The Production Process: The Behavior of Profit-Maximizing Firms

CHAPTER 6
The Production Process:

The Behavior of
Profit-Maximizing Firms
Appendix: Isoquants and Isocosts
Prepared by: Fernando Quijano

and Yvonn Quijano
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
Production
The Behavior of Profit-Maximizing Firms
C H A P T E R 6: The Production Process:
Central to our analysis is

production, the process by
which inputs are combined,
transformed, and turned
into outputs.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 37
Firm and Household Decisions
• Firms demand
factors of
production in
input markets and
supply goods and
services in output
markets.
What Is A Firm?
• 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.
• Many important differences exist
between firms.
Perfect Competition
Perfect competition is 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
• Homogeneous products are

undifferentiated products; products

that are identical to, or
indistinguishable from, one another.
• In a perfectly competitive market,
individual firms are price-takers.
Firms have no control over price;
price is determined by the interaction
of market supply and demand.
Demand Facing a Single Firm
in a Perfectly Competitive Market
• The perfectly competitive firm faces a perfectly

elastic demand curve for its product.
The Behavior of
Profit-Maximizing Firms
• The three decisions that all

firms must make include:
1.
How much
output to 2.
supply Which
production 3.
technology How much
to use of each
input to
demand
Profits and Economic Costs
• Profit (economic profit) is the

difference between total revenue

and total economic cost.
• Total revenue is the amount

received from the sale of the
product:
• Total cost (total economic cost)

is 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 rate of return, often referred to

as the yield of the investment, is the

annual flow of net income generated
by an investment expressed as a
percentage of the total investment.
• 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, the normal
rate of return be nearly the same as the
interest rate on risk-free government
bonds.
• Out-of-pocket costs are sometimes

referred to as explicit costs or

accounting costs.
• Economic costs, often referred to
as implicit cots, include the full
opportunity cost of every input.
Calculating Total
Revenue, Total Cost, and Profit
Initial Investment: $20,000

Market Interest Rate Available: .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
a
There is a loss of $1,000.
Short-Run Versus Long-Run Decisions
• The short run is a period of

time for which two conditions

hold:
1. The firm is operating under a
fixed scale (or fixed factor) of
production, and
2. Firms can neither enter nor exit
the industry.
Short-Run Versus Long-Run Decisions
• 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.
The Bases of Decisions
• The fundamental things to know with

the objective of maximizing profit are:
1. 2. 3.
The market The techniques The prices
price of of production of inputs
the output that are
available
Determining the
Optimal Method of Production
Price of output Production techniques Input prices

Determines Determine total cost and

total revenue optimal method of production
Total revenue
− Total cost with optimal method
=Total profit
• The optimal method of production

is the method that minimizes cost.
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.
Labor Intensive
The Production Function
• 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.
Marginal Product
• Marginal product is
the additional output

that can be produced
by adding one more
unit of a specific input,
ceteris paribus.
The Law of
Diminishing Marginal Returns
• The law of diminishing

marginal returns states

that:
When additional units of a
variable input are added to
fixed inputs, the marginal
product of the variable input
declines.
Average Product
• Average product is
the average amount

produced by each unit
of a variable factor of
production.
Production Function for Sandwiches
Production Function
(2) (3) (4)

(1) TOTAL PRODUCT MARGINAL AVERAGE
LABOR UNITS (BAKPIA PER PRODUCT OF PRODUCT
(EMPLOYEES) HOUR) LABOR 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, Average, and Marginal Product
• 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.
• When average product is

maximum, average product

and marginal product are
equal.
• Then, average product
falls to the left and right of
point B.
Remember that:
• 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
• 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.
Inputs Required to Produce 100 Diapers • Given the

Using Alternative Technologies technologies
UNITS OF UNITS OF
TECHNOLOGY
CAPITAL (K) LABOR (L)
available, the
A 2 10 cost-minimizing
B 3 6 choice depends
C 4 4
D 6 3
on input prices.
E 10 2
Production Functions with Two
Variable Factors of Production
Cost-Minimizing Choice Among Alternative

Technologies (100 Diapers)

(4)
(2) (3) COST (5) COST
(1) UNITS OF UNITS OF WHEN PL = WHEN PL = $5 PK
TECHNOLOGY CAPITAL (K) LABOR (L) $1 PK = $1 = $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
• An isoquant is a graph
that shows all the

combinations of capital
and labor that can be
used to produce a given
amount of output.
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
• Along an isoquant:
• The slope of an
isoquant is called the
marginal rate of
technical substitution.
• An isocost line is a
graph that shows all the

combinations of capital
and labor that are
available for a given
total cost.
• The equation of the
isocost line is:
• Slope of the isocost

line:
• By setting the slopes of the

isoquant and isocost curves

equal to each other,
we derive the firm’s

cost-minimizing
equilibrium condition is
found
• Plotting a series of cost-minimizing combinations of

inputs (at points A, B, and C), yields a cost curve.

The Production Process: The Behavior of Profit-Maximizing Firms

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Production Process: The Behavior of Profit-Maximizing Firms

Uploaded by

Copyright:

Available Formats

CHAPTER 6

The Production Process:

Prepared by: Fernando Quijano

Central to our analysis is

• A firm is an organization that comes

into being when a person or a group

Perfect competition is an industry

structure in which there are:

• Homogeneous products are

undifferentiated products; products

• The perfectly competitive firm faces a perfectly

• The three decisions that all

firms must make include:

• Profit (economic profit) is the

difference between total revenue

• Total revenue is the amount

• Total cost (total economic cost)

• The rate of return, often referred to

as the yield of the investment, is the

• The normal rate of return is a rate

of return on capital that is just

• Out-of-pocket costs are sometimes

referred to as explicit costs or

Initial Investment: $20,000

Market Interest Rate Available: .10 or 10%

Belts from supplier $15,000

• The short run is a period of

time for which two conditions

• The long run is a period of

time for which there are no

• The fundamental things to know with

the objective of maximizing profit are:

Price of output Production techniques Input prices

Determines Determine total cost and

• The optimal method of production

• Production technology refers to the

quantitative relationship between

the additional output

• The law of diminishing

marginal returns states

the average amount

(2) (3) (4)

• Marginal product is the slope

of the total product function.

• When average product is

maximum, average product

• In many production processes, inputs work

together and are viewed as complementary.

Inputs Required to Produce 100 Diapers • Given the

Cost-Minimizing Choice Among Alternative

Technologies (100 Diapers)

that shows all the

Alternative Combinations of Capital (K)

and Labor (L) Required to Produce 50,

graph that shows all the

• Slope of the isocost

• By setting the slopes of the

isoquant and isocost curves

we derive the firm’s

• Plotting a series of cost-minimizing combinations of

inputs (at points A, B, and C), yields a cost curve.

You might also like