The John Bates Clark Model

Like any other unit, a firm is also limited by the technology available. Thus, it can increase its outputs only by increasing its inputs. As usual, this will be expressed by a production function. The output that a firm can produce depends on the land, labor and capital the firm puts to work.
In formulating the neoclassical theory of a firm, John Bates Clark took over the classical categories of land, labor and capital and simplified them in two ways. These are as follows:
1. He assumed that all labor is homogenous-- One labor hour is a perfect substitute for any other labor hour.
2. He ignored the distinction between land and capital, grouping together both kinds of non-human inputs under the general term “capital.” And he assumed that this broadened “capital” is homogenous.
Ofcourse, the simplifying assumptions are not true. John Bates Clark’s conception of a firm is highly simplified, like a map at a very large scale. In more advanced economics, one can get rid of the simplifying assumptions and deal with a much more realistic “map” of a business firm.
In the John Bates Clark model, there are some important differences between labor and capital and they relate to the long and short-run.

Theory of the Firm

For developing the supply and demand approach to economics, the economists first worked out the basis of the demand curve. By treating the demand for a product or service as a rational decision by a (primarily) self-interested individual or family, the economists were able to understand the relation of the demand for one product or service to the demands for other products and services and to many other forms of economic

activity. It was natural to apply the same approach to supply. As a first step, one needs to think about the decision-makers in supplying goods and services and what a “rational decision” to supply goods and services would mean. In economics, this is often called the “theory of the firm.”

A firm is a unit that does business on its own account. Firm is from the Italian word, firma, a signature and the idea is that a firm can commit itself to a contract. Thus, a firm is the decision-maker in supplying goods and services.

There are three main kinds of firms in modern market economies which are as follows:

Proprietorships

A proprietorship (or proprietary business) is a business owned by an individual known as the “proprietor.” Many “mom and pop stores” and other “mom and pop” businesses are proprietorships. Some of the proprietorships are too small even to employ a person full time. Craftsmen, such as plumbers and painters, may have “day jobs” and work as selfemployed proprietors part time after hours. The computer programmers and others may also do that. At the other extreme, some proprietary businesses employ many hundreds of workers in a wide range of specializations. In a proprietorship, a proprietor is almost always the decision-maker for the business. 

Theory of Production

After reading this lesson, you would be able to:

1. Define production function, isoquants, marginal product, price discrimination, monopsonist and the all-or-nothing demand curve.

2. Define increasing, decreasing and constant returns to scale.

3. Distinguish between income and substitution effects.

4. Distinguish between an individual buyer’s demand curve and the industry demand, and between industry demand and the demand curve facing an individual seller.

5. Compute marginal revenue from the demand curve of the seller when that demand curve is given in the form of a table.

6. Compute marginal resource cost from the supply curve of the buyer when supply curve is given in the form of a table.

7. Explain why marginal resource cost equals price for a buyer who is a price taker. 

8. Explain why marginal revenue equals price for a seller who is a price taker, and why marginal revenue is less than price for a seller who is a price maker.

9. Explain what the law of diminishing returns is and under what conditions it holds .

10. Explain why the demand curve, the supply curve for resources and the production function can be treated as boundaries.

Law of Variable Proportions

Law of Variable Proportions is also known as the Law of Diminishing Returns. This law is a generalization which the economists make about the nature of technology which makes possible to combine the same factors of production in a number of different proportions to make the same product. The law states:

When increasing amounts of one factor of production are employed in production along with a fixed amount of some other production factor, after some point, the resulting increases in output of product become smaller and smaller. (That is, first the marginal returns to successive small increases in the variable factor of production turn down and then eventually the overall average returns per unit of the variable input start decreasing.)

s that the available quantity of atleast one factor of production is fixed at a given level and that technological knowledge does not change during the relevant period, the Law of Diminishing Returns normally translates into a statement about the short-run choice of production possibilities facing a firm. Since in the longer run it is virtually always possible for a firm to acquire more of the temporarily “fixed” factor-- building an additional factory building, buying additional land, installing additional machines of the same kind, installing newer and more advanced machinery and so on.

A simple example of the working of the Law of Diminishing Returns comes from gardening. A particular twenty by twenty garden plot will produce a certain number of pounds of tomatoes if the gardener just puts in the recommended number of rows and plants per row, waters them appropriately and keeps the weeds pulled. If the gardener varies this approach by adding a pound of fertilizer to the topsoil but otherwise does

everything the same, he can increase the number of pounds of tomatoes the garden plot yields by quite a bit. One should notice here the amount of land which is being held fixed or constant. If he adds two pounds of fertilizer rather than just one, probably he can get still more tomatoes per season. But the increase in tomatoes harvested by going from one pound to two pounds of fertilizer is probably smaller than the increase he gets by going from zero pounds to one (diminishing marginal returns). Applying three pounds of fertilizer may still increase the harvest but by only a very little bit over the yield available by using just two pounds. Applying four pounds of fertilizer turns out to be overdoing it, i.e. the garden yields fewer tomatoes than applying only three pounds because the plants begin to suffer damage from root-burn. And five pounds of fertilizer turns out to kill nearly all the plants before they even flower.

Marketing Economies

These economies arise because:

I. The advertising expenditure is generally found to have increased less than proportionately with scale. Consequently, larger the output, smaller the advertising cost per unit. Similar situation prevails in case of other types of selling activities.

II. The development and adoption of new models and designs involve considerable expenses in R&D. The larger the output, more thinly this R&D expenditure spreads over output.

c) Managerial Economies. Managerial economies arise because:

I. Larger the firms, greater are the opportunities for the division of managerial tasks. The division of managerial tasks helps managers to specialize in their own areas of responsibility, thus leading to greater efficiency.

II. Teamwork experience. By working in a team, the managers of large firms tend to acquire a more comprehensive outlook as well as a quicker and better decision-making ability.

III. In a large firm, with decentralization in decision-making, the delay in the flow of information is reduced, thereby increasing the efficiency of management.

IV. Modern managerial and organizational techniques. Large firms provide opportunities for the introduction of modern managerial techniques and organizational restructuring. These help the management to increase

efficiency. 

d) Transport and Storage Economies. Storage costs obviously fall with the increase in the size of output, as it provides the economies of increased dimensions (discussed already). The transportation costs, on the other hand, involve an Lshaped average cost curve-transport unit costs falling up to the point of the full

capacity and remaining constant thereafter.

Technical economies

These are associated with fixed capital, which includes machinery and equipment. Such economies arise because of the following
iv)Specialized equipment. The production methods become more mechanized as the output scale increases. This would imply more specialized capital equipment and lower variable costs.

(v) Indivisibility. The machinery and equipment generally have the property of indivisibility, which means that equipment is available only in minimum sizes or in definite ranges of size. When output is increased from zero to the maximum capacity level of the machine, the same machine and equipment are used. As a result the cost of machine is shared between more and more units of output. In short, as the output is increased, the machinery and equipment comes to be utilized more intensively and consequently the cost of production per unit declines.

(vi) Integration of processes. The large size firms enjoy economies of large machines. Integration of processes occurs where one large automatic transfer or numerically controlled machine can carry out a series of consecutive processes, saving labor cost and time required to set up the work on each of a series of successive specialized machines.

(vii) Economies of increased dimensions for many types of equipment both initial and running costs increase less rapidly than capacity (e.g., tanks, blast furnaces and other static and mobile containers). These result in economies of increased dimensions. Any container whose external dimensions are doubled has its volume increased eight times, but the area of its surface walls would have increased only four times. This reduces material costs and, where appropriate, heat loss and surface, air and water resistance per unit.

(viii) Economies in set-up costs. The larger the scale of output, the more a multipurpose machinery is left to one set-up and, therefore, set-up costs of general purpose machines reduce.

Economies of Scale

Economies of scale can be of two kinds-- internal economies and external economies. Internal economies of scale are those which arise from the firm increasing its plant size. On the other hand, external economies arise outside the firm-from improvement (or, deterioration) in the environment in which the firm operates. The economies external to the firm may be realized from actions of other firms in the same or in another industry.

While the internal economies of scale relate only to the long run and determine the shape of the long-run cost curve, the external economies affect the position of the long-run cost curves.

Internal Economies

Internal economies are given in a summary form in the figure given later in the chapter, where these are categorized into real and pecuniary economies. Real economies arise when the quantity of inputs used for a given level of output decreases. While pecuniary economics are those savings in expenses, which accrue to the firm in the nature of relatively, lower prices paid for inputs and lower costs of distribution. These savings arise due to bulk buying and selling by the growing firm

Real Economies of Scale

Real economies are of four kinds:

a. Production economies

b. Marketing economies

c. Managerial economies

d. Transport and storage economies

a) Production Economies

Production economies arise from

(a) Labor

(b) Fixed capital

(c) Inventory requirements of the firm.

Cost Analysis-II

Explicit Costs and Implicit Costs

Economists have classified types of costs as explicit (accounting) costs, and implicit costs. Explicit costs are out of pocket, obvious kinds of costs, e.g., expenses on books, tuition, as, etc. Implicit costs are not really expenses you incur, but involve income or values you are giving up by not doing something that you could have chosen to do. For instance, if you decide to go to school full time instead of working a $20,000 job, you are giving up earning $20,000. This is your implicit cost.

Accounting vs. Economic Costs

Accountants have been primarily concerned with measuring costs for financial reporting purposes. As a result, they define and measure cost by the historical outlay of funds that takes place in the exchange or transformation of a resource. 

Economists have been mainly concerned with measuring costs for decision-making purposes. The objective is to determine the present and future costs (or resources) associated with various alternative courses of action.

In calculating the cost to the firm of producing a given quantity of output, economists include some additional costs that are typically not reflected in financial reports. 

• Explicit cost are considered by both groups

• Implicit costs are considered by economists:

a. Opportunity cost of time

b. Opportunity cost of capital

Economic Profit = Tot Rev - Exp Cost - Imp Cost

A large Modern Corporation

The corporation has relatively few implicit costs, but generally will have some. All labor costs will be expressed in money terms (though benefits and bonuses have to be included), since the shareholders don't supply labor to the corporation as "Mom and Pop" do in a family proprietorship. It will pay interest to bondholders and dividends to shareholders. But the dividends aren't really a cost item -- they include profits distributed to the shareholders. Moreover, the typical corporation will retain some profits and invest them within the business, a "plowback" investment. Conversely, shareholders may take a large part of their payout in appreciation of the stock value and plowback investment is one reason for the appreciation.

Thus we would say that the corporation has a net equity value, that is, that the corporation "owns" a certain amount of capital that it invests in its own business (very much like the absentee owner in the first example). This capital has an opportunity cost, and that opportunity cost is an implicit cost. The stockholders, who own the corporation, ultimately receive (as dividends or appreciation) both the opportunity cost of the equity

capital and any profit left over after it is taken out.

Unit Cost

Costs may be more meaningful if they are expressed on a per-unit basis, as averages per unit of output. In this way, we again distinguish

Opportunity Cost

Connection between the distinctions of fixed vs. variable costs and opportunity costs

In economics, all costs are included whether or not they correspond to money payments. If we have opportunity costs with no corresponding money payments, they are called implicit costs. The implicit costs (as well as the money costs) are included in the cost analysis.

There is some correlation between implicit costs and fixed or variable costs, but this correlation will be different in such different kinds of firms as

A factory owned by an Absentee Investor

This is the easiest case to understand. All of the labor costs to the absentee investor are money costs, including the manager's salary. If the investor has borrowed some of the money he invested in the factory, then there are some money costs of the capital invested -- interest on the loan. However, we must consider the opportunity cost of invested capital as well. The investor's own money that he has used to buy the factory is money that she could have invested in some other business. The return she could have gotten on another investment is the opportunity cost of her own funds invested in the business. This is an implicit cost, and in this case the implicit cost is part of the cost of capital and probably a fixed cost.

Cost Analysis-I

Introduction to Cost

We can look at the business firm from at least two points of view: productivity, inputs, and outputs or outputs and costs. In advanced microeconomics, these two points of view are called "duals." They are equally valid, but they point up different things. They are also opposites from a certain point of view-- the higher the productivity, the lower the costs. By looking at the firm from the point of view of costs, we shift our perspective somewhat, and gain a much more direct understanding of supply.

We also look more directly at the difference between the long and short run. In the short run, we have two major categories of costs:

• Fixed Costs

• Variable Costs

In the long run, however, all costs are variable. Thus, we must study costs under two quite different headings. Costs will vary quite differently in the long run and in the short.

Fixed and Variable Cost 

Variable costs are costs that can be varied flexibly as conditions change. In the John Bates Clark model of the firm, labor costs are the variable costs. Fixed costs are the costs of the investment goods used by the firm, on the idea that these reflect a long-term commitment that can be recovered only by wearing them out in the production of goods and services for sale.

The idea here is that labor is a much more flexible resource than capital investment. People can change from one task to another flexibly (whether within the same firm or in a new job at another firm), while machinery tends to be designed for a very specific use. If it isn't used for that purpose, it can't produce anything at all. Thus, capital investment is much more of a commitment than hiring is. In the eighteen hundreds, when John Bates Clark was writing, this was pretty clearly true.

Economic Efficiency

The production function incorporates the technically efficient method of production. Here, the latest technological processes are used. When the economists use production functions, they assume that the maximum level of output is obtained from any given combination of inputs. It means, they assume that production is technically efficient.

When producers are faced with input prices, the problem is not technical but economic efficiency. How to produce a given amount of output at the lowest possible cost? To be economically efficient, a producer should determine the combination of inputs that solves this problem.

What is technical inefficiency? If, for example, an alternative process can produce the same amount of output using less of one or more inputs and the same amount of all others, the first process is technically inefficient.

If, however, the second process uses less of some inputs but more of others, the economically efficient method of producing a given level of output depends on the prices of the inputs. One might cost less but actually be less technically efficient

Classifying Inputs

1. Fixed Input

A fixed input is one that is required in the production process. The amount of the fixed input employed is constant over a given period of time regardless of the quantity of output produced.

2. Variable Input

It is the one whose quantity employed in the production process is varied, depending on the desired quantity of output to be produced.

Time Frames

1. Short-run

It is a period of time in which one or more of the inputs are fixed.

2. Very Short-run

It is a period of time in which all resources are fixed.

3. Long-run

It is a time period which is long enough so that all resources can be varied.

Applications of the Theory of Production

Production
The creation of any good or service that has an economic value either to consumers or to other producers is called the production. Production analysis focuses on the efficient use of inputs to create outputs. The process involves all the activities associated with providing goods and services.

Managerial Questions
Managerial questions are as follows:
1. Whether to produce or shut down?
2. How much to produce?
3. What input combination to use?
4. What type of technology to use?
Examples
• Physical processing or manufacturing of material goods
• Production of transportation services
• Production of legal advice
• Production of education
• Production of invention (R&D)
• Production of bank loans