Ch 7-The Production

Process: The Behaviour of Profit-

Maximizing Firms
Case, Fair, Oster
Principles of Economics
Pearson
 Outline
• Behavior of profit maximizing firms
• The production process
• The production function
• All firms demand inputs and produce output.
• Firms’ basic aim is to maximize profits and minimize costs.
– Objective function may be profit maximization or minimizing costs
• Production: The process by which inputs are combined,
transformed, and turned into outputs.
• Firm: 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.
Firms need to make three decisions:
• How much output to supply
• Which production technology to use
• How much of each input to demand
 Profits and Economics Costs
• 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.
• 𝑇𝑅 = 𝑃𝑟𝑖𝑐𝑒 𝑥 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
• total cost: Total fixed costs plus total variable costs.
 Profits and Economics Costs
• The term profit will from here on refer to economic profit.

• 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.
 Accounting Profit vs. Economic Profit
• The formula of profit is the same for both accounting and economic profit. The difference
between these concepts is related with the total cost.
• In calculating accounting profit, we consider only explicit costs.
• In calculating economic profit, we consider implicit cost in addition to explicit cost.

Accounting profit:
profit = total revenue − total cost (explicit cost)
Profit= TR-TC
Economic profit=
profit = total revenue − total cost (explicit cost + implicit cost)
Profit=TR-TC
Explicit costs are out of pocket expenses. Implicit costs include opportunity cost of production.
There are two main implicit costs:
• The wage you would earn if you worked somewhere else instead of starting up this business.
• The interest return you give up when investing in this business.
 Short-Run versus Long-Run Decisions

• short run: The period of time for which two conditions hold:
– Firms are operating under a fixed scale (fixed factor) of
production
– 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
– New firms can enter and existing firms can exit the
industry.
 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.
 Production Functions: Total Product,
Marginal Product, and Average Product

• 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.
– Q=f(L,K) with two inputs, L=labour, K=kapital
– Q=L2K2 quantitative relationship
– In short run, K is fixed (fixed scale assumption). Hence Q is
only a function of L such as:
– Q=f(L)
 Production Functions
• Total Product (total production)
• Average Product of Labor (production per unit)
• Marginal product of Labor (additional production of
additional units)

A production function is a numerical representation of

the relationship between inputs and outputs.
 Marginal Product
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.
𝛥𝑇𝑃
MP=
𝛥𝐿
• 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.
• In long run, there is no diminishing returns because the
amount of all factors of production can vary in long run.
 Average Product

• average product The average amount produced by each unit

of a variable factor of production.

total product
average product of labor 
total units of labor

• If marginal product is above average product, the average

rises; if marginal product is below average product, the
average falls.
 Production Function
(2)
(1) (3) (4)
Total Product
Labor Units Marginal Product Average Product of Labor
(Sandwiches per
(Employees) of Labor (Total Product ÷ Labor Units)
Hour)
0 0 — —

10 10.0
1 10
(10-0)/1=10 (10/1=10)
15
12.5
2 25 (25-10)/(2-1)=15
(25/2=12.5)
10 11.7
3 35
(35-25)/1=10 (35/3)=11.7
5 10.0
4 40
(40-35)/1=5 (40/4=10)
2 8.4
5 42
(42-40)/1 (42/5)=8.4
0 7.0
6 42
(42-42)/0=0 (42/6)=7
 Production Function for Sandwiches

• In panel (a), total product (sandwiches) is graphed as a function of labor

inputs.
• 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.
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.
 EXAMPLES
1) The number of repairs produced by a computer repair shop
depends on the number of workers as follows:

Number of
workers Number of Repairs
0 0
1 8
2 20
3 35
4 45
5 52
6 57
7 60
a) Add two more columns to the table and
calculate AP of labor and MP of labor.
Number of Number of
workers Repairs MP of Labor AP of Labor

0 0
1 8 8 8.00
2 20 12 10
3 35 15 11.67
4 45 10 11.25
5 52 7 10.4
6 57 5 9.5
7 60 3 8.57
b) Over what range of labor input are there increasing returns to
labor? Diminishing returns to labor?
Between 1 and 3: increasing returns to labor (because MPL is
increasing)
Between 3 and 7: diminishing returns to labor (MPL is falling)
c) Over what range of labor input is marginal product greater
than average product? What is happening to average product as
employment increases over this range?
MP is greater than AP between 1 and 3.
AP increases first until the third unit of labor then it begins to
fall.
2) Are the following statements true or false? Explain.
a) Total product reaches its highest level where marginal
product is equal to average product. (False)
b) Marginal product and average product are equal when
marginal product is at maximum. (False)
c) When marginal product is equal to zero, average
product is rising.(False)
d) When marginal product is above average, average
product is rising.(True)
e) When marginal product is equal to average product,
output is maximized.(False)
f) When average product increases, marginal product
increases (False)
 Production Functions with Two Variable
Factors of Production
• 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.
 Chapter 7 Appendix: Isoquants and Isocosts

• This appendix presents a more formal analysis of technology

and factor prices and their relationship to cost.
• isoquant A graph that shows all the combinations of capital
and labor that can be used to produce a given amount of
output.
 Alternative Combinations of Capital (K) and Labor (L)
Required to Produce 50, 100, and 150 Units of Output

Qx = 50 Qx = 50 Qx = 100 Qx = 100 Qx = 150 Qx = 150

K L K L K L

A 1 8 2 10 3 10

B 2 5 3 6 4 7

C 3 3 4 4 5 5

D 5 2 6 3 7 4

E 8 1 10 2 10 3
 Isoquants Showing All Combinations of Capital and
Labor That Can Be Used to Produce 50, 100, 150 Units
of Output
The Slope of an Isoquant Is Equal to the Ratio of MPL to
MPK
• For output to remain constant, the loss of output from using
less capital must be matched by the added output produced
by using more labor.
K  MPK  L  MPL

• Slope of isoquant:
K MPL

L MPK

• marginal rate of technical substitution The rate at which a

firm can substitute capital for labor and hold output constant.
 Isocost Line
• An isocost line shows all the combinations of capital
and labor that are available for a given total cost.
Isocost Lines Showing the Combinations of Capital and
Labor Available for $5, $6, and $7

TC=PKK+PLL
 Factor Prices and Input Combinations:
Isocosts
• The equation of the straight line in Figure 7A.3:

( Pk  K)  (PL  L)  TC

• Substituting our data for the lowest isocost line into this
general equation, we get:

($1  K )  ($1  L)  $5, or ( K  L)  5

Figure 7A.4 Isocost Line Showing All Combinations of
Capital and Labor Available for $25

• One way to draw an isocost

line is to determine the
endpoints of that line and
draw a line connecting them.

• Slope of isocost line:

K TC / PL PL
 
L TC / PK PK
 Finding the Least-Cost Technology with
Isoquants and Isocosts
Figure 7A.5 Finding the Least-Cost
Combination of Capital and Labor to
Produce 50 Units of Output
• Profit-maximizing firms will minimize
costs by producing their chosen level of
output with the technology
represented by the point at which the
isoquant is tangent to an isocost line.

• Here the cost-minimizing technology—

3 units of capital and 3 units of labor—
is represented by point C.
 Figure 7A.6 Minimizing Cost of Figure 7A.7 A Cost Curve Shows
Production for qX = 50, qX = 100, the Minimum Cost of Producing
and qX = 150 Each Level of Output

• Plotting a series of cost-minimizing combinations of inputs—shown in

Figure 7A.6 as points A, B, and C—on a separate graph results in a cost
curve like the one shown in Figure 7A.7.
The Cost-Minimizing Equilibrium Condition

• At the point where a line is just tangent to a curve, the two have the same
slope. At each point of tangency, the following must be true:

MPL PL
Slope of isoquant   slope of isocost  
MPK PK
Thus, MPL PL

MPK PK
• For the cost-minimizing equilibrium condition, we divide both sides by PL
and multiply both sides by

MPL MPK

PL PK