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Unformatted text preview: Chapter 8 Production and Supply The basic ideas of production are the same in all their essentials as those involving demand. The chain of reasoning is almost exactly the same - we specify some basic (mathematical) ideas that we think ought to characterize how production occurs, and then we add in some financial information - that is, information characterizing the costs and benefits of certain actions to a firm. We then add in an objective, which is usually profit maximization. We then investigate firms optimal production decisions, and out of these construct a theory of market supply. Once we have the formal apparatus in place, we can then investigate how markets work, and perhaps more importantly the welfare properties of markets. That is, we can combined our theory of supply with our theory of demand, and our measures of consumer benefits deriving from market transactions (i.e., consumers surplus), to see how well market outcomes serve the overall interests of society. But we are getting ahead of ourselves a bit here. Lets start talking about how we imagine production to occur, and how the basic ideas of production might be captured using mathematics. Production is the process by which inputs are turned into outputs . The firm is an entity that turns inputs into outputs via some technology. Inputs consist of anything the firm uses in the production process, like labor, machinery or capital, raw materials, and land. The firm combines these things into new products for sale in the market. We usually imagine that 181 182 CHAPTER 8. PRODUCTION AND SUPPLY the firm pays money to get inputs, and then receives money by selling its output in the market. While most firms generally make several different kinds of output from their inputs, we shall primarily focus on the case in which the firm man- ufactures a single good. Most of the ideas we discuss can be extended to multiple outputs without too much difficulty, and I shall elaborate on this a bit more in a subsequent section. The primary tool for specifying how production occurs is the production function . This is a function that tells us how much output we get from a given set of inputs. If our output is called x , and we have various inputs y 1 ,y 2 ,y 3 ,...y N , we write it something as follows: x = f ( y 1 ,y 2 ,y 3 ,...,y N ) We shall usually restrict attention to two inputs, as most of the main ideas can be fleshed out in this framework without too much difficulty. Our usual inputs will be labor, L , and capital, K . Our generic production function becomes: x = f ( L,K ) (8.1) As we did with utility functions, we shall add in some very basic assumptions we think characterize how production works. This will amount to assuming something about the shape of the production function (8.1). When talking about the economics of production, it is important to keep track of stock variables - those variables that are not measured per unit of time, and flow variables - those variables that make sense only if thought about as occurring...
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- Fall '09