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© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
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The Production Process: The Behavior of Profit Maximizing Firms

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Transcript of "The Production Process: The Behavior of Profit Maximizing Firms"

  1. 1. © 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 CHAPTERCHAPTER 66 Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijanoand Yvonn Quijano The Production Process:The Production Process: The Behavior of Profit-The Behavior of Profit- Maximizing FirmsMaximizing Firms
  2. 2. © 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 ProductionProduction Central to our analysis isCentral to our analysis is productionproduction:: • ProductionProduction is the process by whichis the process by which inputs are combined, transformed,inputs are combined, transformed, and turned into outputs.and turned into outputs.
  3. 3. © 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 What Is AWhat Is A FirmFirm?? • AA firmfirm is an organization that comesis an organization that comes into being when a person or a group ofinto being when a person or a group of people decides to produce a good orpeople 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.
  4. 4. © 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 Perfect CompetitionPerfect Competition • many firmsmany firms, each small relative to the, each small relative to the industry,industry, • producing virtuallyproducing virtually identical productsidentical products andand • in whichin which nono firm is large enough to havefirm is large enough to have anyany control over pricescontrol over prices.. • In perfectly competitive industries, newIn perfectly competitive industries, new competitors cancompetitors can freely enter and exitfreely enter and exit thethe market.market. Perfect competition is an industryPerfect competition is an industry structure in which there are:structure in which there are:
  5. 5. © 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 Homogeneous ProductsHomogeneous Products • Homogeneous productsHomogeneous products areare undifferentiated products;undifferentiated products; products that are identical to, orproducts that are identical to, or indistinguishable from, oneindistinguishable from, one another.another.
  6. 6. © 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 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.
  7. 7. © 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 Demand Facing a Single Firm in aDemand Facing a Single Firm in a Perfectly Competitive MarketPerfectly Competitive Market • If a representative firm in a perfectly competitive market rises theIf a representative firm in a perfectly competitive market rises the price of its output above $2.45, the quantity demanded of that firm’sprice of its output above $2.45, the quantity demanded of that firm’s output will drop to zero. Each firm faces aoutput will drop to zero. Each firm faces a perfectly elastic demandperfectly elastic demand curve,curve, dd..
  8. 8. © 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 The Behavior ofThe Behavior of Profit-Maximizing FirmsProfit-Maximizing Firms • The three decisions that all firms mustThe three decisions that all firms must make include:make include: How much ofHow much of each input toeach input to demanddemand 3.3. WhichWhich productionproduction technology totechnology to useuse 2.2. How muchHow much output tooutput to supplysupply 1.1.
  9. 9. © 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 Profits and Economic CostsProfits and Economic Costs • Profit (economic profit)Profit (economic profit) is the differenceis the difference between total revenue and total cost.between total revenue and total cost. • Total revenueTotal revenue is the amount received from theis the amount received from the sale of the product:sale of the product: ((qq XX PP)) • Total cost (total economic cost)Total cost (total economic cost) is the total ofis 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.
  10. 10. © 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 Normal Rate of ReturnNormal Rate of Return • TheThe normal rate of returnnormal rate of return is a rate ofis a rate of return on capital that is just sufficientreturn on capital that is just sufficient to keep owners and investorsto keep owners and investors satisfied.satisfied. • For relatively risk-free firms, it shouldFor relatively risk-free firms, it should be nearly the same as the interest ratebe nearly the same as the interest rate on risk-free government bonds.on risk-free government bonds.
  11. 11. © 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 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 revenueProfit = total revenue −− total costtotal cost −− $ 1,000$ 1,000aa aa There is a loss of $1,000.There is a loss of $1,000.
  12. 12. © 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 Short-Run Versus Long-Run DecisionsShort-Run Versus Long-Run Decisions • TheThe short runshort run is a period of timeis a period of time for which two conditions hold:for which two conditions hold: 1.1. The firm is operating under a fixedThe 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 anFirms can neither enter nor exit an industry.industry.
  13. 13. © 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 Short-Run Versus Long-Run DecisionsShort-Run Versus Long-Run Decisions • TheThe long runlong run is a period of timeis a period of time for which there are no fixedfor which there are no fixed factors of production. Firms canfactors of production. Firms can increase or decrease scale ofincrease or decrease scale of operation, and new firms canoperation, and new firms can enter and existing firms can exitenter and existing firms can exit the industry.the industry.
  14. 14. © 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 Determining the Optimal MethodDetermining the Optimal Method of Productionof Production Price of outputPrice of output Production techniquesProduction techniques Input pricesInput prices DeterminesDetermines total revenuetotal revenue Determine total cost andDetermine total cost and optimal method ofoptimal method of productionproduction Total revenueTotal revenue −− Total cost with optimal methodTotal cost with optimal method =Total profit=Total profit • TheThe optimal method of productionoptimal method of production is theis the method that minimizes cost.method that minimizes cost.
  15. 15. © 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 The Production ProcessThe Production Process • Production technologyProduction technology refers to therefers to the quantitative relationship between inputsquantitative relationship between inputs and outputs.and outputs. • AA labor-intensive technologylabor-intensive technology reliesrelies heavily on human labor instead ofheavily on human labor instead of capital.capital. • AA capital-intensive technologycapital-intensive technology reliesrelies heavily on capital instead of humanheavily on capital instead of human labor.labor.
  16. 16. © 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 The Production FunctionThe Production Function • TheThe production functionproduction function oror total product functiontotal product function is ais a numerical or mathematicalnumerical or mathematical expression of a relationshipexpression of a relationship between inputs and outputs.between inputs and outputs. It shows units of totalIt shows units of total product as a function ofproduct as a function of units of inputs.units of inputs.
  17. 17. © 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 Marginal Product and Average ProductMarginal Product and Average Product • Marginal productMarginal product is the additional output thatis the additional output that can be produced by adding one more unit of acan be produced by adding one more unit of a specific input,specific input, ceteris paribusceteris paribus.. • Average productAverage product is the average amountis the average amount produced by each unit of a variable factor ofproduced by each unit of a variable factor of production.production. a v e r a g e p r o d u c t o f l a b o r = t o t a l p r o d u c t t o t a l u n i t s o f l a b o r m a r g i n a l p r o d u c t o f l a b o r = c h a n g e i n t o t a l p r o d u c t c h a n g e i n u n i t s o f l a b o r u s e d
  18. 18. © 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 The Law of DiminishingThe Law of Diminishing Marginal ReturnsMarginal Returns • TheThe law of diminishinglaw of diminishing marginal returnsmarginal returns statesstates that:that: When additional units of aWhen additional units of a variable input are added tovariable input are added to fixed inputs, the marginalfixed inputs, the marginal product of the variable inputproduct of the variable input declines.declines.
  19. 19. © 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 Production Function for SandwichesProduction Function for Sandwiches Production FunctionProduction Function (1)(1) LABOR UNITSLABOR UNITS (EMPLOYEES)(EMPLOYEES) (2)(2) TOTAL PRODUCTTOTAL PRODUCT (SANDWICHES(SANDWICHES PER HOUR)PER HOUR) (3)(3) MARGINALMARGINAL PRODUCT OFPRODUCT OF LABORLABOR (4)(4) AVERAGEAVERAGE PRODUCTPRODUCT 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 Totalproduct 0 5 10 15 0 1 2 3 4 5 6 7 Number of employees MarginalProduct
  20. 20. © 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 Total, Average, and Marginal ProductTotal, Average, and Marginal Product • Marginal product is the slopeMarginal product is the slope of the total product function.of the total product function. • At point C, total product isAt point C, total product is maximum, the slope of themaximum, the slope of the total product function is zero,total product function is zero, and marginal productand marginal product intersects the horizontal axis.intersects the horizontal axis. • At point A, the slope of theAt point A, the slope of the total product function istotal product function is highest; thus, marginal producthighest; thus, marginal product is highest.is highest.
  21. 21. © 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 Total, Average, and Marginal ProductTotal, Average, and Marginal Product • When a ray drawn from theWhen a ray drawn from the origin falls tangent to the totalorigin falls tangent to the total product function, averageproduct function, average product is maximum and equalproduct is maximum and equal to marginal product.to marginal product. • Then, average product falls toThen, average product falls to the left and right of point B.the left and right of point B.
  22. 22. © 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 Total, Average, and Marginal ProductTotal, Average, and Marginal Product • As long as marginal productAs long as marginal product rises, average product rises.rises, average product rises. • When average product isWhen average product is maximum, marginal productmaximum, marginal product equals average product.equals average product. • When average product falls,When average product falls, marginal product is less thanmarginal product is less than average product.average product.
  23. 23. © 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 Production Functions with Two VariableProduction Functions with Two Variable Factors of ProductionFactors of Production • In many production processes, inputs workIn many production processes, inputs work together and are viewed as complementary.together and are viewed as complementary. • For example, increases in capital usage lead toFor example, increases in capital usage lead to increases in the productivity of labor.increases in the productivity of labor. Inputs Required to Produce 100 DiapersInputs Required to Produce 100 Diapers Using Alternative TechnologiesUsing Alternative Technologies TECHNOLOGYTECHNOLOGY UNITS OFUNITS OF CAPITAL (K)CAPITAL (K) UNITS OFUNITS 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.
  24. 24. © 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 Production Functions with Two VariableProduction Functions with Two Variable Factors of ProductionFactors of Production Cost-Minimizing Choice Among AlternativeCost-Minimizing Choice Among Alternative Technologies (100 Diapers)Technologies (100 Diapers) (1)(1) TECHNOLOGYTECHNOLOGY (2)(2) UNITS OFUNITS OF CAPITAL (K)CAPITAL (K) (3)(3) UNITS OFUNITS OF LABORLABOR (4)(4) COST WHENCOST WHEN PPLL = $1 P= $1 PKK = $1= $1 (5)(5) COST WHENCOST 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
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