Copyright 2002, Pearson Education Canada1 The Behaviour of Profit-Maximizing Firms and the Production Process Chapter 7

Copyright 2002, Pearson Education Canada2 Firm and Household Decisions (Figure 7.1)

Copyright 2002, Pearson Education Canada3 Production zProduction may be defined as the process by which inputs are combined, transformed, and turned into outputs.

Copyright 2002, Pearson Education Canada4 Perfect Competition zPerfect competition is an industry structure or market organization 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. zIn perfectly competitive industries, new competitors can freely enter and exit the market.

Copyright 2002, Pearson Education Canada5 Firm zA 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.

Copyright 2002, Pearson Education Canada6 Homogeneous Product zHomogeneous products are undifferentiated products; products that are identical to, or indistinguishable from, one another.

Copyright 2002, Pearson Education Canada7 Easy Entry and Easy Exit zEasy entry is the condition that exists when there are no barriers to prevent new firms from competing for profits in a profitable industry. zEasy exit is the condition that exists when firms can simply stop producing their product and leave a market. Firms incur no additional costs by exiting the industry.

Copyright 2002, Pearson Education Canada8 Demand Facing a Single Firm in a Perfectly Competitive Market (Figure 7.2) If a representative firm in a perfectly competitive industry raises 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.

Copyright 2002, Pearson Education Canada9 The Three Decisions All Firms Make zHow much output to supply (quantity of product) zHow to produce that output (which production technology to use) zHow much of each input to demand

Copyright 2002, Pearson Education Canada10 Profit = Total Revenue (TR) - Total Cost (TC) Where Total Revenue is the receipts from the sale of a product (P x q) Profit zProfit is the difference between total revenue and total costs.

Copyright 2002, Pearson Education Canada11 Normal Rate of Profit or Normal Rate of Return zThe normal rate of profit is a rate of profit that is just sufficient to keep owners or investors satisfied. For relatively risk-free firms, it should be nearly the same as the interest rate on risk- free government bonds. zProfits over and above the normal rate of return on investment are called economic profits or excess profits.

Copyright 2002, Pearson Education Canada12 Calculating Total Revenue, Total Cost and Profit For a Small Belt Firm (Table 7.1)

Copyright 2002, Pearson Education Canada13 Short Run vs. Long Run zThe short run is a period of time for which two conditions hold: yThe firm is operating under a fixed scale (fixed factor) of production yFirms can neither enter or exist an industry zThe long run is a period of time for a firm such that there are no fixed factors of production. yFirms can increase or decrease the scale of production yNew firms can enter and existing firms can exit the industry

Copyright 2002, Pearson Education Canada14 The Bases of Firm Decision Making zThe market price of output zThe techniques of production that are available zThe prices of inputs

Copyright 2002, Pearson Education Canada15 Determining the Optimal Method of Production to Maximize Profits (Figure 7.4)

Copyright 2002, Pearson Education Canada16 The Production Process zProduction technology is the relationship between inputs and outputs. zThe optimal method of production, for a profit- maximizing firm, is the one that minimizes costs. zLabour-intensive technology is technology that relies heavily on human labour rather than capital. zCapital-intensive technology is technology that relies heavily on capital rather than human labour.

Copyright 2002, Pearson Education Canada17 Production Function or Total Product Function zThe production function or total product function is a numerical or mathematical expression of a relationship between inputs and outputs. zIt shows units of total product as a function of units of inputs.

Copyright 2002, Pearson Education Canada18 Marginal Product and Average Product zMarginal product is the additional output that can be produced by adding one more unit of a specific input, ceteris paribus. zThe average product is the average amount produced by each unit of a variable factor of production.

Copyright 2002, Pearson Education Canada19 Law of Diminishing Returns zThe law of diminishing returns states that when additional units of an input are added to fixed inputs after a certain point, the marginal product of the variable input declines.

Copyright 2002, Pearson Education Canada20 Labor Total Marginal Average Units Product Product Product Production Function (Sandwich Making) (From Table 7.2)

Copyright 2002, Pearson Education Canada21 Production Function for Sandwiches: Total Product (Figure 7.5)

Copyright 2002, Pearson Education Canada22 Typical Production Function (Figure 7.6) zMarginal and average product curves can be derived from total product curves. zThe marginal product of labour is the slope of the total product curve. zAverage product follows marginal product; it rises when marginal product is above it and falls when marginal product is below it.

Copyright 2002, Pearson Education Canada23 Choice of Technology zTwo things determine the cost of production: yThe technologies that are available yInput prices zProfit maximizing firms will choose the technology that minimizes the cost of production given current market input prices.

Copyright 2002, Pearson Education Canada24 Example of Technology Choice for a Diaper Company (Tables 7.3 & 7.4) Five technologies are available to produce 100 diapers. The choice of technology is based upon relative input prices.

Copyright 2002, Pearson Education Canada25 Review Terms & Concepts zaverage product zcapital-intensive technology zeasy entry zeasy exit zeconomic profits or excess profits zfirm zhomogeneous products zlabour-intensive technology zlaw of diminishing returns zlong run zmarginal product znormal rate of profit or normal rate of return zoptimal method of production

Copyright 2002, Pearson Education Canada26 Review Terms & Concepts (continued) zperfect competition zproduction zproduction function or total product function zproduction technology zprofit zshort run ztotal revenue