Both microeconomics and macroeconomics make distinctions between the short run and the long run. These distinctions have very little to do with some fixed period of time but rather are based on the ability of firms to make changes in their inputs. The short run is defined as the period of time in which firms are able to vary only one of the inputs to production, usually labor. The long run is the period in which firms are able to vary all the inputs in the production process. If you operate a restaurant, in the short run you can only add or subtract workers to adjust the level of production. If your place is busy, you schedule or call up more of your workers. If business is slow, you send the employees home. The long run is the period in which you are able to expand the kitchen or add new equipment. So in response to an increase in business activity, in the short run you can schedule more workers, but in the long run you can make the restaurant bigger.

A firm's short-run production decisions are based on the firm's production function. A production function shows how a firm's output changes as it makes changes to a single input, like labor. The production function is divided into three distinct stages based on what is happening to the firm's output or product.

The Stages of Production Function

The first stage of a production function occurs when firms experience increasing returns. This means that as a firm adds workers, each additional worker contributes more to output than the previous worker. The additional contribution to output from each worker is referred to as marginal product. So in the stage of increasing returns, both output and marginal product are increasing.

The second stage of production is called diminishing returns. In this stage, as the firm increases the number of workers, output still increases, but the additional contribution of each worker decreases. Finally, the firm experiences the third stage of production called negative returns. In this stage, as firms add workers, both output and marginal product decrease.

To illustrate the production function, picture a restaurant on a normal business day. Assume that you are the manager responsible for scheduling workers, but you have no experience and are a little slow at figuring things out. At 6 A.M. the first customer arrives for breakfast. You immediately call up one of your employees and have her rush to work. Employee 1 is able to prepare the food, serve it, and then act as a cashier for the transaction. Later, as more customers arrive and begin demanding service, it becomes obvious to you that more help is needed. Taking out your cell phone, you call up Employees 2 and 3 and order them to work. As they settle in and begin working, a division of labor develops, which increases their individual productivity and the total productivity of the restaurant.

Witnessing the marvelous outcome, you conclude that more is always better and decide to call up Employees 4 through 7. As they begin to work, you notice that the restaurant is able to serve more customers, but the earlier gains in productivity are beginning to diminish. You chalk up these diminishing gains as a fluke, and in order to break through this impasse you bring in Employees 8 through 256. Pretty soon, the restaurant's kitchen is full of employees, with every worker pretty much immobilized like a sardine in a can. The customers are now outraged at the extremely slow service and a little freaked out by your lack of management ability. As a matter of fact, with 256 workers, you are unable to produce anything. This is referred to as negative returns.