Introduction

In Chapter 1, we introduced a series of questions that the tools discussed in this book are designed to help answer. In this chapter, we provide the reader with the necessary theoretical underpinnings in order to answer these questions and to understand the models that are developed in later chapters. This is important as it is necessary to understand which is the most appropriate tool to use in which circumstance and what the limitations are of the different approaches.

In some of the following sections the text is fairly technical, but these sections are useful as a general reference for the practitioner when modeling specific issues. For example, Section 2.5 on the functional forms of the production function provides the required formulae for some of the key economic issues discussed in many chapters.

The study of the production, cost, and profit functions has a long history and the practical applications of modeling these functions are extensive. In line with the questions introduced in Chapter 1, a summary of the major objectives for studying these functions may include the following:

1. (i) If a firm were to expand its operations by increasing its inputs by 10 percent, how much would output increase by? How much lower would its unit costs be (and thus how much lower could it reduce its prices by or increase its margins)?

2. (ii) If a firm were to invest in new IT equipment, how many fewer manual employees would be needed to produce the same level of output? How many more IT personnel would be needed?

3. (iii) Can we consider the use of certain inputs independently of others?

4. (iv) Compared to last year, how much more output can be produced for a given level of inputs?

5. (v) Compared to industry best practice, for a given input level, how much more output can an organization produce compared to its current output level?