6.1 Ch. 6: The Production Process: The Behavior of Profit- Maximizing Firms Production is the process by which inputs are combined, transformed, and turned into outputs. 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.

6.2 Perfect Competition Perfect competition is an industry structure in which There are many buyers and sellers, each small relative to the industry The product is identical (or homogeneous) There is easy entry and exit into and out of the market Buyers and Sellers have perfect knowledge (complete information): households posses a knowledge of the qualities and prices of everything available in the market, and that firms have all available information concerning wage rates, capital costs, and output prices.  no one firm or consumer has any control over price

6.3 Competitive Firms are Price Takers In a perfectly competitive market where no one firm or consumer has any control over price, they are called price-takers. Price is determined by the interaction of market supply and demand. Each firm is small relative to the market Each firm can sell all it wants to sell at the market price  the firm “faces” a perfectly elastic demand curve for its product.

6.4 The Behavior of Profit-Maximizing Firms The three decisions that all firms must make include: How much of each input to demand 3. Which production technology to use 2. How much output to supply 1. All three of these decisions are made in such a way as to maximize the firm’s profits.

6.5 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 = p x q Total cost (total economic cost) is the total of 1. Out of pocket costs 2. Opportunity cost of each factor of production, including a normal rate of return on capital

6.6 Opportunity Cost of Factors of Production In some situations, the opportunity cost of a factor of production is simply what the firm pays for it Other times, a firm may not make an explicit payment for a factor of production, but the use of the factor still incurs an implicit cost Examples:

6.7 Normal Rate of Return 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, it should be nearly the same as the interest rate on risk-free government bonds.

6.8 Calculating Economic Profits: Suppose you decide to open a hotdog stand on campus, because you find that your parents have a perfectly good hotdog cart sitting in the garage. These carts normally rent for $5,000 per year. You decide to quit your job a McDonald’s where you were earning $12,000 a year to run the hotdog stand. In your first year of operation, you sell 30,000 hotdogs at $1 each. The cost of your supplies (hotdogs, rolls, condiments, etc.) were $15,000. Calculate your economic profit:

6.9 A Second Example from the Textbook: Initial Investment: Market Interest Rate Available: $20, 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.10) 2,000 Total Cost $31,000 Profit = total revenue  total cost  $ 1,000 a a There is a loss of $1,000.

6.10 Short-Run Versus Long-Run Decisions The short run is a period of time for which two conditions hold: 1. The firm is operating with at least one factor of production being fixed. 2. Firms can neither enter nor exit an industry. 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. We distinguish between these two time frames because firm’s decision-making will differ depending on whether it is a short-run decision or a long-run decision.

6.11 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. 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.

6.12 Example: Production Function for Sandwiches Production Function (1) LABOR UNITS (EMPLOYEES) (2) TOTAL PRODUCT (SANDWICHES PER HOUR)

6.13 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. For Labor it is: Average product is the average amount produced by each unit of a variable factor of production. For Labor it is: The law of diminishing marginal returns (or diminishing marginal product) states that: When additional units of a variable input are added to fixed inputs, the marginal product of the variable input eventually declines.

6.14 Marginal and Average Product Production Function (1) LABOR UNITS (EMPLOYEES) (2) TOTAL PRODUCT (SANDWICHES PER HOUR) (3) MARGINAL PRODUCT OF LABOR (4) AVERAGE PRODUCT OF LABOR 00 

6.15 Total, Average, and Marginal Product Marginal product is the slope of the total product function. At point C, total product is maximum, the slope of the total product function is zero, and marginal product intersects the horizontal axis. At point A, the slope of the total product function is highest; thus, marginal product is highest.

6.16 Total, Average, and Marginal Product Average 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. 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

6.17 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. Given the technologies available, the cost-minimizing choice depends on input prices. Cost-Minimizing Choice Among Alternative Technologies (100 Diapers) TECHNOLOGY UNITS OF CAPITAL (K) UNITS OF LABOR COST WHEN P L = $1 P K = $1 COST WHEN P L = $5 P K = $1 A210 B36 C44 D63 E 2