Theory of the Firm (Production)
What production is. Short-run and long-run. Diminishing Returns.
What is production:
‘It is the process of converting factor inputs into outputs. So, using the factors production to produce goods and services.’
There are different time periods when it comes to production:
Short-run period: a period in time where at least one of the factors of production are fixed. An example, would be capital. Capital is hard and expensive to change so the short-run period will generally involve a fixed amount of capital, with the firm varying its labour in order to produce different quantities.
Long-run period: a period in time where all factors of production are variable. Everything can be changed. A business may view long run as being in the distant future where they plan on expanding their production by building new factories or buying new machinery etc.
[Make sure you know that ‘short-run and long-run’ mean different things in Microeconomic and Macroeconomics]
So, there is no defined amount of time for the long-run and short-run. It is dependent on the business itself.
For example, a plane manufacturer’s (like Boeing) long-run period will be an extremely long period of time. This is because it will require massive amounts of planning and huge amounts of money for them to expand.
The Law of Diminishing Returns:
It’s important to remember that this law only applies in the short-run. You MUST REMEMBER THIS.
‘The law of diminishing returns is when a firm experiences reduced marginal returns when employing additional units of a factor input. It is only applicable in the short-run.’
For example, a pizza shop is currently in the short run period. It’s fixed capital is the machinery that is used to produce pizzas (e.g. pizza oven). So we are limited by the amount of pizzas that that oven can produce. If the owner wants to produce more pizzas, then initially, the owner can hire more workers to work in the shop. However, the owner simply cannot keep hiring workers because he is limited by the pizza oven itself.
The point is this. You cannot keep adding variable inputs (e.g. more workers) to your production process to increase your output, if one of your factors of production is fixed (e.g. pizza oven). The extra output you get in return will fall and fall until no more additional output can be made. The only way of increasing your output in the long-run is if you upgrade your pizza oven or if you buy another one.
Why does the marginal product rise, then fall?
At lower levels of output, when the firm hires more workers - the firm benefits greatly from specialisation and division of labour in the beginning. Each new employee will be assigned a specific task to organise the production line and speed up production. This will increase the total product and in turn the marginal product will be rising.
However, the extra gains the firm gets cannot increase forever...
At point A, diminishing returns sets in and the additional output gained will increase at a lower rate than before. The total output that the firm produces will keep increasing up until point B. Point B is the firm’s maximum output. Producing beyond this point will actually result in the firm producing less total output than before.
It's also important to recognise that:
While the marginal product curve is positive, total output will continue to increase.
When the marginal product curve is negative, total output will start to decrease.
What you have learned:
Definition of production.
Definition of short-run and long-run period.
The law of diminishing returns
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