6.1Ch. 6: The Production Process:The Behavior of Profit- Maximizing Firms

• Production is the process by which inputs are combined, transformed, and turned into outputs.

• 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.

6.2Perfect Competition

Perfect competition is an industry structure in which • There are many buyers and sellers, each small relative to the

industry

• The product is identical (or homogeneous)

• There is easy entry and exit into and out of the market

• Buyers and Sellers have perfect knowledge (complete information): households posses a knowledge of the qualities and prices of everything available in the market, and that firms have all available information concerning wage rates, capital costs, and output prices.

no one firm or consumer has any control over price

6.3Competitive Firms are Price Takers

• In a perfectly competitive market where no one firm or consumer has any control over price, they are called price-takers. Price is determined by the interaction of market supply and demand.

• Each firm is small relative to the market

• Each firm can sell all it wants to sell at the market price the firm “faces” a perfectly elastic demand curve for its product.

6.4The Behavior ofProfit-Maximizing Firms

The three decisions that all firms must make include:

How much of each input to demand

3.

Which production technology to use

2.

How much output to supply

1.

All three of these decisions are made in such a way as to maximize the firm’s profits.

6.5Profits 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 = p x q• Total cost (total economic cost) is the total of

1. Out of pocket costs2. Opportunity cost of each factor of production, including

a normal rate of return on capital

6.6Opportunity Cost of Factors of Production

• In some situations, the opportunity cost of a factor of production is simply what the firm pays for it

• Other times, a firm may not make an explicit payment for a factor of production, but the use of the factor still incurs an implicit cost

Examples:

6.7Normal Rate of Return

• The normal rate of return is a rate of return on capital that is just sufficient to keep owners and investors satisfied.

• For relatively risk-free firms, it should be nearly the same as the interest rate on risk-free government bonds.

6.8Calculating Economic Profits:

Suppose you decide to open a hotdog stand on campus, because you find that your parents have a perfectly good hotdog cart sitting in the garage. These carts normally rent for $5,000 per year. You decide to quit your job a McDonald’s where you were earning $12,000 a year to run the hotdog stand. In your first year of operation, you sell 30,000 hotdogs at $1 each. The cost of your supplies (hotdogs, rolls, condiments, etc.) were $15,000. Calculate your economic profit:

6.9A Second Example from the Textbook:

Initial Investment:Market Interest Rate Available:

$20,000.10 or 10%

Total Revenue (3,000 belts x $10 each) $30,000

Costs

Belts from supplier $15,000

Labor Cost 14,000

Normal return/opportunity cost of capital ($20,000 x .10) 2,000

Total Cost $31,000

Profit = total revenue total cost $ 1,000a

aThere is a loss of $1,000.

6.10Short-Run Versus Long-Run Decisions

The short run is a period of time for which two conditions hold:1. The firm is operating with at least one factor of

production being fixed.2. Firms can neither enter nor exit an industry.

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.

We distinguish between these two time frames because firm’s decision-making will differ depending on whether it is a short-run decision or a long-run decision.

6.11The Production Process

Production technology refers to the quantitative relationship between inputs and outputs.

• 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 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.

6.12Example: Production Function for Sandwiches

Production Function

(1)LABOR UNITS (EMPLOYEES)

(2)TOTAL PRODUCT

(SANDWICHES PER HOUR)

0 0

1 10

2 25

3 35

4 40

5 42

6 42

0

5

10

15

20

25

30

35

40

45

0 1 2 3 4 5 6 7

Number of employees

Tot

al p

rodu

ct

6.13Marginal 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. For Labor it is:

• Average product is the average amount produced by each unit of a variable factor of production. For Labor it is:

L

TPMPL

L

TPAPL

The law of diminishing marginal returns (or diminishing marginal product) states that:When additional units of a variable input are added to fixed inputs, the marginal product of the variable input eventually declines.

6.14Marginal and Average Product

Production Function

(1)LABOR UNITS (EMPLOYEES)

(2)TOTAL PRODUCT

(SANDWICHES PER HOUR)

(3)MARGINAL

PRODUCT OF LABOR

(4)AVERAGE

PRODUCT OF LABOR

0 0

1 10 10 10.0

2 25 15 12.5

3 35 10 11.7

4 40 5 10.0

5 42 2 8.4

6 42 0 7.0

0

5

10

15

20

25

30

35

40

45

0 1 2 3 4 5 6 7

Number of employees

Tot

al p

rodu

ct0

5

10

15

0 1 2 3 4 5 6 7

Number of employees

Mar

gina

l Pro

duct

6.15Total, Average, and Marginal Product

• Marginal product is the slope of the total product function.

• At point C, total product is maximum, the slope of the total product function is zero, and marginal product intersects the horizontal axis.

• At point A, the slope of the total product function is highest; thus, marginal product is highest.

6.16Total, Average, and Marginal Product

Average 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.

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

6.17Production 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. Given the technologies available, the cost-minimizing choice depends on input prices.

Cost-Minimizing Choice Among Alternative Technologies (100 Diapers)

TECHNOLOGYUNITS OF

CAPITAL (K)UNITS OF

LABOR

COST WHEN PL = $1

PK = $1

COST WHEN PL = $5PK = $1

A 2 10

B 3 6

C 4 4

D 6 3

E 10 2