How the price of a firms output is determined is a topic in

When economists are asked to explain the creation and destruction of jobs in an economy, they will typically begin with a diagram of supply and demand in the labor market. In the labor market, the real wage (on the vertical axis) and the total number of hours worked (on the horizontal axis) are determined by the interaction of labor supply and labor demand. As shown in , equilibrium in the labor market occurs at the wage and employment level such that the number of hours supplied and demanded is equal.

Thus an increase in wages will induce job destruction, and a decrease in wages will induce job creation.

The Production Function

A firm possesses a means of turning inputs into outputs. For example, Starbucks produces, among other things, grande vanilla low-fat decaf lattes. This drink is an example of a Starbucks output. The list of inputs that Starbucks needs to produce this product is much too long to write out in full but includes the following:

• Water, coffee beans, milk, vanilla syrup, paper cups, lids, and electricity
• An espresso machine
• The time of the barista—the person making the drink
• Starbucks’ “blueprints” (that is, the instructions for how to make a grande vanilla low-fat decaf latte)

This list doesn’t include any of the “back office” aspects of Starbucks’ operations, such as accounting, payroll, or the logistics of sourcing coffee beans and delivering them to individual stores. Other firms, of course, would have a very different list of inputs. So if we want to talk in abstract terms about the production of a firm, we need a description of production that could apply not only to Starbucks but also to General Motors, IKEA, your local computer repair store, and a manufacturer of paper clips. Therefore, we group inputs into broad categories called factors of productionThe inputs used in a firm’s production process, primarily physical capital, labor hours, raw materials, and technology..

Toolkit:

Economists group the inputs of any firm into a small number of general categories: raw materials, capital, and labor. We call these inputs a firm’s factors of production.

You can think of raw materials as the things that are transformed in the production process. In our Starbucks example, these include milk, coffee beans, and electricity. Labor refers to the time of the employees who work at a firm, so the time put in by a Starbucks’ barista counts as labor. Capital refers to goods that are used to help with production but are not used up in the process. The espresso machine is one of Starbucks’ capital goods; others are the tables and chairs in the café.

Starbucks’ technologyA means of producing output from inputs.—which we also think of as a factor of production—is the knowledge that allows it to take all these inputs and turn them into an output—the final product that people actually want to buy. It is this knowledge that ultimately lies behind Starbucks’ existence as a firm. Included in the technology are the managerial skills that allow Starbucks to operate effectively.

Figure 8.5 The Technology of a Firm

The production function combines a firm’s physical capital stock, labor, raw materials, and technology to produce output. Technology is the knowledge (the blueprints) that a firm possesses, together with managerial skills.

We represent the production process of a firm schematically in . Our description is quite general and can apply to nearly any kind of firm—for example, a lawyer’s office, Walmart, a university, and a child’s lemonade stand. Most people find it easiest to visualize a production function in terms of physical manufacturing, such as a production line for automobiles. Think of a firm’s capital as factory buildings and machinery; its labor as the workers on the production line; and its raw materials as the steel, plastic, and glass that it purchases.

A Production Function That Uses Only Labor

We summarize the technological possibilities of a firm using a production functionA description of how much output a firm can produce as it varies its inputs., which is a description of how much output a firm can produce as it varies its inputs. Even though a typical firm’s production function contains many different inputs, we can understand most of the key features of the production function using an example where labor is the only factor of production. Although there are few goods or services that literally require no inputs other than labor, there are many services that are highly labor intensive, such as babysitting, housecleaning, and personal training at a gym.

To be concrete, think about housecleaning and suppose it has the following production function:

where we think of productivity as just some number. If output measures clean houses, and if it takes 5 hours of labor to produce one clean house, then productivity is 0.2, and the production function is

The production function tells us the level of output of a firm for given levels of labor input. Labor input is the total hours of labor time used by a firm. At this point, we are not distinguishing between hours worked per person and the number of people working, so a firm with 8 employees each working 20 hours per week has the same weekly labor input as a firm with 4 employees each working 40 hours per week. lists the amount of output that a housecleaning firm can obtain from various levels of input. We call this a linear production function because its graph is a straight line, as shown in .

Table 8.1 Production Function for Housecleaning

Figure 8.6 A Linear Production Function

A production function shows the maximum amount of output produced, given a level of labor input.

The marginal product of laborThe amount of extra output produced from one extra hour of labor input. is the amount of extra output produced from one extra hour of labor input and is defined as

When the production function is linear, the marginal product of labor is constant. It is equal to the number we labeled productivity in our original production function.

In most cases, the marginal product of labor is not constant. To understand why, imagine you are managing a Starbucks outlet. You already have the machines to produce espresso, and you have lots of coffee beans on hand. You also have 500 square feet of space for making coffee and charging customers. But you still need labor. If you have no barista to operate the espresso machine, then you will have no output. If you hire one worker, you will be able to serve coffee to people. Adding the first worker will increase output considerably. However, that person must not only make the coffee but also clear the tables and handle the cash register. Adding a second worker to help with the register and clear tables will increase output even more. Now suppose you keep increasing the number of workers in the 500 square feet of space. After the third or fourth worker, they will start to bump into each other, and the barista will start to be very annoyed and unproductive. In other words, because one of your inputs—the amount of available space—is fixed, each additional worker contributes less and less to output. We call this the diminishing marginal product of laborThe idea that each additional hour of labor input contributes a smaller and smaller amount to output..

is an example of a production function with a diminishing marginal product of labor. In creating this table, the labor input is changed while holding all other inputs (the size of the café, the number of espresso machines, etc.) fixed.

Table 8.2 Production Function for Coffee with a Diminishing Marginal Product of Labor

The marginal product of labor is shown in the third column. For the first few entries, you can calculate it directly from the table because you can easily determine how much output changes from one row to the next. For example, the marginal product of the third hour of labor is 17.3 – 14.1 = 3.2. Finding the marginal product of, say, the 40th unit of labor from the table is trickier because the table doesn’t tell us how much we can produce with 39 hours of labor. Looking back at the formula for the marginal product of labor, however, we can calculate it:

We illustrate this production function in . Notice that while the slope of the production function is always positive, the slope decreases as the labor input increases.

Figure 8.7 A Production Function with a Diminishing Marginal Product of Labor

This production function exhibits diminishing marginal product of labor: as more labor is added to a firm, output increases at a decreasing rate.

Toolkit:

The production function is a description of how much output a firm can produce as it varies its inputs. Typically, we suppose that the production function exhibits the following:

• Positive marginal product of labor
• Diminishing marginal product of labor

The first property means that adding more labor into production means more output—that is, the slope of the production function is positive. The second property explains how the marginal product of labor varies as labor input increases. Though the marginal product of labor is always positive, it will generally decrease as more labor is added to a production process. That is why the second property is called diminishing marginal product of labor. (It is technically possible that the marginal product of labor could even become negative. But because a firm would never pay for workers when they decrease output, we never expect to see a firm operating with a negative marginal product of labor.)

Which of the following topics is most likely to be appropriately studied in a microeconomics course?

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Which of the following is an example of a macroeconomic issue?

What can be defined as the benefit that you might have gained from choosing the next best alternative?