Chapter 7: The Production Process:

The Behaviour of Profit-maximizing Firms

The Three Decisions That All Firms Must Make

The Behaviour of Profit-Maximizing Firms

Profits and Economic CostsWe assume that firms are in business to make a profit and that a firm’s

behaviour is guided by the goal of maximizing profits. profit (economic profit) is the difference between total revenue and total cost.

profit = total revenue - total costtotal 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) full opportunity cost of each factor of production.Out-of-pocket costs are sometimes referred to as explicit costs or accounting

costs. Economic costs include the full opportunity cost of every input. (implicit costs) The term profit will from here on refer to economic profit. So whenever we say

profit = total revenue - total cost, what we really mean is

economic profit = total revenue - total economic cost

Short-Run versus Long-Run Decisions

short run The period of time for which two conditions hold: The firm is operating under a fixed scale (fixed factor) of production, and firms can neither enter nor exit an industry.

long run That period of time for which there are no fixed factors of production: Firms can increase or decrease the scale of operation, and new firms can enter and existing firms can exit the industry.

The Bases of Decisions: Market Price of Outputs, Available Technology, and Input Prices

Determining the Optimal Method of ProductionFaced with a set of input prices, firms must decide on the best, or optimal, method of production optimal method of production is the production method that minimizes cost. With cost determined and the market price of output known, a firm will make a final judgment about the quantity of product to produce and the quantity of each input to demand.

The Production Process

The Production Process (cont.)

The Production Process (cont.)

Choice of Technology

Productivity and the Aggregate Production Function

One of the most important measures of economic performance is productivity, which is a concept measuring the ratio of total output to a weighted average of inputs.Two important variants are labour productivity, which calculates the amount of output per unit of labour and total factor productivity, which measures output per unit of total inputs (typically of capital and labour). Productivity grows because of economies of scale and because of technological change.

Productivity and the Aggregate Production Function

The aggregate production function relates total output to the quantity of inputs and to total productivity. Attempts to measure an aggregate production function for the American economy tend to corroborate theories of production and marginal products. In the 20th century, technological change increased the productivity of both labour and capital. Total factor productivity grew at around 1.5% per year over the 20th century, although from the 1970s to the mid-1990s the rate of productivity growth slowed markedly and real wages stopped growing. But underestimating the importance of new and improved products may lead to a significant underestimate of productivity growth.