ECON 101 Chapter 7: The Production Process: The Behavior of Profit-Maximizing Firms

The Production Process: The Behavior of Profit-Maximizing Firms

Overview

Firms play a central role in microeconomics by demanding factors of production in input markets and supplying goods and services in output markets. Their primary objective is to maximize profit by efficiently transforming inputs into outputs while minimizing costs.

• Firms demand inputs to engage in production and supply outputs to maximize profit.

• Production is the process by which inputs are combined, transformed, and turned into outputs.

• A firm’s cost is determined by the efficiency of its production process.

• Firms exist to sell outputs for more than their cost of production, responding to perceived demand.

7.1 The Behavior of Profit-Maximizing Firms

The Three Key Decisions

To maximize profit, all firms must make three interdependent decisions:

1. How much output to supply

2. How to produce that output (choice of technology)

3. How much of each input to demand

• These decisions are interdependent: a change in one affects the others.

• Technological changes alter the input-output relationship.

Profit Maximization

• Firms select the technology that minimizes cost for a given output level.

• Many technologies can produce the same product; firms choose the least-cost method.

Profit Formula:

• $\text{Profit} = \text{Total Revenue} - \text{Total Cost}$

• $\text{Total Revenue} = (\text{Number of units sold}) \times (\text{Price per unit})$

• Total Cost includes:

  • Out-of-pocket costs (explicit/accounting costs)

  • Opportunity costs of all inputs (implicit/economic costs)

Economic vs. Accounting Profit

• Economic profit accounts for both explicit and opportunity costs.

• Accounting profit only includes explicit costs.

• Most firm inputs are bought with cash (explicit), but capital has an opportunity cost too.

Opportunity Cost of Capital

• The return that could be earned on capital invested elsewhere at similar risk.

• To start a firm, resources must be invested (e.g., equipment, buildings).

• These resources remain tied up as long as the firm operates.

• Firms must replace and maintain capital as it wears out.

• Investments have opportunity costs—funds could earn interest in a bond or deposit.

Rate of Return

• Rate of return = annual flow of net income from an investment ÷ total investment.

• Also called yield.

• Example: $100,000 investment producing $15,000 per year → 15% return.

• Normal rate of return: rate just sufficient to keep owners/investors satisfied with their current investment vs. next-best alternative (opportunity cost of capital).

• The normal rate of return affects incentives:

  • If managers can’t earn enough to satisfy investors, they won’t invest.

  • If firms earn above normal rates, they attract new investors.

Relationship Between Risk and Return

• Secure, steady firms → lower, more stable returns.

• Riskier firms/economies → higher expected returns.

• The normal rate of return is part of total business cost:

  • Normal return = zero economic profit.

  • Above-normal return = positive profit.

Short Run vs. Long Run

• Short run: at least one factor of production is fixed (plant size, etc.); no entry or exit.

• Long run: all factors are variable; firms can enter/exit the industry.

Optimal Method of Production

The optimal production method is the one that minimizes cost for a given level of output.

Diagram description:

• Price of Output → determines Total Revenue

• Input Prices + Production Techniques → determine Total Cost

• Total Revenue – Total Cost (at optimal method) = Total Profit

7.2 The Production Process

Production Technology

Production technology specifies the quantities of inputs needed to produce output.

• Labor-intensive technology – relies heavily on human labor.

• Capital-intensive technology – relies heavily on machinery/capital.

• Firms choose the technology that minimizes cost:

  • When labor is cheap → labor-intensive is optimal.

  • When capital is cheap → capital-intensive is optimal.

Production Function

• Shows relationship between input and output.

• Expressed numerically or graphically.

• Example: total output per number of employees.

Diagram description:

• Curve rising then flattening (total product).

• Second graph shows marginal product of labor (slopes downward after a point).

Key Concepts

• Marginal product (MP): extra output from one more unit of input (holding others constant).

• Law of diminishing returns: as more variable input is added to fixed input, MP declines.

  • Occurs due to limits of capital, not lack of worker skill.

  • Diminishing returns always occur in the short run.

Average Product

• $AP = \frac{\text{Total Product}}{\text{Total Units of Labor}}$

• AP rises, then falls like MP.

• MP curve intersects AP curve at AP’s maximum.

• Production function curve: total product.

• Separate MP and AP curves – both rise, MP peaks earlier and crosses AP at its maximum.

Efforts to Increase Production

• Increasing production eventually hits limits of capacity.

• Capital and labor are complementary inputs – one is useless without the other.

• Adding capital raises productivity of labor (more output per worker).

7.3 Choices of Technology

Productivity and Input Substitution

• Productivity of capital and labor balance each other.

• Inputs can often substitute for each other depending on costs.

• Firms pick production techniques that minimize cost, based on:

  • Wage rate (W)

  • Cost of capital (PK)

Isoquants and Isocosts

• Isoquant: curve showing all combinations of labor and capital yielding the same output.

  • Farther from origin = higher output.

• Marginal product of capital (MPK): additional output from one more unit of capital while keeping output constant.

• Marginal Rate of Technical Substitution (MRTS): $MRTS = \frac{MP_L}{MP_K}$

• Isocost line: shows all combinations of labor and capital available for a given total cost.

  • Formula: $\Delta K / \Delta L = -P_L / P_K$

  • Slope = ratio of input prices.

Diagram description:

• Isoquant curves bowed toward origin.

• Isocost lines are straight, parallel lines.

• Tangency point between them = least-cost combination (optimal input mix).

7.4 Elasticity of Supply and Input Substitution

Elasticity of Supply

Elasticity of supply (Es) measures the responsiveness of quantity supplied (Qs) to a change in price (P).

• $E_s = \frac{\Delta Q_s}{\Delta P} \times \frac{P}{Q_s}$

• High Es: producers expand easily (short setup time, flexible technology).

• Low Es: difficult to expand (like oil).

Elasticity of Labor Supply

• Responsiveness of labor supplied to change in wage rate.

• $E_L = \frac{\Delta Q_{labor}}{\Delta wage\ rate} \times \frac{wage\ rate}{Q_{labor}}$

• At high wages, workers may prefer more leisure instead of working more (backward-bending curve).

7.5 Taxes and Elasticity

• Example: $1 tax per unit raises price for buyers and reduces received price for sellers.

• Taxes shift supply upward → new equilibrium with higher price, lower Qd.

• Elasticity determines tax burden:

  • More inelastic side bears more of the tax.

• Tax reduces total surplus and creates deadweight loss.