Case Econ08 Ab - Az.ppt 07

Chapter
7
The Production Process:
The Behavior of
Profit-Maximizing Firms
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair
The Production Process:
The Behavior of 7
Profit-Maximizing Firms
Chapter Outline
The Behavior of Profit-

Maximizing Firms
Profits and Economic Costs
Short-Run versus Long-Run
Decisions
The Bases of Decisions: Market
Price of Outputs, Available
Technology, and Input Prices
The Production Process

Production Functions: Total
Product, Marginal Product, and
Average Product
Production Functions with Two
Variable Factors of Production
-ti f or Pf o
Choice of Technology
Looking Ahead: Cost and Supply

a M
Appendix: Isoquants and Isocosts

HC
© 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 2 of 33
THE PRODUCTION PROCESS: THE BEHAVIOR
-ti f or Pf o
OF PROFIT-MAXIMIZING FIRMS
FIGURE 7.1 Firm and Household

Decisions
a M
HC
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 33
Although Chapters 7 through 12 describe the behavior of

perfectly competitive firms, much of what we say in these
chapters also applies to firms that are not perfectly
competitive. For example, when we turn to monopoly in
Chapter 13, we will be describing firms that are similar to
competitive firms in many ways. All firms, whether
competitive or not, demand inputs, engage in production,
and produce outputs. All firms have an incentive to
maximize profits and thus to minimize costs.
production The process by which inputs

-ti f or Pf o
are combined, transformed, and turned

into outputs.
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Production Is Not Limited to Firms
firm 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.
-ti f or Pf o
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Perfect Competition
perfect competition An industry structure in

which there are many firms, each small relative
to the industry, producing virtually identical
products and in which no firm is large enough to
have any control over prices. In perfectly
competitive industries, new competitors can
freely enter and exit the market.
homogeneous products Undifferentiated

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products; products that are identical to, or

indistinguishable from, one another.
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-ti f or Pf o
FIGURE 7.2 Demand Facing a Single Firm in a Perfectly Competitive Market

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THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS
All firms must make several basic decisions to achieve what

we assume to be their primary objective—maximum profits.
1. 2. 3.
How much Which production How much of
output to technology each input to
supply to use demand
FIGURE 7.3 The Three Decisions That All Firms Must Make
-ti f or Pf o
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PROFITS AND ECONOMIC COSTS
profit (economic profit) The difference

between total revenue and total cost.
profit = total revenue - total cost
total revenue The amount received from the

sale of the product (q x P).
-ti f or Pf o
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PROFITS AND ECONOMIC COSTS
total cost (total economic cost) The total of

(1) out-of-pocket costs, (2) normal rate of return
on capital, and (3) opportunity cost of each
factor of production.
The term profit will from here on refer to economic

profit. So whenever we say profit = total revenue - total
cost, what we really mean is
-ti f or Pf o
economic profit = total revenue - total economic cost

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Normal Rate of Return
normal rate of return 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.
TABLE 7.1 Calculating Total Revenue, Total Cost, and Profit
INITIAL INVESTMENT: $20,000
MARKET INTEREST RATE AVAILABLE: 0.10 OR 10%
Total revenue (3,000 belts x $10 each) $30,000
Costs
Belts from Supplier 15,000
-ti f or Pf o
Labor cost 14,000

Normal return/Opportunity Cost of Capital ($20,000 x 0.10) 2,000
Total Cost $31,000
a M
Profit = total revenue - total cost −1,000

HC
SHORT-RUN VERSUS LONG-RUN DECISIONS
short run The period of time for which two

conditions hold: The firm is operating under a
fixed scale (fixed factor) of production, and firms
can neither enter nor exit an industry.
long run That period of time for which there

are no fixed factors of production: Firms can
increase or decrease the scale of operation, and
new firms can enter and existing firms can exit
-ti f or Pf o
the industry.
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THE BASES OF DECISIONS: MARKET PRICE OF

OUTPUTS, AVAILABLE TECHNOLOGY, AND INPUT
PRICES
The bases of decision making:
1. The market price of output

2. The techniques of production that are available
3. The prices of inputs
Output price determines potential revenues. The techniques

available tell me how much of each input I need, and input
-ti f or Pf o
prices tell me how much they will cost. Together, the

available production techniques and the prices of inputs
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determine costs.
HC
Price of output Production techniques Input prices
Determines Determine total cost and

optimal
total revenue method of production
Total revenue
−Total cost with optimal method
= Total profit
FIGURE 7.4 Determining the Optimal Method of Production

-ti f or Pf o
optimal method of production The production

method that minimizes cost.
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THE PRODUCTION PROCESS
production technology The quantitative

relationship between inputs and outputs.
labor-intensive technology Technology

that relies heavily on human labor instead
of capital.
capital-intensive technology Technology

that relies heavily on capital instead of
human labor.
-ti f or Pf o
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HC
PRODUCTION FUNCTIONS: TOTAL PRODUCT,

MARGINAL PRODUCT, AND AVERAGE PRODUCT
production function or total product

function 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.
-ti f or Pf o
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HC
TABLE 7.2 Production Function

(2) (4)
(1) TOTAL (3) AVERAGE PRODUCT
LABOR PRODUCT MARGINAL OF LABOR
UNITS (SANDWICHES PRODUCT (TOTAL PRODUCT
EMPLOYEES PER HOUR) OF LABOR LABOR UNITS)
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
-ti f or Pf o
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-ti f or Pf o
FIGURE 7.5 Production Function for Sandwiches

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Marginal Product and the Law of Diminishing

Returns
marginal product The additional output

that can be produced by adding one more
unit of a specific input, ceteris paribus.
law of diminishing returns When additional

units of a variable input are added to fixed
inputs after a certain point, the marginal
product of the variable input declines.
-ti f or Pf o
Diminishing returns always apply in the short run, and in the short run every firm will face
diminishing returns. This means that every firm finds it progressively more difficult to
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increase its output as it approaches capacity production.

Marginal Product versus Average Product
average product The average amount

produced by each unit of a variable factor of
production.
total product
average product of labor =
total units of labor
-ti f or Pf o
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FIGURE 7.6 Total Average and

Marginal Product
-ti f or Pf o
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PRODUCTION FUNCTIONS WITH TWO VARIABLE

FACTORS OF PRODUCTION
In general, additional capital

increases the productivity of
labor. Because capital—
buildings, machines, and so
on—is of no use without
people to operate it, we say
that capital and labor are
complementary inputs.
-ti f or Pf o
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CHOICE OF TECHNOLOGY
TABLE 7.3 Inputs Required to Produce 100 Diapers Using

Alternative Technologies
UNITS OF UNITS OF
TECHNOLOGY CAPITAL (K) LABOR (L)
A 2 10
B 3 6
C 4 4
D 6 3
E 10 2
-ti f or Pf o
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CHOICE OF TECHNOLOGY
TABLE 7.4 Cost-Minimizing Choice Among Alternative Technologies (100 Diapers)

(4) (5)
(2) (3) Cost = (L x PL) + (K x PK)
(1) UNITS OF UNITS OF
PL = $1 PL = $5
TECHNOLOGY CAPITAL (K) LABOR (L)
PK = $1 PK = $1
A 2 10 $12 $52
B 3 6 9 33
C 4 4 8 24
D 6 3 9 21
E 10 2 12 20
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Two things determine the cost of production: (1) technologies that are available and (2)
input prices. Profit-maximizing firms will choose the technology that minimizes the cost of
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production given current market input prices.

REVIEW TERMS AND CONCEPTS
average product production function or total

capital-intensive technology product function
firm production technology
homogeneous products profit (economic profit)
labor-intensive technology short run
law of diminishing returns total cost (total economic cost)
long run total revenue
marginal product 1. Profit = total revenue - total cost
normal rate of return
optimal method of total product
2. Average product of labor =
total units of labor
production
-ti f or Pf o
perfect competition
production
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Appendix
ISOQUANTS AND ISOCOSTS
NEW LOOK AT TECHNOLOGY: ISOQUANTS
TABLE 7A.1 Alternative Combinations of Capital (K) and Labor (L) Required
to Produce 50, 100, and 150 Units of Output
QX = 50 QX = 100 QX = 150
K L K L K L
A 1 8 2 10 3 10
B 2 5 3 6 4 7
C 3 3 4 4 5 5
D 5 2 6 3 7 4
E 8 1 10 2 10 3
-ti f or Pf o
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Appendix
Isoquant A graph
that shows all the
combinations of
capital and labor
that can be used
to produce a given
amount of output.
-ti f or Pf o
FIGURE 7A.1 Isoquants Showing All Combinations of Capital

and Labor That Can Be Used to Produce 50,
a M
100, and 150 Units of Output

HC
Appendix
Slope of isoquant:
∆K MPL
=−
∆L MPK
marginal rate of
technical substitution
The rate at which a
firm can substitute
capital for labor and
hold output constant.
-ti f or Pf o
FIGURE 7A.2 The Slope of an Isoquant Is Equal

to the Ratio of MPL to MPK
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Appendix
FACTOR PRICES
AND INPUT
COMBINATIONS:
ISOCOSTS
isocost line A
graph that shows all
the combinations of
capital and labor
available for a given
total cost.
-ti f or Pf o
FIGURE 7A.3 Isocost Lines Showing the

Combinations of Capital and Labor
Available for $5, $6, and $7
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Appendix
FIGURE 7A.4 Isocost Line Showing All

Combinations of Capital and
Labor Available for $25
Slope of isocost line:
∆K TC / PK PL
=− =−
∆L TC / PL PK
-ti f or Pf o
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Appendix
FINDING THE LEAST-COST TECHNOLOGY WITH

ISOQUANTS AND ISOCOSTS
FIGURE 7A.5 Finding the Least-Cost

Combination of Capital and
Labor to Produce 50 Units of
Output
The firm will choose the combination of

inputs that is least costly. The least costly
way to produce any given level of output is
indicated by the point of tangency between
an isocost line and the isoquant
corresponding to that level of output.
-ti f or Pf o
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-ti f or Pf o
Appendix
FIGURE 7A.6 Minimizing Cost of FIGURE 7A.7 A Cost Curve Shows the
Production for qX = 50, qX Minimum Cost of
= 100, and qX = 150 Producing Each Level of
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Output
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Appendix
THE COST-MINIMIZING EQUILIBRIUM CONDITION
At the point where a line is just tangent to a curve, the two

have the same slope. At each point of tangency, the
following must be true:
MPL PL
σλοπεοφ ισοθυαντ
=− = σλοπεοφ ισοχοστ
=−
MPK PK
MPL PL
Thus, =
MPK PK
Dividing both sides by PL and multiplying both sides by MPK, we get

-ti f or Pf o
MPL MPK
=
PL PK
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Chapter

Fernando & Yvonn Quijano

The Behavior of Profit-

The Production Process

Looking Ahead: Cost and Supply

Appendix: Isoquants and Isocosts

FIGURE 7.1 Firm and Household

Although Chapters 7 through 12 describe the behavior of

production The process by which inputs

are combined, transformed, and turned

Production Is Not Limited to Firms

firm An organization that comes into

perfect competition An industry structure in

homogeneous products Undifferentiated

products; products that are identical to, or

FIGURE 7.2 Demand Facing a Single Firm in a Perfectly Competitive Market

All firms must make several basic decisions to achieve what

PROFITS AND ECONOMIC COSTS

profit (economic profit) The difference

profit = total revenue - total cost

total revenue The amount received from the

PROFITS AND ECONOMIC COSTS

total cost (total economic cost) The total of

The term profit will from here on refer to economic

economic profit = total revenue - total economic cost

normal rate of return A rate of return on

Labor cost 14,000

Profit = total revenue - total cost −1,000

SHORT-RUN VERSUS LONG-RUN DECISIONS

short run The period of time for which two

long run That period of time for which there

THE BASES OF DECISIONS: MARKET PRICE OF

The bases of decision making:

1. The market price of output

Output price determines potential revenues. The techniques

prices tell me how much they will cost. Together, the

Price of output Production techniques Input prices

Determines Determine total cost and

FIGURE 7.4 Determining the Optimal Method of Production

optimal method of production The production

production technology The quantitative

labor-intensive technology Technology

capital-intensive technology Technology

PRODUCTION FUNCTIONS: TOTAL PRODUCT,

production function or total product

TABLE 7.2 Production Function

FIGURE 7.5 Production Function for Sandwiches

Marginal Product and the Law of Diminishing

marginal product The additional output

law of diminishing returns When additional

increase its output as it approaches capacity production.

Marginal Product versus Average Product

average product The average amount

FIGURE 7.6 Total Average and

PRODUCTION FUNCTIONS WITH TWO VARIABLE

In general, additional capital

TABLE 7.3 Inputs Required to Produce 100 Diapers Using

TABLE 7.4 Cost-Minimizing Choice Among Alternative Technologies (100 Diapers)

production given current market input prices.

average product production function or total

ISOQUANTS AND ISOCOSTS

NEW LOOK AT TECHNOLOGY: ISOQUANTS