Unit 4 - Business Production

Behavior
 Factors of Production

The three factors of production are:

1. Land (including all natural resources)
2. Labor (manual, managerial, entrepreneurial)
3. Capital goods (machines, equipment,
buildings)

Microeconomics
 Unit 4 - Business Production
Behavior
 Factor Prices

Prices of factors of production are:

 Wages (payment for labor, including salaries
and commissions)
 Rent (payment for the use of land)
 Interest (payment for the use of capital goods)
 Profits (payment for entrepreneurship)

Microeconomics
 Unit 4 - Business Production
Behavior
 Production Functions

A production function is a relationship

between inputs (factors of production) and
outputs (production).

Microeconomics
 Unit 4 - Business Production
Behavior
 Production Functions

In the table on the next slide, we look at a

simple production function.

We vary the number of workers, or labor

(variable input), and keep the units of
machinery constant (fixed input).

Microeconomics
Unit 4 - Business Production
Behavior
Labor Units of Production
Machinery
0 2 0

1 2 3

2 2 7

3 2 15

4 2 19
Microeconomics
 Unit 4 - Business Production
Behavior
 Production Functions

Marginal production is the additional production

per worker. Adding this in the table, we get (see
next slide):

Microeconomics
 Unit 4 - Business Production
Behavior
Labor Units of Production Marginal
Machinery Production
0 2 0 -

1 2 3 3

2 2 7 4

3 2 15 8

4 2 19 4
 Unit 4 - Business Production
Behavior
 Production Functions
In the table on the previous slide, marginal
production decreases after the 3rd worker.

Adding a variable input to a fixed input eventually

results in decreasing marginal production.

This is the law of diminishing marginal

production.
Microeconomics
 Unit 4 - Business Production
Behavior
 Production Functions

The next slide shows a production function in

which the number of workers increases by more
than 1.

Note that marginal production is the change in

total production divided by the change in the
number of workers,
or: Q/ L
Microeconomics
Unit 4 - Business Production
Behavior
Labor Units of Production Marginal
Machinery Production
0 6 0 -

5 6 10 2

10 6 30 4

15 6 70 8

20 6 100 6
 Unit 4 - Business Production
Behavior
 Production Functions

Average production is the production per

worker, or total production divided by the
number of workers.

Question:
In the previous table, what is average
production when the number of workers is 10?
Microeconomics
 Unit 4 - Business Production
Behavior
 Production Functions

Answer:
Total production = 30, so
average production
= 30 / 10 = 3

Microeconomics
Unit 4 - Business Production
Behavior
Short Run versus Long Run

The short run is the period of

time during which a firm is
unable to change all of its
factors of production
(it has at least one fixed input).

The long run is the period of time during which a firm

can change all of its factors of production.

Microeconomics
Unit 4 - Business Production
Behavior
Production and Costs
A firm’s production and costs are directly related.
Let’s say that a firm employs 10 workers, and 2
units of machinery, and produces 30 products per
week.

Each worker costs $500 per week. Each machine

costs $800.

What are the firm’s total and average costs?

Microeconomics
Unit 4 - Business Production
Behavior
 Production and Costs

The cost of labor is 10 x $500 = $5,000.

The cost of the machinery is 2 x $800 = $1,600.

Total cost is $5,000 + $1,600 = $6,600.

Average cost (cost per product) is $6,600 / 30 = $220.

Microeconomics
Unit 4 - Business Production
Behavior
 Production and Costs

 See Unit 4, Section 3 for additional

examples of the relationship between
production and costs.

Microeconomics
 Unit 4 - Business Production
Behavior
 Nominal and Real Factor Prices
Nominal prices are the actual values charged by
the factor supplier.

Real prices are adjusted for inflation.

For example, if a bank charges 10% interest on a

loan, and inflation is 6%, then the real interest rate
on the loan is 10% minus 6%, or 4%.

Microeconomics
 Unit 4 - Business Production
Behavior
 Factor Prices

In a free market, factor prices are determined by

the demand for and the supply of the factor of
production.

For example, interest rates are determined by the

demand for and the supply of loans.

Microeconomics
Unit 4 - Business Production
Behavior
 Interest Rates
In the next diagram, the equilibrium interest rate is
8%.

Microeconomics
Unit 4 - Business Production
Behavior
 Interest Rates
If the demand for loans increases, then the interest
rate increases:

Microeconomics
Unit 4 - Business Production
Behavior
 Interest Rates and Present Value

Because of interest, the value of money increases

over time. $1,000 today is not the same as $1,000
one year from today.

The present value of a future sum of money is:

PV = F / (1 + i) n

Microeconomics
Unit 4 - Business Production
Behavior
Interest Rates and Present Value

Example 1
Someone promises to pay you $1,000 one year
from today. How much is it worth to you today?
Assume that the interest rate is 6%.

Answer: n
PV = F / (1 + i) 1
PV = $1,000 / (1 + .06) = $1,000 / 1.06 = $943.40

Microeconomics
Unit 4 - Business Production
Behavior
Interest Rates and Present Value

Example 2
Someone promises to pay you $5,000 five years
from today. How much is it worth to you today?
Assume that the market interest rate is 8%.

Answer:
PV = F / (1 + i) n
5
PV = $5,000 / (1 + .08) = $5,000 / 1.47 =
$3401.36
Microeconomics
Unit 4 - Business Production
Behavior
 Interest Rates and Present Value

Example 3
Let’s say that a house
appreciated in value by
4% each year over the
past 80 years. If the house is
worth $500,000 now, what was the value 80 years
ago?

Microeconomics
Unit 4 - Business Production
Behavior
 Interest Rates and Present Value

Example 3 answer:
n
PV = FV / (1 + i)
80
PV 80 years ago = FV (now) / (1 + .04) .
PV = $500,000 / 23.05 = $21,692.

Microeconomics
 Unit 4 - Business Production
Behavior
 Factor Prices

Another factor price is the wage rate.

The equilibrium wage is determined by the
demand for and the supply of labor.

Microeconomics
 Unit 4 - Business Production
Price
of Labor
Behavior
Supply of Labor

$7.00

Demand
for Labor

1,000 Quantity of Labor

 Unit 4 - Business Production
Behavior
 Factor Prices

Some factor prices are determined by the

government, not by demand and supply.

For example, in the next slide, the market wage is

$7, but a minimum wage of $9 is set by the
government.
Microeconomics
 Unit 4 - Business Production
Price Behavior
of Labor
Unemployment
Supply of Labor

$9.00

$7.00

Demand
for Labor

1,000 Quantity of Labor

 Unit 4 - Business Production
 Factor Prices Behavior

Advantages of a minimum wage set above the free

market wage are:
 More income for the minimum wage earners
that are able to maintain their job.
 More incentive for people to work.
 Possibly greater job satisfaction and lower job
turnover.
Microeconomics
 Unit 4 - Business Production
 Factor Prices Behavior

Disadvantages of a minimum wage set

above the market wage:
 Decrease in the quantity demanded for labor.
 Higher production costs and lower profits.

 Higher prices.

 Less money for benefits and training.

 Decrease in exports due to higher prices.

Microeconomics
 Unit 4 - Business Production
 Factor Prices Behavior

Government-set prices that are different from the

market price may have social benefits for some
groups, but lead to economic inefficiencies
(surpluses, shortages, higher prices, unemployment).

Microeconomics
 Unit 4 - Business Production
Behavior
 Factor Prices

A minimum wage raises the

nominal wage,
but not the real wage.

Question:
How can we achieve higher real
wages without government
intervention?

Microeconomics
 Unit 4 - Business Production
Behavior
 Factor Prices

Answer:
By raising productivity.

Question:
What raises productivity?

Microeconomics
 Unit 4 - Business Production
Behavior
 Factor Prices

Answer:
An economic system that
rewards hard work and innovation.

Question:
What kind of economic system rewards work and
innovation?

Microeconomics
 Unit 4 - Business Production
Behavior
 Factor Prices

Answer:
An economic system in which
a government provides essential services
(infrastructure, a legal system, defense, and
protection of private property), and that has
relatively low taxes and limited regulations.
This encourages production and innovation.
Microeconomics