The Production Process: The Behavior of Profit Maximizing Firms

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 66
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
The Production Process:The Production Process:
The Behavior of Profit-The Behavior of Profit-
Maximizing FirmsMaximizing Firms

ProductionProduction
Central to our analysis isCentral to our analysis is productionproduction::
• ProductionProduction is the process by whichis the process by which
inputs are combined, transformed,inputs are combined, transformed,
and turned into outputs.and turned into outputs.

What Is AWhat Is A FirmFirm??
• AA firmfirm is an organization that comesis an organization that comes
into being when a person or a group ofinto being when a person or a group of
people decides to produce a good orpeople decides to produce a good or
service to meet a perceived demand.service to meet a perceived demand.
Most firms exist to make a profit.Most firms exist to make a profit.
• Production is not limited to firms.Production is not limited to firms.

Perfect CompetitionPerfect Competition
• many firmsmany firms, each small relative to the, each small relative to the
industry,industry,
• producing virtuallyproducing virtually identical productsidentical products andand
• in whichin which nono firm is large enough to havefirm is large enough to have
anyany control over pricescontrol over prices..
• In perfectly competitive industries, newIn perfectly competitive industries, new
competitors cancompetitors can freely enter and exitfreely enter and exit thethe
market.market.
Perfect competition is an industryPerfect competition is an industry
structure in which there are:structure in which there are:

Homogeneous ProductsHomogeneous Products
• Homogeneous productsHomogeneous products areare
undifferentiated products;undifferentiated products;
products that are identical to, orproducts that are identical to, or
indistinguishable from, oneindistinguishable from, one
another.another.

Competitive Firms are Price TakersCompetitive Firms are Price Takers
• In a perfectly competitive market,
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.

Demand Facing a Single Firm in aDemand Facing a Single Firm in a
Perfectly Competitive MarketPerfectly Competitive Market
• If a representative firm in a perfectly competitive market rises theIf a representative firm in a perfectly competitive market rises the
price of its output above $2.45, the quantity demanded of that firm’sprice of its output above $2.45, the quantity demanded of that firm’s
output will drop to zero. Each firm faces aoutput will drop to zero. Each firm faces a perfectly elastic demandperfectly elastic demand
curve,curve, dd..

The Behavior ofThe Behavior of
Profit-Maximizing FirmsProfit-Maximizing Firms
• The three decisions that all firms mustThe three decisions that all firms must
make include:make include:
How much ofHow much of
each input toeach input to
demanddemand
3.3.
WhichWhich
productionproduction
technology totechnology to
useuse
2.2.
How muchHow much
output tooutput to
supplysupply
1.1.

Profits and Economic CostsProfits and Economic Costs
• Profit (economic profit)Profit (economic profit) is the differenceis the difference
between total revenue and total cost.between total revenue and total cost.
• Total revenueTotal revenue is the amount received from theis the amount received from the
sale of the product:sale of the product:
((qq XX PP))
• Total cost (total economic cost)Total cost (total economic cost) is the total ofis the total of
1.1. Out of pocket costs,Out of pocket costs,
2.2. Normal rate of return on capital, andNormal rate of return on capital, and
3.3. Opportunity cost of each factor of production.Opportunity cost of each factor of production.

Normal Rate of ReturnNormal Rate of Return
• TheThe normal rate of returnnormal rate of return is a rate ofis a rate of
return on capital that is just sufficientreturn on capital that is just sufficient
to keep owners and investorsto keep owners and investors
satisfied.satisfied.
• For relatively risk-free firms, it shouldFor relatively risk-free firms, it should
be nearly the same as the interest ratebe nearly the same as the interest rate
on risk-free government bonds.on risk-free government bonds.

Calculating Total Revenue, Total Cost,Calculating Total Revenue, Total Cost,
and Profitand Profit
Initial Investment:Initial Investment:
Market Interest Rate Available:Market Interest Rate Available:
$20,000$20,000
.10 or 10%.10 or 10%
Total Revenue (3,000 belts x $10 each)Total Revenue (3,000 belts x $10 each) $30,000$30,000
CostsCosts
Belts from supplierBelts from supplier $15,000$15,000
Labor CostLabor Cost 14,00014,000
Normal return/opportunity cost of capital ($20,000 x .10)Normal return/opportunity cost of capital ($20,000 x .10) 2,0002,000
Total CostTotal Cost $31,000$31,000
Profit = total revenueProfit = total revenue −− total costtotal cost −− $ 1,000$ 1,000aa
aa
There is a loss of $1,000.There is a loss of $1,000.

Short-Run Versus Long-Run DecisionsShort-Run Versus Long-Run Decisions
• TheThe short runshort run is a period of timeis a period of time
for which two conditions hold:for which two conditions hold:
1.1. The firm is operating under a fixedThe firm is operating under a fixed
scale (fixed factor) of production, andscale (fixed factor) of production, and
2.2. Firms can neither enter nor exit anFirms can neither enter nor exit an
industry.industry.

Short-Run Versus Long-Run DecisionsShort-Run Versus Long-Run Decisions
• TheThe long runlong run is a period of timeis a period of time
for which there are no fixedfor which there are no fixed
factors of production. Firms canfactors of production. Firms can
increase or decrease scale ofincrease or decrease scale of
operation, and new firms canoperation, and new firms can
enter and existing firms can exitenter and existing firms can exit
the industry.the industry.

Determining the Optimal MethodDetermining the Optimal Method
of Productionof Production
Price of outputPrice of output Production techniquesProduction techniques Input pricesInput prices
DeterminesDetermines
total revenuetotal revenue
Determine total cost andDetermine total cost and
optimal method ofoptimal method of
productionproduction
Total revenueTotal revenue
−− Total cost with optimal methodTotal cost with optimal method
=Total profit=Total profit
• TheThe optimal method of productionoptimal method of production is theis the
method that minimizes cost.method that minimizes cost.

The Production ProcessThe Production Process
• Production technologyProduction technology refers to therefers to the
quantitative relationship between inputsquantitative relationship between inputs
and outputs.and outputs.
• AA labor-intensive technologylabor-intensive technology reliesrelies
heavily on human labor instead ofheavily on human labor instead of
capital.capital.
• AA capital-intensive technologycapital-intensive technology reliesrelies
heavily on capital instead of humanheavily on capital instead of human
labor.labor.

The Production FunctionThe Production Function
• TheThe production functionproduction function oror
total product functiontotal product function is ais a
numerical or mathematicalnumerical or mathematical
expression of a relationshipexpression of a relationship
between inputs and outputs.between inputs and outputs.
It shows units of totalIt shows units of total
product as a function ofproduct as a function of
units of inputs.units of inputs.

Marginal Product and Average ProductMarginal Product and Average Product
• Marginal productMarginal product is the additional output thatis the additional output that
can be produced by adding one more unit of acan be produced by adding one more unit of a
specific input,specific input, ceteris paribusceteris paribus..
• Average productAverage product is the average amountis the average amount
produced by each unit of a variable factor ofproduced by each unit of a variable factor of
production.production.
a v e r a g e p r o d u c t o f l a b o r =
t o t a l p r o d u c t
t o t a l u n i t s o f l a b o r
m a r g i n a l p r o d u c t o f l a b o r =
c h a n g e i n t o t a l p r o d u c t
c h a n g e i n u n i t s o f l a b o r u s e d

The Law of DiminishingThe Law of Diminishing
Marginal ReturnsMarginal Returns
• TheThe law of diminishinglaw of diminishing
marginal returnsmarginal returns statesstates
that:that:
When additional units of aWhen additional units of a
variable input are added tovariable input are added to
fixed inputs, the marginalfixed inputs, the marginal
product of the variable inputproduct of the variable input
declines.declines.

Production Function for SandwichesProduction Function for Sandwiches
Production FunctionProduction Function
(1)(1)
LABOR UNITSLABOR UNITS
(EMPLOYEES)(EMPLOYEES)
(2)(2)
TOTAL PRODUCTTOTAL PRODUCT
(SANDWICHES(SANDWICHES
PER HOUR)PER HOUR)
(3)(3)
MARGINALMARGINAL
PRODUCT OFPRODUCT OF
LABORLABOR
(4)(4)
AVERAGEAVERAGE
PRODUCTPRODUCT
OF LABOROF LABOR
00 00 −− −−
11 1010 1010 10.010.0
22 2525 1515 12.512.5
33 3535 1010 11.711.7
44 4040 55 10.010.0
55 4242 22 8.48.4
66 4242 00 7.07.0
0
5
10
15
20
25
30
35
40
45
0 1 2 3 4 5 6 7
Number of employees
Totalproduct
0
5
10
15
0 1 2 3 4 5 6 7
Number of employees
MarginalProduct

Total, Average, and Marginal ProductTotal, Average, and Marginal Product
• Marginal product is the slopeMarginal product is the slope
of the total product function.of the total product function.
• At point C, total product isAt point C, total product is
maximum, the slope of themaximum, the slope of the
total product function is zero,total product function is zero,
and marginal productand marginal product
intersects the horizontal axis.intersects the horizontal axis.
• At point A, the slope of theAt point A, the slope of the
total product function istotal product function is
highest; thus, marginal producthighest; thus, marginal product
is highest.is highest.

• When a ray drawn from theWhen a ray drawn from the
origin falls tangent to the totalorigin falls tangent to the total
product function, averageproduct function, average
product is maximum and equalproduct is maximum and equal
to marginal product.to marginal product.
• Then, average product falls toThen, average product falls to
the left and right of point B.the left and right of point B.

• As long as marginal productAs long as marginal product
rises, average product rises.rises, average product rises.
• When average product isWhen average product is
maximum, marginal productmaximum, marginal product
equals average product.equals average product.
• When average product falls,When average product falls,
marginal product is less thanmarginal product is less than
average product.average product.

Production Functions with Two VariableProduction Functions with Two Variable
Factors of ProductionFactors of Production
• In many production processes, inputs workIn many production processes, inputs work
together and are viewed as complementary.together and are viewed as complementary.
• For example, increases in capital usage lead toFor example, increases in capital usage lead to
increases in the productivity of labor.increases in the productivity of labor.
Inputs Required to Produce 100 DiapersInputs Required to Produce 100 Diapers
Using Alternative TechnologiesUsing Alternative Technologies
TECHNOLOGYTECHNOLOGY
UNITS OFUNITS OF
CAPITAL (K)CAPITAL (K)
UNITS OFUNITS OF
LABOR (L)LABOR (L)
AA 22 1010
BB 33 66
CC 44 44
DD 66 33
EE 1010 22
• Given the
technologies
available, the
cost-minimizing
choice depends
on input prices.

Production Functions with Two VariableProduction Functions with Two Variable
Factors of ProductionFactors of Production
Cost-Minimizing Choice Among AlternativeCost-Minimizing Choice Among Alternative
Technologies (100 Diapers)Technologies (100 Diapers)
(1)(1)
TECHNOLOGYTECHNOLOGY
(2)(2)
UNITS OFUNITS OF
CAPITAL (K)CAPITAL (K)
(3)(3)
UNITS OFUNITS OF
LABORLABOR
(4)(4)
COST WHENCOST WHEN
PPLL = $1 P= $1 PKK = $1= $1
(5)(5)
COST WHENCOST WHEN
PPLL = $1 P= $1 PKK = $1= $1
AA 22 1010 $12$12 $52$52
BB 33 66 99 3333
CC 44 44 88 2424
DD 66 33 99 2121
EE 1010 22 1212 2020

The Production Process: The Behavior of Profit Maximizing Firms

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