The document discusses key concepts related to production, firms, and markets. It defines production as the process of combining inputs to create outputs. A firm is an organization that produces goods or services to meet demand in order to earn profits. Perfect competition is described as a market structure with many small firms, homogeneous products, and firms as price takers. The document also discusses production functions and how firms determine optimal input levels to maximize profits.

1. Production
Central to our analysis is production:
• Production is the process by which
inputs are combined, transformed,
and turned into outputs.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

2. What Is A 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.
• Production is not limited to firms.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

3. Perfect Competition
Perfect competition is an industry
structure 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.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

4. Homogeneous Products
• Homogeneous products are
undifferentiated products;
products that are identical to, or
indistinguishable from, one
another.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

5. Competitive 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.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

6. Demand Facing a Single Firm in a
Perfectly Competitive Market
• 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 will drop to zero. Each firm faces a perfectly elastic demand
curve, d.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

7. The Behavior of
Profit-Maximizing Firms
• The three decisions that all firms must
make include:
1. 2. 3.
Which
How much How much of
production
output to each input to
technology to
supply demand
use
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

8. Profits and Economic Costs
• Profit (economic profit) is the difference
between total revenue and total cost.
• Total revenue is the amount received from the
sale of the product:
(q X P)
• Total cost (total economic cost) is the total of
1. Out of pocket costs,
2. Normal rate of return on capital, and
3. Opportunity cost of each factor of production.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

9. Normal Rate of Return
• The normal rate of return is a rate of
return on capital that is just sufficient
to keep owners and investors
satisfied.
• For relatively risk-free firms, it should
be nearly the same as the interest rate
on risk-free government bonds.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

10. Calculating Total Revenue, Total Cost,
and Profit
Initial Investment: $20,000
Market Interest Rate Available: .10 or 10%
Total Revenue (3,000 belts x $10 each) $30,000
Costs
Belts from supplier $15,000
Labor Cost 14,000
Normal return/opportunity cost of capital ($20,000 x .10) 2,000
Total Cost $31,000
Profit = total revenue − total cost − $ 1,000a
a
There is a loss of $1,000.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

11. Short-Run Versus Long-Run Decisions
• The short run is a period of time
for which two conditions hold:
1. The firm is operating under a fixed
scale (fixed factor) of production, and
2. Firms can neither enter nor exit an
industry.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

12. Short-Run Versus Long-Run Decisions
• The long run is a period of time
for which there are no fixed
factors of production. Firms can
increase or decrease scale of
operation, and new firms can
enter and existing firms can exit
the industry.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

13. Determining the Optimal Method
of Production
Price of output Production techniques Input prices
Determines Determine total cost and
total revenue optimal method of
production
Total revenue
− Total cost with optimal method
=Total profit
• The optimal method of production is the
method that minimizes cost.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

14. The Production Process
• Production technology refers to the
quantitative relationship between inputs
and outputs.
• A labor-intensive technology relies
heavily on human labor instead of
capital.
• A capital-intensive technology relies
heavily on capital instead of human
labor.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

15. The Production 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.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

16. 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.
c h a n g e in to ta l p ro d u c t
m a rg in a l p ro d u c t o f la b o r =
c h a n g e in u n its o f la b o r u s e d
• Average product is the average amount
produced by each unit of a variable factor of
production.
to ta l p ro d u c t
a v e ra g e p ro d u c t o f la b o r =
to ta l u n its o f la b o r
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

17. The Law of Diminishing
Marginal Returns
• The law of diminishing
marginal returns states
that:
When additional units of a
variable input are added to
fixed inputs, the marginal
product of the variable input
declines.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

18. Production Function for Sandwiches
45
Production Function 40
35
30
Total product
(2) (3) (4) 25
(1) TOTAL PRODUCT MARGINAL AVERAGE
20
LABOR UNITS (SANDWICHES PRODUCT OF PRODUCT
(EMPLOYEES) PER HOUR) LABOR OF LABOR 15
10
0 0 − − 5
0
1 10 10 10.0
0 1 2 3 4 5 6 7
2 25 15 12.5 Number of employees
15
3 35 10 11.7
Marginal Product
10
4 40 5 10.0
5 42 2 8.4 5
6 42 0 7.0
0
0 1 2 3 4 5 6 7
Number of employees
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

19. Total, Average, and Marginal Product
• Marginal product is the slope
of the total product function.
• At point A, the slope of the
total product function is
highest; thus, marginal product
is highest.
• At point C, total product is
maximum, the slope of the
total product function is zero,
and marginal product
intersects the horizontal axis.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

20. Total, Average, and Marginal Product
• When a ray drawn from the
origin falls tangent to the total
product function, average
product is maximum and equal
to marginal product.
• Then, average product falls to
the left and right of point B.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

21. Total, Average, and Marginal Product
• As long as marginal product
rises, average product rises.
• When average product is
maximum, marginal product
equals average product.
• When average product falls,
marginal product is less than
average product.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

22. Production Functions with Two Variable
Factors of Production
• In many production processes, inputs work
together and are viewed as complementary.
• For example, increases in capital usage lead to
increases in the productivity of labor.
Inputs Required to Produce 100 Diapers
Using Alternative Technologies • Given the
UNITS OF UNITS OF technologies
TECHNOLOGY CAPITAL (K) LABOR (L) available, the
A 2 10
cost-minimizing
B 3 6
choice depends
C 4 4
D 6 3
on input prices.
E 10 2
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

23. Production Functions with Two Variable
Factors of Production
Cost-Minimizing Choice Among Alternative
Technologies (100 Diapers)
(2) (3) (4) (5)
(1) UNITS OF UNITS OF COST WHEN COST WHEN
TECHNOLOGY CAPITAL (K) LABOR PL = $1 PK = $1 PL = $1 PK = $1
A 2 10 $12 $52
B 3 6 9 33
C 4 4 8 24
D 6 3 9 21
E 10 2 12 20
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair