The Production Process: The Behavior of Profit-Maximizing Firms

1. The Production Process:The Behavior of Profit-Maximizing Firms Appendix: Isoquants and Isocosts

2. Production Central to our analysis is production, the process by which inputs are combined, transformed, and turned into outputs.

3. Firm and Household Decisions • Firms demand factors of production in input markets and supply goods and services in output markets.

4. 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 among firms.

5. Perfect Competition • 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. Perfect competition is an industry structure in which there are:

6. 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.

7. Demand Facing a Single Firmin a Perfectly Competitive Market • The perfectly competitive firm faces a perfectly elastic demand curve for its product.

8. 1. How much output to supply 2. 3. Which production technology to use How much of each input to demand The Behavior ofProfit-Maximizing Firms • The three decisions that all firms must make include:

9. 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:

10. Profits and Economic Costs • Total cost (total economic cost) is the total of • Accounting costs (Explicit or out-of-pocket costs): involve a direct money outlay for factors of production. • Economic costs (Implicit costs): do not involve a direct money outlay. They include the full opportunity cost of every input.

11. Profits and Economic Costs • The most important opportunity cost is that is included in economic cost is the opportunity cost of capital. • Rate of return is the annual flow of net income generated by an investment expressed as a percentage of the total nvestment. • The normal rate of return is a rate of return on capital that is just sufficient to keep owners and investors satisfied.

12. Calculating Total Revenue, Total Cost, and Profit

13. Short-Run Versus Long-Run Decisions • The short run is a period of time in which the quantity of some inputs, called fixed inputs can not be changed. • A fixed factor is usually an element of capital (such as plant and equipment), but it might be land or the supply of skilled labor. • Inputs that can be varied in the short run are called variable factors.

14. 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 all inputs.

15. 3. 1. 2. The market price ofthe output The techniques of production that are available The prices of inputs The Bases of Decisions • The fundamental things to know with the objective of maximizing profit are:

16. Determining the Optimal Method of Production • The optimal method of production is the method that minimizes cost.

17. 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.

18. 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.

19. Production Function for Sandwiches

20. Marginal Product • Marginal product is the additional output that can be produced by adding one more unit of a specific input, ceteris paribus.

21. The Law ofDiminishing Marginal Returns • The law of diminishing marginal returnsor marginal productstates that: When additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines. Example: As more and more workers (variable input) are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment (fixed input).

22. Average Product • Average product is the average amount produced by each unit of a variable input.

23. 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.

24. Total, Average, and Marginal Product • If marginal product is above average product, the average rises. • If marginal product is below average product, the average falls. • When average product is maximum, average product and marginal product are equal.

25. Production Functions with Two Variable Factors of Production

26. Two things determine the cost of production: Technologies that are available Input prices. Profit-maximizing firms will choose the technology that minimizes the cost of production given input prices. Choice of Technology

27. Appendix: Isoquants and Isocosts • 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.

28. Appendix: Isoquants and Isocosts

29. Appendix: Isoquants and Isocosts • The slope of an isoquant is called the marginal rate of technical substitution. • Along an isoquant:

30. Appendix: Isoquants and Isocosts • 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:

31. Appendix: Isoquants and Isocosts • Slope of the isocost line:

32. Appendix: Isoquants and Isocosts • 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