Production and Cost Review for AP Economics
Review questions for this study guide can be found at:
Main Topics: Short-Run Production Functions, Law of Diminishing Returns, Short-Run Costs, Connecting Production and Cost, Long-Run Costs, Economies of Scale
Short-Run Production Functions
How do economic resources like labor, capital, natural resources, and entrepreneurial talent become a cup of lemonade, or a ton of copper, or a 30-second television commercial? A production function is the mechanism for combining production resources, with existing technology, into finished goods and services. In other words, a production function takes inputs and creates output. In a production function that uses only labor (L) and capital (K):
Fixed and Variable Inputs
The short run is a period of time too brief to change the plant capacity. This implies that some production inputs cannot be changed in the short run. These are fixed inputs. During the short run, firms can adjust production to meet changes in demand for their output. This implies that some inputs are variable inputs. Using only labor and capital, we assume that labor can be changed in the short run, but capital (i.e., the plant capacity) is fixed.
Short-Run Production Measures
By its very nature, production lends itself to be quantified and as a result you need to study these three production measures. To keep it simple, capital is assumed to be fixed while labor can be changed to produce more or less output.
- Total Product (TPL) of Labor is the total quantity, or total output, of a good produced at each quantity of labor employed.
- Marginal Product (MPL) of Labor is the change in total product resulting from a change in the labor input. MPL = ΔTPL/ΔL. If labor is changing one unit at time, MPL = ΔTPL.
- Average Product (APL) of Labor is also a measure of average labor productivity and is total product divided by the amount of labor employed. APL = TPL/L.
As you can see, MPL and APL are both derived from TPL. It is useful to see how these three measures are related with a numerical example.
In the production period of a month, Molly's lemonade stand combines variable inputs of her labor (and the raw materials) to the fixed inputs of her table and her license to operate. Molly adds employees to her plant and forecasts the change in production (cups per day) in Table 8.2
As Molly employs more workers to the fixed plant capacity (the table on the corner), total product increases, eventually peaks, and then begins to fall. This production function can be seen in Figure 8.1
Law of Diminishing Marginal Returns
Imagine what happens to the lemonade stand as Molly adds more and more workers. At first, tasks are divided. (For example, Josh squeezes the lemons; Molly adds the sugar; Kelli stirs.) Specialization occurs. The marginal productivity of successive workers is rising in the early stage of production, but at some point, adding more workers increases the total product by a lesser amount. Maybe the fourth worker is pouring the lemonade and stocking while the fifth is taking money and making change. Beyond the fifth worker, the table is too crowded with employees, cups are spilled, product is wasted, and total production actually falls. The marginal contribution of these workers is negative. This illustrates one of the most important production concepts in the short run, the Law of Diminishing Marginal Returns, which states that as successive units of a variable resource are added to a fixed resource, beyond some point the marginal product falls.