Chapter 7
The Production Process:
The Behavior of ProfitMaximizing Firms
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Production
Central to our analysis is production:
Production is the process by which inputs are
combined, transformed, and turned into outputs.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
What Is A Firm?
A firm is an organization that comes into
being when a person or a group of people
decides to produce a good or service to
meet a perceived demand. Most firms exist
to make a profit.
Production is not limited to firms.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Perfect Competition: Characteristics
many firms, each small relative to the industry,
producing virtually identical products -Homogeneous products that
are undifferentiated products or indistinguishable from, one another
in which no firm is large enough to have any control over prices of
its products or the price of inputs they buy.
Hence, individual firms are price-takers. This means that firms have
no control over price. Price is determined by the interaction of
market supply and demand.
In perfectly competitive industries, new competitors can freely enter
and exit the market.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Demand Facing a Single Firm in a
Perfectly Competitive Market
If a representative firm in a perfectly competitive market rises the
price of its output above $2.45, the quantity demanded of that
firms output will drop to zero. Each firm faces a perfectly elastic
demand curve, d.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Behavior of
Profit-Maximizing Firms
The three decisions that all firms must
make include:
1.
2.
3.
How much
output to
supply
Which
production
technology to
use
How much of
each input to
demand
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Behavior of
Profit-Maximizing Firms
Once the level of output has been determined, the
choice of technology determines the input demand
Change in technology changes both 1st and 3rd
decision
With different technology, different levels of output
can be produced or same level of output can also be
produced
A profit maximizing firm chooses the technology
that minimizes its cost for a given level of output
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Profits and Economic Costs
Profit (economic profit) is the difference between total revenue
and total cost.
Total revenue is the amount received from the sale of the
product:
TR=(q X p)
Profit = Total Revenue- Total Cost
Total cost (total economic cost) is the total of
1.
Out of pocket costs- explicit costs/accounting costs
2.
Opportunity cost of each factor of production- implicit costs
Economic Profit = Total Revenue- Total Economic Cost
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Normal Rate of Return:
The Opportunity cost of capital
The most important opportunity cost that is included in economic
cost is the economic cost of capital, measured in terms of Normal
rate of return .
Rate of Return= annual flow of net income generated by an
investment, expressed as a % of total investment- also called
yield on investment.
The normal rate of return is a rate of return on capital that is just
sufficient to keep owners and investors satisfied.
Normal rate of return is considered to be a part of total cost of
business
For relatively risk-free firms, it should be nearly the same as the
interest rate on risk-free government bonds.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Implication
If a firm is earning exactly the normal rate of
return on capital, it is earning zero profits
If the level of profit is positive, it means that the
firm is earning above normal rate of return on
capital.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Calculating Total Revenue, Total Cost,
and Profit
Initial Investment:
Market Interest Rate Available:
Total Revenue (3,000 belts x $10 each)
$20,000
.10 or 10%
$30,000
Costs
Belts from supplier
$15,000
Labor Cost
14,000
Normal return/opportunity cost of capital ($20,000 x
.10)
Total Cost
$31,000
Profit = total revenue - total cost
aThere
2,000
- $ 1,000a
is a loss of $1,000.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Short-Run Versus Long-Run Decisions
The short run is a period of time for which two
conditions hold:
1. The firm is operating under a fixed scale (fixed factor)
of production, and
2. Firms can neither enter nor exit an industry.
Which factors are fixed in the short run differs from
industry to industry
No hard and fast rule to define the period of short run
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Short-Run Versus Long-Run Decisions
The long run is a period of time for which there
are no fixed factors of production. Firms can
increase or decrease scale of operation, and new
firms can enter and existing firms can exit the
industry.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The basis of decisions: Market price of
outputs, available technology and input prices
- Market price of output determines the Revenues
- Techniques of production and Price of Inputs determines
the Costs
The optimal method of production is the method that
minimizes cost.
With cost determined and market price of output known, a
firm makes the final judgment about the quantity of
product to produce and quantity of each input to demand
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Determining the Optimal Method
of Production
Price of output
Determines
total revenue
Production techniques
Input prices
Determine total cost and
optimal method of
production
Total revenue
- Total cost with optimal method
=Total profit
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Production Process
Production technology refers to the quantitative relationship
between inputs and outputs.
Most outputs can be produced by a number of different techniques
which include:
A labor-intensive technology relies heavily on human labor instead of
capital.
A capital-intensive technology relies heavily on capital instead of
human labor.
The final choice of technology should be the one that minimizes cost.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Production Function
The production function or total product function is
a numerical or mathematical expression of a
relationship between inputs and outputs.
It shows units of total product as a function of units
of inputs.
Q= f(X1,X2,X3,...,Xn)
where:
Q = quantity of output
X1,X2,X3,...,Xn = factor inputs (such as capital, labour, land or
raw materials
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Marginal Product and Average Product
Marginal product is the additional output that can
be produced by adding one more unit of a specific
input, ceteris paribus( i.e., holding all other inputs
constant).
change in total product
marginal product of labor =
change in units of labor used
Average product is the average amount
produced by each unit of a variable factor of
production.
total product
average product of labor =
total units of labor
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Law of Diminishing
Marginal Returns
The law of diminishing marginal returns
states that:
When additional units of a variable input are added
to fixed inputs, the marginal product of the variable
input declines.
Diminishing returns always apply in the short run
and every firm will face diminishing returns which
means that every firm finds it progressively more
difficult to increase its output as it approaches
capacity production
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Production Function for Sandwiches
45
40
Production Function
(3)
MARGINAL
PRODUCT OF
LABOR
(4)
AVERAGE
PRODUCT
OF LABOR
10
10
10.0
25
15
12.5
35
10
11.7
40
10.0
42
8.4
42
7.0
Total product
(2)
TOTAL PRODUCT
(SANDWICHES
PER HOUR)
30
25
20
15
10
5
0
0
Principles of Economics, 6/e
Number of employees
10
5
0
0
2002 Prentice Hall Business Publishing
15
Marginal Product
(1)
LABOR UNITS
(EMPLOYEES)
35
2
3
4
5
Number of employees
Karl Case, Ray Fair
Total, Average, and Marginal Product
Marginal product is the slope
of the total product function.
At point A, the slope of the
total product function is
highest; thus, marginal
product is highest.
At point C, total product is
maximum, the slope of the total
product function is zero, and
marginal product intersects the
horizontal axis.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Total, Average, and Marginal Product
As long as marginal product
rises, average product rises.
When average product is
maximum, marginal product
equals average product.
When average product falls,
marginal product is less
than average product.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Total, Average, and Marginal Product
When a ray drawn from the
origin falls tangent to the
total product function,
average product is
maximum and equal to
marginal product.
Then, average product falls
to the left and right of point
B.
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Production Functions with Two Variable
Factors of Production
In many production processes, inputs work
together and are viewed as complementary.
For example, increases in capital usage lead to
increases in the productivity of labor.
Inputs Required to Produce 100 Diapers
Using Alternative Technologies
TECHNOLOGY
UNITS OF
CAPITAL (K)
UNITS OF
LABOR (L)
10
10
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Given the
technologies
available, the
cost-minimizing
choice depends
on input prices.
Karl Case, Ray Fair
Production Functions with Two Variable
Factors of Production
Cost-Minimizing Choice Among Alternative
Technologies (100 Diapers)
(1)
TECHNOLOGY
(2)
UNITS OF
CAPITAL (K)
(3)
UNITS OF
LABOR
(4)
COST
WHEN PL = $1
PK = $1
10
$12
$52
33
24
21
10
12
20
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
(5)
COST WHEN
PL = $5 PK = $1
Karl Case, Ray Fair
Hence , two things determine cost of
production:
1. technologies that are available and
2. input prices
Profit maximizing firm chooses that
technology that minimizes cost of production
at the given current market price of inputs
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
