Production Functions

In this lesson, we are going to talk about the supply curve and, if you will allow me to jump to the end for a second, the supply curve is based upon costs. So, if we want to try to figure out just what kind of prices producers charge, and how much (or how little) they can accept in exchange for their goods and stay in business, we need to think about what exactly creates the costs of doing business for a supplier (or seller or producer - remember, they are synonymous, the same thing.)

From here on, when talking about suppliers, I will use the term "firm," which is basically a form of shorthand for "an entity that makes things (or provides services) and sells them with the expectation of making a profit." This is what most firms are. As always, we can add a lot of fine print about exceptions and variations, but that does not help us with the illustration of basic concepts. It's better for all of us if we keep things simple. Of course, a firm could consist of an individual person, or an international mega-corporation with a workforce and budget that dwarfs several Eastern European countries, but they have the same basic goal: make things and sell them for enough money to be able to stay in business for another day, and pay the owners of the firm enough to compensate them for their investment.

A firm that does not turn a profit can only stay in business for as long as its owners can pump money into it, which is usually something like "not long." Firms exist to make a profit. More on just what a "profit" is later.

So, what do firms do to make a profit?

A firm takes things and converts them into products. Inputs are converted into outputs.

The inputs that go into making a product can form a list that can be almost endless. To understand this, just refer to the previous page addressing the gasoline value chain, and think about the scope and scale of the entire enterprise required to find oil in the ground and convert it to the fuel in your tank.

Oil, property rights, seismic equipment, drilling rigs, pipelines, tankers, refineries, fuel and electricity to run these machines, people to operate the machines, people to fix the machines, buildings to house the machines, trucks to haul the gasoline to stores, gasoline to power those trucks, people to drive them, lawyers to make sure the company meets all regulations, paper to store records on, computers to process billing records, people to run those computers, furniture for those people to sit on, health care insurance for all those people, telephones to allow them to communicate, creative people to make advertisements for gasoline, waste disposal systems for refineries and offices, and so on. This is not even considering the needs of the firms that are selling gasoline to the end-user, and it is not considering the needs of the firms that make the trucks or machinery, or provide the health care, or host computer records, and so on.

My point here is that analysing the economics of running a business can be very complicated, and, as you may have noticed, economists like to simplify things. It makes the world an easier place to try to figure out, and lets us sleep at night.

So, to simplify things, we take the many and varied inputs into some production process, and divide them into a few simplified classes of inputs, for example:

• Labor (L): simply put, people.
• Materials (M): physical things that get used up to make products.
• Energy (E): electricity, petroleum products, and so on.
• Capital (K): machines and buildings (and may also include land). Does not get “used up” in production.

These four things are abbreviated L, M, E, and K. The things produced, the outputs, are labeled Y. Some people use only K and L. Others use K, L, and M. Since this course is part of a degree program focusing on energy use, it is important for us to view energy as a separate class of inputs, as we are often concerned about how we can maintain or maximize output while consuming less energy. It might be tempting to lump energy in with other "consumables" under the category of "materials" (M). However, in our orange juice example, we have physical materials like oranges and bottles and boxes, and we have "intangible" things we consume that are not an intrinsic, physical part of the final product. Mostly, this describes energy; we require energy to move machine parts or to add heat or to drive chemical reactions, but we do not sell the product based upon how much energy is in it. For this reason, it can be useful for us to break energy out into a separate class of input. This enables the entire field of "energy efficiency."

The relationship between the input and the outputs is called a “Production Function.” Written in math terms, the production function is:

The inputs K, L, E, and M are called “factors of production.” The production function tells us the maximum amount of output (Y) that can be produced from a certain quantity of factors.