Producers Behaviour,

Production Function,
Profits 1
2
 Cost and Profit
 Producers: Maximize profit
 Opportunity Cost VS Sunk Cost
– All resources have an opportunity cost
 Explicit costs
– Payments for resources
 Implicit costs
– Opportunity cost of resources owned by the firm / firm owners
– No cash payment
3
Alternative Measures of Profit

 Accounting profit
– Total revenue minus explicit costs
 Economic profit
– Total revenue minus all costs (implicit and
explicit)
• Opportunity cost of all resources
 Normal profit

4
Basis for Comparison Accounting Profit Economic Profit Normal Profit

Accounting Profit is Economic Profit is the

the net income of the remaining surplus Normal Profit is the least
Meaning company earned left after deducting amount of profit needed
during a particular total costs from total for its survival.
accounting year. revenue.

Economic Profit =
Accounting Profit =
Total Revenue - Total Revenue = Total Cost
Calculation Total Revenue -
(Total Explicit + (i.e. explicit and implicit)
Total Explicit Cost
Total Implicit Cost)

Shows how well the

Reflects the Helpful in knowing the
company is
Advantage Profitability of the future prospects of the
allocating its
company. company.
resources. 5
 A Car Dealer Accounts
Total Revenue Rs 105,000
Less Explicit Costs:
Assistant's Salary -Rs. 21,000
Material and Equipment -Rs.20,000
Equals Accounting Profit Rs. 64,000
Less Implicit Costs:
Owners forgone Salary -Rs.50,000
Forgone Interest on Savings -Rs. 1,000
Forgone Garage Rental -Rs.1,200
Equals Economic Profit Rs. 11,800
6
Production in the Short Run

 Variable resources
– Can be varied quickly
 Fixed resources
– Cannot be altered easily
 Short run
– At least one resource is fixed
 Long run
– No resource is fixed
7
 Total and Marginal Product

 Total product
 Production function
– Relationship between amount of resources employed
and total product
 Marginal product
– Change in total product from an additional unit of
resource

8
 9

Source: https://www.youtube.com/watch?v=CfioxJ4E_h4&feature=youtu.be
Law of Diminishing Marginal Returns (Also known as,
Law of Variable Proportions, Principle of Diminishing
Marginal Productivity)

 Increasing marginal returns

– Marginal product increases

 Diminishing marginal returns

– Marginal product decreases

 Law of diminishing marginal returns

10
Law of Variable Proportions

11
Three Stages of Production

12
 The Short-Run Relationship Between Units of
Labor and Tons of Furniture Moved

Units of the Variable Resources Total Product Marginal Product

(Worker-days) (Tons moved per day) (Tons moved per day)
0 0 --
1 2 2
2 5 3
3 9 4
4 12 3
5 14 2
6 15 1
7 15 0
8 14 -1
Marginal product increases as the firm hires each of the first three workers, reflecting
increasing marginal returns. Then marginal product declines, reflecting diminishing
marginal returns. Adding more workers may, at some point, actually reduce total product 13
(as occurs here with an eighth worker) because workers start getting in each other’s way.
 Effects of an Increase in Demand
15 (a) Total product

Total product
Total

(tons/day)
product
10

0 5 10 Workers per day

Increasing Diminishing but

5 (b) Marginal product
Marginal product

marginal positive
4 returns marginal returns Negative
3 marginal
(tons/day)

2 Marginal returns
1 product
0

14
5 10 Workers per day
 Long Run: A Closer Look at
Production and Cost

 Production function
 Technologically efficient production

 Isoquant
– All technologically efficient combinations of 2
resources
15
 Production in the Long Run

 Isoquants
– Farther from origin: greater output rates
– Negative slope
– Don’t intersect

– Convex to the origin

16
Slope of an Isoquant

 Marginal rate of technical substitution

– MRTS
– Slope of isoquant

– MRTS = MPL/MPK

17
A Firm’s Production Function Using Labor
and Capital: Production per Month

18
 A Firm’s Isoquants
Isoquants:
Units of capital per month
- negative slope
10 a h
f - convex to the origin
g
b Q3 (475) Q3: 475 units of output
5 e
c Q2 (415) Q2: 415 units of output
d
Q1 (290)

0 5 10
Units of labor per month

Q1: all technologically efficient combinations of labor and capital

that can be used to produce 290 units of output 19
 Cost (Production Budget)
 Iso cost line
 All combinations of capital and labor
 Can be hired for a given total cost
 Are parallel
 Slope of iso cost line
– Negative
– Price of labor divided by price of capital

20
 A Firm’s Isocost Lines
Slope = -w/r = -Rs.1,500/Rs.2,500 = -0.6
Each isocost line
Units of capital per month

10
– Combinations of labor and
TC capital that can be purchased
TC = R for a given amount of total cost
s
TC = R .22,
5 = R s.19 500 – Slope is negative wage
s .1 ,0
5,0 00 divided by the rental cost of
00
capital

0 5 10 15
Units of labor per month

Higher costs: isocost lines farther from origin 21

 Firms’ Objectives

 Profit maximization
 Cost minimization
 Minimum cost to produce a given output
– Tangency between isocost line and
isoquant
• Slope = MRTS = w/r

22
A Firm’s Optimal Combination
of Inputs
TC = Rs.19,000

Units of capital per month

10 e: isoquant Q2 is tangent
to the isocost line
a f

5 e Q3 (475)
Q2 (415)
Q1 (290)

0 5 10
Units of labor per month
23
 A Firm’s Expansion Path
Expansion path
- Slopes up to the right
- More of both
resources is needed

Units of capital per month

TC to increase output
4
TC Expansion path
3

TC d
2
c Q4
TC h
1
b
C a Q3
Q2
Q1

0 L L’
Units of labour per month 24
Ridge Lines and Economic Region of Production

25
Other Shapes of Isoquants

26
Questions???

27