PRODUCTION AND

BUSINESS ORGANIZATION

Theory of Production
and Marginal Products

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.
Total Product designates the total amount of output produced
in physical units.
The Marginal Product of an input is the extra output produced
by 01 additional unit of that input while other inputs are held
constant.
Average Product equals total output divided by total units of
input.

Marginal Product Is Derived

from Total Product

Chapter 6
Figure 6-1

Theory of Production
and Marginal Products

The Law of Diminishing Returns holds that we will get less

and less extra output when we add additional doses 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.

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. But what would happen if all inputs were increased by the
same proportion? This refers to 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 (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-then-proportional increase in total output.

Short Run and Long Run

To account for the role of time in production and costs, we
distinguish between two different time periods.

Short Run is a period in which firms can adjust production by

changing variable factors such as materials and labor but
cannot change fixed factors such as capital. The factors which
are increased in the short run are called variable factors.
Long Run is a period sufficiently long that all factors including
capital can be adjusted. The factors that can only be changed
in the long run are called fixed factors.

Technological Change

Process Innovation occurs when new engineering knowledge

improves production techniques for existing products whereas
Product Innovation occurs whereby new or improved products
are introduced in the marketplace.

Technological change
shifts production function
Upward

Value of Networking Increases as

Membership Rises

Chapter 6
Figure 6-4

Productivity and the Aggregate

Production Function

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.

Productivity Growth from Economies of Scale

Empirical Estimates of the Aggregate production Function

Business Organizations

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.
The most compelling factor leading to the organization of
production in firms arises from economies of mass production.
A second function of firms is raising resources for large-scale
production.
A third reason for the existence of firms is to manage the
production process.

Big, Small, and Infinitesimal Businesses

The Individual Proprietorship

The Partnership

The Corporation