Chapter 7

The Production Process:

The Behavior of Profit-
Maximizing Firms

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Production

Central to our analysis is production:

• Production is the process by which inputs are

combined, transformed, and turned into outputs.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Perfect Competition: Characteristics

• many firms, each small relative to the industry,

• producing virtually identical products -Homogeneous products that

are undifferentiated products or indistinguishable from, one another

• in which no firm is large enough to have any control over prices of

its products or the price of inputs they buy.

• Hence, individual firms are price-takers. This means that firms have
no control over price. Price is determined by the interaction of
market supply and demand.

• In perfectly competitive industries, new competitors can freely enter

and exit the market.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Demand Facing a Single Firm in a
Perfectly Competitive Market

• If a representative firm in a perfectly competitive market rises the

price of its output above $2.45, the quantity demanded of that
firm’s output will drop to zero. Each firm faces a perfectly elastic
demand curve, d.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Behavior of
Profit-Maximizing Firms
• Once the level of output has been determined, the
choice of technology determines the input demand

• Change in technology changes both 1st and 3rd

decision

• With different technology, different levels of output

can be produced or same level of output can also be
produced

• A profit maximizing firm chooses the technology

that minimizes its cost for a given level of output

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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:
TR=(q X p)
Profit = Total Revenue- Total Cost

• Total cost (total economic cost) is the total of

1. Out of pocket costs- explicit costs/accounting costs
2. Opportunity cost of each factor of production- implicit costs

Economic Profit = Total Revenue- Total Economic Cost

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Normal Rate of Return:
The Opportunity cost of capital
• The most important opportunity cost that is included in economic
cost is the economic cost of capital, measured in terms of Normal
rate of return .
• Rate of Return= annual flow of net income generated by an
investment, expressed as a % of total investment- also called
yield on investment.

• The normal rate of return is a rate of return on capital that is just

sufficient to keep owners and investors satisfied.
• Normal rate of return is considered to be a part of total cost of
business
• For relatively risk-free firms, it should be nearly the same as the
interest rate on risk-free government bonds.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Implication

• If a firm is earning exactly the normal rate of

return on capital, it is earning zero profits

• If the level of profit is positive, it means that the

firm is earning above normal rate of return on
capital.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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 2,000
.10)
Total Cost $31,000
Profit = total revenue - total cost - $ 1,000a
aThere is a loss of $1,000.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

- Which factors are fixed in the short run differs from

industry to industry
- No hard and fast rule to define the period of short run
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The basis of decisions: Market price of
outputs, available technology and input prices
- Market price of output determines the Revenues

- Techniques of production and Price of Inputs determines

the Costs

• The optimal method of production is the method that

minimizes cost.

• With cost determined and market price of output known, a

firm makes the final judgment about the quantity of
product to produce and quantity of each input to demand

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Production Process

• Production technology refers to the quantitative relationship

between inputs and outputs.

Most outputs can be produced by a number of different techniques

which include:
• 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 final choice of technology should be the one that minimizes cost.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.
Q= f(X1,X2,X3,...,Xn)
where:
• Q = quantity of output
• X1,X2,X3,...,Xn = factor inputs (such as capital, labour, land or
raw materials

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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( i.e., holding all other inputs
constant).
change in total product
marginal product of labor =
change in units of labor used

• Average product is the average amount

produced by each unit of a variable factor of
production.
total product
average product of labor =
total units of labor

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

Diminishing returns always apply in the short run

and every firm will face diminishing returns – which
means that every firm finds it progressively more
difficult to increase its output as it approaches
capacity production

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Production Function for Sandwiches
45
40
Production Function 35

Total product
30
(2) (3) (4) 25
(1) TOTAL PRODUCT MARGINAL AVERAGE
20
LABOR UNITS (SANDWICHES PRODUCT OF PRODUCT
(EMPLOYEES) PER HOUR) LABOR OF LABOR 15
10
0 0 - - 5
0
1 10 10 10.0 0 1 2 3 4 5 6 7
2 25 15 12.5 Number of employees
15

Marginal Product
3 35 10 11.7
10
4 40 5 10.0
5 42 2 8.4 5

6 42 0 7.0
0
0 1 2 3 4 5 6 7
Number of employees

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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
Using Alternative Technologies
• Given the
UNITS OF UNITS OF technologies
TECHNOLOGY CAPITAL (K) LABOR (L) available, the
A 2 10
cost-minimizing
B 3 6
choice depends
C 4 4
on input prices.
D 6 3
E 10 2

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Production Functions with Two Variable
Factors of Production

Cost-Minimizing Choice Among Alternative

Technologies (100 Diapers)
(2) (3) (4) COST (5)
(1) UNITS OF UNITS OF WHEN PL = $1 COST WHEN
TECHNOLOGY CAPITAL (K) LABOR PK = $1 PL = $5 PK = $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

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Hence , two things determine cost of
production:

1. technologies that are available and

2. input prices

Profit maximizing firm chooses that

technology that minimizes cost of production
at the given current market price of inputs

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair