6 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair The Production Process: The Behavior of Profit-Maximizing Firms Appendix: Isoquants and Isocosts

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 37 Production Central to our analysis is production, the process by which inputs are combined, transformed, and turned into outputs.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 37 Firm and Household Decisions Firms demand factors of production in input markets and supply goods and services in output markets.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 37 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 among firms.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 37 Perfect Competition 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. Perfect competition is an industry structure in which there are:

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 37 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.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 37 Demand Facing a Single Firm in a Perfectly Competitive Market The perfectly competitive firm faces a perfectly elastic demand curve for its product.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 37 The three decisions that all firms must make include: Which production technology to use 2. How much output to supply 1. The Behavior of Profit-Maximizing Firms How much of each input to demand 3.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 37 Profits and Economic Costs Profit (economic profit) is the difference between total revenue and total economic cost. Total revenue is the amount received from the sale of the product:

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 37 Profits and Economic Costs Total cost (total economic cost) is the total of 1. Accounting costs (Explicit or out- of-pocket costs): involve a direct money outlay for factors of production. 2. Economic costs (Implicit costs): do not involve a direct money outlay. They include the full opportunity cost of every input.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 37 Profits and Economic Costs The most important opportunity cost is that is included in economic cost is the opportunity cost of capital. Rate of return is the annual flow of net income generated by an investment expressed as a percentage of the total nvestment. The normal rate of return is a rate of return on capital that is just sufficient to keep owners and investors satisfied.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 37 Calculating Total Revenue, Total Cost, and Profit 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.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 37 Short-Run Versus Long-Run Decisions The short run is a period of time in which the quantity of some inputs, called fixed inputs can not be changed. A fixed factor is usually an element of capital (such as plant and equipment), but it might be land or the supply of skilled labor. Inputs that can be varied in the short run are called variable factors.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 37 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 all inputs.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 37 The Bases of Decisions The fundamental things to know with the objective of maximizing profit are: The prices of inputs 3. The techniques of production that are available 2. The market price of the output 1.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 37 Determining the Optimal Method of Production Price of outputProduction techniquesInput prices Determines total revenue 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.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 37 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.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 37 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.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 37 Production Function for Sandwiches Production Function (1) LABOR UNITS (EMPLOYEES) (2) TOTAL PRODUCT (SANDWICHES PER HOUR) (3) MARGINAL PRODUCT OF LABOR (4) AVERAGE PRODUCT OF LABOR 00 

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 37 Marginal Product Marginal product is the additional output that can be produced by adding one more unit of a specific input, ceteris paribus.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 37 The Law of Diminishing Marginal Returns The law of diminishing marginal returns or marginal product states that: When additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines. Example: As more and more workers (variable input) are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment (fixed input).

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 37 Average Product Average product is the average amount produced by each unit of a variable input.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 37 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.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 37 Total, Average, and Marginal Product If marginal product is above average product, the average rises. If marginal product is below average product, the average falls. When average product is maximum, average product and marginal product are equal.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 37 Production Functions with Two Variable Factors of Production Cost-Minimizing Choice Among Alternative Technologies (100 T-Shirts) (1) TECHNOLOGY (2) UNITS OF CAPITAL (K) (3) UNITS OF LABOR (L) (4) COST WHEN P L = $1 P K = $1 (5) COST WHEN P L = $5 P K = $1 A210$12$52 B36933 C44824 D63921 E

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 37 Choice of Technology Two things determine the cost of production: 1)Technologies that are available 2)Input prices. Profit-maximizing firms will choose the technology that minimizes the cost of production given input prices. Profit-maximizing firms will choose the technology that minimizes the cost of production given input prices.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 37 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.

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 37 Appendix: Isoquants and Isocosts Alternative Combinations of Capital (K) and Labor (L) Required to Produce 50, 100, and 150 Units of Output q x = 50q x = 100q x = 150 KLKLKL A B C D E

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 37 Appendix: Isoquants and Isocosts The slope of an isoquant is called the marginal rate of technical substitution. Along an isoquant:

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 37 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. The equation of the isocost line is:

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 37 Appendix: Isoquants and Isocosts Slope of the isocost line:

C H A P T E R 6: The Production Process: The Behavior of Profit-Maximizing Firms © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 37 Appendix: Isoquants and Isocosts By setting the slopes of the isoquant and isocost curves equal to each other, we derive the firm’s cost- minimizing equilibrium condition is found