Summary

This chapter introduces and analyzes the creative process of production. Several important properties of production systems are examined.

• A production function specifies the maximum output that can be produced for a given amount of inputs. A discrete production function involves distinct, or "lumpy," patterns for input combinations. In a continuous production function, inputs can be varied in a unbroken marginal fashion.

• The returns to scale characteristic of a production system describes the output effect of a proportional increase in all inputs. The relation between output and variation in only one of the inputs used is described as the returns to a factor.

• The total product indicates the total output from a production system. The marginal product of a factor, MPX, is the change in output associated with a one-unit change in the factor input, holding all other inputs constant. A factor's average product is the total product divided by the number of units of that input employed.

• The law of diminishing returns states that as the quantity of a variable input increases, with the quantities of all other factors being held constant, and the resulting rate of increase in output eventually diminishes.

• An isoquant represents the different combinations of inputs that can be used efficiently to produce a specified quantity of output. Efficiency in this case refers to technical efficiency, meaning the least-cost production of a target level of output.

• Input substitution, or the systematic replacement of productive factors, is an important consideration when judging the efficiency of any production system. The marginal rate of technical substitution measures the amount of one input that must be substituted for another to maintain a constant level of output. It is irrational for a firm to use any input combination outside the ridge lines that indicate the bounds of positive marginal products.

• The marginal revenue product is the amount of revenue generated by employing the last input unit. Profit maximization requires that marginal revenue product and marginal cost be set equal for each input. Economic efficiency is achieved in the overall economy when all firms employ resources to equate each input's marginal revenue product and marginal cost. In all instances, it is important to consider the net marginal revenue of each input, or marginal revenue after all variable costs. Similarly important is the firm's isocost curve (or budget line), or line of constant costs. An expansion path depicts optimal input combinations as the scale of production expands.

• Constant returns to scale exist when a given percentage increase in all inputs leads to that same percentage increase in output. Increasing returns to scale are prevalent if the proportional increase in output is larger than the underlying proportional increase in inputs. If output increases at a rate less than the proportionate increase in inputs, decreasing returns to scale are present.

• Output elasticity, e0, is the percentage change in output associated with a 1 percent change in all inputs, and it is a practical means for returns-to-scale estimation. Power production functions indicate a multiplicative relation between input and output and are often used in production function estimation.

• One of the most prominent uses of economic survey information is to track the pace of economic betterment, or productivity growth, in the overall economy. Productivity growth is the rate of increase in output per unit of input. Labor productivity refers to the relationship between output and the worker time used to generate that output. It is the ratio of output per worker hour. In multifactor productivity measures, output is related to combined inputs of labor, capital, and intermediate purchases.

The successful analysis and estimation of production relations is fundamental to the ongoing success of any organization. Concepts developed in this chapter can be used to understand, refine, and improve the policies of successful companies.

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