Chapter 5 Industerial Mangement

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1Copyright 2014, Prof. TagelsirMohamed


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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)

Copyright 2014, Prof. TagelsirMohamed9


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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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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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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


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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Chapter 5 Industerial Mangement