Appendix (Chapter 7)

The Production Process:

The Behavior of Profit-Maximizing

Firms

Profit-Maximizing Firms in Perfectly Competitive

IndustriesThe primary objective of a firm is to

maximize profits

Components of Economic Profit

Input or Factor A resource used by a firm to help it make products.

Land, Labor and Capital are examples of inputs.

Output or ProductA resource made and sold by a firm.

Cars, haircuts, and pizza slices are examples of outputs.

Economic Profit = Total Revenue - Total Cost

Total Revenue (TR) = Price per unit of output x Quantity of output sold

Total Cost (TC) = Total Variable Cost + Total Fixed Cost

Total Variable Cost (TVC) = The cost of all Variable Inputs.

Total Fixed Cost (TFC) = The cost of all Fixed Inputs.

Variable Inputs

are those inputs whose use does vary with the quantity of output produced.

Fixed Inputs

are those inputs whose use does not vary with the quantity of output produced.

Components of Economic Profit

Both Total Variable Cost (TVC) and Total Fixed Cost (TFC)

are composed of two kinds of costs:

Accounting Cost - Cost of all purchased inputs

Opportunity Cost - Value of all non-purchased inputs in their next-best uses.

Includes, for example,

value of the business owner’s time and effort in his/her next-best activity, value of a business owner's money in its next-best use.

Components of Economic Profit

Two Decision Situations:  The Long-Run and The Short-

RunIn economics, the Long-Run and the Short-Run are not defined in terms of time, but rather in terms of how many things in a situation are considered

parameters vs. variables.The long run and the short run do not refer to a specific period of time such as

3 months or 5 years. The difference between the short run and the long run is the flexibility decision makers have.

Short-Run is a period of time in which the quantity of at least one input is fixed and the

quantities of the other inputs can be varied.

Long-Run is a period of time in which the quantities of all inputs can be varied.

Short-Run Parameters for a Firm in a Perfectly Competitive

Industry For a firm in a Perfectly Competitive industry, the Short-Run

typically means that the following things are held fixed as parameters:

Technology Price of Output Prices of Inputs Quantities of one (or more) Inputs

Measuring Productivity of an Input

Productivity of a particular input is measured in three ways:

Total Product of an Input The total amount of output produced from all units of input used,

holding the use of all other inputs constant.

Average Product of an Input The total amount of output produced per unit of input used,

holding the use of all other inputs constant.

Marginal Product of an Input The additional amount of output produced from the use an additional unit

of input, holding the use of all other inputs constant.

Law of Diminishing Returns

Law of Diminishing Returns

A concept in economics that if one factor of production

(number of workers, for example) is increased while other factors

(machines and workspace, for example) are held constant, the output

per unit of the variable factor will eventually diminish.

Production function is the technical relationship between inputs and outputs over a given

period of time

Mathematıcal Expressıon Of Productıon Functıon

Normally a production function is written as

Q = F ( L , K , I , R ,E )Where :Q - the maximum quantity of output L - Labor, K - Capital, I - Land, R - Raw material, E - Efficiency parameter

PRODUCTION FUNCTION

On the basis of characteristics of inputs

production function normally divided into two broad categories :

With one variable input or variable production function (Short Run)

With two variable inputs or constant production function (Long Run)

TYPES OF PRODUCTION FUNCTION

PRODUCTION FUNCTION WITH ONE VARIABLE INPUT

The short run production function shows the maximum output a firm can produce when only one of its inputs can be varied

other inputs remaining constant

It can be written as

Q= F ( L , K )

Q - output L - labor K - capital (fixed amount)

ISOQUANTSAn Isoquant is the set of all combinations of variable inputs that could be used to

produce a given quantity of output in the short run. Iso – «Equal»; Quant – «quantity»

Isoquant – a line of equal quantity

Taking the production function

Q = F ( L , K)

With a fixing level of output Q at some quantity we have an implicit relationship

between units labor( L ) and capital (K)

Qc = F ( L , K )

It is possible to produce the same amount of output by using different

combination of input.

INPUT COMBINATIONS POINT CAPITAL LABOR (UNITS)A 40 600B 28 700C 18 800D 12 900E 8 1000

The manufacturer wants to know which different combinations of inputs can be used to produce 150 thousand tons of output

ISOQUANTS- example -

Point A - at curve Q1 shows 40 Capital and 600 Labor units give the 150 Thousands tons of output. All points B , C, D, E (combinations) may infer that the level of output remains the same at all points on the same isoquant.

CHARACTERISTICS OF ISOQUANTS

Slope downwards from left to right

Using more of input to produce the same level of output must imply using less of other input

slope = - (ΔK / ΔL) A higher isoquant represent a higher output.

Isoquants do not intersect.

Convex to the origin.

Margınal Rate Of Substıtutıon MRTS

MRTS

measures the reduction in one input due to unit increase in the other

input that is just sufficient to maintain the same level of output

MRTS = slope of isoquant = K = - MPL

L MPK

 Cost-Minimizing Decisions in Factor Markets

To minimize the cost of producing a given, or "target," level of output, a

firm chooses the least-cost combination of inputs to produce the target

level of output. When choosing the least-cost combination of inputs,

the firm faces two constraints:

the prices it must pay for the inputs, and

the firm's technology. 

ISOCOST

is a concept showing how input prices constrain a firm's choice of

variable inputs.

ISOCOSTISOCOST line is the budget line of a producer in terms of two inputs.

ISOCOST line is points of all the different combinations of labor and capital that firm

can employ given the total cost and prices of inputs.

ISOCOST lines expressed as C = w L + r K

Where price of labor is wage - w price of the capital is interest - r total cost is - C

Usually the ISOCOST line is linear with slope equal to ratio of the factor prices.

The intercept of the ISOCOST line on the capital axis is the maximum

amount of capital employed when labor is not used in the production process

is given by C / r ; similarly the intercept in labor axis is given by C / w

Slope = (ΔK /Δ L) = {(C/r)/(C/w)} = w/r

The set of parallel ISOCOST lines is called ISOCOST map.

Line AB basic ISOCOST line.

AB1 shows a rise in W more of labor can acquired.

AB 2 shows a fall in W.

Same as for BA2 and BA1

ISOCOST MAP

For minimum cost we need ISOCOST line

and maximum output we need ISOQUANTS.