Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factors of Production

The three factors of production are:

1. Land (including all natural resources)

2. Labor (manual, managerial, entrepreneurial)

3. Capital goods (machines, equipment, buildings)

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factor Prices

Prices of factors of production are: Wages (payment for labor, including salaries

and commissions) Rent (payment for the use of land) Interest (payment for the use of capital goods) Profits (payment for entrepreneurship)

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production Functions

A production function is a relationship between inputs (factors of production) and outputs (production).

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production Functions

In the table on the next slide, we look at a simple production function.

We vary the number of workers, or labor (variable input), and keep the units of machinery constant (fixed input).

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

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Labor Units of Machinery

Production

0 2 0

1 2 3

2 2 7

3 2 15

4 2 19

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production Functions

Marginal production is the additional production per worker. Adding this in the table, we get (see next slide):

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Labor Units of Machinery

Production Marginal Production

0 2 0 -

1 2 3 3

2 2 7 4

3 2 15 8

4 2 19 4

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production Functions

In the table on the previous slide, marginal production decreases after the 3rd worker.

Adding a variable input to a fixed input eventually results in decreasing marginal production.

This is the law of diminishing marginal production.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production Functions

The next slide shows a production function in which the number of workers increases by more than 1.

Note that marginal production is the change in total production divided by the change in the number of workers, or: Q / L

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Labor Units of Machinery

Production Marginal Production

0 6 0 -

5 6 10 2

10 6 30 4

15 6 70 8

20 6 100 6

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production Functions

Average production is the production per worker, or total production divided by the number of workers.

Question:In the previous table, what is average production when the number of workers is 10?

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production Functions

Answer:Total production = 30, so average production = 30 / 10 = 3

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Short Run versus Long Run

The short run is the period of time during which a firm is unable to change all of its factors of production (it has at least one fixed input).

The long run is the period of time during which a firm can change all of its factors of production.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production and Costs

A firm’s production and costs are directly related. Let’s say that a firm employs 10 workers, and 2 units of machinery, and produces 30 products per week.

Each worker costs $500 per week. Each machine costs $800.

What are the firm’s total and average costs?

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production and Costs

The cost of labor is 10 x $500 = $5,000.

The cost of the machinery is 2 x $800 = $1,600.

Total cost is $5,000 + $1,600 = $6,600.

Average cost (cost per product) is $6,600 / 30 = $220.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Production and Costs

See Unit 4, Section 3 for additional examples of the relationship between production and costs.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Nominal and Real Factor Prices

Nominal prices are the actual values charged by the factor supplier.

Real prices are adjusted for inflation.

For example, if a bank charges 10% interest on a loan, and inflation is 6%, then the real interest rate on the loan is 10% minus 6%, or 4%.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factor Prices

In a free market, factor prices are determined by the demand for and the supply of the factor of production.

For example, interest rates are determined by the demand for and the supply of loans.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Interest Rates

In the next diagram, the equilibrium interest rate is 8%.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Interest Rates

If the demand for loans increases, then the interest rate increases:

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Interest Rates and Present Value

Because of interest, the value of money increases over time. $1,000 today is not the same as $1,000 one year from today.

The present value of a future sum of money is:

PV = F / (1 + i)

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Interest Rates and Present Value

Example 1Someone promises to pay you $1,000 one year from today. How much is it worth to you today? Assume that the interest rate is 6%.

Answer:PV = F / (1 + i) PV = $1,000 / (1 + .06) = $1,000 / 1.06 = $943.40

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n1

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Interest Rates and Present Value

Example 2Someone promises to pay you $5,000 five years from today. How much is it worth to you today? Assume that the market interest rate is 8%.

Answer:PV = F / (1 + i) PV = $5,000 / (1 + .08) = $5,000 / 1.47 = $3401.36

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n5

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Interest Rates and Present Value

Example 3Let’s say that a house appreciated in value by 4% each year over the past 80 years. If the house is worth $500,000 now, what was the value 80 years ago?

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Interest Rates and Present Value

Example 3 answer:

PV = FV / (1 + i)

PV 80 years ago = FV (now) / (1 + .04) .PV = $500,000 / 23.05 = $21,692.

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80

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factor Prices

Another factor price is the wage rate.

The equilibrium wage is determined by the demand for and the supply of labor.

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Price of Labor

Quantity of Labor

Demand for Labor

Supply of Labor

$7.00

1,000

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factor Prices

Some factor prices are determined by the government, not by demand and supply.

For example, in the next slide, the market wage is $7, but a minimum wage of $9 is set by the government.

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Price of Labor

Quantity of Labor

Demand for Labor

Supply of Labor

$7.00

1,000

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

$9.00

Unemployment

Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior Factor Prices

Advantages of a minimum wage set above the free market wage are: More income for the minimum wage earners

that are able to maintain their job. More incentive for people to work. Possibly greater job satisfaction and lower job

turnover.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior Factor Prices

Disadvantages of a minimum wage set above the market wage:

Decrease in the quantity demanded for labor. Higher production costs and lower profits. Higher prices. Less money for benefits and training. Decrease in exports due to higher prices.

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior Factor Prices

Government-set prices that are different from the market price may have social benefits for some groups, but lead to economic inefficiencies (surpluses, shortages, higher prices, unemployment).

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factor Prices

A minimum wage raises the nominal wage, but not the real wage.

Question: How can we achieve higher real wages without government intervention?

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factor Prices

Answer:

By raising productivity.

Question:What raises productivity?

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factor Prices

Answer:An economic system that rewards hard work and innovation.

Question:What kind of economic system rewards work and innovation?

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Unit 4 - Business Production Unit 4 - Business Production BehaviorBehavior

Factor Prices

Answer:An economic system in which a government provides essential services (infrastructure, a legal system, defense, and protection of private property), and that has relatively low taxes and limited regulations. This encourages production and innovation.

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