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Production functionFrom Wikipedia, the free encyclopedia

Graph of Total, Average, and Marginal Product

Inmicroeconomicsandmacroeconomics, a production function is afunctionthat specifies the output of a

firm, an industry, or an entire economy for all combinations ofinputs. This function is an assumed technological

relationship, based on the current state ofengineeringknowledge; it does not represent the result of economic

choices, but rather is an externally given entity that influences economic decision-making. Almost all economic

theories presuppose a production function, either on the firm level or the aggregate level. In this sense, the

production function is one of the key concepts ofmainstreamneoclassicaltheories. Some non-mainstream

economists, however, reject the very concept of an aggregate production function.[1][2]

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Contents

[hide]

1 Concept of production functions

2 Specifying the production function

3 Production function as a graph

4 Stages of production

5 Shifting a production function

6 Homogeneous and homothetic production functions

7 Aggregate production functions

8 Criticisms of production functions

o 8.1 On the concept of capital

o 8.2 On the empirical relevance

o 8.3 Natural resources

9 See also

10 References

11 Further references and external links

[edit]Concept of production functions

Inmicro-economics, a production function is afunctionthat specifies the output of a firm for all combinations

of inputs. A meta-production function (sometimes metaproduction function) compares the practice of theexisting entities converting inputs into output to determine the most efficient practice production function of the

existing entities, whether the most efficient feasible practice production or the most efficient actual practice

production.[3]clarification needed In either case, the maximum output of a technologically-determined production

process is amathematical functionof one or more inputs. Put another way, given the set of all technically

feasible combinations of output and inputs, only the combinations encompassing a maximum output for a

specified set of inputs would constitute the production function. Alternatively, a production function can be

defined as the specification of the minimum input requirements needed to produce designated quantities of

output, given available technology. It is usually presumed that unique production functions can be constructed

for every production technology.

By assuming that the maximum output technologically possible from a given set of inputs is achieved,

economists using a production function in analysis are abstracting from the engineering and managerial

problems inherently associated with a particular production process. The engineering and managerial problems

oftechnical efficiencyare assumed to be solved, so that analysis can focus on the problems ofallocative

efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to

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TheLeontief production functionapplies to situations in which inputs must be used in fixed

proportions; starting from those proportions, if usage of one input is increased without another

being increased, output will not change. This production function is given by

Other forms include theconstant elasticity of substitutionproduction function (CES), which is

a generalized form of the Cobb-Douglas function, and the quadratic production function. The

best form of the equation to use and the values of the parameters (a,b,c,...) vary from

company to company and industry to industry. In a short run production function at least one

of theX's (inputs) is fixed. In the long run all factor inputs are variable at the discretion of

management.

[edit]Production function as a graph

Quadratic Production Function

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Any of these equations can be plotted on a graph. A typical (quadratic) production function is

shown in the following diagram under the assumption of a single variable input (or fixed

ratios of inputs so the can be treated as a single variable). All points above the production

function are unobtainable with current technology, all points below are technically feasible,

and all points on the function show the maximum quantity of output obtainable at the

specified level of usage of the input. From the origin, through points A, B, and C, the

production function is rising, indicating that as additional units of inputs are used, the quantity

of output also increases. Beyond point C, the employment of additional units of inputs

produces no additional output (in fact, total output starts to decline); the variable input is

being used too intensively. With too much variable input use relative to the available fixed

inputs, the company is experiencing negative marginal returns to variable inputs, and

diminishing total returns. In the diagram this is illustrated by the negative marginal physical

product curve (MPP) beyond point Z, and the declining production function beyond point C.

From the origin to point A, the firm is experiencing increasing returns to variable inputs: As

additional inputs are employed, output increases at an increasing rate. Bothmarginal

physical product(MPP, the derivative of the production function) and average physical

product (APP, the ratio of output to the variable input) are rising. The inflection point A

defines the point beyond which there are diminishing marginal returns, as can be seen from

the declining MPP curve beyond point X. From point A to point C, the firm is experiencing

positive but decreasing marginal returns to the variable input. As additional units of the input

are employed, output increases but at a decreasing rate. Point B is the point beyond which

there are diminishing average returns, as shown by the declining slope of the average

physical product curve (APP) beyond point Y. Point B is just tangent to the steepest ray from

the origin hence the average physical product is at a maximum. Beyond point B,

mathematical necessity requires that the marginal curve must be below the average curve

(Seeproduction theory basicsfor further explanation.).

[edit]Stages of production

To simplify the interpretation of a production function, it is common to divide its range into 3

stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing

output per unit, the latter reaching a maximum at point B (since the average physical product

is at its maximum at that point). Because the output per unit of the variable input is improving

throughout stage 1, a price-taking firm will always operate beyond this stage.

In Stage 2, output increases at a decreasing rate, and the average andmarginal physical

productare declining. However, the average product of fixed inputs (not shown) is still rising,

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because output is rising while fixed input usage is constant. In this stage, the employment of

additional variable inputs increases the output per unit of fixed input but decreases the output

per unit of the variable input. The optimum input/output combination for the price-taking firm

will be in stage 2, although a firm facing a downward-sloped demand curve might find it most

profitable to operate in Stage 1. In Stage 3, too much variable input is being used relative to

the available fixed inputs: variable inputs are over-utilized in the sense that their presence on

the margin obstructs the production process rather than enhancing it. The output per unit of

both the fixed and the variable input declines throughout this stage. At the boundary between

stage 2 and stage 3, the highest possible output is being obtained from the fixed input.

[edit]Shifting a production function

By definition, in the long run the firm can change its scale of operations by adjusting the level

of inputs that are fixed in the short run, thereby shifting the production function upward as

plotted against the variable input. If fixed inputs are lumpy, adjustments to the scale of

operations may be more significant than what is required to merely balance production

capacity with demand. For example, you may only need to increase production by a million

units per year to keep up with demand, but the production equipment upgrades that are

available may involve increasing productive capacity by 2 million units per year.

Shifting a Production Function

If a firm is operating at a profit-maximizing level in stage one, it might, in the long run, choose

to reduce its scale of operations (by selling capital equipment). By reducing the amount of

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fixed capital inputs, the production function will shift down. The beginning of stage 2 shifts

from B1 to B2. The (unchanged) profit-maximizing output level will now be in stage 2.

CobbDouglas production functionFrom Wikipedia, the free encyclopedia

A two-input CobbDouglas production function

Ineconomics, the CobbDouglas functional form ofproduction functionsis widely used to represent the

relationship of an output to inputs. Similar functions were originally used byKnut Wicksell(18511926), while

the Cobb-Douglas form was developed and tested against statistical evidence byCharles CobbandPaul

Douglasduring 19001947.

Contents

[hide]

1 Formulation

2 History

3 Difficulties and criticisms

o 3.1 Dimensional analysis

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o 3.2 Lack of microfoundations

4 Some applications

5 Various representations of the production function

o

5.1 Translog (transcendental logarithmic) production function6 Derived from a CES function

7 See also

8 References

9 External links

[edit]Formulation

In its most standard form for production of a single good with two factors, the function is

where:

Y= total production (the monetary value of all goods produced in a year)

L =laborinput

K=capitalinput

A =total factor productivity

and are theoutput elasticitiesof labor and capital, respectively. These values are constants

determined by available technology.

Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in

production,ceteris paribus. For example if = 0.15, a 1% increase in labor would lead to approximately a

0.15% increase in output.

Further, if:

+ = 1,

the production function hasconstant returns to scale: Doubling capital K and labour L will also double

output Y. If

+ < 1,

returns to scale are decreasing, and if

+ > 1

returns to scale are increasing. Assumingperfect competitionand + = 1, and can be

shown to be labor and capital's share of output.

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Cobb and Douglas were influenced by statistical evidence that appeared to show that labor and

capital shares of total output were constant over time in developed countries; they explained this

by statistical fittingleast-squares regressionof their production function. There is now doubt over

whether constancy over time exists.

[edit]History

Paul Douglasexplains that his first formulation of the CobbDouglas production function was

developed in 1927, when seeking a functional form to relate estimates he had calculated for

workers and capital, he spoke with mathematician and colleagueCharles Cobbwho suggested a

function of the form Y= bLkC1 kpreviously used byKnut Wicksell. Estimating this usingleast

squares, he obtained a result for the marginal productivity of labour (k) to 0.75$ --- which was

subsequently confirmed by theNational Bureau of Economic Researchto be %74.1. Later work

in the 1940s prompted them to allow for the exponents on Cand L vary, resulting in estimates

that subsequently proved to be very close to improved measure of productivity developed at that

time.[1]

A major criticism at the time was that estimates of the production function, although seemingly

accurate, were based on such sparse data that it was hard to give them much credibility.

Douglas' remarked "I must admit I was discouraged by this criticism and thought of giving up the

effort, but there was something which told me I should hold on."[1]The breakthrough came in

usingUS censusdata, which wascross sectionaland provided a large number of observations.

Douglas presented the results of these findings, along with those for other countries, at his 1947

address as president of theAmerican Economic Association. Shortly afterwards, Douglas went

into politics and was stricken by ill health --- resulting in little further development on his side.

However, two decades later, his production function was widely used, being adopted by

economists such asPaul SamuelsonandSolow.[1]The CobbDouglas production function is

especially notable for being the first time an aggregate or economy-wide production function had

been developed, estimated, and the presented to the profession for analysis; it marked a

landmark change in how economists approachedmacroeconomics.[2]

[edit]Difficulties and criticisms

[edit]Dimensional analysis

The CobbDouglas model is criticized by someAustrianeconomists such asWilliam Barnett IIon

the basis ofdimensional analysis. They argue it does not having meaningful or economically

reasonableunits of measurementunless + = 1.[3]However, other economists in reply to

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Barnett have argued that the units used are not fundamentally more unnatural than other units

commonly used in physics such alogtemperature or distance squared.[4]

[edit]Lack of microfoundations

The CobbDouglas production function was not developed on the basis of any knowledge ofengineering, technology, or management of the production process. It was instead developed

because it had attractive mathematical characteristics, such asdiminishing marginal returnsto

either factor of production and the property that expenditure on any given input is a constant

fraction of total cost. Crucially, there are nomicrofoundationsfor it. In the modern era, economists

try to build models up from individual agents acting, rather than imposing a functional form on an

entire economy. However, many modern authors have developed models which give Cobb

Douglas production function from the micro level; manyNew Keynesianmodels, for example.[5]It

is nevertheless a mathematical mistake to assume that just because the CobbDouglas function

applies at the micro-level, it also always applies at the macro-level. Similarly, it is not necessarily

the case that a macro CobbDouglas applies at the disaggregated level. An early

microfoundation of the aggregate CobbDouglas technology based on linear activities is derived

in Houthakker (1955).[6]

Leontief production functionFrom Wikipedia, the free encyclopedia

Ineconomics, the Leontief production function orfixed proportions production function is aproduction

functionthat implies thefactors of productionwill be used in fixed (technologically pre-determined) proportions,

as there is nosubstitutabilitybetween factors. It was named afterWassily Leontiefand represents a limiting

case of theconstant elasticity of substitutionproduction function.

The function is of the form

where q is the quantity of output produced, z1 and z2 are the utilised quantities of input 1 and input 2

respectively, and a and b are technologically determined constants.

[edit]Example

Suppose that the intermediate goods "tires" and "steering wheels" are used in the production of

automobiles (for simplicity of the example, to the exclusion of anything else). Then in the above

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formulaq refers to the number of automobiles produced, z1 refers to the number of tires used, and z2 refers

to the number of steering wheels used. Then the Leontief production function is

Number of cars = Min{ times the number of tires, 1 times the number of steering wheels}.

SHORT-RUN PRODUCTION ANALYSIS:

An analysis of the production decision made by a firm in the short run, with the ultimate

goal of explaining the law of supply and the upward-sloping supply curve. The central

feature of this short-run production analysis is the law of diminishing marginal returns,

which results in the short run when larger amounts of a variable input, like labor, are added

to a fixed input, like capital. A contrasting analysis is long-run production analysis.

The analysis ofshort-run productionsets the stage to better understand thesupply-side of

themarket. How producers respond to price depends, in part, on their ability to combine

inputs to produce output. This ability is guided by thelaw of diminishing marginal returns,

which states that the productivity of avariable inputdeclines as more is added to afixed

input.

If productivity declines, then more of the variable input is needed as thequantityproduced

increases. This results in an increase inproduction cost, which means producers need toreceive a higher price. The connection between higher price and more production is essenceof thelaw of supply.

Two Runs: Short and Long

The first step in the analysis of short-run production is a distinction between the short run

and the long run. This distinction is intertwined with the distinction between fixed andvariable inputs.

Short Run: The short run is a period of time in which at least one input used forproduction and under the control of the producer is variable and at least one input isfixed.

Long Run: The long run is a period of time in which at all inputs used for productionand under the control of the producer are variable.

The difference between short run and long run depends on the particular production activity.

For some producers, the short run lasts a few days. For others, the short run can last for

decades.

Two Inputs: Fixed and Variable

The analysis of short-run production assumes that at least one input in the production

process is fixed and at least one is variable. As already noted, the fixed and variable inputs

are intertwined with the notion of short run and long run.

http://pop_dsp%28%27pop_gls.pl/?k=short-run%20production%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=short-run%20production%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=short-run%20production%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=supply%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=supply%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=supply%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=law%20of%20diminishing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=law%20of%20diminishing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=law%20of%20diminishing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=variable%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=variable%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=variable%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=fixed%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=fixed%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=fixed%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=fixed%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=quantity%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=quantity%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=production%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=production%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=production%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=law%20of%20supply%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=law%20of%20supply%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=law%20of%20supply%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=production%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=quantity%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=fixed%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=fixed%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=variable%20input%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=law%20of%20diminishing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=supply%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=short-run%20production%27,500,400)

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Fixed Input: A fixed input is an input used in production and under the control of theproducer that does not change during the time period of analysis (the short run).

Variable Input: A variable input is an input used in production and under the controlof the producer that does change during the time period of analysis (the short run).

The variable input used by most producers is more often than notlabor. The fixed input for

most production operations is usually capital. The presumption is that the size of a firm's

workforce can be adjusted more quickly that the size of thefactoryor building, the amount

of equipment, and other capital.

Note that the phrase "under the control of the producer" is included in the specifications of

short run, long run, fixed input, and variable input. The reason is that short-run production

analysis is most concerned with how producers adjust the inputs under the control inresponse to changing prices.

Any production activity invariably includes inputs (fixed and variable) that are beyond thecontrol of the producer, includinggovernmentlaws and regulations, social customsandinstitutions, weather, and the forces of nature. These other variables are certainly

worthy of consideration, but are not fundamental to explaining and understanding the basicprinciples of market supply

Three Returns: Increasing, Decreasing, and Negative

The addition of a variable input (like labor) to a fixed input (like capital) can have one of

three basic results. First, production might increase at a increasing rate. Second, production

might increase at a decreasing rate. Third, production might actually decrease. These three

alternatives are technically termedincreasing marginal returns,decreasing marginal

returns, and negative marginal returns.

Increasing Marginal Returns: This occurs if each additional unit of a variable inputadded to a fixed input causes incremental production to increase. For example, the

one worker contributes 10 units of output to production, the next worker contributesanother 12 units, and the subsequent worker contributes 14 units. With increasingmarginal returns, each worker contributes more to production that the previousworker.

Decreasing Marginal Returns: This occurs if each additional unit of a variable inputadded to a fixed input causes incremental production to decrease. For example, theone worker contributes 10 units of output to production, the next worker contributesanother 8 units, and the subsequent worker contributes only 6 units. With decreasing

marginal returns, each worker contributes less to production that the previousworker.

http://pop_dsp%28%27pop_gls.pl/?k=labor%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=labor%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=labor%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=firm%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=firm%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=firm%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=factory%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=factory%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=factory%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=government%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=government%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=government%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=institution%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=institution%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=increasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=increasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=increasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=decreasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=decreasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=decreasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=decreasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=decreasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=decreasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=increasing%20marginal%20returns%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=institution%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=government%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=factory%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=firm%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=labor%27,500,400)

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Negative Marginal Returns: This results if the addition of a variable input added to afixed input actually causes the total production to decline. For example, if 10 workers

produce a total of 100 units of output, and 11 workers produce a total of 99 units,then the eleventh worker is said to have negative marginal returns.

Most short-run production involves increasing marginal returns with the addition of the first

few units of a variable input. This inevitably gives way to decreasing marginal returns. While

negative marginal returns are somewhat rare, they do eventually result if too many units of

a variable input are added.

One Law

The inevitability of decreasing marginal returns is captured by the most important economic

principle in short-run production analysis--the law of diminishing marginal returns.

The Law of Diminishing Marginal Returns: This law states that as more and more of avariable input is added to a fixed input in short-run production, then themarginalproduct(that is, the marginal returns) of the variable input eventually declines.

While most short-run production is likely to see increasing marginal returns, eventually,

inevitably, most certainly, decreasing marginal returns occur.

The law of diminishing marginal returns means that increased production of a good requires

more and more of the variable input. For example, the first 50 units of production can be

had with only 5 workers. However, the next 50 units might required an additional 10workers.

With more the variable input needed, the cost of production rises. And as the productioncost rises, the price that producers need to receive also increases. Hence, a higher pricecorresponds with a larger quantity, which is the law of supply. The positive law of supply

connection between price and quantity, as such, can be traced to the law of diminishingmarginal returns.

Three Product Curves

Three Curves

http://pop_dsp%28%27pop_gls.pl/?k=marginal%20product%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=marginal%20product%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=marginal%20product%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=marginal%20product%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=marginal%20product%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=marginal%20product%27,500,400)

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This graph presents the three "product" curves that

form the foundation of short-run production

analysis. This particular set of curves depict the

hourly production of Waldo's Super Deluxe TexMex

Gargantuan Tacos (with sour cream and jalapeno

peppers) for different quantities of labor, thevariable input. The fixed input is the building,

cooking and preparation equipment, cash register,

tables, chairs, and other capital that comprise

Waldo's TexMex Taco World restaurant.

Total Product Curve: The curve labeled TP isthetotal product curve, the total number of

TexMex Gargantuan Tacos produced per hourfor a given amount of labor. If Waldo (theowner of Waldo's TexMex Taco World) hires

more employees, he can expect a greater

production of TexMex Gargantuan Tacos untilhe reaches peak production at 7 and 8

workers. Click the [TP] button to highlightthis curve.

Marginal Product Curve: The MP curve isthemarginal product curve, and the one thatis key to the study of short-run production.

The MP curve indicates how the total production of TexMex Gargantuan Tacos

changes when an extra worker is hired. For example, hiring a fifth worker means

that Waldo's TexMex Taco World can produce an additional 10 TexMex GargantuanTacos per hour. Most important, the marginal product declines after the second

worker is hired, which is the law of diminishing marginal returns, the driving principlein the study of short-run production. Click the [MP] button to highlight this curve.

Average Product Curve: Theaverage product curve, labeled AP, indicates theaverage number of TexMex Gargantuan Tacos produced by Waldo's workers. If, forexample, Waldo has a staff of 7, then each produces about 17 TexMex GargantuanTacos per hour--on average. Click the [AP] button to highlight this curve.

Three Production Stages

Three Stages

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Short-run production exhibits three distinct stages

reflected by the shapes and slopes of the three

product curves--total product, marginal product,

and average product.

Stage I: The first stage is increasingmarginal returns and is characterized by theincreasingly steeper positive slope of the

total product curve, the positive slope of the

marginal product curve, and the positiveslope of the average product curve.Moreover, the marginal product curvereaches a peak at the end of Stage I.

Stage II: The second stage is decreasingmarginal returns and is reflected in thepositive but flattening slope of the total

product curve and the negative slope of the

marginal product curve. Moreover, theaverage product reaches a peak and is equalto marginal product in this stage. The

marginal product curve intersects the horizontal quantity axis at the end of Stage II.

Stage III: The third and last stage is negative marginal returns illustrated by thenegative value of marginal product and the negative slope of the total product curve.Average product is positive, but the average product curve has a negative slope.

One Step

This analysis of short-run production is but the first step in a brisk walk toward a better

understanding market supply. Further steps include the cost of short-run production,

especiallymarginal cost, and themarket structurein which a firm operates, such asperfect

competitionormonopoly.

Production Cost: An understanding of market supply builds on the short-runproduction analysis and the key role played by the law of diminishing marginal

returns. Because the productivity of the variable input decreases, a larger quantity is

needed as production increases. This larger quantity, however, entails greater

production cost, as reflected in a positively-sloped marginal cost curve.

Market Structure: The market supply also depends on the structure of the market,especially the degree of competition and the resultingmarket controlof each firm.

Competitive markets, with limited control over the price, tend to produce output by

equating price and marginal cost. Because marginal cost increases with production,so too does price. However, less competitive markets, with greater market control by

http://pop_dsp%28%27pop_gls.pl/?k=marginal%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=marginal%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=marginal%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%20structure%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%20structure%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%20structure%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=perfect%20competition%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=perfect%20competition%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=perfect%20competition%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=perfect%20competition%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=monopoly%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=monopoly%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=monopoly%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%20control%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%20control%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%20control%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=monopoly%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=perfect%20competition%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=perfect%20competition%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%20structure%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=marginal%20cost%27,500,400)

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the participating firms, need not equate price and marginal cost. As such, a higherprice might not correspond with a larger quantity.

RETURNS TO SCALE:

Changes in production the occur when all resources are proportionately changed in the long

run. Returns to scale come in three forms--increasing, decreasing, or constant based on

whether the changes in production are proportionally more than, less than, or equal to the

proportional changes in inputs. Returns to scale are the guiding principle for long-run

production, playing a similar role that the law of diminishing marginal returns plays for

short-run production.

Returns to scale answer the question: Iflabor,capital, and other inputs ALL increase by the

same proportion (say 10 percent) does output increase by more than, less than, or equal to

this proportion (more than 10 percent, less than 10 percent, or exactly 10 percent)? The

answer indicates that returns to scale can take one of three forms:increasing returns to

scale,decreasing returns to scale, andconstant returns to scale.

Increasing Returns to Scale: This occurs if a proportional increase in all inputs underthe control of a firm results in a greater than proportional increase inproduction. Inother words, a 10 percent increase in labor, capital, and other inputs, results in aproduction increase that is greater than 10 percent.

Decreasing Returns to Scale: This occurs if a proportional increase in all inputs underthe control of a firm results in a less than proportional increase in production. In

other words, a 10 percent increase in labor, capital, and other inputs, results in aproduction increase that is less than 10 percent.

Constant Returns to Scale: This occurs if a proportional increase in all inputs underthe control of a firm results in an equal proportional increase in production. In other

words, a 10 percent increase in labor, capital, and other inputs, results in an equal10 percent increase in production.

Long-Run Stuffed Amigo Production

Suppose, for example, that The Wacky Willy Company employs 1,000 workers in a 5,000

square foot factory to produce 1 million Stuffed Amigos (those cute and cuddly armadillos,

tarantulas, and lizards) each month. Returns to scale indicate what happens to production if

the scale of operation expands to 2,000 workers in a 10,000 square foot factory--a doubling

of the inputs.

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If production increases to exactly 2 million Stuffed Amigos, twice the original quantity, thenThe Wacky Willy Company has constant returns to scale. If production increases by more

than 2 million Stuffed Amigos, then The Wacky Willy Company has increasing returns toscale. And if production increases by less than 2 million Stuffed Amigos, then The WackyWilly Company has decreasing returns to scale.

Economies and Diseconomies of ScaleReturns to scale are the flip slide ofeconomies of scaleanddiseconomies of scale. However,

whereas economies and diseconomies of scale focus on cost, returns to scale focus on

production.

Economies of scale indicate thatlong-run average costdecreases, which correspondsto increasing returns to scale in terms of production.

Diseconomies of scale indicate that long-run average cost increases, which

corresponds to decreasing returns to scale in terms of output.

Constant returns to scale for production terms results when long-run average costneither increases nor decreases.

The anticipated pattern for most production activities is that increasing returns to scale

emerge for relatively small levels of production, which is then following be constant returns

to scale and finally decreasing returns to scale. This pattern is represented by a U-shaped

long-run average cost curve.

NOT Marginal ReturnsDo not confuse increasing and decreasing returns to scale with increasing and

decreasingmarginal returns. While these phrases sound similar, they are quite different.

Increasing and decreasing returns to scale relate to the long run in which all inputs underthe control of the firm are variable. Increasing and decreasing marginal returns related to

the short run in which one or more input is variable and one or more input is fixed.

The existence offixed inputs in the short run gives rise to increasing and decreasing

marginal returns. In particular, decreasing marginal returns result because the capacity ofthe fixed input or inputs is being reached. However, in the long run, there are no fixedinputs, so no capacity constraint, so no marginal returns.

COST:

An alternative term for economic or opportunity cost, which is the highest valued alternative

foregone in the pursuit of an activity. Opportunity cost is one of the most fundamental

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concepts used in the study of economics, hence when the term cost is used in the study of

economics without modification, it usually means economic or opportunity cost.

Becauseeconomists like to economize on effort, the succinct term cost is also frequently

used in lieu ofopportunity costoreconomic cost. In fact, whenever the term cost is used in

economics, absent of any modifiers, it inevitably means economic or opportunity cost.

Starting With Scarcity

The ultimate source of cost is the pervasive problem ofscarcity(unlimited wants and needs,

butlimited resources). Whenever limited resources are used to satisfy one want or need, an

unlimited number of other wants and needs remain unsatisfied. Hence pursuing one activity

means alternatives are not pursued. Herein lies the essence of cost. Doing one thing

prevents doing another.

Cost Plus...

There are a seemingly endless number of modifiers that can be used with the term cost.

Here is a lengthy, but necessarily incomplete list.

Accounting Cost: An actual outlay or expense incurred inproductionthat shows upafirm's accounting statements or records, which may or may not be an opportunitycost.

Average Cost: The opportunity cost incurred per unit in the production of a good,calculated by dividing the total cost of production by the quantity of output produced

Explicit Cost: An opportunity cost that involves amoneypayment and usuallyamarkettransaction.

External Cost: An opportunity that is not included in the market price of a goodbecause it is not included in thesupply price.

Fixed Cost: An opportunity that does not change with changes in the quantity of

output produced.

Historical Cost: An accounting principle stating that expenses are recorded in termsof original or acquisition cost, which may or may not reflect opportunity cost orcurrent market value.

http://pop_dsp%28%27pop_gls.pl/?k=economist%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=economist%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=economist%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=opportunity%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=opportunity%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=opportunity%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=economic%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=economic%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=economic%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=scarcity%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=scarcity%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=scarcity%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=unlimited%20wants%20and%20needs%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=unlimited%20wants%20and%20needs%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=unlimited%20wants%20and%20needs%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=limited%20resources%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=limited%20resources%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=limited%20resources%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=production%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=production%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=production%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=firm%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=firm%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=firm%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=money%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=money%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=money%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=supply%20price%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=supply%20price%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=supply%20price%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=supply%20price%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=market%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=money%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=firm%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=production%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=limited%20resources%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=unlimited%20wants%20and%20needs%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=scarcity%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=economic%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=opportunity%20cost%27,500,400)http://pop_dsp%28%27pop_gls.pl/?k=economist%27,500,400)

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Implicit Cost: An opportunity cost that does NOT involve a money payment or amarket transaction.

Marginal Cost: The change in total opportunity cost resulting from a change in thequantity of output produced by a firm in the short run.

Production Cost: The opportunity cost of usinglabor,capital,land,andentrepreneurshipin the production of goods and services.

Total Cost: The opportunity cost incurred by all of the factors of production used by afirm to produce a good or service, including wages paid to labor, rent paid for theland, interest paid to capital owners, and anormal profitpaid to entrepreneurs.

Variable Cost: An opportunity cost that changes with changes in the quantity ofoutput produced.

This is a modest list at best. Other terms contain the word "cost" include average variable

cost, total variable cost, average fixed cost, total fixed cost, total factor cost, average factor

cost, and marginal factor cost. Other "cost" terms pop up in the study of economics as

attention is directed to specific topics and issues.

Circular flow of incomeFrom Wikipedia, the free encyclopedia

This article may need to bewikifiedto meet Wikipedia'squality standards. Pleasehelpby

addingrelevantinternal links, or by improving the article'slayout.(June 2010)Click [show] on right for more details.[show]

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In this simplified image, the relationship between the decision-makers in the circular flow model is shown. Larger arrows

show primary factors, whilst the red n ,.0p;smaller arrows show subsequent or secondary factors.

Ineconomics, the terms circular flow of income orcircular flow refer to a simple economic model which

describes the reciprocal circulation of income between producers and consumers.[1][2]In the circular flow model,

the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively

and provide each other with factors in order to facilitate the flow of income[1]. Firms provide consumers with

goods and services in exchange for consumer expenditure and "factors of production" from households. More

complete and realistic circular flow models are more complex. They would explicitly include the roles of

government and financial markets, along with imports and exports.

Human wants are unlimited and are of recurring nature therefore, production process remains a continuous and

demanding process. In this process, household sector provides various factors of production such as land,

labour, capital and enterprise to producers who produce by goods and services by co-ordinating them.

Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the

household sector. Again household sector spends this income to fulfil its wants in the form of consumption

expenditure. Business sector supplies them goods and services produced and gets income in return of it. Thus

expenditure of one sector becomes the income of the other and supply of goods and services by one section of

the community becomes demand for the other. This process is unending and forms the circular flow of income,

expenditure and production.Reference- S.Dinesh Introduction to Macro Economics.

A continuous flow of production, income and expenditure is known as circular flow of income. It is circular

because it has neither any beginning nor an end. The circular flow of income involves two basic principles:- 1.In

any exchange process, the seller or producer receives the same amount what buyer or consumer spends.

2.Goods and services flow in one direction and money payment to get these flow in return direction, causes a

circular flow.

http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/File:Circular_flow_of_goods_income.pnghttp://en.wikipedia.org/wiki/File:Circular_flow_of_goods_income.pnghttp://en.wikipedia.org/wiki/File:Circular_flow_of_goods_income.pnghttp://en.wikipedia.org/wiki/File:Circular_flow_of_goods_income.pnghttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Circular_flow_of_income#cite_note-sloman_economics_p12-0http://en.wikipedia.org/wiki/Economics

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Circular flows are classified as: Real Flow and Money Flow. Real Flow- In a simple economy, the flow of factor

services from households to firms an

d corresponding flow of goods and services from firms to households s known to be as real flow.

Assume a simple two sector economy- household and firm sectors, in which the households provides factorservices to firms, which in return provides goods and services to them as a reward. Since there will be an

exchange of goods and services between the two sectors in physical form without involving money, therefore, it

is known as real flow.

Money Flow- In a modern two sector economy, money acts as a medium of exchange between goods and

factor services. Money flow of income refers to a monetary payment from firms to households for their factor

services and in return monetary payments from households to firms against their goods and services.

Household sector gets monetary reward for their services in the form of rent, wages, interest, and profit form

firm sector and spends it for obtaining various types of goods to satisfy their wants. Money acts as a helpingagent in such an exchange.

NATIONAL INCOME AND GROSS DOMESTIC PRODUCT:

National income (NI) is the total income earned by the citizens of the national economyresulting from their ownership of resources used in the production of final goods and

services during a given period of time, usually one year. Gross domestic product (GDP) is

the total market value of all final goods and services produced within the politicalboundaries of an economy during a given period of time, usually a year. Although national

income is generated by the production of gross domestic product, the value of productiondoes not entirely result in earned income. In other words, national income can be derivedfrom gross domestic product after a few adjustments.

The vast majority of domesticproductionis undertaken byfactors of productionowned bydomestic citizens (national incomeis about 80 percent ofgross domestic product).However, key differences do exist. The six main differences between gross domestic product

and national income are (1)capital consumption adjustment, (2)indirect business taxes,

(3)business transfer payments, (4)net foreign factor income, (5) government subsidiesless surplus of government enterprises, and (6)statistical discrepancy.

The following equation captures the relation between national income (NI) and gross

domestic product (GDP):

NI = GDP- Capital Consumption Adjustment - Indirect Business Taxes- Business Transfer Payments + Net Foreign Factor Income

+ Government Subsidies less Current Surplus of Government Enterprises

- Statistical Discrepancy

Net Foreign Factor Income

Net foreign factor income is the difference between factor payments received from

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theforeign sectorby domestic citizens and factor payments made to foreign

citizens for domestic production. This is, by the way, the key difference between

gross DOMESTIC product and gross NATIONAL product. Net foreign factor income

actually represents a two-part adjustment between gross domestic product and

national income.

A portion of the revenue received from producing DOMESTIC output is actually

paid to foreign citizens. As such, factor payments made to foreign citizens for

domestic production, much like the capital consumption adjustment and indirect

business taxes, are revenue generated from gross DOMESTIC product that is notpart of NATIONAL income received by domestic citizens.

However, in a classic example of turn-about is fair play, a portion of the incomeearned by domestic citizens is the result of production that is part of gross

domestic product for OTHER nations. These are factor payments received from the

foreign sector by domestic citizens. They are added to factor payments generatedby domestic production to obtain national income.

NATIONAL INCOME AND NET DOMESTIC PRODUCT:

National income (NI) is the total income earned by the citizens of the national

economy resulting from their ownership of resources used in the production of

final goods and services during a given period of time, usually one year. Net

domestic product (NDP) is the total market value of all final goods and services

produced within the political boundaries of an economy during a given period of

time, usually a year, after adjusting for the depreciation of capital. Although

national income is generated by the production of net domestic product, the value

of production does not entirely result in earned income. In other words, national

income can be derived from net domestic product after a few adjustments.

The vast majority of domesticproductionis undertaken byfactors of

productionowned by domestic citizens (national incomeis about 90 percent ofnet

domestic product). However, key differences do exist. The five main differences

between net domestic product and national income are (1)indirect business

taxes, (2)business transfer payments, (3)net foreign factor income, (4)

government subsidies less surplus of government enterprises, and (5)statistical

discrepancy.

The following equation captures the relation between national income (NI) and net

domestic product (NDP):

NI = NDP- Indirect Business Taxes