Till now:

Consumer behavior
- how consumers make choices
- maximize utility subject to budget constraint
- focus was on the demand side of the output
market

Change of focus:
Other side of the market system- producers or firms
• The economy is made up of thousands of firms that
produce the goods and services
– Honda produces cars, Phillips produces LED bulbs, Kelloggs
produces breakfast cereal,…

All firms have certain common features

- use inputs and transform them into outputs
- Profit maximization goal

Our Objective:
-Examine firm/producer behavior
-What decisions lead to the supply curve in a market
THE PRODUCTION PROCESS: THE BEHAVIOR OF PROFIT-
MAXIMIZING FIRMS

production
The process by which inputs are combined, transformed,
and turned into outputs.

firm
An organization that comes into being when a person (eg.
barber) or a group of people (eg. salon) decides to
produce a good or service
THE PRODUCTION PROCESS: THE BEHAVIOR OF PROFIT-
MAXIMIZING FIRMS

A firm’s behavior depends on

The type of industry it belongs to

-How many competitors are there
-How large are the competitors
-What is the extent of competition between the firms
Motivation question:

What would happen if your local grocery store raised the price of sugar by 50 %?

What would happen if your local power supply firm raised the price of electricity by 50 %?
Motivation: Competition and market structure
If your local grocery store raised the price of sugar by 50 %, it
is most likely to see a large drop in the amount of sugar sold.

Its customers would quickly switch to other grocery stores.

In contrast, if your local power supply firm raised the price of

electricity by 50 %, it would see only a small decrease in the revenue.

Consumers would be unlikely to find another power supplier.

The difference between the sugar market and the electricity market:
There are many grocery stores in the neighborhood,
but there is only one power supply firm

This difference in market structure shapes the pricing and

production decisions of the firms that operate in these markets
THE PRODUCTION PROCESS: THE BEHAVIOR
OF PROFIT-MAXIMIZING FIRMS
We focus on the benchmark case: Perfect competition

Perfect competition: features

-An industry structure in which there are many firms and many
consumers
-Each very small relative to the industry,
-Each producing identical (homogeneous) products ,
-Each firm has little / no ability to influence market prices

-OPEC?
-Patented drug?
-Pepsi , coke?
Perfect competition: features contd.

Also, in perfectly competitive industries, there is free

entry and exit

-If existing firms are making profits, then ?

-If existing firms are making losses, then ?

Perfect competition: features contd.

Also, in perfectly competitive industries, there is free

entry and exit

-If existing firms are making profits, then ?

-new firms are likely to enter the market
-No barriers to entry

-If existing firms are making losses, then ?

-they have the option to exit the market
-No barriers to exit
THE PRODUCTION PROCESS: THE BEHAVIOR OF
PROFIT-MAXIMIZING FIRMS
Homogeneous products:
Undifferentiated products; products that are identical or indistinguishable
from one another.

Eg. Sugar sold at different grocery stores

Agricultural commodities
- rice produced by farmer 1 is identical as rice produced by farmer 2
 THE PRODUCTION PROCESS: THE BEHAVIOR OF
PROFIT-MAXIMIZING FIRMS

Implication:
Firms in perfectly competitive markets do not make decision about price.

Each firm takes market price as “given”

Thus competitive firms are “price takers”

Given the availability of perfect substitutes, if any firm charges a price >
market price, then no quantity will be sold. Why?
THE MEANING OF COMPETITION

Perfectly competitive market

a market with many buyers and sellers trading identical products so that
each buyer and seller is a price taker

Conditions:
1. There are many buyers and many sellers in the market.
2. The goods offered by the various sellers are similar / homogenous

As a result of these conditions, the actions of any single buyer or seller

in the market have a negligible impact on the market price.

Each buyer and seller takes the market price as given.

 Demand Faced by a Single Firm in a Perfectly Competitive Market

A representative perfectly competitive

The Market

Price per Ton (Rs.)

firm
Market Supply
Price per Ton (Rs.)

P*
P*

Market Demand

Tons of Rice (per year) Tons of Rice (per year)

THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS

Objective of firm: maximize profits

Given this objective, all firms must make the following
basic decisions

1. 2. 3.
How much How to How much of
output to produce the each input to
supply output/Which demand
production
technology
to use
production technology The quantitative relationship
between inputs and outputs.

labor-intensive technology Technology that relies

heavily on labor instead of capital.
Eg. Agriculture, handicraft, services

capital-intensive technology Technology that relies

heavily on capital instead of labor.
Eg. car, oil extraction
THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS

Technology
-determines how much inputs are required to produce
a certain level of output

Change in Technology
-Will lead to change in the relationship between inputs
and output.

-Automation leads to less labor required to produce

same amount of output (eg. computerization )
 THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS
profit = total revenue - total cost

total revenue
= amount received from the sales of a product (q x P)

Eg. Consider a dairy farm producing q quantity of milk

and selling each unit at the market price P.

Since the farm is very small compared to the market

for milk, it
takes the price as given by market conditions.

Thus the price of milk does not depend on the quantity

of output that the farm produces and sells.

If the farm doubles the amount of milk production, the

price of
milk remains the same, and their total revenue
doubles.
 How to measure costs?
Consider a cookie factory.

The owner of the firm buys inputs (eg. flour, sugar, mixers and ovens)
and hires workers to produce output (cookies)

If she produces 10,000 cookies and sells them at Rs 2/cookie, her total
revenue is 20,000.

In contrast, the measurement of a firm’s total cost is more subtle.

Economist’s view of a firm’s cost of production:

-include all the opportunity costs of making the product

-What is the opportunity cost of making cookies?

 How to measure costs?
Explicit costs

Cost of inputs: flour, sugar, labor

Accountants consider explicit costs only

Implicit costs
Suppose the cookie factory owner has “work from home” skills and could
earn Rs 100 per hour working from home.

For every hour that the owner works at her cookie factory, she gives up Rs
100. This forgone income is also part of her costs

Economists consider both explicit and implicit costs

 Exercise
• If the owner of a business pays himself no
salary

• Accounting cost = ?
• Economic cost ?
• If the owner of a business pays himself no salary

• Accounting cost is = zero

– since there is no monetary transaction i.e. no explicit cost

• Economic cost is positive

– Reflects opportunity cost of time of the owner
– Econ cost would be the value of the next best alternative
use of his time, i.e. the amount that the owner could have
earned from the next best job
• A firm that has positive accounting profit does not necessarily have
positive economic profit

• Accounting profit = Revenue – Explicit costs

• Economic profit = Revenue – (Explicit costs + Implicit costs)

• When we add the implicit costs, it is possible to have negative Economic

profit
Suppose, a firm owner used 300,000 of her savings to buy her
cookie factory from the previous owner.

If she had instead deposited the money in a savings account that

pays an interest rate of 5 %, she would have earned 15,000 per
year.

To own her cookie factory, therefore, she has given up 15,000 a

year in terms of interest income.

This forgone 15,000 is one of the implicit opportunity costs of

producing cookies

Accountant will not consider this cost

Economist will consider this opportunity cost of capital

Calculating Total Revenue, Total Cost, and Profit

INITIAL INVESTMENT: 20,000

MARKET INTEREST RATE: 10%

Total revenue (3,000 x 10 each) 30,000

Costs

inputs from Supplier 15,000

Labor cost 14,000

Opportunity Cost of Capital (20,000 x 0.10) 2,000

Total Cost 31,000

Economic Profit = total revenue - total cost -1,000

• economists and accountants measure costs differently
• they also measure profit differently
• because the accountant ignores the implicit costs, accounting profit is larger
than economic profit
THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS

Total economic cost comprises of

(1) explicit costs i.e. out-of-pocket costs

(2) implicit costs

economic profit = total revenue - total economic cost

Short run
The period of time for which two conditions hold:
The firm is operating with fixed factor of production, and
firms can neither enter nor exit an industry.

• The short run is a planning period over which the managers of a firm
must consider one or more of their factors of production as fixed in
quantity.

• For example, a car manufacturer may regard its plant size (capacity) as a
fixed factor over the next 1 year.

• Other factors of production could be changed during the year, but the
plant size must be regarded as a constant
• When the quantity of a factor of production cannot be changed during a
particular period, it is called a fixed factor of production.

• For the car manufacturer, the plant is a fixed factor of production for at
least a year.

• Note: factor (s) of production whose quantity can be changed during a

particular period is called a variable factor of production
– Eg. labor
 THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS

The planning period over which a firm can consider all factors of
production as variable is called the long run

long run
1.That period of time for which there are no fixed factors of production ,
i.e. all inputs become variable

2. New firms can enter and existing firms can exit the industry.

Car manufacturer may consider alternatives such as modifying the

plant, building a new plant, or selling the plant and even leaving the
business
THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS

Decision making by firm/producer depends on the

following factors:

1. The market price of output (GIVEN)

2. The techniques of production that are available
3. The prices of inputs (GIVEN)

Output price determines revenues.

The available techniques dictate how much of each

input is needed

Input prices tell how much inputs will cost.

THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS

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
THE PRODUCTION PROCESS

The Short-Run Production Function

production function or total product function

A numerical or mathematical expression of a relationship between

inputs and outputs.

It shows units of total product as a function of inputs.

Our first task is to explore the nature of the production function.

 Production in Short Run
• Consider a hypothetical firm that produces sandwiches

• Assumptions:
1. Size of factory is fixed in short run
– capital is fixed input /factor of production
– Eg. The firm owns only one sandwich grill

2. The firm can vary the quantity of sandwiches produced only by changing
the number of workers
- thus labor is the only variable input/factor of production
• Total product curve shows the quantities of
output that can be obtained from different
amounts of a variable factor of production,
assuming other factors of production are fixed
 THE PRODUCTION PROCESS

Production Function
(2) (4)
(1) TOTAL (3) AVERAGE PRODUCT
LABOR PRODUCT MARGINAL OF LABOR
(sandwiches PRODUCT
per hour) OF LABOR

0 0 - -
1 10 10 10.0
2 25 15 12.5
3 35 10 11.7
4 40 5 10.0
5 42 2 8.4
6 42 0 7.0
THE PRODUCTION PROCESS
THE PRODUCTION PROCESS

marginal product The additional output that can be

produced by adding one more unit of a variable
input, ceteris paribus.

The slope of a total product curve is a measure of

the change in output associated with a change in the
amount of the variable factor, when the quantities of
all other factors are held constant

Note: as the number of workers increases, the

marginal product initially increases and then starts to
decline. Why?
Law of diminishing returns
When additional units of a variable input are added to fixed inputs, after a
certain point, the marginal product of the variable input declines.

In the short run, given limited fixed factor(s) every firm will face
diminishing returns.

This means that a firm would find it progressively more difficult to increase
its output as it approaches the capacity production

recall: the capacity of sandwich shop = 42 /hr

THE PRODUCTION PROCESS

Marginal Product and Average Product

average product The average amount produced

by each unit of a variable factor of
production.

total product
average product of labor 
total units of labor
THE PRODUCTION PROCESS
THE PRODUCTION PROCESS

PRODUCTION FUNCTIONS WITH TWO VARIABLE FACTORS

OF PRODUCTION

Consider 2 variable inputs: labor and capital (eg. equipment)

In general, additional capital increases the productivity of labor.

Eg. workers become more productive if number of grills is

increased
CHOICE OF TECHNOLOGY

Technique A is most labor intensive

Technique E is most capital intensive
Inputs Required to Produce 100 jackets Using
Alternative Technologies
UNITS OF UNITS OF
TECHNOLOGY CAPITAL (K) LABOR (L)
A 2 10
B 3 6
C 4 4
D 6 3
E 10 2

Q. How does a firm choose production technique?

 CHOICE OF TECHNOLOGY
Cost-Minimizing Choice Among Alternative Technologies (100 jackets)
(2) (3) (4)
(1) UNITS OF UNITS OF Cost = (L x PL) + (K x PK)
TECHNOLOGY CAPITAL (K) LABOR (L)
PL = 1
PK = 1
A 2 10 12
B 3 6 9
C 4 4 8
D 6 3 9
E 10 2 12
CHOICE OF TECHNOLOGY

Two things determine the cost of production:

(1) technologies that are available and

(2) input prices.

Profit-maximizing firms will choose the technology that

minimizes the cost of production given current market input
prices.
 CHOICE OF TECHNOLOGY

Q. What if labor becomes expensive? Wage rate

increases from 1 to 5/hr
Cost-Minimizing Choice Among Alternative Technologies (100 jackets)
(4) (5)
(2) (3) Cost = (L x PL) + (K x PK)
(1) UNITS OF UNITS OF
TECHNOLOGY CAPITAL (K) LABOR (L) PL = 1 PL = 5
PK = 1 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
If labor becomes expensive, firms can
adopt labor-saving technology : use more
capital than labor
 CHOICE OF TECHNOLOGY

So far, we have considered only single level of output

-What is the best technology to produce 100 jackets at a given set of prices
-Given by least cost technology

-What if the level of output changes?

Alternative Combinations of Capital (K) and Labor (L) Required to
Produce different Levels of Output
QX = 50 QX = 100 QX = 150
K L K L K L

A 1 8 2 10 3 10
B 2 5 3 6 4 7
C 3 3 4 4 5 5
D 5 2 6 3 7 4
E 8 1 10 2 10 3
 Isoquants

Isoquant
A graph that shows all
the combinations of
inputs (here capital and
labor) that can be used
to produce a given
amount of output.

Isoquants Showing All Combinations of Capital and Labor that Can Be Used
to Produce 50, 100, and 150 Units of Output
Appendix
Slope of isoquant:
K MPL

L MPK

Marginal Rate of Technical

Substitution (MRTS)

The rate at which a firm can

substitute capital for labor and
hold output constant
= absolute slope
Isocost line
FACTOR PRICES AND
INPUT COMBINATIONS:
ISOCOSTS

isocost line A graph that

shows all the combinations
of capital and labor
available for a given total
cost.

Isocost Lines Showing the Combinations of Capital and Labor

available for 5, 6, and 7
Slope of isocost line:
K TC / PK P
  L
L TC / PL PK
Note: Each point on an isoquant represents a different technology

Q. Which point to choose?

Firm will choose the combination of (L,K) where cost is minimized

Since each point on an isoquant lies on an isocost line, the firm can
determine the cost of each combination of (L,K) for given input prices
 Appendix
FINDING THE LEAST-COST TECHNOLOGY WITH
ISOQUANTS AND ISOCOSTS

Finding the Least-Cost Combination

of Capital and Labor to Produce 50
Units of Output

The firm will choose the combination of

inputs that is least costly.

The least costly way to produce any given

level of output is indicated by
the point of tangency between
an isocost line and the isoquant
corresponding to that level of
output.
 Appendix

Minimizing Cost of Production for Minimum Cost of Producing

qX = 50, qX = 100, and qX = 150, Each Level of Output
given pL=1=pK
THE COST-MINIMIZING EQUILIBRIUM CONDITION

At the point where a line is just tangent to a curve, the two

have the same slope. At the point of tangency, the following
must be true:

MPL P
slope of isoquant    slope of isocost   L
MPK PK

MPL PL

MPK PK

MPL MPK

PL PK