C H APTER
___________________________________
6
___________________________________
___________________________________
The Production Process:
The Behavior of
Profit-Maximizing Firms
___________________________________
___________________________________
Appendix: Isoquants and Isocosts
Prepared by: Fernando Q uijano
and Yvonn Q uijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
___________________________________
Karl Case, Ray Fair
C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
Production
___________________________________
Central to our analysis is
production, the process by
which inputs are combined,
transformed, and turned
into outputs.
___________________________________
___________________________________
___________________________________
___________________________________
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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Firm and Household Decisions
___________________________________
• Firms demand
factors of
production in
input markets
and supply goods
and services in
output markets.
___________________________________
___________________________________
___________________________________
___________________________________
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Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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___________________________________
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 exist
between firms.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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Perfect Competition
___________________________________
Perfect competition is an industry
structure in which there are:
___________________________________
• 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.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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___________________________________
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.
___________________________________
© 2004 Prentice Hall Business Publishing
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Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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Demand Facing a Single Firm
in a Perfectly Competitive Market
___________________________________
___________________________________
___________________________________
___________________________________
• The perfectly competitive firm faces a perfectly
elastic demand curve for its product.
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
The Behavior of
Profit-Maximizing Firms
___________________________________
• The three decisions that all
firms must make include:
1.
How much
output to
supply
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
___________________________________
2.
Which
production
technology
to use
___________________________________
3.
How much
of each
input to
demand
Karl Case, Ray Fair
___________________________________
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C H A P T E R 6: The Production Process:
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Profits and Economic Costs
___________________________________
•
Profit (economic profit) is the
difference between total revenue
and total economic cost.
___________________________________
___________________________________
economic profit = total revenue − total economic cost
•
Total revenue is the amount
received from the sale of the
product:
___________________________________
(q x P )
___________________________________
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Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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___________________________________
Profits and Economic Costs
___________________________________
•
Total cost (total economic cost)
is the total of
___________________________________
1. Out of pocket costs,
2. Normal rate of return on capital, and
___________________________________
3. Opportunity cost of each factor of
production.
___________________________________
___________________________________
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
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___________________________________
Profits and Economic Costs
___________________________________
• The rate of return, often referred to
as the yield of the investment, is the
annual flow of net income generated
by an investment expressed as a
percentage of the total investment.
___________________________________
___________________________________
___________________________________
___________________________________
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C H A P T E R 6: The Production Process:
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Profits and Economic Costs
___________________________________
• The normal rate of return is a rate
of return on capital that is just
sufficient to keep owners and
investors satisfied.
___________________________________
___________________________________
• For relatively risk-free firms, the normal
rate of return be nearly the same as the
interest rate on risk-free government
bonds.
___________________________________
___________________________________
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
Profits and Economic Costs
___________________________________
• Out-of-pocket costs are sometimes
referred to as explicit costs or
accounting costs.
___________________________________
___________________________________
• Economic costs, often referred to
as implicit cots, include the full
opportunity cost of every input.
___________________________________
___________________________________
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Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
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
2,000
___________________________________
$31,000
Profit = total revenue − total cost
aThere
___________________________________
14,000
Normal return/opportunity cost of capital ($20,000 x .10)
Total Cost
− $ 1,000a
is a loss of $1,000.
___________________________________
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Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
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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 (or fixed factor) of
production, and
___________________________________
2. Firms can neither enter nor exit
the industry.
___________________________________
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Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
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.
___________________________________
___________________________________
___________________________________
___________________________________
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
The Bases of Decisions
___________________________________
• The fundamental things to know with
the objective of maximizing profit are:
1.
2.
3.
The market
price of
the output
The techniques
of production
that are
available
The prices
of inputs
___________________________________
___________________________________
___________________________________
___________________________________
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
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
• The optimal method of production
is the method that minimizes cost.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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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.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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Marginal Product
___________________________________
• Marginal product is
the additional output
that can be produced
by adding one more
unit of a specific
input, ceteris paribus.
___________________________________
___________________________________
___________________________________
marginal product of labor =
© 2004 Prentice Hall Business Publishing
change in total product
change in units of labor used
Principles of Economics, 7/e
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
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.
___________________________________
___________________________________
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C H A P T E R 6: The Production Process:
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Average Product
___________________________________
• 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
___________________________________
___________________________________
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
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___________________________________
Production Function for Sandwiches
___________________________________
Production Function
(2)
TOTAL PRODUCT
(SANDWICHES
PER HOUR)
40
(3)
MARGINAL
PRODUCT OF
LABOR
(4)
AVERAGE
PRODUCT
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
___________________________________
35
Total product
(1)
LABOR UNITS
(EMPLOYEES)
45
30
25
20
15
10
5
0
0
1
2
3
4
5
6
7
___________________________________
10
5
0
0
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
___________________________________
Number of employees
15
Marginal Product
C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
1
2
3
4
5
Number of employees
Karl Case, Ray Fair
6
7
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C H A P T E R 6: The Production Process:
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___________________________________
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.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
___________________________________
___________________________________
___________________________________
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C H A P T E R 6: The Production Process:
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Total, Average, and Marginal Product
___________________________________
• When average product is
maximum, average product
and marginal product are
equal.
• Then, average product
falls to the left and right of
point B.
___________________________________
___________________________________
___________________________________
___________________________________
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
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___________________________________
___________________________________
Total, Average, and Marginal Product
© 2004 Prentice Hall Business Publishing
___________________________________
Remember that:
___________________________________
• 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.
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C H A P T E R 6: The Production Process:
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___________________________________
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.
TECHNOLOGY
UNITS OF
CAPITAL (K)
A
B
C
D
E
UNITS OF
LABOR (L)
2
3
4
6
10
© 2004 Prentice Hall Business Publishing
___________________________________
• Given the
technologies
available, the
cost-minimizing
choice depends
on input prices.
Inputs Required to Produce 100 Diapers
Using Alternative Technologies
10
6
4
3
2
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C H A P T E R 6: The Production Process:
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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 (L)
(4)
COST WHEN
PL = $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
___________________________________
(5)
COST WHEN
PL = $5 PK = $1
___________________________________
___________________________________
___________________________________
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
Review Terms and Concepts
___________________________________
Accounting costs
Marginal product
Average product
Normal rate of return
CapitalCapital-intensive technology
Optimal method of production
Economic costs
OutOut-ofof-pocket costs
Economic profit
Perfect competition
Explicit costs
production
Firm
Production function or total product function
Homogeneous products
Production technology
Implicit costs
Profit (economic profit)
LaborLabor-intensive technology
Short run
Law of diminishing returns
Total cost (total economic cost)
Long run
Total revenue
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
___________________________________
___________________________________
___________________________________
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
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.
___________________________________
___________________________________
___________________________________
___________________________________
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Principles of Economics, 7/e
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
Appendix: Isoquants and Isocosts
___________________________________
Alternative Combinations of Capital
(K) and Labor (L) Required to Produce
50, 100, and 150 Units of Output
qx = 100
qx= 150
K
L
K
L
K
A
1
qx = 50
8
2
10
3
10
___________________________________
L
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
___________________________________
___________________________________
___________________________________
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
Appendix: Isoquants and Isocosts
© 2004 Prentice Hall Business Publishing
___________________________________
• Along an isoquant:
___________________________________
∆K ⋅ MPK = − ∆L ⋅ MPL
• The slope of an
isoquant is called the
marginal rate of
technical substitution.
MPL
∆K
=−
MPK
∆L
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
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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.
PK ⋅ K + PL ⋅ L
Principles of Economics, 7/e
Karl Case, Ray Fair
___________________________________
___________________________________
• The equation of the
isocost line is:
© 2004 Prentice Hall Business Publishing
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
Appendix: Isoquants and Isocosts
___________________________________
• Slope of the isocost
line:
___________________________________
TC / PK
P
∆K
=−
=− L
TC / PL
PK
∆L
___________________________________
___________________________________
___________________________________
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
___________________________________
___________________________________
Appendix: Isoquants and Isocosts
© 2004 Prentice Hall Business Publishing
___________________________________
• By setting the slopes of the
isoquant and isocost curves
equal to each other,
MPL PL
=
MPK PK
___________________________________
we derive the firm’s costminimizing equilibrium
condition is found
Principles of Economics, 7/e
MPL MPK
=
PLKarl Case, Ray
PKFair
Karl Case, Ray Fair
___________________________________
___________________________________
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C H A P T E R 6: The Production Process:
The BehaviorofProfit-M axim izing Firm s
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Appendix: Isoquants and Isocosts
___________________________________
• Plotting a series of cost-minimizing combinations of
inputs (at points A, B, and C), yields a cost curve.
___________________________________
___________________________________
___________________________________
___________________________________
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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