Production
Firms turn inputs into outputs. How output changes as inputs are added determines a firm's costs and supply decisions.
Firms and their goal
A firm is an organisation that combines inputs (labour, capital, land, and entrepreneurship) to produce goods or services. Economists usually assume firms aim to maximise profit: total revenue minus total cost. Real firms may also pursue growth, market share, or social goals, but profit is a strong driving force.
Short run and long run
In the short run, at least one input is fixed, usually capital such as factory size; the firm can change only variable inputs like labour and materials. In the long run, all inputs can change: the firm can build new factories or close down. The length of the 'long run' differs by industry.
The production function
A production function shows the maximum output from given inputs. Total product is total output; marginal product of labour is the extra output from one more worker; average product is output per worker. These concepts reveal how productive each additional worker is.
Diminishing marginal returns
In the short run, as more workers are added to fixed capital, marginal product eventually falls. A small café's first few staff add a lot, but with only one espresso machine, the eighth worker adds little. This law of diminishing marginal returns is about the short run, when something is fixed.
Worked example
A bakery with one oven employs workers. Output per day: 1 worker, 50 loaves; 2 workers, 120; 3 workers, 170; 4 workers, 200; 5 workers, 210. Marginal products are 50, 70, 50, 30, 10. Specialisation makes the second worker especially productive, then diminishing returns set in as the single oven becomes the bottleneck.
Returns to scale
In the long run, if doubling all inputs more than doubles output, there are increasing returns to scale; exactly doubles, constant returns; less than doubles, decreasing returns. Returns to scale describe the long run, when all inputs vary, and should not be confused with diminishing marginal returns.
Technology and productivity
Better technology lets the same inputs produce more, shifting the production function upward. Productivity, output per worker or per hour, is the main driver of rising living standards over time. Training, better management, and new machines all raise productivity.
Specialisation and the division of labour
Adam Smith described a pin factory where dividing the work into many simple tasks let ten workers make tens of thousands of pins a day, far more than if each made whole pins alone. Specialisation lets workers build skill and avoid switching between tasks.
Key takeaways
Firms combine inputs to make output and are usually assumed to maximise profit. In the short run some inputs are fixed; in the long run all can change. Marginal product is the extra output from one more worker; it eventually diminishes when capital is fixed. Returns to scale describe long-run changes in all inputs. Technology and specialisation raise productivity.
Flashcard
Combines inputs to produce output
Check your understanding
A restaurant adds a fifth cook to its small kitchen and output rises only slightly. This illustrates: