© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 6 Prepared by: Fernando Quijano and Yvonn Quijano The Production

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

C

H A

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C H

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R66

Prepared by: Fernando Prepared by: Fernando QuijanoQuijano

and Yvonn Quijano and Yvonn Quijano

The Production Process:The Production Process:The Behavior of Profit- The Behavior of Profit-

Maximizing FirmsMaximizing Firms


ProductionProduction

Central to our analysis is Central to our analysis is productionproduction::

• ProductionProduction is the process by which is the process by which inputs are combined, transformed, inputs are combined, transformed, and turned into outputs.and turned into outputs.


What Is A What Is A FirmFirm??

• A A firmfirm is an organization that comes is an organization that comes into being when a person or a group of into being when a person or a group of people decides to produce a good or people decides to produce a good or service to meet a perceived demand. service to meet a perceived demand. Most firms exist to make a profit.Most firms exist to make a profit.

• Production is not limited to firms.Production is not limited to firms.


Perfect CompetitionPerfect Competition

• many firmsmany firms, each small relative to the , each small relative to the industry,industry,

• producing virtually producing virtually identical productsidentical products and and

• in which in which nono firm is large enough to have firm is large enough to have any any control over pricescontrol over prices..

• In perfectly competitive industries, new In perfectly competitive industries, new competitors can competitors can freely enter and exitfreely enter and exit the the market.market.

Perfect competition is an industry Perfect competition is an industry structure in which there are:structure in which there are:


Homogeneous ProductsHomogeneous Products

• Homogeneous productsHomogeneous products are are undifferentiated products; undifferentiated products; products that are identical to, or products that are identical to, or indistinguishable from, one indistinguishable from, one another.another.


Competitive Firms are Price TakersCompetitive Firms are Price Takers

• In a perfectly competitive market, individual firms are price-takers. This means that firms have no control over price. Price is determined by the interaction of market supply and demand.


Demand Facing a Single Firm in a Demand Facing a Single Firm in a Perfectly Competitive MarketPerfectly Competitive Market

• If a representative firm in a perfectly competitive market rises the price If a representative firm in a perfectly competitive market rises the price of its output above $2.45, the quantity demanded of that firm’s output of its output above $2.45, the quantity demanded of that firm’s output will drop to zero. Each firm faces a will drop to zero. Each firm faces a perfectly elastic demandperfectly elastic demand curve, curve, dd..


The Behavior ofThe Behavior ofProfit-Maximizing FirmsProfit-Maximizing Firms

• The three decisions that all firms must The three decisions that all firms must make include:make include:

How much of How much of each input to each input to

demanddemand

3.3.

Which Which production production

technology to technology to useuse

2.2.

How much How much output to output to

supplysupply

1.1.


Profits and Economic CostsProfits and Economic Costs

• Profit (economic profit)Profit (economic profit) is the difference is the difference between total revenue and total cost.between total revenue and total cost.

• Total revenueTotal revenue is the amount received from the is the amount received from the sale of the product:sale of the product:

((qq X X PP))

• Total cost (total economic cost)Total cost (total economic cost) is the total of is the total of

1.1. Out of pocket costs,Out of pocket costs,

2.2. Normal rate of return on capital, andNormal rate of return on capital, and

3.3. Opportunity cost of each factor of production.Opportunity cost of each factor of production.


Normal Rate of ReturnNormal Rate of Return

• The The normal rate of returnnormal rate of return is a rate of is a rate of return on capital that is just sufficient return on capital that is just sufficient to keep owners and investors to keep owners and investors satisfied.satisfied.

• For relatively risk-free firms, it should For relatively risk-free firms, it should be nearly the same as the interest rate be nearly the same as the interest rate on risk-free government bonds.on risk-free government bonds.


Calculating Total Revenue, Total Cost, Calculating Total Revenue, Total Cost, and Profitand Profit

Initial Investment:Initial Investment:Market Interest Rate Available:Market Interest Rate Available:

$20,000$20,000.10 or 10%.10 or 10%

Total Revenue (3,000 belts x $10 each)Total Revenue (3,000 belts x $10 each) $30,000$30,000

CostsCosts

Belts from supplierBelts from supplier $15,000$15,000

Labor CostLabor Cost 14,00014,000

Normal return/opportunity cost of capital ($20,000 x .10)Normal return/opportunity cost of capital ($20,000 x .10) 2,0002,000

Total CostTotal Cost $31,000$31,000

Profit = total revenue Profit = total revenue total cost total cost $ 1,000$ 1,000aa

aaThere is a loss of $1,000.There is a loss of $1,000.


Short-Run Versus Long-Run DecisionsShort-Run Versus Long-Run Decisions

• The The short runshort run is a period of time is a period of time for which two conditions hold:for which two conditions hold:

1.1. The firm is operating under a fixed The firm is operating under a fixed scale (fixed factor) of production, andscale (fixed factor) of production, and

2.2. Firms can neither enter nor exit an Firms can neither enter nor exit an industry.industry.


Short-Run Versus Long-Run DecisionsShort-Run Versus Long-Run Decisions

• The The long runlong run is a period of time is a period of time for which there are no fixed for which there are no fixed factors of production. Firms can factors of production. Firms can increase or decrease scale of increase or decrease scale of operation, and new firms can operation, and new firms can enter and existing firms can exit enter and existing firms can exit the industry.the industry.


Determining the Optimal MethodDetermining the Optimal Methodof Productionof Production

Price of outputPrice of output Production techniquesProduction techniques Input pricesInput prices

Determines Determines total revenuetotal revenue

Determine total cost and Determine total cost and optimal method of optimal method of

productionproduction

Total revenueTotal revenueTotal cost with optimal methodTotal cost with optimal method

=Total profit=Total profit

• The The optimal method of productionoptimal method of production is the is the method that minimizes cost.method that minimizes cost.


The Production ProcessThe Production Process

• Production technologyProduction technology refers to the refers to the quantitative relationship between inputs quantitative relationship between inputs and outputs.and outputs.

• A A labor-intensive technologylabor-intensive technology relies relies heavily on human labor instead of heavily on human labor instead of capital.capital.

• A A capital-intensive technologycapital-intensive technology relies relies heavily on capital instead of human heavily on capital instead of human labor. labor.


The Production FunctionThe Production Function

• The The production functionproduction function or or total product functiontotal product function is a is a numerical or mathematical numerical or mathematical expression of a relationship expression of a relationship between inputs and outputs. between inputs and outputs. It shows units of total It shows units of total product as a function of product as a function of units of inputs.units of inputs.


Marginal Product and Average ProductMarginal Product and Average Product

• Marginal productMarginal product is the additional output that is the additional output that can be produced by adding one more unit of a can be produced by adding one more unit of a specific input, specific input, ceteris paribusceteris paribus..

• Average productAverage product is the average amount is the average amount produced by each unit of a variable factor of produced by each unit of a variable factor of production.production.

av erag e p ro d u c t o f lab o r = to ta l p ro d u c t

to ta l u n its o f lab o r

m arg in a l p ro d u c t o f lab o r = ch an g e in to ta l p ro d u c t

ch an g e in u n its o f lab o r u sed


The Law of DiminishingThe Law of DiminishingMarginal ReturnsMarginal Returns

• The The law of diminishing law of diminishing marginal returnsmarginal returns states states that:that:

When additional units of a When additional units of a variable input are added to variable input are added to fixed inputs, the marginal fixed inputs, the marginal product of the variable input product of the variable input declines.declines.


Production Function for SandwichesProduction Function for Sandwiches

Production FunctionProduction Function

(1)(1)LABOR UNITS LABOR UNITS (EMPLOYEES)(EMPLOYEES)

(2)(2)TOTAL PRODUCT TOTAL PRODUCT

(SANDWICHES (SANDWICHES PER HOUR)PER HOUR)

(3)(3)MARGINAL MARGINAL

PRODUCT OF PRODUCT OF LABORLABOR

(4)(4)AVERAGE AVERAGE PRODUCT PRODUCT OF LABOROF LABOR

00 00

11 1010 1010 10.010.0

22 2525 1515 12.512.5

33 3535 1010 11.711.7

44 4040 55 10.010.0

55 4242 22 8.48.4

66 4242 00 7.07.0

0

5

10

15

20

25

30

35

40

45

0 1 2 3 4 5 6 7

Number of employees

Tot

al p

rodu

ct

0

5

10

15

0 1 2 3 4 5 6 7

Number of employees

Mar

gina

l Pro

duct


Total, Average, and Marginal ProductTotal, Average, and Marginal Product

• Marginal product is the slope Marginal product is the slope of the total product function.of the total product function.

• At point C, total product is At point C, total product is maximum, the slope of the maximum, the slope of the total product function is zero, total product function is zero, and marginal product and marginal product intersects the horizontal axis.intersects the horizontal axis.

• At point A, the slope of the At point A, the slope of the total product function is total product function is highest; thus, marginal product highest; thus, marginal product is highest.is highest.



• When a ray drawn from the When a ray drawn from the origin falls tangent to the total origin falls tangent to the total product function, average product function, average product is maximum and equal product is maximum and equal to marginal product.to marginal product.

• Then, average product falls to Then, average product falls to the left and right of point B.the left and right of point B.



• As long as marginal product As long as marginal product rises, average product rises.rises, average product rises.

• When average product is When average product is maximum, marginal product maximum, marginal product equals average product.equals average product.

• When average product falls, When average product falls, marginal product is less than marginal product is less than average product.average product.


Production Functions with Two Variable Production Functions with Two Variable Factors of ProductionFactors of Production

• In many production processes, inputs work In many production processes, inputs work together and are viewed as complementary.together and are viewed as complementary.

• For example, increases in capital usage lead to For example, increases in capital usage lead to increases in the productivity of labor.increases in the productivity of labor.

Inputs Required to Produce 100 Diapers Inputs Required to Produce 100 Diapers Using Alternative TechnologiesUsing Alternative Technologies

TECHNOLOGYTECHNOLOGYUNITS OF UNITS OF

CAPITAL (K)CAPITAL (K)UNITS OF UNITS OF LABOR (L)LABOR (L)

AA 22 1010

BB 33 66

CC 44 44

DD 66 33

EE 1010 22

• Given the technologies available, the cost-minimizing choice depends on input prices.


Production Functions with Two Variable Production Functions with Two Variable Factors of ProductionFactors of Production

Cost-Minimizing Choice Among Alternative Cost-Minimizing Choice Among Alternative Technologies (100 Diapers)Technologies (100 Diapers)

(1)(1)TECHNOLOGYTECHNOLOGY

(2)(2)UNITS OF UNITS OF

CAPITAL (K)CAPITAL (K)

(3)(3)UNITS OF UNITS OF

LABORLABOR

(4) (4) COST WHEN COST WHEN

PPLL = $1 P = $1 PKK = $1 = $1

(5) (5) COST WHEN COST WHEN

PPLL = $1 P = $1 PKK = $1 = $1

AA 22 1010 $12$12 $52$52

BB 33 66 99 3333

CC 44 44 88 2424

DD 66 33 99 2121

EE 1010 22 1212 2020

Documents

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 6 Prepared by: Fernando Quijano and Yvonn Quijano The Production