The items that make up the first group of inputs are called intermediate
products because they are the output of one firm but the input for
another. If these intermediate products are traced back to their sources,
all production can be accounted for by the services of the other three
kinds of input, which we first discussed in Chapter 1 and which are
called factors of production. These are the gifts of nature, such as soil and
raw materials, called land; physical and mental efforts provided by
people, called labour; and factories, machines, and other human-made
aids to production, called capital.
The production function describes the technological relationship
between the inputs that a firm uses and the output that it produces. In
terms of functional notation, a simplified production function (in which
we ignore the role of land) is written as
where Q is the flow of output, K is the flow of capital services, and L is the
flow of labour services. f is the production function itself. Changes in the
firm’s technology, which alter the relationship between inputs and
output, are reflected by changes in the function f. The production function
specifies the maximum amount of output that can be obtained from any
given amounts of inputs.
We will see an example of a production function later in this chapter, and
several Study Exercises at the end of the chapter deal with various
properties of production functions.
Q=f(K, L)1