CHAPTER 6

PRODUCTION AND BUSINESS ORGANIZATION

I. CHAPTER OVERVIEW

This chapter begins a discussion of the concepts economists use to investigate the purpose of forming any
business: production and subsequent supply of goods and/or services to consumers. Remember the supply
curve that you generated back in Chapter 3 of this Study Guide. It defined a relationship between the price of a
product and the quantity of that same product that producers are willing and able to produce in a given time
period. You will add to the definition of this relationship by exploring first the fundamental relationships that
describe a production process, and second the most common organizational structures of firms in the U.S.
economy. You will be answering two basic questions: What characteristics are common to most production
processes? How are firms defined and organized?

II. LEARNING OBJECTIVES

After you have read Chapter 6 in your text and completed the exercises in this Study Guide chapter, you should
be able to:
1. Define a production function and relate it to the notions of (a) total product, (b) marginal product, and
(c) average product.
2. Explain the law of diminishing marginal returns. Define constant, increasing and decreasing
returns to scale, and relate each to the law of diminishing marginal returns.
3. Compare and contrast the measures of total productivity and the productivity of a particular input.
Relate both to technological change and the law of diminishing marginal returns.
4. Distinguish between the short run and the long run in the context of production.
5. State and explain the stylized facts that describe the growth of the aggregate U.S. economy since the
turn of the century. Describe why it can be said that the experience of the United States over the past two
decades has not been as profitable as its experience over the century taken as a whole.
6. Explain the differences between the three major forms of business organization: proprietorship,
partnership, and corporation.
7. Describe three reasons why firms exist in a modern economy.
8. Define the term unlimited liability as it applies to business organization, and explain the propensity of
large businesses to be incorporated.
9. List the advantages and/or disadvantages of each of the three business forms.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.
A B
__ Production 1. Holds that we will get less and less extra output when we add additional units
function of an input, all other inputs held fixed.
__ Total product 2. Occurs when a balanced increase in all inputs leads to a less-than-proportional
increase in total product.
__ Average product 3. A period of time in which firms can adjust production by changing variable
factors but not fixed factors such as capital.
__ Marginal 4. Tells you how much output you will get from a given amount of inputs.
product
__ Law of diminishing 5. Occurs when new engineering knowledge improves production techniques for
marginal existing products.
__ Constant returns 6. The extra product or output added by 1 extra unit of input while other inputs are
to scale held constant.
__ Increasing 7. Arise when an increase in all inputs leads to a more-than-proportional increase
returns to scale in the level of output.
__ Decreasing 8. Different people are linked together through a particular medium.
returns to scale
__ Short run 9. Occurs when new or improved products are introduced in the marketplace.
__ Long run 10. Designates the total amount of output produced, in physical units.
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__ Network 11. Denotes a case where doubling the use of all inputs leads to a doubling of
output.
__ Fixed cost 12. A period sufficiently long so that all factors, including capital, can be adjusted.
__ Adoption 13. Measures the ratio of total.
externality
__ Process 14. Measures total output divided by total units of an input.
innovation.
__ Product 15. Consumers derive benefits from a number of other consumers who adopt the
innovation good.
__ Productivity 16. Cost associated with an input that is fixed in the short run.

IV. SUMMARY AND CHAPTER OUTLINE

Chapter 6 is divided into two related parts. Section A describes the theory of production; this will provide a
basis for your understanding of production costs, as well as firm output decisions. Section B discusses business
organization in the United States, helping to explain how and why firms do business.

A. Theory of Production and Marginal Products

1. A production function describes a relationship between total product or output of a firm and the
employment of inputs.
2. The average product of an input is total output divided by the level of employment of that input. The
marginal product of an input is the rate at which total output changes as employment changes by one unit—all
other inputs held constant.
3. Marginal product declines in the short run due to the law of diminishing returns. This law states that as you
continue to add variable inputs to a fixed capital base, eventually marginal product will fall.
4. Returns to scale is a long-run concept that reflects the response of total output to proportionate changes in
all inputs. Diminishing marginal productivity (which is a short-run concept) can be consistent with increasing,
decreasing, or constant returns to scale.
5. Time period is critical in defining the sort of adjustments available to firms. In the short run, the firm has
time to manipulate the employment of some inputs (e.g., labor), but the capital stock is usually assumed to be
fixed. Use of all inputs, including the capital stocks and embodied technology, can be altered only in the long
run.
6. When technological change occurs, the production function of the firm may shift. Process innovation leads
to changes in production methods, while product innovation leads to the development of new products for the
marketplace.
7. Productivity measures the amount of output produced per unit of input; productivity growth measures the
rate of growth in the level of productivity.

B. Business Organization
1. Business establishments can be organized as individual proprietorships, as partnerships, or as corporations.
2. Businesses exist for three important reasons. First, firms exist to exploit economies of mass production,
i.e., to take advantage of specialized equipment, assembly lines, and division of labor. Second, entrepreneurs
can raise capital more effectively when businesses are carefully structured. Third, the production process is
organized more efficiently when managers direct the activities of all inputs within a firm.
3. Corporations allow owners to limit their potential liability to the amount they have invested, but this
structure usually requires owners to release the reigns of control to a management team.

V. HELPFUL HINTS

1. Make sure that you take time to carefully plot a production function, along with its related average and
marginal cost curves. Practicing this exercise will help you to understand the relationships between inputs and
output that characterize most production functions.
2. Remember that the law of diminishing returns is a short-run concept, because you are adding variable
inputs to a fixed capital base. This differs from decreasing returns to scale, which involves the changes in
output associated with increasing the use of all inputs, including capital. A change in a capital base always
involves a long-run decision.
3. The law of diminishing returns is compatible with increasing, decreasing, and constant returns to scale; this
can be difficult to understand. Returns to scale and marginal productivity refer to two distinct things: returns to
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scale reflect what happens when there is a proportional change in all inputs; marginal productivity reflects what
happens when there is a one-unit change in only one input (all the others are held fixed).
4. When referring to the products that a firm produces, economists use the terms “total product” and “output”
synonymously.

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.

A. Theory of Production and Marginal Products

1. A production function describes:
a. how input prices change as the firm changes its output level.
b. how much output you will get from a given amount of inputs.
c. the level of output that firms should optimally produce at each price level.
d. a relationship between prices and quantity demanded.
e. all the above.
2. The average product of an input is given by the following ratio:
a. change in total product/total product.
b. change in the employment of one input/change in the employment of all inputs.
c. total employment of all inputs/total employment of one input.
d. total product/total employment of one input.
e. change in total product/change in the employment of one input.
The following data describe a short-run production function for ABC, Inc., which hires workers to produce
widgets. Use Table 6-1 to complete questions 3 through 7.

TABLE 6-1
Quantity of Total
Labor (Workers) Product (Daily)
0 0
10 50
20 150
30 350
40 500
50 600
60 650
70 650
80 640
90 620

3. The marginal product of the first 10 workers is:

a. 0.
b. 5.
c. 10.
d. 50.
e. 500.
4. When ABC, Inc. changes its utilization of labor from 40 to 50 workers, the marginal product is:
a. 0.
b. 5.
c. 10.
d. 50.
e. 500.
5. The average product of 50 workers is:
a. 12.
b. 50.
c. 100.
d. 600.
e. cannot be determined without more information.
6. Diminishing returns set in sometime between:
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a. 10 and 20 workers.
b. 20 and 30 workers.
c. 30 and 40 workers.
d. 40 and 50 workers.
e. 70 and 80 workers.
7. From this production function, you can see that over this range of production ABC, Inc., experiences:
a. increasing returns to scale.
b. decreasing returns to scale.
c. constant returns to scale.
d. diminishing marginal utility.
e. none of the above can be determined from this data.
8. The law of diminishing returns holds that:
a. the total product of any input must eventually reach a maximum and fall as the employment of that
input increases.
b. the average product of any input must eventually reach a minimum and rise as the employment of all
inputs increases proportionately.
c. the marginal product of any input should eventually begin to decline as the employment of that input
increases.
d. the marginal product of any input should eventually begin to fall as the employment of all inputs
increases proportionately
e. the average product of any input should rise before it falls as the employment of that input increases.
9. If a production process displays diminishing returns for all inputs, then:
a. it cannot display constant returns to scale.
b. it must display decreasing returns to scale.
c. it cannot display increasing returns to scale.
d. all the above are true.
e. none of the above is true.
10. If the marginal product of an input is positive, but decreasing as more and more of the input is employed,
then:
a. total product has reached a maximum and is declining.
b. total product is increasing but at a slower and slower rate.
c. average product must be declining.
d. the firm should produce less output.
e. the firm must be operating in the long run.

Figure 6-1

11. If the average product of some input is observed to be higher than its marginal product, then the:
a. marginal product must be increasing with the employment of that input.
b. marginal product must be moving toward the average product.
c. average product must be increasing with the employment of that input.
d. average product must be falling with the employment of that input.
e. total product must be falling with the employment of that input.
12. Which of the following adjustments to economic circumstance might a firm be able to accomplish in the
long run?
a. Adoption of a new computer-based production technology that replaces 50 percent of the labor
working the assembly lines.
b. Increased capacity utilization accomplished by hiring a third shift of workers.
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c. Reduction of the work force by 30 percent in the face of stiff foreign competition.
d. Adoption of cost-cutting measures throughout middle management.
e. All the above are possible in the long run.
13. As a matter of historical record, it is widely agreed that:
a. total productivity in the United States has risen, on average, by nearly 0.5 percent per year since the
turn of the twentieth century.
b. labor productivity has increased in the United States faster than total productivity over the past nine
decades, even though the ratio of capital stock to labor force has remained remarkably constant.
c. the rate of growth of total productivity in the United States over the past 20 years has averaged almost
1 percentage point less than the average over the past 90 years.
d. the rate of return on capital has increased dramatically in the United States since the turn of the
twentieth century due in part to technological innovation.
e. none of the above statements is true.
14. A total product curve has been drawn on a piece of graph paper. If a second curve is drawn to reflect
technological progress which makes labor more productive, then this second curve will appear everywhere:
a. below the original curve and be flatter.
b. above the original curve and be flatter.
c. below the original curve and be steeper.
d. above the original curve and be steeper.
e. above the original curve until diminishing returns set in.
15. Consider the production functions shown in Figure 6-1. Which function displays diminishing marginal
returns to capital?
a. (a)
b. (b)
c. (c)
d. (d)
e. all these functions display diminishing returns.
16. A network occurs when:
a. economies of scale occur in production.
b. different people are linked together through a particular medium.
c. the law of diminishing returns sets in for a production process.
d. firms find an advantage in investing in product innovations.
e. production costs fall as output increases.
17. When I decide to use e-mail to correspond with my business associates, I help to create:
a. economies of scale.
b. diseconomies of scale.
c. diminishing returns.
d. an adoption externality.
e. none of the above.
18. Important features of networks include:
a. they are “tippy”.
b. history matters.
c. the winner often takes all.
d. all of the above.
e. none of the above.
19. The law of diminishing returns is expressed in terms of an eventual decline in the:
a. the total product of an input.
b. average product of an input.
c. marginal product of an input.
d. returns to scale of an input.

B. Business Organization
20. There are important reasons why production in most economies is organized within the firm. These
reasons include the ability to:
a. take advantage of mass production.
b. raise revenues.
c. hire management to organize production more efficiently.
d. all of the above.
e. none of the above.
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21. The term “limited liability” is frequently used in enumerating the characteristics of a corporation. It means
that:
a. any officer of the corporation is strictly limited in his or her ability to speak for the corporation and
commit it to any liability.
b. once shareholders have paid for their stock, they have no further financial obligation, regardless of
how much trouble the corporation gets into.
c. the corporation’s liability to pay dividends to its stockholders is a limited one, since it need pay them
only if it has earned a profit.
d. there are certain obligations which a corporation can legally refuse to pay.
e. the corporation has only a limited obligation to meet claims made by any single person or firm against
it.
22. Five people own equal shares in a partnership. Unlimited liability holds that each of those five people is
responsible for:
a. 20 percent of the partnership’s debts, up to the amount he or she has invested in the business.
b. 20 percent of the partnership’s debts, no matter how large the amount.
c. 100 percent of the partnership’s debts, no matter how large the amount.
d. a percentage of the partnership’s debts, determined by the initial ownership share.
e. none of the partnership’s debts.
23. Today’s most common ownership and control arrangement for large American corporations is best
described by which of the following statements?
a. The professional managers are also the group owning a majority or near-majority of stock, so they can
make all major decisions without real consideration of the wishes of minority stockholders.
b. The professional managers make all the major decisions, and the board of directors does not usually
intervene unless it is losing confidence in those managers.
c. The professional managers control the company on all matters of importance, except they do not make
basic decisions on such matters as production, new plants, and new products, these being left to the board
of directors as stockholder representatives.
d. The board of directors makes the decisions on all matters of real importance; the role of the
professional managers is confined to routine matters.
e. The stockholders rather than the board of directors make major decisions through voting-power control
exercised at stockholder meetings.

Figure 6-2
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TABLE 6-3

VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in this chapter.

A. Theory of Production and Marginal Products

1. Consider a production function that relates the quantity of some good produced (X) with the quantities of
capital (K), labor (L), and material (M) employed. Indicate in the blanks provided in Table 6-2 whether each
stated formula applies to the total product, the marginal product, or the average product of capital, labor, or
material. Use MPK, for example, to indicate the marginal product of capital; APL the average product of labor;
etc. If the stated definition applies to none of the possible combinations, write “N/A” (for “not applicable”).

TABLE 6-2
Formula Terms Describing Formulas
Change in K/change in X = _______
Change in X/quantity of L = _______
Quantity of X /quantity of K = _______
Change in X /change in L = _______
Quantity of X = _______
Quantity of K /quantity of M = _______
Change in X /change in K = _______
Quantity of K /quantity of X = _______

2. Table 6-3 provides the data for a production function that relates the employment of capital (K) and labor
(L) to maximum output levels of some good Y.
a. Fill in the blanks for the marginal and amperage products of labor given capital employment of 4 units
and 8 units.
b. Graph the total product curves for both levels of capital employment in the left panel of Figure 6-2.
(Use different-colored pencils or pens to differentiate the two cases.) Graph the marginal and average product
curves for both cases in the right panel of Figure 6-2. (Use the same colors.)
3. Refer again to the data from problem 2. Suppose that 3 units of labor are employed and that the capital
stock increases from 4 units to 8 units. How does labor productivity, measured in terms of output per unit of
labor, change as the capital stock increases? Carefully explain. Describe the difference between short-run and
long-run decision making in the context of this table.
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VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.

1. Assume that the law of diminishing returns always holds. Are the following statements true or false (T or
F)? Why?
___ a. If average product exceeds marginal product, then average product must be rising.
___ b. If marginal product is equal to average product, average product must be maximized.
___ c. When marginal product is maximized, total product is also maximized.
___ d. Diminishing returns set in where total product begins to fall.
2. Indicate whether you would expect the following actions to be taken by a firm in the short run (SR) or in
the long run (LR):
___ a. Adopting a new, computerized production technique that involves reworking the assembly line.
___ b. Adopting a new, computerized production technique that improves inventory control.
___ c. Having 50 percent of the employees work overtime, amounting to an extra 10 hours per week per
worker.
___ d. Reopening an existing assembly line located closer to a new and developing market.
___ e. Reworking the technology of the assembly technique to reduce material waste by 50 percent.
___ f. Increasing the work force by 10 percent to increase capacity utilization by 5 percent.
___ g. Doubling all inputs to take advantage of increasing returns to scale.
3. Which of the following empirical statements are true (T) and which are false (F) in regard to the experience
of the aggregate U.S. economy?
___ a. Total productivity has risen in the United States by an average rate of 1.5 percent per year throughout
the twentieth century.
___ b. On average, labor productivity grew faster than the 1.5 percent annual rate of growth of total
productivity throughout the twentieth century.
___ c. The return to capital has held remarkably steady in the United States since the beginning of the
twentieth century.
___ d. Since 1970, there has been a decline in the rate of growth of the real wages that support the American
standard of living.
4. Since all the statements recorded in question 3 are true, there must be an economic justification for each
that is consistent with the fundamentals of production. Match each of the following with the empirical
statement that it helps explain:
a. The rate of technological progress nearly matched the rate at which diminishing returns affected
capital. a/ b / c / d
b. Sustained technological progress accounted for sustained growth in overall productivity. a / b / c/ d
c. The capital stock of the United States grew faster than the number of hours of labor supplied
throughout most of the twentieth century. a / b / c / d
d. The rate of growth of total productivity has declined against historical trends. a / b / c / d
5. The computer industry has undergone tremendous change over the past 10 years, with IBM tumbling from
a near-monopoly position to its current place among a large number of competitors. Discuss the changes that
have gone on in this industry as process innovations and product innovations. How is each of these significant
in its own way?
6. In a New York Times article (2/16/97), economist Paul Krugman argued, “Technology, not global
competition, is the principal cause of American income inequality... The onslaught of technology puts a
premium on highly skilled people, driving up their wages but not those of the less skilled.” Using the concepts
from this chapter, explain the relationship between technology and labor productivity. Why might
improvements in technology help to create more inequality in the distribution of income?
7. Professors Samuelson and Nordhaus pose the following question in the text: “How should government
antitrust policy treat monopolists like Microsoft who have been the fortunate winners in the network race?”
Given recent landmark antitrust decisions regarding Microsoft, how have policy makers answered this
questions? Using what you know about the economic benefits and costs of networks, critique the government’s
course of action. Do you think they have done the right thing?
8. Explain three reasons why firms exist. What factors might reduce the importance of these? Explain.
9. Suppose you are organizing a new company, CompuTek. Your firm is going to produce personal
computers, competing with the likes of IBM, Compaq, Dell, etc. List the three alternative firm organizational
structures and discuss the pros and cons of these structures in this case. Which organizational structure is best
for CompuTek? Explain.
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IX. ANSWERS TO STUDY GUIDE QUESTIONS

III. Review of Key Concepts

4 Production function
10 Total product
14 Average product
6 Marginal product
1 Law of diminishing marginal returns
11 Constant returns to scale
7 Increasing returns to scale
2 Decreasing returns to scale
3 Short run
12 Long run
8 Network
15 Adoption externality
5 Process innovation
9 Product innovation
13 Productivity
16 Fixed cost

VI. Multiple Choice Questions

1. B 2. D 3. D 4. C 5. A 6. C
7. E 8. C 9. E 10. B 11. D 12. E
13. C 14. D 15. B 16. B 17. D 18. D
19. C 20. D 21. B 22. C 23. B

VII. Problem Solving

1. N/A, N/A, APK, MP1, TP, N/A, MPK, N/A
2. a.

TABLE 6-3
4 Units of Capital Employed 8 Units of Capital Employed
Labor TP MPL APL Labor TP MPL APL
0 0 - - 0 0 - -
1 22 22 22 1 22.5 22.5 22.5
2 42 20 21 2 44.0 21.5 22.0
3 60 18 20 3 64.5 20.5 21.5
4 76 16 19 4 84.0 19.5 21.0
5 90 14 18 5 102.5 18.5 20.5
6 102 12 17 6 120.0 17.5 20.0
7 112 10 16 7 136.5 16.5 19.5
8 120 8 15 8 152.0 15.5 19.0
9 126 6 14 9 166.5 14.5 18.5
10 130 4 13 10 180.0 13.5 18.0

b. See Figure 6-2.

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Figure 6-2

3. If the capital stock increases from 4 to 8 units, output per unit of labor, or the average product of labor,
increases firm 20 to 21.5. Total product increases from 60 to 64.5 units and the marginal product of the third
worker increases from 18 to 20.5. This must be a long-run decision, since there is a change in the capital base.

VIII. Discussion Questions

l. a. F. Average product must be falling when marginal product is less than average product. The average
falls only when the marginal is pulling it down.
b. T. If the marginal is greater than the average, it pulls the average up. If the marginal is less than the
average, it pushes the average down. The only place they can be equal is when the average is neither rising
nor falling.
c. F. When total product is maximized, marginal product is zero.
d. F. Diminishing returns set in where marginal product begins to fall.
2. a. LR
b. SR
c. SR
d. LR
e. LR
f. SR
g. LR
3. a. T
b. T
c. T
d. T
4. a. c
b. a
c. b
d. d
5. Process innovations include all of the changes made in the methods used to make computers. Significant
engineering methods that have improved production techniques would be included as process innovations.
Product innovations include all of the changes made in the computers themselves. New shapes and styles, new
components, and new capabilities—all of these have changed the computer market. Both process and product
innovations have made the industry more competitive. Process innovations have allowed companies to
manufacture computers more easily and cheaply. Product innovations have given consumers much more
variety in the marketplace.
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6. In order to make technology useful, workers must have enough education and training to use it in the
workplace. Technological innovations have made some workers much more productive because they
understand its importance and how to use it. Their marginal product curves slide upward. However, less
skilled workers are at an even greater disadvantage; even though their marginal product curves may be
unchanged by technological advance, in relative terms they are worse off. They become even more firmly
entrenched in the low end of the labor market, falling even further behind those who are better educated.
7. Recent decisions indicate that policy makers have decided that the benefits derived from having a common
operating system in the computer industry are outweighed by the fact that Microsoft is a near monopoly. The
government has decided that competition in the marketplace is better for consumers in this case.
8. Firms exist in order to take advantage of economies of mass production, to raise resources, and to provide
management of production tasks. As people have quicker and broader access to information, tasks that have
historically been performed in firms might be provided by individual entrepreneurs.
9. Your computer company could be organized as an individual proprietorship, as a partnership, or as a
corporation. Sole proprietorships are usually small, have limited access to resources, and require a tremendous
amount of personal effort. A partnership combines the talents of several individuals but requires the partners to
accept the risk inherent in unlimited liability. Corporations have access to lots of capital and spread risk across
large numbers of people; however, they are subject to double taxation, which limits profitability.
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