Ch. 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.
6.1
Perfect Competition
6.2
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
Competitive Firms are Price Takers
6.3
• 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.
The Behavior of
Profit-Maximizing Firms
6.4
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
All three of these decisions are made in such a way as to
maximize the firm’s profits.
Profits and Economic Costs
•
•
•
6.5
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 costs
2. Opportunity cost of each factor of production, including
a normal rate of return on capital
Opportunity Cost of Factors of Production
6.6
• 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:
Normal Rate of Return
6.7
• 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.
Calculating Economic Profits:
6.8
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:
6.9
A Second Example from the Textbook:
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
Labor Cost
Normal return/opportunity cost of capital ($20,000 x .10)
Total Cost
Profit = total revenue - total cost
aThere
is a loss of $1,000.
$15,000
14,000
2,000
$31,000
- $ 1,000a
Short-Run Versus Long-Run Decisions
6.10
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.
The 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.
6.11
6.12
Example: Production Function for Sandwiches
45
Production Function
40
(1)
LABOR UNITS
(EMPLOYEES)
0
(2)
TOTAL PRODUCT
(SANDWICHES PER
HOUR)
0
Total product
35
30
25
20
15
10
5
0
0
1
10
2
25
3
35
4
40
5
42
6
42
1
2
3
4
5
Number of employees
6
7
Marginal Product and Average Product
6.13
• Average product is the average amount produced by each unit of a variable
factor of production. For Labor it is:
TP
APL 
L
• 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:
TP
MPL 
L
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.
6.14
Marginal and Average Product
45
Production Function
40
(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
Total product
35
30
25
20
15
10
5
0
0
1
2
3
4
5
6
7
6
7
Number of employees
Marginal Product
15
10
5
0
0
1
2
3
4
5
Number of employees
Total, Average, and Marginal Product
6.15
• 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.
Total, Average, and Marginal Product
6.16
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
Production Functions with Two Variable Factors of
Production
6.17
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)
UNITS OF
CAPITAL (K)
UNITS OF
LABOR
A
2
10
B
3
6
C
4
4
D
6
3
E
10
2
TECHNOLOGY
COST WHEN PL
= $1
PK = $1
COST WHEN
PL = $5
PK = $1