Chapter 7

The Production Process:

The Behavior of ProfitMaximizing 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
firms 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.

How much
output to
supply

Which
production
technology to
use

How much of
each input to
demand

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:
Market Interest Rate Available:
Total Revenue (3,000 belts x $10 each)

$20,000
.10 or 10%
$30,000

Costs
Belts from supplier

$15,000

Labor Cost

14,000

Normal return/opportunity cost of capital ($20,000 x

.10)
Total Cost

$31,000

Profit = total revenue - total cost

aThere

2,000

- $ 1,000a

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

Determines
total revenue

Production techniques

Input prices

Determine total cost and

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
(3)
MARGINAL
PRODUCT OF
LABOR

(4)
AVERAGE
PRODUCT
OF LABOR

10

10

10.0

25

15

12.5

35

10

11.7

40

10.0

42

8.4

42

7.0

Total product

(2)
TOTAL PRODUCT
(SANDWICHES
PER HOUR)

30
25
20
15
10
5
0
0

Principles of Economics, 6/e

Number of employees

10
5
0
0

2002 Prentice Hall Business Publishing

15
Marginal Product

(1)
LABOR UNITS
(EMPLOYEES)

35

2
3
4
5
Number of employees

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
TECHNOLOGY

UNITS OF
CAPITAL (K)

UNITS OF
LABOR (L)

10

10

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Given the
technologies
available, the
cost-minimizing
choice depends
on input prices.
Karl Case, Ray Fair

Production Functions with Two Variable

Factors of Production
Cost-Minimizing Choice Among Alternative
Technologies (100 Diapers)
(1)
TECHNOLOGY

(2)
UNITS OF
CAPITAL (K)

(3)
UNITS OF
LABOR

(4)
COST
WHEN PL = $1
PK = $1

10

$12

$52

33

24

21

10

12

20

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

(5)
COST WHEN
PL = $5 PK = $1

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