Author: John Bouman

What’s in This Chapter? This unit describes typical production behavior of businesses, and explains the difference between short-run and long-run production behavior. Businesses use a variety of resources to produce their products, including fixed and variable inputs. Some businesses use primarily variable resources, and others rely on a large amount of fixed resources. When we know something about a firm’s production behavior, we can derive its cost functions. The relationship between production data and costs is discussed. This provides the foundation for a detailed description of cost functions in the next unit (Unit 5). The last two sections of this unit discuss factor prices, the determination of wage and interest rates, and the concept of present value....

Factors of Production The three types of factors of production (inputs) are: 1. Land. Land includes land and other natural, non-man-made materials, such as raw materials, energy sources, and trees. The payment for the use of land is called “rent” in economics. 2. Labor. Labor includes all forms of human productive effort, from blue collar (manual labor) to white collar (office and management work) to  entrepreneurial activities (organizing resources, coming up with ideas, taking risks) to professional athletes and celebrities. Rewards for non-entrepreneurial labor are called wages, salaries, bonuses, or commissions. In this and future units, we will refer to all of these payments as “wages.” We will refer to payments for entrepreneurial activities as “profits.” 3. Capital Goods. Capital goods represent the man-made machines, equipment, buildings, and other tools used to produce products. When we use the term “capital” by itself, we refer to money used to finance the purchase of capital goods. When businesses borrow money to purchase capital goods, they pay “interest” to the lenders. Factor Prices Factor prices are the payments for land, labor, and capital goods. They include 1. Wages. Wages are the payments and rewards for (the price of) non-entrepreneurial labor. 2. Rent. Rent is the payment and reward for the use of land. 3. Interest. Interest is the payment and reward for capital (money) used to purchase capital goods. 4. Profits. Profits...

Production Functions A production function is a relationship between inputs (factors of production) and outputs (products). It illustrates how many workers and machines it might take to produce, for example, 1 bushel of wheat, 2 bushels of wheat, or 1,000 bushels of wheat. Short Run versus Long Run The short run is a time period during which a business cannot vary one or more factors of production. In other words, at least one input is fixed. The long run is a time period during which the firm has the flexibility to change all inputs. It can buy more or bigger machines, hire more workers, and expand the building. The length of the short and long runs varies for each company. For example, if a steel plant cannot vary the size of its factory and the number of its machines for a period of three years, then the short run for this company is a period shorter than three years, and the long run is a period longer than 3 years. On the other hand, if an Internet-based company can vary all of its factors of production, including the space in which it operates, the number of computers, and the number of workers, within three weeks, then the short run for this Internet-based company is a period shorter than three weeks, and the long run is a period longer than...

Total, Average, and Marginal Cost Calculations Once we know a firm’s production behavior, and we know what each factor of production costs, we can derive the firm’s total, average, and marginal costs. Below we have copied the firm’s production behavior from the first table in the previous section (Section 2). Number of Workers Amount of Land in Acres Number of Machines Total Production of Cars Average Production of Labor Marginal Production of Labor 0 2 5 0 – – 1 2 5 3 3 3 2 2 5 7 3.50 4 3 2 5 15 5 8 4 2 5 19 4.75 4 5 2 5 22 4.40 3 6 2 5 23 3.83 1 Let’s assume that the three factors of production used to produce the products in the table are workers, land, and machines. The cost of these factors of production are as follows: 1. Each worker costs the firm $4,000 per month. 2. Each acre of land costs the firm $1,000 per month. 3. Each machine costs the firm $600 per month. The table below illustrates the total cost at each number of workers. Number of Workers Total Worker Cost Amount of Land in Acres Total Land Cost Number of Machines Total Machine Cost Total Cost of All Factors in Dollars Total Production of Cars Average Cost Per Car in Dollars Marginal Cost Per Car in Dollars...

Examples of Government Price Controls In most countries around the world when it comes to factor prices, there is a significant degree of government interference. In the labor market, the establishment of a minimum wage usually means that the wages of certain workers are higher than the free market wage. In some markets, there also may be a cap (a maximum) on wages. For example, in the sports world, some teams are subject to salary caps (these are usually imposed by the league and not by the government). In some countries there is a cap on the amount of interest banks can charge, and in some Muslim countries businesses are not allowed to charge interest at all. In most economies, interest rates are allowed to fluctuate based on supply and demand. However, countries’ central banks control most of the money supply and therefore heavily influence interest rates. Another example of government factor price setting is rent control. Many large cities around the world require landlords in certain areas to charge rent that is below the free market rent. Price Interference in the Labor Market: the Minimum Wage Politicians in industrialized countries often establish a minimum wage in most industries (some industries, for example, restaurant servers, are excluded, because they rely mostly on gratuities). The purpose of a minimum wage is to guarantee any worker a minimum level of income,...