Question

Discuss the objective of firm in production, also discuss the optimum level of inputs application in production for profit maximization to the firm and explain the three stages of return to scale in the production process.        

Answer 1

The theory of the firm provides an explanation for the market supply of goods and services. A firm is defined as any organization of individuals that purchases factors of production (labor, capital, and raw materials) in order to produce goods and services that are sold to consumers, governments, or other firms. The theory of the firm assumes that the firm's primary objective is to maximize profits. In maximizing profits, firms are subject to two constraints: the consumers' demand for their product and the costs of production.

The determination of the profit-maximizing level of input is, as the determination of the profit-maximizing level of output, a mathematical problem if there is perfect knowledge of the supply curves of resources, the production function, and the demand curve. It is another application of the maximization principle, which says that the best level of input is that level for which its marginal benefit to the firm--the extra money the firm can obtain by hiring or buying the input--just equals the marginal cost to the firm of hiring or buying the input. In the jargon of economists, the marginal revenue product of an input should equal the marginal resource cost.

The marginal resource cost depends only on the supply curve of the input. The marginal revenue product is the extra revenue that the firm can obtain from hiring another unit of the resource. It depends both on the extra output that the input produces and on the extra revenue the firm can obtain from each extra unit produced. For example, if adding another unit of input can increase output by three, and selling an extra unit of output increases revenues by $4.00, the marginal revenue product is $12.00. If it costs an extra $10.00 to buy or hire the input, the firm will increase profit by $2.00 if it buys or hires it. If the input costs an extra $14.00, the firm will decrease profits by $2.00 by using it and should consider a reduction in the level of this particular input.

Three stages of return to scale in the production process:

• Increasing Returns to Scale: stage I represents increasing returns to scale. During this stage, the firm enjoys various internal and external economies such as dimensional economies, economies flowing from indivisibility, economies of specialization, technical economies, managerial economies, and marketing economies. Economies simply mean advantages for the firm. Due to these economies, the firm realizes increasing returns to scale. Marshall explains increasing returns in terms of “increased efficiency” of labor and capital in the improved organization with the expanding scale of output and employment factor unit. It is referred to as the economy of the organization in the earlier stages of production.
• Constant Returns to Scale: stage II represents constant returns to scale. During this stage, the economies accrued during the first stage start vanishing and diseconomies arise. Diseconomies refers to the limiting factors for the firm’s expansion. The emergence of diseconomies is a natural process when a firm expands beyond a certain stage. In stage II, the economies and diseconomies of scale are exactly in balance over a particular range of output. When a firm is at constant returns to scale, an increase in all inputs leads to a proportionate increase in output but to an extent.
• Diminishing Returns to Scale: stage III represents diminishing returns or decreasing returns. This situation arises when a firm expands its operation even after the point of constant returns. Decreasing returns mean that the increase in the total output is not proportionate according to the increase in the input. Because of this, the marginal output starts decreasing. Important factors that determine diminishing returns are managerial inefficiency and technical constraints.