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1Copyright 2014, Prof. TagelsirMohamed
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2
Industrial Management
CHAPTER 5
The Theory of the firm
Copyright 2014, Prof. TagelsirMohamed
Professor
Tagelsir Mohamed Gasmelseid
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The Theory of the Firm
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Production Function
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Production Function States the relationship between inputs and
outputs
Inputsthe factors of production classifiedas:
Landall natural resources of the earth not justterra firma! Price paid to acquire land = Rent
Labourall physical and mental human effortinvolved in production
Price paid to labour = Wages Capitalbuildings, machinery and equipment
not used for its own sake but for the contributionit makes to production
Price paid for capital = Interest.
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Production Function
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Inputs Process
Land
Labour
Capital
Product orservice
generated
value added
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Production Function
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Jonathan's Apple Farm Production Function
Apples
(tons/year)
Land
(acres)
Labor
(hired)
Proprietor's
time (hours)
0 100 0 1,100
50 100 2,500 1,100100 100 3,700 1,100
150 100 5,000 1,100
200 100 6,800 1,100
250 100 10,000 1,100
300 100 15,000 1,100350 100 27,000 1,100
The table describes A companys inputs for the annual
production of apples shown in the first column.
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Fixed Factors
A fixed factor is one that does notvary as the quantity producedincreases or decreases.
Some factors are fixed in the shortrun (managerial time).
Some factors are fixed in the medium
run (cultivated acreage).
No factors are fixed in the long run.
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A companys Fixed Factors
The company has two fixed factors
Its cultivated acreage (100
acres) Its own managerial time (1,100
hours)
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Variable Factors
A variable factor is one that must beincreased in order to increase output.
The classic variable factor is labor.
Variable factors usually exhibitdiminishing marginal productivity--the amount of extra product
generated by each additional unit ofthe input, holding other inputsconstant, declines.
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Variable Factors
It must vary his labor input to increasehis production of apples.
At first this variation is modest goingfrom 50 tons/year to 100 tons/yearrequires an additional 1,200 hours
Going from 200 to 250 tons/year
requires an additional 3,200 hours. It cannot increase the size of his farm,
his acreage is fixed.
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Analysisof Production Function:Short Run
In the short run at least one factor fixedin supply but all other factors capable ofbeing changed
Reflects ways in which firms respond tochanges in output (demand)
Can increase or decrease output using
more or less of some factors but somelikely to be easier to change than others
Increase in total capacity only possiblein the long run
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Analysis of Production Function:Short Run
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In times of risingsales (demand)
firms can increaselabour and capitalbut only up to a
certain level theywill be limited by
the amount ofspace. In this
example, land is
the fixed factorwhich cannot be
altered in the shortrun.
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Analysis of Production Function:Short Run
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If demand slows
down, the firm canreduce its variable
factors in thisexample it reduces
its labour andcapital but again,land is the factorwhich stays fixed.
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Analysis of Production Function:Short Run
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If demand slows
down, the firm canreduce its variable
factors in thisexample, it
reduces its labourand capital but
again, land is thefactor which stays
fixed.
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Analysing the ProductionFunction: Long Run
The long run is defined as the period of time taken tovary all factors of production
By doing this, the firm is able to increase its totalcapacitynot just short term capacity
Associated with a change in the scale of production
The period of time varies according to the firmand the industry
In electricity supply, the time taken to build newcapacity could be many years; for a market stallholder, the long run could be as little as a few weeksor months!
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Analysis of Production Function:Long Run
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In the long run, the firm can change all its factors of production thusincreasing its total capacity. In this example it has doubled its capacity.
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Production
Fixed inputs - resources a firm cannot feasiblyvary over the time period involved
Total product - the total output of the firm
Average product - the total output divided bythe amount of the input used to produce thatoutput
Marginal product - the change in total output
that results from a one-unit change in theamount of an input, holding the quantities ofother inputs constant
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The Relationship Between Average andMarginal Product Curves
When the marginal product is greaterthan average product, averageproduct must be increasing.
When the marginal product is lessthan average product, averageproduct must be decreasing.
When the marginal and averageproducts are equal, average productis at a maximum.
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Costs
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Costs
In buying factor inputs, the firmwill incur costs
Costs are classified as:
Fixed costscosts that are not relateddirectly to production rent, rates,insurance costs, admin costs. They canchange but not in relation to output
Variable Costscosts directly relatedto variations in output. Raw materialsprimarily.
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Costs
Total Cost -the sum of all costsincurred in production
TC = FC + VC
Average Costthe cost per unitof output
AC = TC/Output
Marginal Costthe cost of one moreor one fewer units of production
MC= TCnTCn-1units
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Revenue
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Revenue
Total revenuethe total amountreceived from selling a given output
TR = P x Q
Average Revenuethe averageamount received from selling each unit
AR = TR / Q
Marginal revenuethe amountreceived from selling one extra unitof output
MR = TRnTR n-1units
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Profit
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Profit
Profit = TR TC
The reward for enterprise
Profits help in the process of directingresources to alternative uses in freemarkets
Relating price to costs helps a firm toassess profitability in production
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Profit
Normal Profitthe minimum amountrequired to keep a firm in its current lineof production
Abnormal or Supernormal profitprofit made over and above normalprofit Abnormal profit may exist in situations
where firms have market power
Abnormal profits may indicate the existenceof welfare losses
Could be taxed away without alteringresource allocation
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Profit
Sub-normal Profitprofit belownormal profit
Firms may not exit the market even ifsub-normal profits made if they are ableto cover variable costs
Cost of exit may be high
Sub-normal profit may be temporary (orperceived as such!)
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Profit
Assumption that firms aim tomaximise profit
May not always hold true there are other objectives
Profit maximising output would bewhere MC = MR
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Profit
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Why?Cost/Revenue
Output
MR
MRthe additionto total revenue as
a result ofproducing one
more unit ofoutput the price
received fromselling that extra
unit.
MC MC The cost ofproducing ONEextra unit ofproduction
100
20
150
Totaladded
toprofit
If the firm decides toproduce one more unit the 101stthe additionto total cost is now 18,
the addition to total
revenue is 140 the firmwill add 128 to profit. it is worth expanding
output.
101
18
140
Added tototalprofit
30
120
Addedto totalprofit
The process continuesfor each successive
unit produced.Provided the MC isless than the MR it
will be worthexpanding output as
the differencebetween the two is
ADDED to total profit
102
40
145
104103
Reducestotal
profit bythis
amount
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Factors Giving Rise toIncreasing Returns
Specializationand division of labor
Volume capacity increases fasterthan area dimensions (arithmeticrelationship)
Available of techniquesthat areunique to large-scale operation.
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Factors Giving Rise toDecreasing Returns
Inefficiency of managing largeoperations:
Coordination and control become difficult
Loss or distortion of information
Complexity of communication channels
More time is required to make and
implement decisions.
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