Production and

Business Organization

Economics
Department of Economics
Paul A. Samuelson & William D Nordhaus
Faculty of Economics and Bussiness
Ch. 6
Airlangga University
 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.
• The production function shows the
relationship between quantity of inputs
used to make a good and the quantity of
output of that good
 Total, Average & Marginal Product

• Total product
– Total amount of output produced in physical units.

• Average product
– Total output devided by total units of input.

• Marginal product
– The extra product or output added by 1 extra unit of
that input while other inputs are held constant.
The Production Function

• Marginal Product
– The marginal product of any input in the
production process is the increase in output
that arises from an additional unit of that
input.
 The Production Function
• Diminishing Marginal Product
– Diminishing marginal product is the property
whereby the marginal product of an input
declines as the quantity of the input
increases.
• Example: As more and more workers are hired at a
firm, each additional worker contributes less and
less to production because the firm has a limited
amount of equipment.
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 other input
constant.
 RETURNS TO SCALE

• The responsiveness of total product when all

the inputs are increased proportionately.
– Constant Returns To Scale (CRTS)
• Output increased in the same proportion
– Increasing Returns To Scale (IRTS) = economies
of scale
• Output increased in the higher proportion
– Decreasing Returns To Scale (DRTS)
• Output increased in the lower proportion
 Short Run & Long Run

• Short run
– A period which firms can adjust production by
changing variable factors (input) such as
materials and labor but can not change fixed
factors such as capital.

• Long run
– A period sufficiently long so that all factors
(fixed input) including capital can be adjusted.
 Technological Change

...refers to improvements in the processes for

producing goods and services, changes in
old products, or introduction of new products.
 Technological Change

• Process innovation
– Occurs when new engineering knowledges
improves production techniques for existing
products.
• Product innovation
– New or improved products are introduced in the
marketplace.
 Productivity

... is a concept measuring the ratio of total

output to a weighted average of inputs.

– Suppose that firm’s inputs increased by 1% and that

becauses economies of scale output increased by 3%
the productivity rose by 2 % (=3-1).

• Labor productivity, Capital productivity, Total Productivity

 Productivity..
• Labor productivity : calculates the amount
of output per unit of labor
• Capital productivity : calculates the
amount of output per unit of capital
• Total productivity : measures output per
unit of total outputs
Empirical Estimates of the Aggregate
Production Function
• Total factor productivity has been increasing over
the last century because of technological progress
and higher levels of workers education and skill
• The avarage rate of total productivity growth was
slightly under 11/2% per year since 1900
• Over the twentieth century, labor productivity grew
at an average rate of slightly more than 2% per
year
• The capital stock has been growing faster than
number of worker hours
 Business Organization

Firms or business enterprise exist for

many reasons, but the most important
is that business firms are specialized
organizations devoted to managing the
process of production
 Business Organization….
In the first place, production is organized in
firms because of economies of specialization
(Efficient production)

A second function of firms is raising

resources for large scale production

A third reason for the existence of firms is to

manage and coordinate the production
process
 The Individual proprietorship

The individual proprietorship, the

classic small business often called
“mom-and-pop” stores. These business
are large in number but small in total
sales
 The Partnership

Any two or more people can get

together and form a partnership
Each agrees to provide a fraction of the
work and capital and to share a
percentage of the profits and losses
 The Corporation

A corporation is a form of business

organization chartered in one of the 50
states or abroad and owned by a
number of individual stockholders
The central features of a modern corporation are
following :

•The ownership of a corporation is

determined by the ownership of the
company’s common stock
•In principle, the shareholders control the
companies they own
•The corporation’s managers and directors
have the legal power to make decisions for
the corporations