Profit-Maximizing Firms and Economic Costs

Study Notes

A firm aims to maximize profits.
Decisions for maximizing profits:
- How much output to supply (quantity of product)
- How to produce the output (which production technique/technology to use)
- How much of each input to demand
These decisions are interconnected.
Changing technology alters the relationship between input and output quantities.

Profit = Total Revenue - Total Cost
- Total revenue is the amount received from selling the product (quantity * price).
- Total cost includes out-of-pocket costs and the opportunity cost of factors of production.
  - Out-of-pocket costs are explicit or accounting costs.
  - Opportunity costs are implicit costs.
“Profit” from here on refers to economic profit.
- Economic profit = Total revenue - Total economic cost
Normal rate of return is the rate of return that keeps owners and investors satisfied.
- It's the opportunity cost of capital.
- A rate below normal makes raising resources for new capital difficult.

Production: Transforming inputs into outputs.
Production technology specifies the quantities of inputs needed for a given output.
- Labor-intensive technology relies on human labor.
- Capital-intensive technology relies on capital equipment.

Production function (or total product function): A mathematical representation of the relationship between inputs and outputs.
It shows units of total product as a function of units of inputs.

Marginal product: The additional output from hiring one more unit of a specific input, holding all other inputs constant.
Law of diminishing returns: After a certain point, adding more of a variable input to fixed inputs leads to decreasing marginal product of the variable input.
Example: Adding more workers to a fixed workspace may lead to decreasing productivity per worker.