CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 61 7 The Production Process: The Behavior of Profit-Maximizing Firms The Behavior of Profit-Maximizing Firms Profits and Economic CostsShort-Run Versus Long-Run DecisionsThe Bases of Decisions: Market Price of Outputs, Available Technology,and Input Prices The Production ProcessProduction Functions: Total Product, Marginal Product, and AverageProduct Production Functions with Two Variable Factors of Production Choice of TechnologyLooking Ahead: Cost and SupplyAppendix: Isoquants and Isocosts CHAPTER OUTLINE PART II THE MARKET SYSTEM Choices Made by Households and Firms

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 2 Terms and Concepts: accounting costs: muhasebe maliyetleri, doğrudan yapılmış olan parasal giderler average product: ortalama ürün capital-intensive technology: sermaye yoğun teknoloji economic costs: iktisadi maliyetler, cari fiyat maliyetleri economic profit: ekonomik kar explicit costs: açık maliyetler firm: firma, işletme homogeneous products: homojen ürünler implicit costs: kaydedilmeyen (gizli, örtük) maliyet labor-intensive technology: emek yoğun teknoloji law of diminishing returns: azalan verimler yasası Long run: uzun dönem marginal product: marjinal ürün

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 3 Terms and Concepts: normal rate of return:normal getiri oranı optimal method of production: en uygun-optimal üretim yöntemi out-of-pocket costs: cepten çıkan-nakit-peşin ödenen maliyetler perfect competition: tam rekabet production: üretim, istihsal production function or total product function: üretim fonksiyonu production technology: üretim teknolojisi profit (economic profit): kar (ekonomik kar) short run: kısa dönem total cost (TC, total economic cost): toplam maliyet (toplam ekonomik maliyet) total revenue (TR): toplam gelir (toplam hasılat) Profit=total revenue–total cost: kar=toplam gelir (toplam hasıla) – toplam maliyet

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of 61  FIGURE II.1 Firm and Household Decisions Firms demand factors of production in input markets and supply goods and services in output markets. To simplify our analysis, we have not included the government and international sectors in this circular flow diagram. These topics will be discussed in detail later.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 5 of 42 The Production Process: The Behavior of Profit-maximizing Firms production The process by which inputs are combined, transformed, and turned into outputs. Production Is Not Limited to Firms firm 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. Firm is production unit in market system.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 6 of 42 In which of the following industries is perfect competition more likely to prevail? a.Airlines. b.Energy. c.Agriculture. d.Satellite communications.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 42 In which of the following industries is perfect competition more likely to prevail? a.Airlines. b.Energy. c.Agriculture. d.Satellite communications.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 8 Perfect Competition Firms in perfectly competitive industries do not differentiate their products, and do not make decisions about price. 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. Firm decides only how much to produce and how to produce it. The best examples of perfect competition are probably found in agriculture. The perfectly competitive firm faces a perfectly elastic demand curve for its product.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 9 Demand Facing a Single Firm in a Perfectly Competitive Market If a representative firm in a perfectly competitive market raises the price of its output above $2.45, the quantity demanded of that firm’s output will drop to zero. Each firm faces a perfectly elastic demand curve, d.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 42 The Behavior of Profit-Maximizing Firms All firms must make several basic decisions to achieve what we assume to be their primary objective—maximum profits.  FIGURE 7.1 The Three Decisions That All Firms Must Make

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 11 There close relationship among the three decision given below. The first and last choices are linked by the second choice. 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.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 42 The Behavior of Profit-Maximizing Firms Profits and Economic Costs We assume that firms are in business to make a profit and that a firm’s behavior is guided by the goal of maximizing profit. profit (economic profit) The difference between total revenue and total cost. profit = total revenue - total cost total revenue The amount received from the sale of the product (q x P).

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 42 The Behavior of Profit-Maximizing Firms Profits and Economic Costs total cost (total economic cost) The total of (1)out-of-pocket costs, (2)normal rate of return on capital, and (3) opportunity cost of each factor of production. economic profit = total revenue - total economic cost The term profit will from here on refer to economic profit. So whenever we say profit = total revenue - total cost, what we really mean is

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 42 The Behavior of Profit-Maximizing Firms Profits and Economic Costs Normal Rate of Return When someone decides to start a firm, that person must commit resources such as plant and some equipment. Plant and equipment wear out and must be replaced. Firms that decide to expand must put new capital in place. Whenever resources are used to invest in a business, there is an opportunity cost. 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. For example, when investment is $ and yearly flow of profit is $ then rate of return is 15% (15.000x100/ =15). normal rate of return 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

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 42 The Behavior of Profit-Maximizing Firms Profits and Economic Costs For relatively risk-free firms, the normal rate of return be nearly the same as the interest rate on risk-free government bonds. A normal rate of return is considered a part of the total cost of business. Adding a normal rate of return to total cost has an important implications: When a firm earns exactly a normal rate of return, it is earning zero profit as we have defined profit. If the level of profit is positive, the firm is earning an above-normal rate of capital. Out-of-pocket costs are sometimes referred to as explicit costs or accounting costs. Economic costs, often referred to as implicit cots. TABLE 7.1 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 cost14,000 Normal return/Opportunity Cost of Capital ($20,000 x 0.10)2,000 Total Cost$31,000 Profit = total revenue - total cost  $1,000

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 42 Among the components of total cost is: a.Total revenue. b.A normal rate of return. c.Economic profit. d.Productivity. e. None of the above.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 17 of 42 Among the components of total cost is: a.Total revenue. b.A normal rate of return. c.Economic profit. d.Productivity. e. None of the above.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 18 of 42 The Behavior of Profit-Maximizing Firms Short-Run Versus Long-Run Decisions The decisions made by a firm (how much to produce, how to produce, and what inputs to demand) all take time into account. Because the character of immediate response differs from long-run adjustments, it is useful to define two time periods: The short run and The long run No hard –and- fast rule specifies how long the short run and the long run are. The duration of the short run and the long run differ from industry to industry.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 42 The Behavior of Profit-Maximizing Firms Short-Run Versus Long-Run Decisions short run The period of time for which two conditions hold: The firm is operating under a fixed scale (fixed factor) of production, and firms can neither enter nor exit an industry. First the short run is defined as that period during which existing firms have some fixed factor production that is, during which time some factors locks them into their current scale of operations. Second, new firms cannot enter, and existing firms cannot exit an industry in the short run. Firms may curtail operations, but they are still locked into some costs, even though they may be in the process of going out of business. Just which factor or factors of production are fixed in the short run differs from industry to industry. long run That period of time for which there are no fixed factors of production: Firms can increase or decrease the scale of operation, and new firms can enter and existing firms can exit the industry.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 20 of 42 The Behavior of Profit-Maximizing Firms The Bases of Decisions: Market Price of Outputs, Available Technology, and Input Prices The fundamental purpose of the firm is to maximize profit. Since profit equals total revenue minus total cost, each firm needs to know the cost of its production and price of its products. The cost mainly depends on production techniques available and input prices. In the language of economics, we need to know three things that are the fundamental things with the objective of maximizing profit: 1. The market price of output 2. The techniques of production that are available 3. The prices of inputs Output price determines potential revenues. The techniques available tell me how much of each input I need, and input prices tell me how much they will cost. Together, the available production techniques and the prices of inputs determine costs.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 21 of 42 The Behavior of Profit-Maximizing Firms The Bases of Decisions: Market Price of Outputs, Available Technology, and Input Prices optimal method of production The production method that minimizes cost. With cost determined and the market price of output known (given in perfect competition), a firm will make a final judgment about the quantity of product to produce and the quantity of each input to demand.  FIGURE 7.2 Determining the Optimal Method of Production

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 of 42 The Production Process Production is the process through which inputs are combined and transformed into outputs. production technology The quantitative relationship between inputs and outputs. labor-intensive technology Technology that relies heavily on human labor instead of capital. In choosing the most appropriate technology, firms choose the one that minimizes the cost of production.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 23 of 42 Firms in an economy with high labor costs have an incentive to use: a.Labor-intensive technologies. b.Capital-intensive technologies. c.Less than optimal production technologies. d.The production method than maximizes cost.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 42 Firms in an economy with high labor costs have an incentive to use: a.Labor-intensive technologies. b.Capital-intensive technologies. c.Less than optimal production technologies. d.The production method than maximizes cost.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 of 42 The Production Process Production Functions: Total Product, Marginal Product, And Average Product 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 units of inputs. We know that the relationship between inputs and outputs is the production technology. A production function shows units of total product as a function of units of inputs. In the figure on the next page, the total product (output) is graphed as a function of labor inputs according to the values taken from the table below. TABLE 7.2 Production Function (1) Labor Units (Employees) (2) Total Product (Sandwiches per Hour) (3) Marginal Product of Labor (4) Average Product of Labor (Total Product + Labor Units)  

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 42 The Production Process Production Functions: Total Product, Marginal Product, And Average Product  FIGURE 7.3 Production Function for Sandwiches A production function is a numerical representation of the relationship between inputs and outputs. In Figure 7.3(a), total product (sandwiches) is graphed as a function of labor inputs. The marginal product of labor is the additional output that one additional unit of labor produces. Figure 7.3(b) shows that the marginal product of the second unit of labor at the sandwich shop is 15 units of output; the marginal product of the fourth unit of labor is 5 units of output.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 27 of 42 The shape of the short-run production function is fundamentally attributed to: a.A labor constraint. b.A capital constraint. c.The assumption that not all workers are equally capable. d. All of the above.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 28 of 42 The shape of the short-run production function is fundamentally attributed to: a.A labor constraint. b.A capital constraint. c.The assumption that not all workers are equally capable. d. All of the above.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 29 of 42 The Production Process Production Functions: Total Product, Marginal Product, And Average Product marginal product The additional output that can be produced by adding one more unit of a specific input, ceteris paribus. law of diminishing returns (formulated by D. Ricardo for agriculture) When additional units of a variable input are added to fixed inputs after a certain point, the marginal product of the variable input declines. Diminishing returns or diminishing marginal product, begin to show up when more and more units of variable input are added to a fixed input, such as scale of plant. Recall that we defined the short run as that period in which some fixed factor of production constraints the firm. It than follows that: Diminishing returns always apply in the short run, and in the short run every firm will face diminishing returns. This means that every firm finds it progressively more difficult to increase its output as it approaches capacity production. Marginal Product and the Law of Diminishing Returns

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 30 of 42 The Production Process Production Functions: Total Product, Marginal Product, And Average Product Marginal Product Versus Average Product average product The average amount produced by each unit of a variable factor of production. Average product follows marginal products, but it does not change as quickly. If marginal product is above average product, the average rises; If marginal product is below average product, the average falls.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 31 Production Function for Sandwiches Production Function (1) LABOR UNITS (EMPLOYEES) (2) TOTAL PRODUCT (SANDWICHE S PER HOUR) (3) MARGINAL PRODUCT OF LABOR (4) AVERAGE PRODUCT OF LABOR 00 

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 32 Total, Average, and Marginal Product Marginal product and average product can be derived from total product. Marginal product is the slope of the total product function. Marginal product increase till L 1. At point A where the units of labor is L 1, the slope of the total product function is highest; thus, marginal product is highest. At point C where the units of labor is L 3, total product is maximum, the slope of the total product function is zero, and marginal product intersects the horizontal axis.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 33 of 42 The Production Process Production Functions: Total Product, Marginal Product, And Average Product Marginal Product Versus Average Product  FIGURE 7.4 Total Average and Marginal Product Marginal and average product curves can be derived from total product curves. Average product is at its maximum at the point of intersection with marginal product. TABLE 7.2 Production Function (1) Labor Units (Employe es) (2) Total Product (Sandwiches per Hour) (3) Marginal Product of Labor (4) Average Product of Labor (Total Product + Labor Units)  

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 34 Total, Average, and Marginal Product Average product can also be derived from total product. Average product is at its maximum at the point of intersection with marginal product. Then, average product falls to the left and right of point B where the units of labor is L 2. When average product is maximum, average product and marginal product are equal.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 35 Total, Average, and Marginal Product 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.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 36 of 42 The relationship between the average product of labor (AP L ) and the marginal product of labor (MP L ) is as follows: a.When MP L is below AP L, AP L rises. b.When MP L is above AP L, AP L rises. c.AP L increases as long as MP L increases. d.MP L > AP L when AP L is declining. e.When MP L is equal to AP L, AP L is minimum.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 37 of 42 The relationship between the average product of labor (AP L ) and the marginal product of labor (MP L ) is as follows: a.When MP L is below AP L, AP L rises. b.When MP L is above AP L, AP L rises. c.AP L increases as long as MP L increases. d.MP L > AP L when AP L is declining. e.When MP L is equal to AP L, AP L is minimum.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 38 of 42 The Production Process Production Functions with Two Variable Factors of Production How Fast Should a TruckDriver Go? Modern technology, in the form of on-board computers, allows a modern trucking firm to monitor driving speed and instructs drivers.

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 39 of 42 Choice of Technology TABLE 7.3 Inputs Required to Produce 100 Diapers Using Alternative Technologies TechnologyUnits of Capital (K)Units of Labor (L) ABCDEABCDE 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. Production Functions with Two Variable Factors of Production

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 40 of 42 Choice of Technology TABLE 7.4 Cost-Minimizing Choice Among Alternative Technologies (100 Diapers) (4)(5) (1) Technology (2) Units of Capital (K) (3) Units of Labor (L) Cost = (L X P L ) + (K X P K ) PL= $1 PK = $1 PL = $5 PK = $1 ABCDEABCDE $ $ Two things determine the cost of production that are: 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 prices. Technology C is cost-minimizing choice according to input costs in column 4, and technology E is cost-minimizing choice according to input costs in column 5. Production Functions with Two Variable Factors of Production

CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 41 of 42 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. UPS Technology SpeedsGlobal Shipping New UPS Technologies Aim to Speed Worldwide Package Delivery Information Week