The Production Process:

The Behavior of Profit-

Maximizing Firms

A Presentation by

Anamitra Roy
 Production

Central to our analysis is production:

• Production is the process by which inputs are
combined, transformed, and turned into
outputs.
• Four factors of Production:
o Land,
o Labour,
o Capital
o Organisation
 Production

Production: Outputs:
Inputs/ raw materials
The Firm Goods services
 What is a firm?

• A firm is an organization that comes into being

when a person or a group of people decide to
produce a good or service to meet a perceived
demand. Most firms exist to make a profit.

• Production is not limited to firms.

 The Behavior of
Profit-Maximizing Firms
• The three decisions that all firms must make
include:

1. 2. 3.
Which
How much How much of
production
output to each input to
technology to
supply? demand?
use?
 Profits and Economic Costs
• Profit (economic profit) is the difference between total
revenue and 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,
2. Normal rate of return on capital---- Opportunity cost of
each factor of production.
Normal Rate of Return

• 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.
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

(fixed factor) of production, and
2. Firms can neither enter nor exit an 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.
Determining the Optimal Method
of Production
Price of output Production Input
techniques 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.
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 and Average
Product
• Marginal product is the additional output that can be
produced by adding one more unit of a specific input,
ceteris paribus.

chan ge in total p rod u ct

m argin al p ro du ct o f lab or =
chang e in un its o f labo r u sed
• Average product is the average amount produced by each
unit of a variable factor of production.

to tal p ro d u ct
av erag e p ro d u ct o f lab o r =
to tal u n its o f lab o r
 Law of Diminishing Returns
• The amount of fixed factor and technological state remaining
constant as the amount of the variable input ( L) is increased
MPL first increases ,reaches maximum and then diminishes.
• Total production function first increases at an increasing rate
then increases at an diminishing rate and finally falls.
The Law of Diminishing
Marginal Returns
When additional units of a
variable input are added to
fixed inputs, the marginal
product of the variable input
will first increase and then
decrease, ceteris paribus.
 Production Function for
Sandwiches 45
40
Production Function 35
30

Total product
(4) 25
(1) (2) AVERAG
20
LABOR TOTAL (3) E
15
UNITS PRODUCT MARGINAL PRODUCT
10
(EMPLOYEES (SANDWICHES PRODUCT OF
5
) PER HOUR) OF LABOR LABOR
0
0 0 - - 0 1 2 3 4 5 6 7
Number of employees
1 10 10 10.0 15

Marginal Product
2 25 15 12.5 10

3 35 10 11.7 5
4 40 5 10.0
0
5 42 2 8.4 0 1 2 3 4 5 6 7
Number of employees
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.
Total, Average, and Marginal
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.
Total, Average, and 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.
 Long run production function
• Isoquants
– Technical efficiency is least-cost production.
– Locus of combinations of two factors of production which
will give equal amount of output, given the technology

• Returns to Scale
- measure output effect of increasing all inputs, given the
technology.
Marginal Rate of Technical
Substitution
Slope of Isoquant = MRTSXY=-MPX/MPY
• Rational Limits of Input Substitution
– MPX<0 or MPY<0 are never observed.
 Optimal Combination of
Multiple Inputs
• Cost Equation
– Least-cost production occurs when MPL/W = MPK/r and
W/r = MPL/MPK
• Expansion Path
– Shows efficient input combinations as output grows.
• Illustration of Optimal Input Proportions
– Input proportions are optimal when no additional output
could be produce for the same cost.
– Optimal input proportions is a necessary but not sufficient
condition for profit maximization.
Thank you.