Chapter 7 Notes: The Production Process

The Production Process: The Behavior of Profit-Maximizing Firms

7.1 The Behavior of Profit-Maximizing Firms

• Firms aim to maximize profits and minimize costs.

• Production: Process of combining inputs, transforming them into outputs to meet perceived demands.

• Firm: An organization that decides to produce a good or service to meet a perceived demand.

Firm Decisions for Maximum Profits

• Firms make several basic decisions to achieve maximum profits:

  1. How much output to supply.

  2. Which production technology to use.

  3. How much of each input to demand.

Profits and Economic Costs

• Profit: The difference between total revenue and total cost.

  • profit = total revenue - total cost

• Total Revenue: The total amount a firm takes in from selling its product; the price per unit times the quantity of output.

• Total Cost: Total fixed costs plus total variable costs.

• Economic Profit:

  • Profit that accounts for both explicit and opportunity costs.

  • profit = total revenue - total cost (economic profit)

Short-Run vs. Long-Run Decisions

• Short Run:

  • The period when the firm operates under a fixed scale (fixed factor) of production.

  • Firms can neither enter nor exit the industry.

• Long Run:

  • The period when 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.

Bases of Decisions

• A firm needs to know:

  • Market price of output: potential revenues.

  • Production techniques available: how much input is needed.

  • Input prices: costs.

• Optimal Method of Production: The production method that minimizes cost for a given level of output.

Determining the Optimal Method of Production

• Price of output determines total revenue.

• Production techniques and input prices determine total cost and optimal method of production.

• Total Profit = Total Revenue - Total Cost

Production Functions

• Production Function (or Total Product Function):

  • A numerical or mathematical expression of the relationship between inputs and outputs.

  • Shows units of total product as a function of units of inputs.

• Further explanation: A production function illustrates how much output can be produced from different combinations of inputs. Imagine you're baking cookies. The production function would show how many cookies you can make with different amounts of flour, sugar, and eggs. It's a way of visualizing the relationship between what you put in (inputs) and what you get out (total product).

Marginal Product and Diminishing Returns

• Marginal Product: The additional output 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.

Marginal Product vs. Average Product

• Average Product: The average amount produced by each unit of a variable factor of production.

• Relationship:

  • If marginal product is above average product, the average rises.

  • If marginal product is below average product, the average falls.

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.

Production with Two Variable Factors

• 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.

• Building new, modern plants and equipment enhances a nation’s productivity.

Choice of Technology

• Cost of production is determined by:

  • Technologies that are available.

  • Input prices.

• Profit-maximizing firms choose the technology that minimizes the cost of production, given current market input prices.