THE PRODUCTION PROCESS :THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS
THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS
Production : The process by which inputs are combined,transformed,and turned into outputs. Firm : An organization that comes into being when a person or group of people decides to produce a good or services to made a perceived demand Three decisions that all firms must make:
1. How much output to supply
2. How to produce that output
3. How much of each input to demand
a) PROFITS AND ECONOMIC COSTS
Profit (economic profit): The difference between total revenue and total cost.
Total revenue: The amount received from the sale of the product (q x P). Total cost (total economic cost) : The total of
1. out-of-pocket costs
2. normal rate of return on capital
3. opportunity cost of each factor of production.
b) NORMAL RATE OF RETURN
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. c) SHORT RUN VS 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. d) THE BEST OF DECISION : MARKET PRICE OF OUTPUTS,AVAILABLE TECHNOLOGY,AND INPUT PRICES The bases of decision making:
1. The market price of output
2. The techniques of production that are available
3. The prices of input
Determining the Optimal Method of Production
Optimal method of production: The productionmethod that minimizes cost. 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. a) PRODUCTION FUNCTION : 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.
b) 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. c) MARGINAL PRODUCT VS AVERAGE PRODUCT
Average product: The average amount produced by each unit of a variable factor production.
In general, additional capital increases the productivity of labor. Because capital—buildings, machines, and so on—is of no use without people to operate it, we say that capital and labor are complementary inputs.
d) ISOQUANT AND ISOCOST
Isoquant: A graph that shows all the combinations of capital and labor that can be used to produce a given amount of output. Slope of isoquant:
Marginal rate of technical substitution :The rate at which a firm can substitute capital for labor and hold output constant. Isocostline: A graph that shows all the combinations of capital and labor available for a given total cost. Slope of isocost line:
e) 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:
Dividing both sides by PL and multiplying both sides by MPK, we get
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