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Central to our analysis is Central to our analysis is productionproduction::
• ProductionProduction is the process by which is the process by which inputs are combined, transformed, inputs are combined, transformed, and turned into outputs.and turned into outputs.
• A A firmfirm is an organization that comes is an organization that comes into being when a person or a group of into being when a person or a group of people decides to produce a good or people decides to produce a good or service to meet a perceived demand. service to meet a perceived demand. Most firms exist to make a profit.Most firms exist to make a profit.
• Production is not limited to firms.Production is not limited to firms.
• many firmsmany firms, each small relative to the , each small relative to the industry,industry,
• producing virtually producing virtually identical productsidentical products and and
• in which in which nono firm is large enough to have firm is large enough to have any any control over pricescontrol over prices..
• In perfectly competitive industries, new In perfectly competitive industries, new competitors can competitors can freely enter and exitfreely enter and exit the the market.market.
Perfect competition is an industry Perfect competition is an industry structure in which there are:structure in which there are:
• Homogeneous productsHomogeneous products are are undifferentiated products; undifferentiated products; products that are identical to, or products that are identical to, or indistinguishable from, one indistinguishable from, one another.another.
Competitive Firms are Price TakersCompetitive Firms are Price Takers
• In a perfectly competitive market, individual firms are price-takers. This means that firms have no control over price. Price is determined by the interaction of market supply and demand.
Demand Facing a Single Firm in a Demand Facing a Single Firm in a Perfectly Competitive MarketPerfectly Competitive Market
• If a representative firm in a perfectly competitive market rises the price If a representative firm in a perfectly competitive market rises the price of its output above $2.45, the quantity demanded of that firm’s output of its output above $2.45, the quantity demanded of that firm’s output will drop to zero. Each firm faces a will drop to zero. Each firm faces a perfectly elastic demandperfectly elastic demand curve, curve, dd..
Profits and Economic CostsProfits and Economic Costs
• Profit (economic profit)Profit (economic profit) is the difference is the difference between total revenue and total cost.between total revenue and total cost.
• Total revenueTotal revenue is the amount received from the is the amount received from the sale of the product:sale of the product:
((qq X X PP))
• Total cost (total economic cost)Total cost (total economic cost) is the total of is the total of
1.1. Out of pocket costs,Out of pocket costs,
2.2. Normal rate of return on capital, andNormal rate of return on capital, and
3.3. Opportunity cost of each factor of production.Opportunity cost of each factor of production.
• The The normal rate of returnnormal rate of return is a rate of is a rate of return on capital that is just sufficient return on capital that is just sufficient to keep owners and investors to keep owners and investors satisfied.satisfied.
• For relatively risk-free firms, it should For relatively risk-free firms, it should be nearly the same as the interest rate be nearly the same as the interest rate on risk-free government bonds.on risk-free government bonds.
Short-Run Versus Long-Run DecisionsShort-Run Versus Long-Run Decisions
• The The short runshort run is a period of time is a period of time for which two conditions hold:for which two conditions hold:
1.1. The firm is operating under a fixed The firm is operating under a fixed scale (fixed factor) of production, andscale (fixed factor) of production, and
2.2. Firms can neither enter nor exit an Firms can neither enter nor exit an industry.industry.
Short-Run Versus Long-Run DecisionsShort-Run Versus Long-Run Decisions
• The The long runlong run is a period of time is a period of time for which there are no fixed for which there are no fixed factors of production. Firms can factors of production. Firms can increase or decrease scale of increase or decrease scale of operation, and new firms can operation, and new firms can enter and existing firms can exit enter and existing firms can exit the industry.the industry.
• Production technologyProduction technology refers to the refers to the quantitative relationship between inputs quantitative relationship between inputs and outputs.and outputs.
• A A labor-intensive technologylabor-intensive technology relies relies heavily on human labor instead of heavily on human labor instead of capital.capital.
• A A capital-intensive technologycapital-intensive technology relies relies heavily on capital instead of human heavily on capital instead of human labor. labor.
• The The production functionproduction function or or total product functiontotal product function is a is a numerical or mathematical numerical or mathematical expression of a relationship expression of a relationship between inputs and outputs. between inputs and outputs. It shows units of total It shows units of total product as a function of product as a function of units of inputs.units of inputs.
Marginal Product and Average ProductMarginal Product and Average Product
• Marginal productMarginal product is the additional output that is the additional output that can be produced by adding one more unit of a can be produced by adding one more unit of a specific input, specific input, ceteris paribusceteris paribus..
• Average productAverage product is the average amount is the average amount produced by each unit of a variable factor of produced by each unit of a variable factor of production.production.
av erag e p ro d u c t o f lab o r = to ta l p ro d u c t
to ta l u n its o f lab o r
m arg in a l p ro d u c t o f lab o r = ch an g e in to ta l p ro d u c t
The Law of DiminishingThe Law of DiminishingMarginal ReturnsMarginal Returns
• The The law of diminishing law of diminishing marginal returnsmarginal returns states states that:that:
When additional units of a When additional units of a variable input are added to variable input are added to fixed inputs, the marginal fixed inputs, the marginal product of the variable input product of the variable input declines.declines.
Total, Average, and Marginal ProductTotal, Average, and Marginal Product
• Marginal product is the slope Marginal product is the slope of the total product function.of the total product function.
• At point C, total product is At point C, total product is maximum, the slope of the maximum, the slope of the total product function is zero, total product function is zero, and marginal product and marginal product intersects the horizontal axis.intersects the horizontal axis.
• At point A, the slope of the At point A, the slope of the total product function is total product function is highest; thus, marginal product highest; thus, marginal product is highest.is highest.
Total, Average, and Marginal ProductTotal, Average, and Marginal Product
• When a ray drawn from the When a ray drawn from the origin falls tangent to the total origin falls tangent to the total product function, average product function, average product is maximum and equal product is maximum and equal to marginal product.to marginal product.
• Then, average product falls to Then, average product falls to the left and right of point B.the left and right of point B.
Production Functions with Two Variable Production Functions with Two Variable Factors of ProductionFactors of Production
• In many production processes, inputs work In many production processes, inputs work together and are viewed as complementary.together and are viewed as complementary.
• For example, increases in capital usage lead to For example, increases in capital usage lead to increases in the productivity of labor.increases in the productivity of labor.
Inputs Required to Produce 100 Diapers Inputs Required to Produce 100 Diapers Using Alternative TechnologiesUsing Alternative Technologies
TECHNOLOGYTECHNOLOGYUNITS OF UNITS OF
CAPITAL (K)CAPITAL (K)UNITS OF UNITS OF LABOR (L)LABOR (L)
AA 22 1010
BB 33 66
CC 44 44
DD 66 33
EE 1010 22
• Given the technologies available, the cost-minimizing choice depends on input prices.