Production and Business Organization

A. Theory of Production and Marginal Products

1. The relationship between the quantity of output (such as wheat, steel, or automobiles) and the quantities of inputs (of labor, land, and capital) is called the production function. Total product is the total output produced. Average product equals total output divided by the total quantity of inputs. We can calculate the marginal product of a factor as the extra output added for each additional unit of input while holding all other inputs constant.


2. According to the law of diminishing returns, the marginal product of each input will generally decline as the amount of that input increases, when all other inputs are held constant.


3. The returns to scale reflect the impact on output of a balanced increase in all inputs. A technology in which doubling all inputs leads to an exact doubling of outputs displays constant returns to scale. When doubling inputs leads to less than double (more than double) the quantity of output, the situation is one of decreasing (increasing) returns to scale.


4. Because decisions take time to implement, and because capital and other factors are often very long-lived, the reaction of production may change over different time periods. The short run is a period in which variable factors, such as labor or material inputs, can be easily changed but fixed factors cannot. In the long run, the capital stock (a firm's machinery and factories) can depreciate and be replaced. In the long run, all inputs, fixed and variable, can be adjusted.


5. Technological change refers to a change in the underlying techniques of production, as occurs when a new product or process of production is invented or an old product or process is improved. In such situations, the same output is produced with fewer inputs or more output is produced with the same inputs. Technological change shifts the production function upward.


6. Attempts to measure an aggregate production function for the American economy tend to corroborate theories of production and marginal products. In the twentieth century, technological change increased the productivity of both labor and capital. Total factor productivity (measuring the ratio of total output to total inputs) grew at around 1½ percent per year over the twentieth century, although from the 1970s to the mid-1990s the rate of productivity growth slowed markedly and real wages stopped growing. But underestimating the importance of new and improved products may lead to a significant underestimate of productivity growth.

B. Business Organizations

7. Business firms are specialized organizations devoted to managing the process of production.


8. Firms come in many shapes and sizes—with some economic activity in tiny one-person proprietorships, some in partnerships, and the bulk in corporations. Each kind of enterprise has advantages and disadvantages. Small businesses are flexible, can market new products, and can disappear quickly. But they suffer from the fundamental disadvantage of being unable to accumulate large amounts of capital from a dispersed group of investors. Today's large corporation, granted limited liability by the state, is able to amass billions of dollars of capital by borrowing from banks, bondholders, and stock markets.


9. In a modern economy, business corporations produce most goods and services because economies of mass production necessitate that output be produced at high volumes, the technology of production requires much more capital than a single individual would willingly put at risk, and efficient production requires careful management and coordination of tasks by a centrally directed entity.


10. The modern corporation may involve divided incentives because of the divorce of ownership from control, which has produced the vast gulf between executive compensation and average wages.