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RTIITheMarketSystem:C

hoicesMadebyHouseholdsa

ndFirms

2012 Pearson Education, Inc. Publishing as Prentice Hall

Prepared by: Fernando Quijano & Shelly TefftCASE FAIR OSTER

P R I N C I P L E S O F

MICROECONOMICST E N T H E D I T I O N


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ndFirms



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ndFirms


CHAPTER OUTLINE

7The Production Process:The Behavior ofProfit-Maximizing Firms

The Behavior of Profit-Maximizing Firms

Profits and Economic Costs

Short-Run versus Long-Run Decisions

The Bases of Decisions: Market Price of Outputs, Available

Technology, and Input Prices

The Production ProcessProduction Functions: Total Product, Marginal Product, and

Average Product

Production Functions with Two Variable Factors of Production

Choice of Technology

Looking Ahead: Cost and Supply

Appendix: Isoquants and Isocosts


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ndFirms


production The process by which inputs arecombined, transformed, and turned into outputs.

firm An organization that comes into being whena person or a group of people decides to producea good or service to meet a perceived demand.


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All firms must make several basic decisionsto achieve what we assume to be theirprimary objectivemaximum profits.

FIGURE 7.1 The Three DecisionsThat All Firms Must Make



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profit (economic profit) The differencebetween total revenue and total cost.

profit = total revenue total cost

total revenue The amount received fromthe sale of the product (q x P).




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total cost (total economic cost) The totalof (1) out-of-pocket costs and (2)opportunity cost of all factors of production.

economic profit = total revenue total economic cost

The termprofitwill from here on refer to economic profit.

So whenever we say profit = total revenue total cost,what we really mean is




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normal rate of return A rate of return oncapital that is just sufficient to keep ownersand investors satisfied. For relatively risk-free

firms, it should be nearly the same as theinterest rate on risk-free government bonds.

TABLE 7.1 Calculating Total Revenue, Total Cost, and Profit

Initial Investment:

Market Interest Rate Available:

$20,000

0.10, or 10%

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

Belts from Supplier $15,000

Labor cost 14,000

Normal return/opportunity cost of capital ($20,000 x 0.10) 2,000

Total Cost $31,000

Profit = total revenue total cost $1,000a



Normal Rate of Return

aThere is a loss of $1,000.


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hoicesMadebyHouseholdsandFirms


short run The period of time for which twoconditions hold: The firm is operating under a fixedscale (fixed factor) of production, and firms canneither enter nor exit an industry.

long run That period of time for which there areno fixed factors of production: Firms can increaseor decrease the scale of operation, and new firms

can enter and existing firms can exit the industry.


Short-Run versus Long-Run Decisions


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In the language of economics, a firm needs to know three things:

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 availableproduction techniques and the prices of inputs determine costs.


The Bases of Decisions: Market Price of Outputs, Available Technology,

and Input Prices


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optimal method of production The production method that minimizes cost.

FIGURE 7.2 Determining the Optimal Method of Production


The Bases of Decisions: Market Price of Outputs, Available Technology,

and Input Prices


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production technology The quantitativerelationship between inputs and outputs.

labor-intensive technology Technology thatrelies heavily on human labor instead of capital.

capital-intensive technology Technology thatrelies heavily on capital instead of human labor.

The Production Process


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production function ortotal product function Anumerical or mathematical expression of arelationship between inputs and outputs. It showsunits of total product as a function of units of inputs.

TABLE 7.2 Production Function

(1)

Labor Units(Employees)

(2)

Total Product(Sandwiches per Hour)

(3)

Marginal Productof Labor

(4)

Average Product of Labor(Total Product Labor Units)

01

23456

010

2535404242

10

1510

520

10.0

12.511.710.0

8.47.0


Production Functions: Total Product, Marginal Product, and Average Product


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FIGURE 7.3 Production Function for SandwichesAproduction 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 productof 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.




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marginal product The additional output thatcan be produced by adding one more unit of a

specific input, ceteris paribus.

law of diminishing returns When additionalunits of a variable input are added to fixedinputs, after a certain point, the marginalproduct of the variable input declines.

Every firm will face diminishing returns, which alwaysapply in the short run. This means that every firmfinds it progressively more difficult to increase itsoutput as it approaches capacity production.



Marginal Product and the Law of Diminishing Returns


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average product The average amount produced

by each unit of a variable factor of production.

total productaverage product of labor

total units of labor



Marginal Product versus Average Product


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FIGURE 7.4 Total Average and Marginal ProductMarginal 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.


Production Functions: Total Product,

Marginal Product, and Average ProductMarginal Product versus

Average Product


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Production Functions with Two Variable Factors of Production

Inputs work together in production.

Additional capital increases the productivity of labor.

Capital and labor are complementary inputs.


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In farming, as in manufacturing, we need agiven combination of labor and capital toproduce output, here a crop.

In the 1990s, an area of Ghana changed froman exclusive reliance on maize as the

agricultural crop to the development ofpineapple farms.

The choice of how much fertilizer to use washighly dependent on how much fertilizer theirmore successful neighbor farmers used.

Social learning obviously plays a role in thediffusion of manufacturing technology as well.

Learning about Growing Pineapples in Ghana

E C O N O M I C S I N P R A C T I C E


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TABLE 7.3 Inputs Required to Produce 100 Diapers Using Alternative TechnologiesTechnology Units of Capital (K) Units of Labor (L)

A

B

C

D

E

2346

10

106432

TABLE 7.4 Cost-Minimizing Choice among Alternative Technologies (100 Diapers)

(1)Technology

(2)Units of Capital (K)

(3)Units of Labor (L)

Cost = (L X PL) + (KX PK)

(4) (5)PL = $1PK= $1

PL = $5PK= $1

A

B

C

D

E

2346

10

106432

$12989

12

$5233242120



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PARTIITheMarketSystem:ChoicesMadebyHouseholdsandFirms


Two things determine the cost of production:

(1) Technologies that are available.

(2) Input prices.

Profit-maximizing firms will choose thetechnology that minimizes the cost ofproduction given current market input prices.



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The trucking business gives us an opportunityto think about choice among technologies in aconcrete way.

Modern technology, in the form of on-boardcomputers, allows a modern trucking firm to

monitor driving speed and instruct drivers.

How Fast Should a Truck Driver Go?

E C O N O M I C S I N P R A C T I C E

Fuel Price $3.50 $4.00 $4.50

Drive Fast $124.97 $133.33 $141.63

Drive Slowly $126.66 $133.33 $139.99


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Looking Ahead: Cost and Supply

So far, we have looked only at a single level of output.

One of our main objectives in the next chapter is todetermine the amount that a competitive firm willchoose to supplyduring a given time period.


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PARTIITheMarketSystem:ChoicesMadebyHouseholds

andFirms


average product

capital-intensive technology

firm

labor-intensive technology

law of diminishing returns

long run

marginal product

normal rate of return

optimal method of production

production

production function ortotal product function

production technology

profit (economic profit)

short run

total cost (total economic cost)

total revenue

Profit = total revenue

total cost

s of labortotal unit

ucttotal prodaboroduct of lAverage pr

R E V I E W T E R M S A N D C O N C E P T S


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isoquant A graph that shows all the combinations of capital andlabor that can be used to produce a given amount of output.

FIGURE 7A.1 Isoquants Showing AllCombinations of Capital and Labor ThatCan Be Used to Produce 50, 100, and 150Units of Output

TABLE 7A.1 Alternative Combinations ofCapital (K) and Labor (L)Required to Produce 50, 100,and 150 Units of Output

QX= 50 QX= 100 QX = 150

K L K L K L

A

B

C

D

E

1

2

3

5

8

8

5

3

2

1

2

3

4

6

10

10

6

4

3

2

3

4

5

7

10

10

7

5

4

3

CHAPTER 7 APPENDIX

Isoquants and Isocosts

New Look at Technology: Isoquants


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FIGURE 7A.2 The Slope of an IsoquantIs Equal to the Ratio ofMPL to MPK

Slope of isoquant:

K

L

MP

MP

L

K

marginal rate of technical substitution The rate at which afirm can substitute capital for labor and hold output constant.

CHAPTER 7 APPENDIX


New Look at Technology: Isoquants

KMPK

= L MPL

1

For output to remain constant, theloss of output from using less capitalmust be matched by the added outputproduced by using more labor.


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isocost line A graph that shows all the combinationsof capital and labor available for a given total cost.

FIGURE 7A.3 Isocost Lines Showingthe Combinations of Capital and LaborAvailable for $5, $6, and $7

An isocost line shows all the

combinations of capital and labor thatare available for a given total cost.

CHAPTER 7 APPENDIX


Factor Prices and Input Combinations: Isocosts

(PK

K) + (PL

L) = TC


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FIGURE 7A.4 Isocost Line ShowingAll Combinations of Capital and LaborAvailable for $25

Slope of isocost line:

/

/

K L

L K

K TC P P

L TC P P

One way to draw an isocost line is to

determine the endpoints of that lineand draw a line connecting them.

CHAPTER 7 APPENDIX


Factor Prices and Input Combinations: Isocosts


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FIGURE 7A.5 Finding the Least-Cost Combination of Capital andLabor to Produce 50 Units of Output

Profit-maximizing firms will

minimize costs by producing theirchosen level of output with the

technology represented by the

point at which the isoquant is

tangent to an isocost line.

Here the cost-minimizing

technology3 units of capital and

3 units of labor

is represented bypoint C.

CHAPTER 7 APPENDIX


Finding the Least-Cost Technology with Isoquants and Isocosts


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FIGURE 7A.6 Minimizing Cost ofProduction forqX = 50, qX = 100, and qX = 150

Plotting a series of cost-minimizing combinations of inputsshown in this graph as pointsA, B, and C on a

separate graph results in a cost curve like the one shown in Figure 7A.7.

FIGURE 7A.7 A Cost Curve Shows the MinimumCost of Producing Each Level of Output

CHAPTER 7 APPENDIX


Finding the Least-Cost Technology with Isoquants and Isocosts


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K

L

K

L

P

P

MP

MP isocostofslopeisoquantofslope

At the point where a line is just tangent to a curve,the two have the same slope. At each point oftangency, the following must be true:

Thus,

K

L

K

L

P

P

MP

MP

Dividing both sides by PL and multiplying bothsides by MPK, we get

K

K

L

L

P

MP

P

MP

CHAPTER 7 APPENDIX


The Cost-Minimizing Equilibrium Condition


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isocost line

isoquant

marginal rate of technical substitution

1. Slope of isoquant:

2. Slope of isocost line:

K

L

MP

MP

L

K

/

/K L

L K

K TC P P

L TC P P

A P P E N D I X R E V I E W T E R M S A N D C O N C E P T S

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