Download Chapter 7

The Behaviour of Profit-Maximizing
Firms and the Production Process
Chapter 7
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Firm and Household Decisions
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(Figure 7.1)
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Production
Production may be defined as the process by
which inputs are combined, transformed, and
turned into outputs.
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Perfect Competition
Perfect competition is an industry structure or
market organization 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.
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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.
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Homogeneous Product
Homogeneous products are undifferentiated
products; products that are identical to, or
indistinguishable from, one another.
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Easy Entry and Easy Exit
Easy entry is the condition that exists when
there are no barriers to prevent new firms from
competing for profits in a profitable industry.
Easy exit is the condition that exists when firms
can simply stop producing their product and
leave a market. Firms incur no additional costs
by exiting the industry.
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Demand Facing a Single Firm in a
Perfectly Competitive Market (Figure 7.2)
If a representative firm in a perfectly competitive industry raises
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.
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The Three Decisions All Firms Make
How much output to supply (quantity of
product)
How to produce that output (which production
technology to use)
How much of each input to demand
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Profit
Profit is the difference between total revenue
and total costs.
Profit = Total Revenue (TR) - Total Cost (TC)
Where Total Revenue is the receipts
from the sale of a product (P x q)
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Normal Rate of Profit or Normal Rate
of Return
The normal rate of profit is a rate of profit that
is just sufficient to keep owners or investors
satisfied. For relatively risk-free firms, it should
be nearly the same as the interest rate on riskfree government bonds.
Profits over and above the normal rate of return
on investment are called economic profits or
excess profits.
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Calculating Total Revenue, Total Cost
and Profit For a Small Belt Firm (Table 7.1)
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Short Run vs. Long Run
The short run is a period of time for which two
conditions hold:
The firm is operating under a fixed scale (fixed factor)
of production
Firms can neither enter or exist an industry
The long run is a period of time for a firm such
that there are no fixed factors of production.
Firms can increase or decrease the scale of production
New firms can enter and existing firms can exit the
industry
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The Bases of Firm Decision Making
The market price of output
The techniques of production that are available
The prices of inputs
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Determining the Optimal Method of
Production to Maximize Profits (Figure 7.4)
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The Production Process
Production technology is the relationship between
inputs and outputs.
The optimal method of production, for a profitmaximizing firm, is the one that minimizes costs.
Labour-intensive technology is technology that
relies heavily on human labour rather than capital.
Capital-intensive technology is technology that
relies heavily on capital rather than human labour.
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Production Function or Total Product
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.
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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.
The average product is the average amount
produced by each unit of a variable factor of
production.
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Law of Diminishing Returns
The law of diminishing returns states that when
additional units of an input are added to fixed
inputs after a certain point, the marginal
product of the variable input declines.
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Production Function (Sandwich Making)
(From Table 7.2)
Labor
Units
0
1
2
3
4
5
6
20
Total
Product
0
10
25
35
40
42
42
Marginal
Product
--10
15
10
5
2
0
Average
Product
--10.0
12.5
11.7
10.0
8.4
7.0
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Production Function for Sandwiches:
Total Product (Figure 7.5)
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Typical Production Function
(Figure 7.6)
 Marginal and average product
curves can be derived from
total product curves.
 The marginal product of labour
is the slope of the total
product curve.
 Average product follows
marginal product; it rises when
marginal product is above it
and falls when marginal
product is below it.
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Choice of Technology
Two things determine the cost of production:
The technologies that are available
Input prices
Profit maximizing firms will choose the
technology that minimizes the cost of
production given current market input prices.
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Example of Technology Choice for a
Diaper Company (Tables 7.3 & 7.4)
Five technologies are available to produce 100 diapers. The choice
of technology is based upon relative input prices.
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Review Terms & Concepts
 average product
 capital-intensive
technology
 easy entry
 easy exit
 economic profits or
excess profits
 firm
 homogeneous products
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 labour-intensive
technology
 law of diminishing returns
 long run
 marginal product
 normal rate of profit or
normal rate of return
 optimal method of
production
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Review Terms & Concepts
(continued)
 perfect competition
 production
 production function or
total product function
 production technology
 profit
 short run
 total revenue
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