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Ch.6 Notes - Intermediate Microeconomics Professor Yongmin...

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Intermediate Microeconomics Professor Yongmin Chen Topic 5 : Inputs and Production Functions Firm Owners and Managers: A Principle-agent Problem A firm is usually assumed to maximize profit. This is what we would expect if the firm is run by its owners. Most modern corporations, however, are run by managers who are not owners of the firm. Of course, there is no reason why the managers would have the same objectives as the owners. Much of the economic research in the last twenty years or so is concerned with how to solve this type of principle-agent problem. There are two basic mechanisms: the internal mechanism and the external mechanism. Internal mechanism: through compensation scheme and through the monitoring by the board of directors. External mechanism: the market for corporate control. Discussion: the forms and effectiveness of these mechanisms. Production Function Just as a consumer faces the budget constraint in consumption, a firm faces the constraint of technology in production. Given a technology, there will be a set of feasible combinations of inputs and outputs. Fixed inputs and variable inputs. Suppose the production process requires only one variable input, say labor (L), and the output is denoted by X. When L=0, X=0. When L increases, the maximum X that can be produced also increases. See a graphic explanation in class. The technologically feasible set of all input and output combinations is called a production set. For any level of input, there is a maximum level of output that can be produced under the existing technology. These maximum levels of output constitute the boundary of the production set, which can be denoted by X = X(L) and is called a production function. Thus a production function specifies the maximum levels of outputs as a function of inputs.
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Example 5-1: X = L 1/2 The production function passes through the origin. The shape of the production function is determined by technology. For a given technology, a production function is obtained.
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