CHAPTER 7

The Behavior of Profit-Maximizing Firms

• Production: The process by which inputs are combined,

transformed, and turned into outputs.
• 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.
• The three decisions that all firms must make to achieve
maximum profits: (1) How much output to supply (quantity of
product) , 2. How to produce that output (which production
technique/technology to use), (3) How much of each input to
demand.
• The first and last choices are linked by the second choice. Once
a firm has decided how much to produce, the choice of a
production method determines the firm’s input requirements.
• Similarly, given a technique of production, any set of input
quantities determines the amount of output that can be
produced. Changing the technology of production will change
the relationship between input and output quantities.
• A profit maximizing firm chooses the technology that
minimizes its costs for a given level of output.
• We assume that firms are in business to make a profit and that
a firm’s behavior is guided by the goal of maximizing profits.
• Profit is the difference between total revenue and total cost.
Profit = total revenue - total cost
• Total revenue is the amount received from the sale of the
product (q x P).
• Total cost (total economic cost) is the total of (1) out-of-
pocket costs and (2) opportunity cost of all factors of
production, including a normal rate of return on capital.
• Out-of-pocket costs are sometimes referred to as explicit costs
or accounting costs. These refer to costs as an accountant
would calculate them.
• Economic costs include the opportunity cost of every input.
These opportunity costs are often referred to as implicit costs.
The term profit will from here on refer to economic profit.
• The most important opportunity cost that is included in
economic cost is the opportunity cost of capital. The way we
treat the opportunity cost of capital is to add a normal rate of
return to capital as part of economic cost.
• Rate of return is the annual flow of net income generated by
an investment expressed as a percentage of the total
investment.
• 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.
• 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 the industry.
• To know how much it costs to produce a good or service, a firm
needs to know three things (the bases of decisions) : (1) The
market price of output, (2) The techniques of production that
are available, and (3) The prices of inputs.
• 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.
• 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.
• 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.
• Average product: The average amount produced by each unit
of a variable factor of production.
• Marginal Product > Average Product : Average Product
increase
• Marginal Product < Average Product : Average Product
decrease
• Marginal Product = Average Product : Average Product
maximum
 CHAPTER 8
SHORT RUN COSTS AND OUTPUT DECISIONS

• There are three decisions facing firms:

a. The quantity of output to supply
b. How to produce that output (which technique to use)
c. The quantity of each input to demand
• The short run is a period of time for which two conditions hold:
a. The firm is operating under a fixed scale (fixed factor) of
production,
b. Firms can neither enter nor exit an industry.

Costs in the short run

TC = TFC + TVC
Where, TC: Total Costs
TFC: Total Fixed Cost
TVC: Total Variable Cost
• Fixed Cost is any cost that does not depend on the firm’s level of
output. These costs are incurred even if the firm is producing
nothing.
• Average Fixed Cost (AFC), is the total fixed cost (TFC) divided
by the number of units of output (q).
• Variable cost is a cost that depends on the level of production
chosen.
• Average Variable Cost (AVC), is the total variable cost (TVC)
divided by the number of units of output (q).
• Marginal Cost (MC), is the increase in total cost that result from
producing one more unit of output. Marginal cost reflects changes
in variable costs. Causes marginal cost is the cost of one additional
unit.

• Average variable cost is the average variable cost per unit of all
units being produced. So, average variable cost follows marginal
cost, but lags behind.
• Sunk costs occur when firms have no control over fixed costs in
the short run.
• Accounting costs are Out-of-pocket costs or costs as an
accountant would define them. Sometimes referred to as explicit
costs.
• Economic costs are costs that include the full opportunity costs of
all inputs. These include what are often called implicit costs.
• In the short run, every firm is constrained by some fixed input that
(1) leads to diminishing returns to variable inputs and (2) limits its
capacity to produce. As a firm approaches that capacity, it becomes
increasingly costly to produce successively higher levels of output.
Marginal costs ultimately increase with output in the short run.
• The relationship between marginal cost and average variable cost:
a. When marginal cost is below average cost, AC is declining.
b. When marginal cost is above average cost, AC is increasing.
• Output Decisions
Remember that we are working under two assumptions:
a. that the industry we are examining is perfectly
competitive
b. that firms choose the level of output that yields the
maximum total profit
o Revenue
a. Total Revenue is the total amount that a firm takes in from
the sale of its output. TR = P x q
b. Marginal Revenue is the additional revenue that a firm
takes in when it increases output by one additional unit.
o In perfect competition, MR = P, therefore, the profit-maximizing
perfectly competitive firm will produce up to the point where the
price of its output is just equal to short run marginal cost. The key
idea is that firms will produce as long as marginal revenue
exceeds marginal cost.