for-profit firms in the private sector in this course.
 We assume these firms’ owners are driven to maximize profit.
 Profit π = R – C, where R = p.q, p is price per unit, q is quantity sold
 To maximize profits, a firm must produce as efficiently as possible.
 A firm engages in efficient production (achieves technological efficiency) if it
cannot produce its current level of output with fewer inputs, given existing
knowledge about technology and the organization of production. Equivalently,
the firm produces efficiently if, given the quantity of inputs used, no more
output could be produced using existing knowledge.
 Efficient production is a necessary condition, and not sufficient condition, for
profit maximization.
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Inputs of Production
Capital (K), Labor (L), and Material (M)
 Capital (K ). Long-lived inputs such as land, buildings (factories, stores),
and equipment (machines, trucks)
 Labor (L). Human services such as those provided by managers, skilled
workers (architects, economists, engineers, plumbers), and less-skilled
workers (custodians, construction laborers, assembly-line workers)
 Materials (M). Raw goods (oil, water, wheat) and processed products
(aluminum, plastic, paper, steel)
Production and Variability of Inputs

Production Function
 The various ways inputs can be transformed into output are summarized in
the production function
 Production function : the relationship between the quantities of inputs
used and the maximum quantity of output that can be produced, given
current knowledge about technology and organization. OR
 production function or total product function A numerical or mathematical
expression of a relationship between inputs and outputs. It shows units of
total product as a function of units of inputs.
 Production function if the company only uses labor and capital:

q = f(L,K)
• Production q units of output (e.g. wrapped candy bars)
• L is the amount of units of labor services (days of work by relatively unskilled
assembly-line workers)
• K is the amount of units of capital (the number of conveyor belts).
 Function shows the efficient production process
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Production and Variability of Inputs

Time and Variability of Input
 A firm can change its input in the short and in the long run. The amount
of material and unskilled worker can change quickly in the short run. But
manufacturing plant, equipment, needs more time to be changed, and can
be changed in the long run only
 The short run is a period of time so brief that at least one factor of
production cannot be varied practically
 Fixed input : A factor that cannot be varied practically in the short
run
 Variable input is a factor of production whose quantity can be
changed in the short run.
 The long run is a period of time that long enough that all inputs can be
varied. No fixed input in the long run, all factors are variable
Short Run Production

One Variable and One Fixed Input
 A computer manufacturing company, using capital of eight workbenches fully
equipped with tools, electronic probes, and other equipment for testing computers
 In the short run, assumed that capital is a fixed input and labor is a variable input.
In this case, the firm can have higher output only by increasing the amount of labor
 Short Run Production Function :

 q is output, but also called total product; the short run production function is also
called the total product of labor
 Marginal product of labor (MPL ) : the change of total output resulted from using
an extra unit of labor, holding other factors constant
 Average product of labor (APL) is the ratio of output, q, to the number of workers,
L, used to produce that output :
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Total Product, MPL, and APL
TABLE 4.1 Production Function
(1) Labor Units (2) Total Product (3) Marginal Product (4) Average Product of Labor
(Employees) (Sandwiches per Hour) of Labor (Total Product + Labor Units)
0 0 - -
1 10 10 10.0
2 25 15 12.5
3 35 10 11.7
4 40 5 10.0
5 42 2 8.4
6 42 0 7.0
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Production Relationship with Variable Labor
Interpretations of the graphs :
 Total product of labor curve shows
output rises with labor until L=20.
 APL and MPL both first rise and then fall as
L increases.
 Initial increases due to specialization
of activities; more workers are a
good thing
 Eventual declines result when
workers begin to get in each other’s
way as they struggle with having a
fixed capital stock
 MPL curve first pulls APL curve up and
then pulls it down, thus, MPL intersects
APL at its maximum.
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TP, MPL, and APL with Fixed Capital
Capital, Labor, Output,Total Marginal Product Average Product Marginal product of labor (MPL)
K L Product, Q of Labor, MPL = of Labor, APL =  When the number of workers
∆Q/∆L Q/L increases from 1 to 2, output rises
8 0 0 by (18-5) or 13. Marginal product
of labor is 13
8 1 5 5 5
8 2 18 13 9 Average product of labor (APL)
8 3 36 18 12  Nine workers can assemble 108
8 4 56 20 14 computers a day, so the average
8 5 75 19 15 product of labor (APL) for 9
8 6 90 15 15
workers is = 108/9 = 12
computers a day
8 7 98 8 14
 Ten workers can produce 110
8 8 104 6 13
computers in a day, so the average
8 9 108 4 12 product of labor (APL) for 10
8 10 110 2 11 workers is = 110/10 = 11
8 11 110 0 10 computers a day
8 12 108 -2 9  The increase of labors from 9 to 10
lowers the average product of
8 13 104 -4 8
labor
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Law of Diminishing Marginal Returns (LDMR)
 The law of diminishing marginal returns (or Diminishing Marginal Product)
holds that if a firm keeps increasing an input, holding all other inputs and
technology constant, the corresponding increases in output will become
smaller eventually.
 Occurs at L=10 in previous graph

 Mathematically :
Note that when MPL begins to fall, TP is still increasing.
 LDMR is really an empirical regularity more than a law.

 Application : Malthus and the Green Revolution.
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Long Run Production

Two Variable Inputs
 In the long run (LR), all inputs are variable.
 In the LR, we assume that both labor and capital are variable inputs.
 The company can analyze which combination of capital and labor that can give
company’s expected output
 The freedom to vary both inputs provides firms with many choices of how to
produce (labor-intensive vs. capital-intensive methods).
 Consider a Cobb-Douglas production function where A, a, and b are constants :
 Hsieh (1995) estimated such a production function for a U.S. electronics firm:
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Long Run Production

LR Production Isoquants
Isoquant is a curve that shows
the efficient combinations of
labor and capital that can
produce a same level of output
If the production function is q =
f (L,K), then the equation for an
isoquant where output is held
constant.
A production isoquant graphically

summarizes the efficient
combinations of inputs (labor
and capital) that will produce a
specific level of output.
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Long Run Production

Isoquants
Output produced with two variable These isoquants show the combinations of labor and
inputs. In this case, the combination of capital that produce various levels of output. Isoquants
6 capital and 1 labor (capital intensive) farher from the origin correspond to higher levels of
gives the same output with output.
combination of 1 capital and 6 labor
(labor intensive), that is 24 units of Point a, b, c, and d are various
output combinations of labor and
capital the firm can use to
produce q = 24 units of output.
Labor, L
Capital,
K
If the firm holds capital constant
1 2 3 4 5 6 at 2 and increases labor from 1
(point e) to 3 (c) to 6 (f), its
1 10 14 17 20 22 24 shifts from the q = 14 isoquant
to the 24 isoquant and to q =
2 14 20 24 28 32 35 35 isoquant.
3 17 24 30 35 39 42
4 20 28 35 40 45 49
5 22 32 39 45 50 55
6 24 35 42 49 55 60
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Long Run Production

Isoquants and Isocosts
Isoquant A graph that shows all the
combinations of capital and labor that can Isoquants Showing All
be used to produce a given amount of Combinations of Capital and
output. Labor That Can Be Used to
Produce 50, 100, and 150 Units
Alternative Combinations of Capital (K) and Labor (L) of Output
Required to Produce 50, 100, and 150 Units of Output
QX = 50 QX = 100 QX = 150
K L K L K L
A 1 8 2 10 3 10
B 2 5 3 6 4 7
C 3 3 4 4 5 5
D 5 2 6 3 7 4
E 8 1 10 2 10 3
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Long Run Production

The Slope of an Isoquant Is Equal The Slope of an Isocost line Is Equal
to the Ratio of MPL to MPK to the Ratio of PL to PK
Slope of isoquant:
K MPL
-
L MPK
Slope of isocost line:

K TC/ P P
- - K L
L TC/ P P L K
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Long Run Production

Factor Prices And Input Combinations: Isocosts
isocost line. A graph that shows all the combinations of capital and labor available for a given total cost.
Isocost Lines Showing the Combinations of Capital

and Labor Available for $5, $6, and $7
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Long Run Production

Finding The Least-cost Technology with Isoquants and Isocosts
 Finding the Least-Cost Combination of

Capital and Labor to Produce 50 Units of
Output .
 Profit-maximizing firms will minimize costs by
producing their chosen level of output with
the technology represented by the point at
which the isoquant is tangent to an isocost
line.
 Here the cost-minimizing technology—3 units
of capital and 3 units of labor—is represented
by point C.
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Long Run Production

Finding The Least-cost Technology with Isoquants and Isocosts
A Cost Curve Shows the Minimum
Cost of Producing Each Level of
Output .
Plotting a series of cost-minimizing combinations

Minimizing Cost of Production for qX = 50, of inputs—shown in this graph as points A, B, and
qX = 100, and qX = 150 C— on a separate graph results in a cost curve
like the one shown in above figure.
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Long Run Production

Types of isoquants :
1. Perfect substitutes 2. Fixed-proportions 3.Convex
(e.g. q = x + y) (e.g. q = min{g, b} ) (e.g. q = L0.5K0.5 )
(a) if the inputs are perfect (b if the inputs cannot be (c) Typical isoquants lie between the
substitutes, each isoquant is a substituted at all, the isoquants extreem cases of straight lines and
straight line are right angles (the dashed lines right angles. Along a curved isoquant,
show that the isoquants would the ability to substitute one input
be right angles if we included another varies
inefficient production.
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Long Run Production

Substitutability of Inputs
 The slope of an isoquant shows the ability of a firm to replace one input
with another (holding output constant).
 Marginal rate of technical substitution (MRTS) is the slope of an
isoquant at a single point.
 MRTS tells us how many units of K the firm can replace with an extra
unit of L (q constant)
MPL = marginal product of labor

MPK = marginal product of capital
 Thus,
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Long Run Production

Substitutability of Inputs
Substituting Inputs : Marginal Rate of Technical Substitution Varies along an Isoquant
 Moving from point a to b, a U.S. Printing firm
(Hsieh, 1995) can produce the same among
of output, q = 10, using six fewer units of
capital, ∆K = 16, if it uses one more worker,
∆L = 1. Thus, its MRTS = ∆K/∆L = -6.
 Moving from point b to c, its MRTS is = -3. If
it adds yet another worker, moving from c
to d, its MRTS is -2. Finally, if it move from, d
to e, its MRTS is -1.
 Thus, because it curves away from the
origin, this isoquant exhibit a diminishing
marginal rate of technical substituition. That
is each extra worker allows the firm to
reduce capital by smaller amount as the
ratio of capital to labor falls.
 The more L the firm has, the harder it is to
replace K with L.
 MRTS diminishes along a convex isoquant.
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Long Run Production

Cobb Douglas Production Function
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Long Run Production

LR Production Isoquants
 Properties of isoquants :
1. The farther an isoquant is from the origin, the greater the level of
output.
2. Isoquants do not cross.
3. Isoquants slope downward.
4. Isoquants must be thin.
 The shape of isoquants (curvature) indicates how readily a firm can substitute
between inputs in the production process.
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Long Run Production

Elasticity of Substitution
 Elasticity of substitution measures the ease with which a firm can substitute capital
for labor.
 Can also be expressed as a logarithmic derivative:
 Example: CES production function,
 Constant elasticity :
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Return to Scale
Constant Return to Scale
 How much does output change if a firm increases all its inputs
proportionately?
 In the long run, the companies do not only face the situation to choose
the combination of inputs which can give a certain output. Sometimes, the
companies need to be expanded, and increase the L and K.
 When the inputs are increased by a certain percentage, and it results in
the same percentage of increase in output, the production function
exhibits constant return to scale,  Doubling inputs, doubles output 
f(2L, 2K) = 2 f(L,K) = 2q
 If a company uses x1 pounds of Idaho potatoes and y1 Maine potatoes to
produce q1 = x1 + y1 pounds of potato salad.
 When it double both inputs, x2 = 2 x1 Idaho and y2 = 2 y1 Maine potatoes,
then q2 = x2 + y2 = 2 x1 + 2 y1 = 2 q1
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Return to Scale
Increasing Return to Scale

 Production function exhibits increasing returns to scale when a
percentage increase in inputs is followed by a larger percentage increase in
output.
• f(2L, 2K) > 2f(L, K) = 2q
• Occurs with greater specialization of L and K; one large plant more
productive than two small plants
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Return to Scale
Decreasing Return to Scale

 Production function exhibits decreasing returns to scale when a
percentage increase in inputs is followed by a smaller percentage increase in
output.
• f(2L, 2K) < 2f(L, K) = 2q
• Occurs because of difficulty organizing and coordinating activities as firm
size increases.
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Return to Scale
Varying Returns to Scale
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Return to Scale In US Manufacturing
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Productivity and Technical Change
 Even if all firms are producing efficiently (an assumption we make in this chapter),
firms may not be equally productive.
 Relative productivity of a firm is the firm’s output as a percentage of the output that
the most productive firm in the industry could have produced with the same inputs.
 Relative productivity depends upon:
1. Management skill/organization
2. Technical innovation
3. Union-mandated work rules
4. Work place discrimination
5. Government regulations or other industry restrictions
6. Degree of competition in the market
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Productivity and Technical Change

 An advance in firm knowledge that allows more output to be produced with the
same level of inputs is called technical progress.
• Example : Nano by Tata Motors
• Neutral technical change involves more output using the same ratio of inputs.
• Non-neutral technical change involves altering the proportion in which inputs are used
to produce more output.
 Organizational change may also alter the production function and increase output.
• Examples: automated production of Gillette razor blades, mass production of Ford
automobiles
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References
 Perloff, Jeffrey M., 2012, Microeconomics. 6th edition. Boston: Pearson
 Karl E. Case, Ray C. Fair & Sharon M. Oster, Principle of Economics, 9ty edition, Prentice-Hall
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27/09/2020

FAKULTAS REKAYASA INDUSTRI

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

 Short Run Production : One Variable and One Fixed Input

 Long Run Production: Two Variable Inputs

 Productivity and Technical Change

Firms and Production 2 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

The Ownership and Management of A Firm

Firms and Production 3 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

The Ownership and Management of A Firm

Firms and Production 4 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

The Ownership and Management of A Firm

Firms and Production 5 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

What Owners Want ?

Firms and Production 6 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Firms and Production 7 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Production and Variability of Inputs

 Production function if the company only uses labor and capital:

Firms and Production 8 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Production and Variability of Inputs

Firms and Production 9 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Short Run Production

 Short Run Production Function :

Firms and Production 10 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Short Run Production

Firms and Production 11 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Short Run Production

Firms and Production 12 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Short Run Production

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Short Run Production

 Occurs at L=10 in previous graph

Note that when MPL begins to fall, TP is still increasing.

 LDMR is really an empirical regularity more than a law.

Firms and Production 14 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Long Run Production

Firms and Production 15 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Long Run Production

A production isoquant graphically

Firms and Production 16 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Long Run Production

Firms and Production 17 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Long Run Production

Firms and Production 18 of 36

IEI2C2 - PENGANTAR ILMU EKONOMI TEL U – FAK. REKAYASA INDUSTRI

Long Run Production

Slope of isocost line:

Firms and Production 19 of 36