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Principles of Economics Thirteenth Edition Chapter 7 The Production Process: The Behavior of Profit- Maximizing Firms...

Principles of Economics Thirteenth Edition Chapter 7 The Production Process: The Behavior of Profit- Maximizing Firms Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 7.1 The Three Decisions That All Firms Must Make Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Profits and Economics Costs (1 of 3) profit The difference between total revenue and total cost. profit = total revenue − total cost total revenue The total amount that a firm takes in from the sale of its product: the price per unit times the quantity of output the firm decides to produce. total cost Total fixed costs plus total variable costs. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Profits and Economics Costs (2 of 3) 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: economic profit = total revenue − total economic cost economic profit Profit that accounts for both explicit and opportunity costs. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Profits and Economics Costs (3 of 3) Normal Rate of Return The way we treat the opportunity cost of capital is to add a normal rate of return to capital as part of economic cost. 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Table 7.1 Calculating Total Revenue, Total Cost, and Profit $20,000 Initial Investment: Market Interest Rate Available: 0.10, or 10% Total revenue (3,000 belts × $10 each) $30,000 Costs Blank Belts from Supplier $15,000 Labor cost $14,000 Normal return/opportunity cost of capital ($20,000 × 0.10) $2,000 Total Cost $31,000 Profit = total revenue − total cost -$1,000 a Minus dollar 1,000 super a a There is a loss of $1,000. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved 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. 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Bases of Decisions: Market Price of Outputs, Available Technology, and Input Prices A firm needs to know three things: 1. Market price of output: potential revenues 2. Production techniques that are available: how much input needed 3. Input prices: costs optimal method of production The production method that minimizes cost for a given level of output. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 7.2 Determining the Optimal Method of Production Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Production Process production technology The quantitative relationship between inputs and outputs. labor-intensive technology Technology that relies heavily on human labor instead of capital. capital-intensive technology Technology that relies heavily on capital instead of human labor. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Production Functions: Total Product, Marginal Product, and Average Product (1 of 3) 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Table 7.2 Production Function (1) (2) (4) (3) Total Product Labor Units Marginal Product Average Product of Labor (Sandwiches per (Employees) of Labor (Total Product ÷ Labor Units) Hour) 0 0 — — 1 10 10 10.0 10.0 2 25 15 12.5 3 35 10 11.7 4 40 5 10.0 10.0 5 42 2 8.4 6 42 0 7.0 7.0 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Production Functions: Total Product, Marginal Product, and Average Product (2 of 3) Marginal Product and the Law of Diminishing Returns marginal product The additional output that can be produced by adding one more unit of a specific input, ceteris paribus. law of diminishing returns When additional units of a variable input are added to fixed inputs, after a certain point, the marginal product of the variable input declines. Every firm faces diminishing returns, which always apply in the short run. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 7.3 Production Function for Sandwiches A production function is a numerical representation of the relationship between inputs and outputs. In panel (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. Panel (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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Production Functions: Total Product, Marginal Product, and Average Product (3 of 3) Marginal Product versus Average Product average product The average amount produced by each unit of a variable factor of production. totalproduct averageproduct of labor = totalunits of labor If marginal product is above average product, the average rises; if marginal product is below average product, the average falls. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Production Functions with Two Variable Factors of Production (1 of 2) Inputs work together in production. Capital and labor are complementary inputs. Additional capital increases the productivity of labor—that is, the amount of output produced per worker per hour. This simple relationship lies at the heart of worries about productivity at the national and international levels. Building new, modern plants and equipment enhances a nation’s productivity. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Production Functions with Two Variable Factors of Production (2 of 2) In the past decade, China has accumulated capital (that is, built plants and equipment) at a very high rate. The result has been growth in the average quantity of output per worker in China. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Choice of Technology TABLE 7.3 Inputs Required to Produce 100 Diapers Using Alternative Technologies Technology Units of Capital (K) Units of Labor (L) A 2 10 B 3 6 C 4 4 D 6 3 E 10 2 TABLE 7.4 Cost-Minimizing Choice among Alternative Technologies (100 Diapers) (1) (2) (3) (4) (5) Technology Units of Capital (K) Units of Labor (L) PL = $1 P sub L PL = $5 P sub L PK = $1 P sub K PK = $1 P sub K A 700 100 $12 $52 B 650 200 9 33 C 510 380 8 24 D 400 500 9 21 E 300 550 12 20 Two things determine the cost of production: (1) technologies that are available and (2) input prices. Profit-maximizing firms choose the technology that minimizes the cost of production, given current market input prices. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Review Terms and Concepts average product production function or total capital-intensive technology product function economic profit production technology firm profit labor-intensive technology short run law of diminishing returns total cost (total economic cost) long run total revenue marginal product Equations: normal rate of return profit = total revenue - total cost optimal method of production Production Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved