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# 178.307 Markets, Firms and Consumers Lecture 6- Production Theory.

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178.307 Markets, Firms and Consumers Lecture 6- Production Theory

Neoclassical Model Overview – Firm is posited as a profit maximiser. – Production is outcome of combining inputs with a production technology. – This can be represented as a production function. Many technologies share certain general properties. These properties are useful for theoretical inference. – Closed – Convex – Free disposal

Aside on Lagrangeans Lagrangeans are a way of solving constrained optimisation problems. It consists of two parts – An objective function (to maximise or minimise) – A constraint function – These are combined to make the Lagrangean.

Example http://www.massey.ac.nz/~bjmoyle/mu/Fun_ with_Lagrangeans_files/frame.htm http://www.massey.ac.nz/~bjmoyle/mu/Fun_ with_Lagrangeans_files/frame.htm

Production Functions Cobb-Douglas Q=aL α K 1- α In empirical work this has form – lnQ=lna + αlnL + (1- α)lnK The function is continuous (isoquants smooth) Leontief Fixed ratio technology Q=a 1 L + a 2 K – Used in linear programming models – Used in input-output models

The Cobb-Douglas Function Note we are minimising expenditures in this Lagrangean. We then solve for the Capital-Labour ratio

Capital-Labour Ratio This implies that the capital-labour ratio is independent of the level of output. It means the ratio is a function of the input-prices only.

Factor Demand

Neoclassical Model considered The model is very techonology based. We can infer that they may be – Increasing returns to scale – Decreasing returns to scale – Constant returns to scale But technology transfers aren’t easy. US response to Japanese car-competition – Invest heavily in ‘technology based’ production – Copy some production techniques (JIT). – Results surprising Japanese managed plants out-performed others. Eg. Toyota ran GM Freemont plant

Experience Output may depend on how much experience workers have with their equipment. They acquire ‘tacit knowledge’ about production. This can also be modelled as learning curves. – Costs are partly related to experience. – Based on studies during WW2 of assembly lines.

The Ariel Four Square 1955

Corporate Culture and Productivity Demise of the British motorcylce industry – Retreated upmarket to avoid Japanese competition. – Believed hand-made product could not be matched. – Scope to improve not recognised or searched for. Corporate Culture – Share beliefs and assumptions about how the firm operates. – Has advantages Save time at meetings Communictaion breakdowns avoided – Disadvantages Act as “blinkers” New ideas incomprehensible.

Firm as a coalition Despite corporate culture, firm may be a coalition of different subgroups. These groups have their own subgoals. – Clashes avoided by organisation. Payments to members of a coalition are a result of bargaining. Coalitions stable because – Avoid turbulent environments – Insulate their subgroup from attack – Take up organisational slack.

Organisational slack Individuals have private knowledge about scope for productivity gains. While coalition meets aspirations of individual, knowledge is not used. ‘slack squeezes out profit’- Selten When going gets ‘tough’ (aspirations not met, firm’s output or input) burdens get redistributed. This is to keep members participating. Note- organisational slack does not exist in the simple neoclassical firm.

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