Theory Of Production: Profit Maximizing Firms PDF

University of Perpetual Help System San Gabriel, General Mariano Alvarez, Cavite THEORY OF PRODUCTION: THE BEHAVIOR OF PROFIT- MAXIMIZING FIRMS The Behavior of Profit-Maximizing Firms ▪ All firms must make several basic decisions...

University of Perpetual Help System San Gabriel, General Mariano Alvarez, Cavite THEORY OF PRODUCTION: THE BEHAVIOR OF PROFIT- MAXIMIZING FIRMS The Behavior of Profit-Maximizing Firms ▪ All firms must make several basic decisions to achieve their primary objective—maximum profits. 1. How much output to supply (quantity of product) 2. How to produce that output (which production technique/technology to use) 3. How much of each input to demand ▪ These three decisions are linked. If a firm knows how much it wants to produce and has a given production technology, it automatically knows how many of any of its inputs it needs. ▪ Changing the technology of production will change the relationship between input and output quantities. Profits and Economic Costs ▪ Firms make their decisions with the goal of maximizing profits. Profit is the difference between total revenue and total cost: profit = total revenue - total cost Total revenue is the amount received from the sale of the product; it is equal to the number of units sold (q) times the price received per unit (P). Total cost is less straightforward to define. We define total cost here to include (1) out-of-pocket costs and (2) opportunity cost of all inputs or factors of production. Out-of-pocket costs are sometimes referred to as explicit costs or accounting costs. These refer to costs as an accountant would calculate them. Economic costs include the opportunity cost of every input. These opportunity costs are often referred to as implicit costs. 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 Normal Rate of Return. A normal rate of return is the rate that is just sufficient to keep owners and investors satisfied between the investment they are doing and their next-best alternative investments. In other words, the normal rate of return is the opportunity cost of capital. If the rate of return were to fall below normal, it would be difficult or impossible for managers to raise resources needed to purchase new capital. Short-Run versus Long-Run Decisions The short run is a decision period during which the business has a fixed scale or a fixed factor of production and there is neither exit nor entry from the business. Which factor or factors of production are fixed in the short run differs from industry to industry. 1|P a ge  University of Perpetual Help System San Gabriel, General Mariano Alvarez, Cavite The long run is defined as the decision period over which firms can choose to expand or contract all of their factors of production. Firms can plan for any output level they find desirable. The Production Process Production is the process through which inputs are combined and transformed into outputs. A production technology tells us the specific quantities of inputs needed to produce any given service or good. 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. Production Functions: Total Product, Marginal Product, and Average Product The relationship between inputs and outputs—that is, the production technology—expressed numerically or mathematically is called a production function (or total product function) A production function shows units of total product as a function of units of inputs. Marginal Product and the Law of Diminishing Returns Marginal product is the additional output that can be produced by hiring one more unit of a specific input, holding all other inputs constant. The law of diminishing returns states that after a certain point, when additional units of a variable input are added to fixed inputs (in this case, the building and grill), the marginal product of the variable input (in this case, labor) declines. The British economist David Ricardo first formulated the law of diminishing returns on the basis of his observations of agriculture in nineteenth-century England. Within a given area of land, he noted, successive “doses” of labor and capital added to the same amount of land yielded smaller and smaller increases in crop output. 2|P a ge  University of Perpetual Help System San Gabriel, General Mariano Alvarez, Cavite Marginal Product versus Average Product Average product is the average amount produced by each unit of a variable factor of production. Average product “follows” marginal product, but it does not change as quickly. If marginal product is above average product, the average rises; if marginal product is below average product, the average falls. 3|P a ge