Production

A firm is an organization that converts inputs, such as labour, materials and capital, into outputs, such as goods and services, which it sells. Most goods and services are produced by firms, followed by government with non-profit institutions and households supplying the rest.

In most countries, for profit firms have one of three legal forms. Sole proprietorships are firms owned and run by a single individual. Partnerships are business jointly owned and controlled by two or more people. The owners operate under a partnership agreement. If any partner leaves, the agreement ends.

Corporations are owned by shareholders, in proportion to the number of shares they hold. The shareholders elect a board of directors, who in turn appoint managers to run the corporation. Corporations differ in that they have limited liability. The personal assets of the corporate owner cannot be used to pay a corporation’s debt. The most shareholders can lose is the amount they have invested.

In larger firms, managers will run the company. Economists assume that they will wish to maximise profit. To do this they must produce as efficiently as possible. A firm engages in efficient production, and achieves technological efficiency if it cannot produce its current level of output with fewer inputs. This is a necessary condition for profit maximisation.

 

A firm uses technology to transform inputs into outputs. There are three main types of outputs. Capital services include the use of long-lived inputs such as land, buildings and equipment. Labour services include the work performed by managers, skilled workers and less skilled workers. Materials include raw goods, and processed products that are typically consumed in making, or incorporated in the final product.

The various ways that a firm can transform inputs into output are summarized in the production function; the relationship between the quantities of inputs used and the maximum quantity of output.

A firm can more easily adjust its inputs in the short run than in the long run. The more time a firm has to adjust its inputs, the more factors of production it can alter. The short run is a period of time so brief that at least one factor of production is fixed. The long run is a lengthy enough period that all inputs can be varied.

 

Law of Diminishing Marginal Returns

This law determines the shapes of the total product and marginal product of labour curves as a firm uses more and more labour. It holds that if a firm keeps increasing an input, holding all other inputs fixed and without any technological process the corresponding increases in output will become smaller eventually. There is a difference from diminishing marginal returns and diminishing returns. DMR means the growth in output is still positive, but it is less than previous. Diminishing returns implies that output itself is falling.

 

In the long run, all inputs are variable.  As a result, a firm can substitute one input for another  and maintain a given level of output.  Some inputs can be perfectly substituted, sometimes it is impossible to substitute one input for another. Most lie between these two extremes.

In the long run, a firm can increase its output by building a second plant and staffing it with the same number of workers as in the first plant. If, when all inputs are increased by a uniform amount, output increases by that same amount, the production function is said to exhibit constant returns to scale.

If output rises more than in proportion to the uniform amount, the production function is said to exhibit increasing returns to scale. A technology exhibits increasing returns to sale if doubling inputs more than doubles outputs. For example, the firm could, instead of building a duplicate factory, could instead build a single large plant, allowing for greater specialization of labour.

If output rises less than in proportion to the uniform increase in input, the production function exhibits decreasing returns to scale. One reason for this is the difficulty of organising, coordinating and integrating activities increases with firm size.

Many production functions have increasing returns to scale for small amounts of output, constant returns for moderate outputs and decreasing returns for large amounts of output.

 

Although all firms in an industry produce efficiently given what they know and what institutional and other constraints they face, some firms may be more productive than others. They can produce more output from a given bundle of inputs. Due to innovations such as technical progress and new methods of organising production, a firm can produce more today than it could in the past from the same bundle of inputs. Such innovations change the production function