ALLOCATION EFFECT: The goal of imposing taxes to change the allocation of resources, that is, to discourage the production, consumption, or exchange or one type of good usually in favor of another. This is one of two reasons that governments impose taxes. The other reason is the revenue effect. Because people would rather not pay taxes, taxes create disincentives to produce, consume, and exchange. If society deems that less of a particular good, such as alcohol, pollution, or cigarettes are "bad," then a tax can reduce its production and consumption, and thus change the allocation of resources.
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SHORT-RUN PRODUCTION ANALYSIS:
An analysis of the production decision made by a firm in the short run, with the ultimate goal of explaining the law of supply and the upward-sloping supply curve. The central feature of this short-run production analysis is the law of diminishing marginal returns, which results in the short run when larger amounts of a variable input, like labor, are added to a fixed input, like capital. A contrasting analysis is long-run production analysis. The analysis of short-run production sets the stage to better understand the supply-side of the market. How producers respond to price depends, in part, on their ability to combine inputs to produce output. This ability is guided by the law of diminishing marginal returns, which states that the productivity of a variable input declines as more is added to a fixed input.
If productivity declines, then more of the variable input is needed as the quantity produced increases. This results in an increase in production cost, which means producers need to receive a higher price. The connection between higher price and more production is essence of the law of supply.
Two Runs: Short and LongThe first step in the analysis of short-run production is a distinction between the short run and the long run. This distinction is intertwined with the distinction between fixed and variable inputs.
The difference between short run and long run depends on the particular production activity. For some producers, the short run lasts a few days. For others, the short run can last for decades.
- Short Run: The short run is a period of time in which at least one input used for production and under the control of the producer is variable and at least one input is fixed.
- Long Run: The long run is a period of time in which at all inputs used for production and under the control of the producer are variable.
Two Inputs: Fixed and VariableThe analysis of short-run production assumes that at least one input in the production process is fixed and at least one is variable. As already noted, the fixed and variable inputs are intertwined with the notion of short run and long run.
The variable input used by most producers is more often than not labor. The fixed input for most production operations is usually capital. The presumption is that the size of a firm's workforce can be adjusted more quickly that the size of the factory or building, the amount of equipment, and other capital.
- Fixed Input: A fixed input is an input used in production and under the control of the producer that does not change during the time period of analysis (the short run).
- Variable Input: A variable input is an input used in production and under the control of the producer that does change during the time period of analysis (the short run).
Note that the phrase "under the control of the producer" is included in the specifications of short run, long run, fixed input, and variable input. The reason is that short-run production analysis is most concerned with how producers adjust the inputs under the control in response to changing prices.
Any production activity invariably includes inputs (fixed and variable) that are beyond the control of the producer, including government laws and regulations, social customs and institutions, weather, and the forces of nature. These other variables are certainly worthy of consideration, but are not fundamental to explaining and understanding the basic principles of market supply
Three Returns: Increasing, Decreasing, and NegativeThe addition of a variable input (like labor) to a fixed input (like capital) can have one of three basic results. First, production might increase at a increasing rate. Second, production might increase at a decreasing rate. Third, production might actually decrease. These three alternatives are technically termed increasing marginal returns, decreasing marginal returns, and negative marginal returns.
Most short-run production involves increasing marginal returns with the addition of the first few units of a variable input. This inevitably gives way to decreasing marginal returns. While negative marginal returns are somewhat rare, they do eventually result if too many units of a variable input are added.
- Increasing Marginal Returns: This occurs if each additional unit of a variable input added to a fixed input causes incremental production to increase. For example, the one worker contributes 10 units of output to production, the next worker contributes another 12 units, and the subsequent worker contributes 14 units. With increasing marginal returns, each worker contributes more to production that the previous worker.
- Decreasing Marginal Returns: This occurs if each additional unit of a variable input added to a fixed input causes incremental production to decrease. For example, the one worker contributes 10 units of output to production, the next worker contributes another 8 units, and the subsequent worker contributes only 6 units. With decreasing marginal returns, each worker contributes less to production that the previous worker.
- Negative Marginal Returns: This results if the addition of a variable input added to a fixed input actually causes the total production to decline. For example, if 10 workers produce a total of 100 units of output, and 11 workers produce a total of 99 units, then the eleventh worker is said to have negative marginal returns.
One LawThe inevitability of decreasing marginal returns is captured by the most important economic principle in short-run production analysis--the law of diminishing marginal returns.
While most short-run production is likely to see increasing marginal returns, eventually, inevitably, most certainly, decreasing marginal returns occur.
- The Law of Diminishing Marginal Returns: This law states that as more and more of a variable input is added to a fixed input in short-run production, then the marginal product (that is, the marginal returns) of the variable input eventually declines.
The law of diminishing marginal returns means that increased production of a good requires more and more of the variable input. For example, the first 50 units of production can be had with only 5 workers. However, the next 50 units might required an additional 10 workers.
With more the variable input needed, the cost of production rises. And as the production cost rises, the price that producers need to receive also increases. Hence, a higher price corresponds with a larger quantity, which is the law of supply. The positive law of supply connection between price and quantity, as such, can be traced to the law of diminishing marginal returns.
Three Product Curves
This graph presents the three "product" curves that form the foundation of short-run production analysis. This particular set of curves depict the hourly production of Waldo's Super Deluxe TexMex Gargantuan Tacos (with sour cream and jalapeno peppers) for different quantities of labor, the variable input. The fixed input is the building, cooking and preparation equipment, cash register, tables, chairs, and other capital that comprise Waldo's TexMex Taco World restaurant.
- Total Product Curve: The curve labeled TP is the total product curve, the total number of TexMex Gargantuan Tacos produced per hour for a given amount of labor. If Waldo (the owner of Waldo's TexMex Taco World) hires more employees, he can expect a greater production of TexMex Gargantuan Tacos until he reaches peak production at 7 and 8 workers. Click the [TP] button to highlight this curve.
- Marginal Product Curve: The MP curve is the marginal product curve, and the one that is key to the study of short-run production. The MP curve indicates how the total production of TexMex Gargantuan Tacos changes when an extra worker is hired. For example, hiring a fifth worker means that Waldo's TexMex Taco World can produce an additional 10 TexMex Gargantuan Tacos per hour. Most important, the marginal product declines after the second worker is hired, which is the law of diminishing marginal returns, the driving principle in the study of short-run production. Click the [MP] button to highlight this curve.
- Average Product Curve: The average product curve, labeled AP, indicates the average number of TexMex Gargantuan Tacos produced by Waldo's workers. If, for example, Waldo has a staff of 7, then each produces about 17 TexMex Gargantuan Tacos per hour--on average. Click the [AP] button to highlight this curve.
Three Production Stages
Short-run production exhibits three distinct stages reflected by the shapes and slopes of the three product curves--total product, marginal product, and average product.
- Stage I: The first stage is increasing marginal returns and is characterized by the increasingly steeper positive slope of the total product curve, the positive slope of the marginal product curve, and the positive slope of the average product curve. Moreover, the marginal product curve reaches a peak at the end of Stage I.
- Stage II: The second stage is decreasing marginal returns and is reflected in the positive but flattening slope of the total product curve and the negative slope of the marginal product curve. Moreover, the average product reaches a peak and is equal to marginal product in this stage. The marginal product curve intersects the horizontal quantity axis at the end of Stage II.
- Stage III: The third and last stage is negative marginal returns illustrated by the negative value of marginal product and the negative slope of the total product curve. Average product is positive, but the average product curve has a negative slope.
One StepThis analysis of short-run production is but the first step in a brisk walk toward a better understanding market supply. Further steps include the cost of short-run production, especially marginal cost, and the market structure in which a firm operates, such as perfect competition or monopoly.
- Production Cost: An understanding of market supply builds on the short-run production analysis and the key role played by the law of diminishing marginal returns. Because the productivity of the variable input decreases, a larger quantity is needed as production increases. This larger quantity, however, entails greater production cost, as reflected in a positively-sloped marginal cost curve.
- Market Structure: The market supply also depends on the structure of the market, especially the degree of competition and the resulting market control of each firm. Competitive markets, with limited control over the price, tend to produce output by equating price and marginal cost. Because marginal cost increases with production, so too does price. However, less competitive markets, with greater market control by the participating firms, need not equate price and marginal cost. As such, a higher price might not correspond with a larger quantity.
SHORT-RUN PRODUCTION ANALYSIS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: March 3, 2024].
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