CH 06

CHAPTER 6
The Production Process:

The Behavior of Profit-
Maximizing Firms
Prepared by: Fernando

Quijano
and Yvonn Quijano
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Production
Central to our analysis is production:
Production is the process by which

inputs are combined, transformed,
and turned into outputs.
What Is A Firm?
A firm is an organization that comes

into being when a person or a group of
people decides to produce a good or
service to meet a perceived demand.
Most firms exist to make a profit.
Production is not limited to firms.
Perfect Competition
Perfect competition is an industry

structure in which there are:
many firms, each small relative to the
industry,
producing virtually identical products and
in which no firm is large enough to have
any control over prices.
In perfectly competitive industries, new
competitors can freely enter and exit the
market.
Homogeneous Products
Homogeneous products are

undifferentiated products;
products that are identical to, or
indistinguishable from, one
another.
Competitive 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.
Demand Facing a Single Firm in a
Perfectly Competitive Market
If a representative firm in a perfectly competitive market rises the price

of its output above $2.45, the quantity demanded of that firms output
will drop to zero. Each firm faces a perfectly elastic demand curve, d.
The Behavior of
Profit-Maximizing Firms
The three decisions that all firms must
make include:
1. 2. 3.
Which
How much How much of
production
output to each input to
technology to
supply demand
use
Profits and Economic Costs
Profit (economic profit) is the difference

between total revenue and total cost.
Total revenue is the amount received from the
sale of the product:
(q X P)
Total cost (total economic cost) is the total of
1. Out of pocket costs,
2. Normal rate of return on capital, and
3. Opportunity cost of each factor of production.
Normal Rate of Return
The normal rate of return is 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.
Calculating Total Revenue, Total Cost,
and Profit
Initial Investment: $20,000

Market Interest Rate Available: .10 or 10%
Total Revenue (3,000 belts x $10 each) $30,000
Costs
Belts from supplier $15,000

Labor Cost 14,000
Normal return/opportunity cost of capital ($20,000 x .10) 2,000
Total Cost $31,000
Profit = total revenue total cost $ 1,000a

a
There is a loss of $1,000.
Short-Run Versus Long-Run Decisions
The short run is a period of time

for which two conditions hold:
1. The firm is operating under a fixed
scale (fixed factor) of production, and
2. Firms can neither enter nor exit an
industry.
Short-Run Versus Long-Run Decisions
The long run is a period of time

for which there are no fixed
factors of production. Firms can
increase or decrease scale of
operation, and new firms can
enter and existing firms can exit
the industry.
Determining the Optimal Method
of Production
Price of output Production techniques Input prices
Determines Determine total cost and

total revenue optimal method of
production
Total revenue
Total cost with optimal method
=Total profit
The optimal method of production is the

method that minimizes cost.
The Production Process
Production technology refers to the

quantitative relationship between inputs
and outputs.
A labor-intensive technology relies

heavily on human labor instead of
capital.
A capital-intensive technology relies

heavily on capital instead of human
labor.
The Production Function
The production function or

total product function is 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.
Marginal Product and Average Product
Marginal product is the additional output that

can be produced by adding one more unit of a
specific input, ceteris paribus.
c h a n g e in to ta l p ro d u c t
m a rg in a l p ro d u c t o f la b o r =
c h a n g e in u n its o f la b o r u s e d
Average product is the average amount

produced by each unit of a variable factor of
production.
to ta l p ro d u c t
a v e ra g e p ro d u c t o f la b o r =
to ta l u n its o f la b o r
The Law of Diminishing
Marginal Returns
The law of diminishing

marginal returns states
that:
When additional units of a
variable input are added to
fixed inputs, the marginal
product of the variable input
declines.
Production Function for Sandwiches
45
Production Function 40
35
30
Total product
(2) (3) (4) 25
(1) TOTAL PRODUCT MARGINAL AVERAGE
20
LABOR UNITS (SANDWICHES PRODUCT OF PRODUCT
(EMPLOYEES) PER HOUR) LABOR OF LABOR 15
10
0 0 5
0
1 10 10 10.0
0 1 2 3 4 5 6 7
2 25 15 12.5 Number of employees
15
3 35 10 11.7
Marginal Product
10
4 40 5 10.0
5 42 2 8.4 5
6 42 0 7.0
0
0 1 2 3 4 5 6 7
Number of employees
Total, Average, and Marginal Product
Marginal product is the slope

of the total product function.
At point A, the slope of the
total product function is
highest; thus, marginal product
is highest.
At point C, total product is
maximum, the slope of the
total product function is zero,
and marginal product
intersects the horizontal axis.
When a ray drawn from the

origin falls tangent to the total
product function, average
product is maximum and equal
to marginal product.
Then, average product falls to
the left and right of point B.
As long as marginal product

rises, average product rises.
When average product is

maximum, marginal product
equals average product.
When average product falls,

marginal product is less than
average product.
Production Functions with Two Variable
Factors of Production
In many production processes, inputs work
together and are viewed as complementary.
For example, increases in capital usage lead to
increases in the productivity of labor.
Inputs Required to Produce 100 Diapers
Using Alternative Technologies Given the
UNITS OF UNITS OF technologies
TECHNOLOGY CAPITAL (K) LABOR (L) available, the
A 2 10
cost-minimizing
B 3 6
choice depends
C 4 4
D 6 3
on input prices.
E 10 2
Production Functions with Two Variable
Factors of Production
Cost-Minimizing Choice Among Alternative

Technologies (100 Diapers)
(2) (3) (4) (5)

(1) UNITS OF UNITS OF COST WHEN COST WHEN
TECHNOLOGY CAPITAL (K) LABOR PL = $1 PK = $1 PL = $1 PK = $1
A 2 10 $12 $52
B 3 6 9 33
C 4 4 8 24
D 6 3 9 21
E 10 2 12 20

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CHAPTER 6

The Production Process:

Prepared by: Fernando

Central to our analysis is production:

Production is the process by which

A firm is an organization that comes

Production is not limited to firms.

Perfect competition is an industry

Homogeneous products are

In a perfectly competitive market,

If a representative firm in a perfectly competitive market rises the price

Profit (economic profit) is the difference

The normal rate of return is a rate of

For relatively risk-free firms, it should

Initial Investment: $20,000

Belts from supplier $15,000

Profit = total revenue total cost $ 1,000a

The short run is a period of time

The long run is a period of time

Determines Determine total cost and

The optimal method of production is the

Production technology refers to the

A labor-intensive technology relies

A capital-intensive technology relies

The production function or

Marginal product is the additional output that

Average product is the average amount

The law of diminishing

Marginal product is the slope

When a ray drawn from the

As long as marginal product

When average product is

When average product falls,

Cost-Minimizing Choice Among Alternative

(2) (3) (4) (5)

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