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Production Theory - Chapter 7 Production Theory Production...

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Chapter 7: Production Theory Production Theory attempts to provide a framework for studying the production of goods and services within a firm. It is the first theory that will be studied within the more encompassing Theory of the Firm. Additionally, Production Theory shares a close relationship with both Cost Minimization Theory and Profit Maximization Theory, which will be presented in later chapters. One additional note to make about Production Theory is that it must be studied in both the long run and the short run. The Production Function Much like the Laws of Supply and Demand, Production Theory has its own function. It is known as the Production Function . The Production Function is simply a mathematical equation which links the inputs of production into the eventual output (Q). Following is an example of a production function where the inputs are capital (K), labor (L), raw materials (RM), and technology (T): Figure 7.1: Complex Production Function = , , Q fK L RMT This type of production function is known as a complex production function . Any production function with three or more inputs is considered complex. Conversely, any production function with two or less inputs is considered a simple production function . Complex production functions require three or more dimensions to represent graphically, so we’re going to stick with analyzing a simple production function: Figure 7.2: Simple Production Function = , , Q fK LRM T Short Run vs. Long Run The production process in any firm can occur in either the short run or the long run. The short run is simply the period of time when production occurs with at least one fixed input . A fixed input refers to any input that remains constant, while the others may be either fixed or variable. In our analysis, capital (K) will be the fixed input while labor (L)
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will be the variable input . A variable input may change at any time in the production process. Production in the long run occurs with all variable inputs. Hence, the long run production process has no fixed (constant) inputs. In our case, both capital (K) and labor (L) will be variable. Production in the Short Run We will begin by analyzing production in the short term. The first important fact to note is that all production processes within the short run are subject to the Law of Diminishing Returns. The Law of Diminishing Returns states that when a variable input (labor) is added to a fixed input (capital), initially output (Q) will increase at an increasing rate, then output will increase at a decreasing rate, and eventually output will decrease. As an example, consider a car factory with a set amount of machinery, which will act as the fixed input (capital). If more and more workers are added (labor), they will eventually overcrowd and there won’t be enough machinery for production or room for them to walk.
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