Efficient Production and Profit Maximization in Firms: A Critical Evaluation

Question 1

A firm engages in efficient production (achieves technological efficiency) if it cannot produce its current level of output with fewer inputs, given existing knowledge about technology and the organization of production. Equivalently, the firm produces efficiently if, given the quantity of inputs used, no more output could be produced using existing knowledge. Is the notion of “efficient production” alone a sufficient condition to ensure that a firm’s profit is maximized? Critically evaluate your arguments.

A firm uses a technology or production process to transform inputs or factors of production into outputs. Firms use many types of inputs. Most of these inputs can be grouped into three broad categories: (i) Capital, (ii) Labour and (iii) Materials. The output can be a service, such as an consultancy services or a physical product, such as a metal beams or apples. Hence, Firms can transform inputs into outputs in many different ways. Evaluate the role played by the “production process” and the “production function” in relation to firm’s profit maximisation

Suppose that we have 15 plants in the same industry for a given year (the data are shown in Table 1 and in Excel format). For each plant, we know the total output, the monetary value of Capital and the number of working hours. Assume that the output in the industry can be estimated using the CobbDouglas Production Function:

Q = AKα

Q = total production (the real value of all goods produced in a year)

L = labor input (the total number of person-hours worked in a year)

K = capital input (the real value of all machinery, equipment, and buildings)

A = total factor productivity and your usual depreciation by utility in day after α and β are the output elasticities of capital and labour respectively.

Table 1: Output in tons, capital in US dollars AND labour in worker hours for 15 plants

1. Estimate the Cobb-Douglas Production coefficients, namely A, α and β, explaining the process of your calculations. Discuss the meaning of the α and β coefficients. Confine all your calculations to two decimal points.
2. Discuss whether the industry exhibits Constant Returns to Scale (CRS), Decreasing Returns to Scale (DRS) or Increasing Returns to Scale (IRS) based on the outcomes of 3(a). Briefly evaluate the implications of your answer for the industry.