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Appendix ( Chapter 7 )

The Production Process: The Behavior of Profit-Maximizing Firms. Appendix ( Chapter 7 ). Profit-Maximizing Firms in Perfectly Competitive Industries. The primary objective of a firm is to maximize profits. Components of Economic Profit. Input or Factor

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Appendix ( Chapter 7 )

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  1. The Production Process: • The Behavior of • Profit-Maximizing Firms Appendix (Chapter 7)

  2. Profit-Maximizing Firms in Perfectly Competitive Industries The primary objective of a firm is to maximize profits

  3. Components of Economic Profit Input or Factor A resource used by a firm to help it make products. Land, Labor and Capital are examples of inputs. Output or Product A resource made and sold by a firm.  Cars, haircuts, and pizza slices are examples of outputs.

  4. Components of Economic Profit Economic Profit = Total Revenue - Total Cost  Total Revenue (TR)= Price per unit of output x Quantity of output sold  Total Cost (TC)= Total Variable Cost + Total Fixed Cost Total Variable Cost(TVC) = The cost of all Variable Inputs.   Total Fixed Cost(TFC) = The cost of all Fixed Inputs.   Variable Inputs are those inputs whose use does vary with the quantity of output produced.  Fixed Inputs are those inputs whose use does not vary with the quantity of output produced.

  5. Components of Economic Profit • Both Total Variable Cost (TVC) and Total Fixed Cost (TFC) • are composed of two kinds of costs: • Accounting Cost -Cost of all purchasedinputs • Opportunity Cost-Value of all non-purchased inputs in their next-best uses.  • Includes, for example, • value of the business owner’s time and effort in his/her next-best activity, • value of a business owner's money in its next-best use.

  6. Two Decision Situations:  The Long-Run and The Short-Run In economics, the Long-Run and the Short-Run are not defined in terms of time, but rather in terms of how many things in a situation are considered parameters vs. variables. The long run and the short run do not refer to a specific period of time such as 3 months or 5 years. The difference between the short run and the long run is the flexibility decision makers have. Short-Run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. Long-Run is a period of time in which the quantities of all inputs can be varied.

  7. Short-Run Parameters for a Firm in a Perfectly Competitive Industry  • For a firm in a Perfectly Competitive industry, the Short-Run typically means that the following things are held fixed as parameters:  • Technology • Price of Output  • Prices of Inputs • Quantities of one (or more) Inputs

  8. Measuring Productivity of an Input Productivity of a particular input is measured in three ways:  Total Product of an Input The total amount of output produced from all units of input used, holding the use of all other inputs constant.  Average Product of an Input The total amount of output produced per unit of input used, holding the use of all other inputs constant.  Marginal Product of an Input The additional amount of output produced from the use an additional unit of input, holding the use of all other inputs constant. 

  9. Law of Diminishing Returns Law of Diminishing Returns A concept in economics that if one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the output per unit of the variable factor will eventually diminish.

  10. PRODUCTION FUNCTION Production function is the technical relationship between inputs and outputs over a given period of time Mathematıcal Expressıon Of Productıon Functıon Normally a production function is written as Q = F ( L , K , I , R ,E ) Where : Q - the maximum quantity of output L - Labor, K -Capital, I -Land, R -Raw material, E -Efficiency parameter

  11. TYPES OF PRODUCTION FUNCTION • On the basis of characteristics of inputs • production function normally divided into two broad categories : • With one variable input or variable production function(Short Run) • With two variable inputs or constant production function(Long Run)

  12. PRODUCTION FUNCTION WITH ONE VARIABLE INPUT The short run production function shows the maximum output a firm can produce when only one of its inputs can be varied other inputs remaining constant It can be written as Q= F ( L , K) Q- output L- labor K-capital (fixed amount)

  13. ISOQUANTS An Isoquant is the set of all combinations of variable inputs that could be used to produce a given quantity of output in the short run.    • Iso– «Equal»; Quant –«quantity» • Isoquant – a line of equal quantity Taking the production function Q = F ( L , K) With a fixing level of output Q at some quantity we have an implicit relationship between units labor( L ) and capital (K) Qc = F ( L , K ) It is possible to produce the same amount of output by using different combination of input.

  14. ISOQUANTS - example - The manufacturer wants to know which different combinations of inputs can be used to produce 150 thousand tons of output • Point A- at curve Q1 shows 40Capital and 600 Labor units give the 150 Thousands tons of output. • All points B , C,D,E (combinations) may infer that the level of output remains the same at all points on the same isoquant.

  15. CHARACTERISTICS OF ISOQUANTS • Slope downwards from left to right • Using more of input to produce the same level of output must imply using less of other input • slope = -(ΔK / ΔL) • A higher isoquant represent a higher output. • Isoquants do not intersect. • Convex to the origin.

  16. Margınal Rate Of Substıtutıon MRTS MRTS measures the reduction in one input due to unit increase in the other input that is just sufficient to maintain the same level of output MRTS  =  slope of isoquant  =  K    =     - MPL L              MPK

  17. Cost-Minimizing Decisions in Factor Markets • To minimize the cost of producing a given, or "target," level of output, a firm chooses the least-cost combination of inputs to produce the target level of output.  When choosing the least-cost combination of inputs, the firm faces two constraints: • the prices it must pay for the inputs, and • the firm's technology. • ISOCOST • is a concept showing how input prices constrain a firm's choice of variable inputs.

  18. ISOCOST • ISOCOST line is the budget line of a producer in terms of two inputs. • ISOCOST line is points of all the different combinations of labor and capital that firm can employ given the total cost and prices of inputs. • ISOCOST lines expressed as • C = w L + r K • Where • price of labor is wage -w • price of the capital is interest -r • total cost is -C • Usually the ISOCOST line is linear with slope equal to ratio of the factor prices.

  19. ISOCOST MAP • The intercept of the ISOCOST line on the capital axis is the maximum amount of capital employed when labor is not used in the production process is given by C / r ; similarly the intercept in labor axis is given by C / w • Slope = (ΔK /Δ L) = {(C/r)/(C/w)} = w/r • The set of parallel ISOCOST lines is called ISOCOST map. • Line AB basic ISOCOST line. • AB1 shows a rise in W more of labor can acquired. • AB 2 shows a fall in W. • Same as for BA2 and BA1

  20. For minimum cost we need ISOCOST line and maximum output we need ISOQUANTS.

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