Behavior Of Profit Maximizing Firms And The Production Process

Introductory Microeconomics

Unit IV – The Firm and Perfect Market Structure

Lesson: Behavior of Profit Maximizing Firms and The Production

Process

Lesson Developer: Jasmin

Jawaharlal Nehru University

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 Behavior Of Profit Maximizing Firms And The Production Process

Table of Contents

Behavior of Profit Maximizing Firms and the Production Process

Learning Outcomes
Introduction
Production

Profit Maximizing Firms: Behavior

 Profits and Costs

 Normal Rate of Return to Capital

Decision in the Short Run and the Long Run

Factors Effecting Decisions of the Firms

Production Process

 Production Functions and Concepts of Total Product, Marginal

Product and Average Product
 Law of Diminishing Returns: Marginal Product Function
 Marginal Product and Average Product
 Production Function: The Case of Two Variable Inputs

Choice of Technology

Conclusion
Summary
Exercises
Glossary
References
Web-links

Appendix

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 Behavior Of Profit Maximizing Firms And The Production Process

Behavior of Profit Maximizing Firms and the Production

Process

Learning Outcomes

The objective of this lesson is to acquaint the reader with the behavior of the profit
maximizing firms in a perfectly competitive market structure, the production process and
how are the decisions related to the production process taken. After having gone through
the chapter, the reader should be able to understand the concept of perfect competition.
The decisions regarding the amount of the output to be produced, which production
technology should be used to produce the output and the quantity of inputs to be used in
the production are crucial for any firm, the lesson, looks into these aspects as well. The
reader will attain a deeper understanding of the concepts like profits, total revenue, total
cost and the normal rate of return. The chapter analyses in detail, how do the decisions and
response of the firms differ in the short and the long-run. It also discusses the factors that
influence the important decisions that the firms have to take, the production process which
involves a discussion on the types of technology, concepts of total, marginal and average
product and production function. The last section of the chapter discusses the question of
the choice of technology and its connection with the input markets. The practice questions
at the end of the chapter will help the reader, get a clear picture of the topics discussed in
the lesson. The appendix to this chapter introduces the idea of isocosts, isoquants and the
cost-minimizing optimum combination of inputs.

Introduction

An idea parallel to the concept of household decisions and consumer choice is that of the
production decisions taken by the firms. The households decide what and how much to
consume of different goods, given the prices and the income, they make decisions about the
number of hours to work. Firms in the market are also involved in a similar exercise,
wherein they decide about the inputs and their quantity that they should use in the
production process such that least cost is incurred given the input prices and the level of
output which will be profitable for them to produce. All the firms involved in production aim
at maximizing their profits and minimizing their costs, therefore optimization is equally vital
for the firms as well. The firms are involved in the production process, in which the inputs

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 Behavior Of Profit Maximizing Firms And The Production Process

are combine to produce output. The decisions related to production have a definite
implication for the profits and the viability of the firm. Figure 1 illustrates the circular flow
diagram, which shows the demand and supply of the inputs as well as the output. It shows
the demand and supply decision of firms and households. It is very important to understand
the questions that are faced by the firms and how are they answered. The chapter aims at
solving all these puzzles.

Figure 1 : Decisions of the firms and households

Production

Production can be defined as a process whereby, inputs are combined, processed and
converted into output. Production is a vital function of a firm be it of any size and internal
structure. There are a set of assumptions on which the analysis in this chapter is based. The
assumptions are listed below:

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 Behavior Of Profit Maximizing Firms And The Production Process

Production is not confined only to firms: The function of production is not confined only
to the firms in the market. Households can also process and convert inputs like land, labor,
capital etc. into output. A household that has a kitchen garden, combines land, labor,
manure, fertilizers, seeds and other tools to grow vegetables. Government utilizes various
factors of production to provide various services of public utility.

Firms are different from households and government in the sense that they produce goods
or services to meet the demand for those goods or services to make profits.

Firms differ from each other on the basis of their size, type of organization and the market
structure that they function in. We analyze the case of perfect competition here.

Perfect Competition: There are characteristics particular to a perfectly competitive

industry. The industry comprises of a large number of relatively small firms that produce
homogeneous goods. No specific firm can control market price of either the output it
produces or the inputs that it uses for production. Hence, two features specific to the
perfectly competitive industry are that each firm is very small compared to the size of the
industry and all the firms in a perfectly competitive industry produce identical goods.

Resultantly, each firm in the industry takes the market price, which is determined by the
supply and demand, as given. These firms can be described as “price-takers”. At the given
price, the firms can decide how much output to supply, quantity of inputs to purchase and
how to produce the output.

Since the products produced by the firms are homogeneous, no firm can charge a price
above the market price as the consumers, in this case will easily shift to the other sellers in
the market and the firm who fixed a price above the market price will incur losses. Also, it is
very clear, that no firm would want to charge a price below the market price, since it can
sell any quantity of output at the given market price. The demand for output produced by
such a firm is also perfectly elastic. For instance, let’s consider the case of Ram who sells
pens in a perfectly competitive market. Part a in figure 2 depicts the supply and demand
conditions in the market. Say the price set by the market is Rs.5 per pen. Part b in figure 2
represents the demand curve being faced by a perfectly competitive firm for its output. It
would not be beneficial for Ram to raise the price of pen above Rs.5, since the consumers
will shift their demand to the other sellers and he will not be able to sell any pen. On the
other hand, he would not want to fix a price below Rs.5, because he can sell as many
number of pens at this price as he wants.

Figure 2 : A perfectly competitive market structure and the demand faced by a single firm

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 Behavior Of Profit Maximizing Firms And The Production Process

In the perfectly competitive industry it is also assumed that the entry is easy, it is very easy
for the firms to enter and exit the industry. If the existing firms in the industry are earning
high profits, new firms would also enter. For example even if there are several stationery
shops, there are no barriers for a new stationery shop to spring up. Similarly the exit is
also easy, if a firm is incurring losses, it can easily shut down the business. Firms might face
losses when there is changing technology, changes in tastes and preferences, rise in costs
of production or when there is a fall in prices due to intense competition. Though it is hard
to find a perfectly competitive set up in the real world, certain markets are quite close to
perfect competition, when it comes to their structure and the way of functioning. Few
examples can be pointed out here, for instance, markets for agricultural goods, vendors
who sell food and other articles on the street etc.

Profit Maximizing Firms: Behavior

The objective of any firm is to achieve the maximum level of profits. There are several
decisions facing the firm that have a definite influence on its profits. The basic questions
that the firms need to answer are: the quantity of the good to be produced, the quantity of
each factor of production to be purchased for producing the good and the technology to
choose for producing that good. Figure 3 shows the decisions that a firm needs to make. If
a firm has decided upon the quantity of the good to produce, the choice of production
technique can determine the quantity of inputs to be used for producing the decided
quantity of output. The type of technology has an important role to play, as it defines how
effectively the inputs are transformed into output. For an example, a potato chips factory,
using complex machinery and equipment and a few laborers can produce a larger number of
packs of potato chips as compared to a small scale firm that makes potato chips primarily
using laborers, who perform major proportion of their work manually.

Figure 3 : Decisions facing a firm

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 Behavior Of Profit Maximizing Firms And The Production Process

Profits and Costs

We have already discussed, that any firm functions in the market, primarily to make profits.
Since, profits are so vital for any firm, it is important to understand what profit is. Profit can
be defined as the difference between the total revenue and the total cost of the firm.

Total revenue is the amount of money that a firm receives out of selling its output; it’s the
quantity of output sold (q) multiplied by the per unit price of that good (p). Total cost or the
total economic cost includes three elements. First being the explicit/accounting or out of
pocket costs, which is the cost of raw materials and other inputs used in the production. The
normal rate of return on capital and the opportunity cost of each factor of production are
the other two elements of the total economic cost. The normal rate of return on capital and
the opportunity cost of each factor of production can be categorized as implicit costs.
Opportunity costs are implicit and need to be included in the total cost incurred by the firm.
For example, a person who owns a business also contributes his labor services to it, but
does not get any wage in return, instead of running his own business, he could have worked
as an employee and would have got a wage for his labor. The wage that this person loses
out is the opportunity cost of his labor which needs to be added to the total economic cost.
The opportunity cost of capital, in a similar fashion is equally important. The opportunity
cost of capital can be accounted for by including the normal rate of return to capital in the
total economic costs.

Normal Rate of Return

Capital is required to establish a firm or to start a business. Money is required purchase and
set up machinery, equipment, furniture etc. This implies that this capital will stay tied up
with the business for a long period. Fresh investments also need to be made, even when the
firm or the business has been in place for a long time. There is an opportunity attached with
this invested capital. The investor or the proprietor, instead of investing his funds in the
business, could have invested them in some financial security, which would have given him
returns. This rate of return is the opportunity cost of using or investing one’s capital in the
business.

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 Behavior Of Profit Maximizing Firms And The Production Process

The concept of rate of return needs to be understood. A person who has invested his funds
in a business, will get a stream of returns. The rate of return can be described as the annual
flow of net returns on investment, expressed as a proportion of the total investment. A
normal rate of return, on the other hand, can be defined as the rate of return that keeps the
investors and owners satisfied. If the rate of return falls below the normal rate of return, the
owners will get a lower return if they invest in the business, they could earn a higher
returns by putting the funds in the financial securities, bonds or anywhere else. Under
normal conditions, i.e. when there is a consistent stream of revenue, there is no uncertainty
about the future, the firm earns a steady stream of revenues, the normal rate of return will
be quite close to the rate of return on risk-free government securities.

Let’s define economic profit now. Economic profit is the difference between the total
revenue and the total economic costs.

With this definition, it is easy to see that when the firm earns a rate of return equal to the
normal rate of return, firms don’t earn any profits. On the other hand, if the firm is earning
a positive sum of profit, it implies that the rate of return is above the normal rate of return
to capital. A positive level of profit will keep the investors happy and motivate new firms to
enter the industry. A negative profit, means that the rate of return is below the normal rate
of return to capital. In such a case the firms might shut down the business and move out of
the industry, a few might contract and the fresh investments will be hard to come by.

A Numerical Example

Suppose Ravi is planning to start a small-scale business. He plans to sell radios. To start the business, he
needs a shop. The money required to purchase this shop is Rs.1000000. Ravi has decided to sell 30000
radios annually at a price of Rs.100 per radio. He purchases the radio from a supplier and each radio
costs him Rs.50. He will need a person to stay on the sales counter, who will work for a yearly wage of
Rs.400000. The rate of interest on government securities is 10%, so Ravi wants to earn at least 10% on
his investment. Let’s work out the profit for this venture.

Table 1: Calculating Profits for Ravi’s Venture

Total Revenue (30000 radios x Rs.100) Rs.3000000
Economic Costs
Amount Paid to the supplier (30000 radios Rs.1500000
x Rs.50)
Wage paid to the worker Rs.400000
Opportunity cost of Capital (Rs.1000000 x Rs.100000
0.10)
Total Economic Costs Rs.2000000
Economic Profit = Total Revenue – Rs.1000000
Total Economic Costs
A profit of Rs.1000000

Ravi earns a revenue of Rs.3000000, out of his venture. The total economic costs have been
calculated by including the opportunity cost of capital or the normal return to the capital.
The economic profit generated by this venture is Rs.1000000.

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Decision in the Short Run and the Long Run

Various decisions taken by a firm are with respect to the time period. There are decisions
that need to be made in the short-run, for instance, the quantity of good to be produced
with the existing machinery or plant. Also there are decisions that are made over the long
run, like expansion of a factory, setting up a new plant etc. Hence, time is another
important factor that is taken into consideration while a firm is making decisions. Decisions
and reactions of a firm in the short-run often differ from the kind of questions and decisions
that a firm is faced with in the long-run.

Short-run can be defined with the help of two features. In the short-run, some factor of
production for the firms existing in the industry, is given to be fixed i.e. the quantity or
scale of that factor cannot be altered. Also, in the short-run the entry and the exit of firms
from the industry is difficult. It can be said that there are bottlenecks in the entry and the
exit of the firms. A firm winding up its business, in order to move out of the industry, might
still find some locked up fixed costs which are yet to be recovered. The factor of production
which is fixed, differs from one industry to the other. For a firm the plant or the machinery
can be a limit, for a professional his time can be a constraint, for a bakery the place of work
i.e. the shop might be a constraint. Land as an input is also fixed in the short run.

Long-run is the time period where no factor of production is fixed, nor are there any
restrictions or difficulties in the entry and the exit of the firms from the industry. Firms are
free to alter the scale at which they operate.

Factors Effecting Decisions of the Firms

Profit of the firms depends on the cost to produce the good and the price for which it can be
sold. Cost of production is determined by the production techniques and the prices of
inputs. Hence, the decisions of a profit maximizing firm will be based on factors three
important factors: market price at which the firm can sell each unit of the good it produces,
the production technologies available and price of each factor of production or input.

The firms are always on a look out for an optimal method of production. The optimal
method of production is the one, through which the firm incurs the least cost in production.
Once the cost minimizing method of production has been chosen and the market price of
the good and inputs is also known, firm can decide about the quantity of output to be sold
and the quantity of inputs to purchase. This has been illustrated in figure 4.

Figure 4 : The optimal method of production

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Production Process
Production is any process through which the inputs are processed and converted into
output. Production technology is a functional relationship between the inputs and the
output. For example producing a cotton shirt requires cotton, threads, buttons, dyes,
machinery, electricity, laborers and other inputs. It is possible that a good can be produced
through a number of different production techniques. The technology can be labor intensive
or capital intensive. A production technique that uses more of labor relative to capital, is
called a labor intensive production technology. On the other hand, a production technique
that uses more of capital relative to labor, is a capital-intensive technology. For example, to
make a swimming pool in a resort 50 laborers can be employed, with necessary tools and
equipment. This is a labor intensive technique. On the other hand, the swimming pool can
also be made with the help of 15 laborers, a crane and other machinery. This is a capital-
intensive technique. Since, the firm tries to choose the method of production which
minimizes the cost, a firm in an economy with abundant supply of cheap labor will use
labor-intensive techniques of production. However, in the economy where, the labor is short
in supply and the wages are high, the firms will have a tendency to use more of capital
relative to labor in the production process.

Production Functions and Concepts of Total Product, Marginal Product and

Average Product

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A production function can be describe as the mathematical relationship between the inputs
and the output. The total product function shows the total number of units of output that
will result on using different units of inputs.

For example, in a bakery one worker, working alone can produce 12 cookies in an hour. If
another worker is added, both the workers produce a total of 27 cookies in an hour, which
means that the second worker can produce 15 cookies in an hour. With the third worker the
total number of cookies produced rises to 37, i.e. the third worker adds only 10 cookies.
This could be because with three workers, the kitchen gets crowded and workers come in
each other’s way. Also the number of ovens is fixed, so three workers get to work on with a
fixed number of ovens, so there is a capital constraint. Note that we assume that all the
workers are equally efficient, it is the constraint of space and capital which leads to fall in
the number of cookies added to the total production by the third worker. With the addition
of the fourth and the fifth worker, these constraints are felt more strongly and the addition
made to the total production of cookies by each worker falls. With the fourth worker, the
total production of cookies rises to 40 and with the fifth worker it rises to 41 cookies. With
the sixth worker there is no further rise in the total production.

Tale 2: Production Function

Laborers Total Product Marginal Product of Average Product of
(Cookies Per Hour) Labor Labor
0 0 - -
1 12 12 12
2 27 15 13.5
3 37 10 12.33
4 40 3 10
5 41 1 8.2
6 41 0 6.83

Part a of figure 5 shows the total product function.

Law of Diminishing Returns: Marginal Product Function

Marginal product can be defined as the additional units of output that can be produced by
employing an additional unit of a particular input, holding the quantity of other inputs fixed.
Table 2 above shows the marginal product of labor. The first unit of labor in the bakery
produces 12 cookies, the second unit of labor adds 15 cookies to the total production, the
marginal product of the third worker is 10 cookies, fourth worker adds 3 cookies, fifth
worker produces 1 cookie, while the marginal product of the sixth unit of labor is 0. Part b
of figure 5 shows the curve for marginal product of labor.

Figure 5 : Production function for cookies

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According to the law of diminishing returns or the law of variable proportions, beyond a
particular point, if additional units of a variable input are employed along with fixed inputs,
the marginal product of the variable input falls.

Law of Diminishing Returns

In the Essay on the Influence of a Low Price of Corn on the Profits of Stock (1815), the
British economist David Ricardo introduced the law of diminishing marginal returns. Ricardo
derived the law mostly out of his observations of agriculture and land, labor and capital
involved in it.

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It is the short run where the firm or a factory or a farmer faces the constraint of fixed
inputs. Hence law of diminish returns always applies in the short run.

Marginal Product and Average Product

Average product is the amount of output produced on an average by each unit of the
variable input employed. Table 2 also shows the average product of labor. The average
product of labor is calculated by dividing the total output the total number of units of labor
used. For instance the average product of the first two units of labor is 13.5 (27/2), while
the average product of 6 units of labor is 6.83 (41/6).

The average product and marginal product are related to each other, however the average
product is not very quick to change, as compared to the marginal product. If the marginal
product exceeds the average product, the average product increases. For instance, Sam
participates in a competition that has five rounds and he has already completed two rounds.
Suppose he gets points for each round and his average for the first two rounds is 10, if he
scores 8 in the third round, his average for three rounds will fall but not all the way to 8, the
average will be 9.33. If he gets 12 points his average will rise but not all the way up to 12,
the average will be 10.66. Table 2 shows that the marginal product has been falling after

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employing the third worker. Though the average product also falls with the marginal
product, it has been falling slowly, when compared with the marginal product. Figure 6
shows the graph of the Total product and the graph of marginal and average product. The
marginal product curve is nothing but a depiction of the slope of the total product function.
As figure 6 shows, the marginal and average product curves start out together. While the
marginal product is rising and is above the average product curve, the average product
rises with it but at a slower pace. The marginal product curve reaches its maximum at point
A with number of workers, before the average product reaches its maximum at point B
with number of workers. At point A, the marginal product curve begins to fall since at
this point the additional u nits of output that an extra worker generates, begins to fall due
to fixed inputs or capacity constraints. At point B, the average product and marginal product
of labor are equal. The average product of labor continues to rise till point B, while the
marginal product has already begun to fall at point A. Average product is equal to the
marginal product of labor, when it reaches its highest point B. Beyond point B and till the
point C, the marginal product continues to decline and it is less than the average product of
labor. The average product also follows this decline in the marginal product. At the point
where units of labor are employed, the marginal product falls to 0, i.e. an additional unit
of labor cannot add to the output. This is point C and this is where the firm reaches its
capacity and the total product is at its maximum.

Figure 6 : Total product, average product and marginal product

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Production Function: The Case of Two Variable Inputs

Inputs are usually used in conjunction with each other. Labor and capital are two inputs
which can be seen as complementary in nature. Using more capital in the production
process can raise the productivity of labor. So, if the demand for cookies is on a rise, while
the bakery has hit its capacity of production, where all the workers are working with fixed
inputs for example a single oven, the owner of the bakery can think of expanding the
production capability of the bakery. He can infuse more capital in terms of another oven for
the bakery. The additional oven can raise the productivity of the labor as it will raise the
average output that a single worker can produce in an hour.

Choice of Technology
As we have discussed, inputs are used in conjunction with each other. The factors of
production are complementary in nature. Labor and capital are used together in production
and reach others productivity. However, different factors of production also act as
substitutes for each other. If capital is expensive relative to labor in an economy, the firms
will be motivated to shift to labor-intensive techniques of production. Similarly if labor is
relatively expensive compared to capital, the firms would want to shift to capital intensive
techniques. The type of production technique which will be chosen by the firm depends on
the prices of inputs determined by the input markets. Suppose, Rahul wants to manufacture
150 toys in a week. Table 3 shows several options of production technology that can be
used to produce these 150 toys.

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Table 3: Production Technologies Available to Produce 150 Toys

Technology Units of Capital (K) Units of Labor/Hours of
Labor (L)
A 3 10
B 4 7
C 5 6
D 6 3
E 7 1

Analyzing, different production technologies, it is easy to see that out of all the options,
technology A is the most labor intensive while technology E is the most capital intensive.
Since, the firm chooses the production technique which minimizes the cost, its ultimate
decision will depend on the market prices of the inputs. Let’s assume that the wage rate
(W) is Rs.1 and the cost of capital per hour (R) is Rs.5. The total cost corresponding to each
production technique can be calculate given the input prices.

Given the input prices, technology A is the one that will produce 150 toys at the least cost,
which is Rs.25, as shown in table 4. All the other technologies cost more than this amount.
Hence, the firm will choose technology which is the most labor-intensive technique. Now, if
the wage rate rises to Rs.7 and the cost of using capital per hour stays fixed at Rs.5, the
cost minimizing production technique after the rise in wage rate is option E. The cost of
production with technology E is Rs.42 after the rise in wages, as shown in table 4. So, the
firm will choose option E which is the most capital intensive technique out of all the options.

Hence, the cost of production depends on the available production techniques and the input
prices decided by the input markets.

Table 4: Alternative Production Techniques and corresponding Cost [Cost = (LxW) +

(KxR)]
Technology Units of Capital Units of Labor/ Cost when Cost when
(K) Hours of Labor W=Rs.1 W=Rs.7
(L) And R=Rs.5 And R=Rs.5
A 3 10 25 85
B 4 7 27 69
C 5 6 31 67
D 6 3 33 51
E 7 1 36 42

Conclusion
The lesson throws light on important elements that go into the decision making process of a
firm. The ultimate goal of any firm is to generate profits for itself. Decisions taken by the
firm effect its profit. These decisions are regarding the quantity of output to be produced,
choice of production technique and the quantity of inputs to purchase. Hence, it is important
to understand the market structure in which a firm operates, the types of production
techniques that are available for production and what does the cost of production depend
on. The decisions made are such that, the profits should be maximized while the cost should
be minimized.

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Summary
The chapter focuses on how the production decisions are taken at the firm level. Case of the
firm functioning in a perfectly competitive set up has been discussed. Following points
summarize the chapter.

 Firms differ in size and structure. For instance a firm functioning in a perfectly
competitive industry is a price-taker.
 Perfect competition is a market structure where there are several firms that are
small in size relative to the industry, each firm produces identical goods and there is
no restriction on entry and exit of the firms.
 The demand curve facing a firm in a perfectly competitive industry is perfectly
elastic, i.e. at this price the firm can sell any amount of output, but it will not be able
to sell anything if it fixes a price above this price. Also the firm will not want to
reduce the price it charges below the market price.
 Profit maximizing firms have to take three basic decisions. The first being the
quantity of output to produce, second, the choice of production technique and the
third, the quantity of inputs to purchase.
 The ultimate aim of the firm is to make profit. Profit is the difference between total
revenue and total cost of the firm.
 The total economic costs include out of pocket costs that are explicit in nature, the
opportunity cost of each input and the normal rate of return to capital which are
implicit in nature.
 The normal rate of return to capital is the rate of return which is sufficient to keep
the investors and owners satisfied. In normal conditions, it is quite close to the rate
of interest on risk-free government securities.
 If the firm makes positive profit, it implies that the rate of return that it earns is
greater than the normal rate of return to capital.
 Decisions made by the firm also take into consideration the time period. Short run
differs from the long-run since it involves fixed inputs and the entry and exit of the
firms from the industry is constrained.
 Decisions to be taken by the firm depend on market price of the good it produces,
the production technologies available and the input prices.
 A production function entails how the inputs are related to output. It is a
mathematical relationship between inputs and output.
 Marginal product is the additional units of output produced by employing an
additional unit of variable input. The law of diminishing returns states that beyond a
particular point, if additional units of a variable input are employed along with fixed
inputs, the marginal product of the variable input falls.
 Average product is the average amount of output produce by each unit of variable
input employed. It is related to the marginal product. It rises when the marginal is
above the average product, it is equal to the marginal product at its highest level
and falls when the marginal product falls below it.
 Capital and labor are inputs, complementary in nature, but they can also act as
substitutes.
 A profit maximizing firm uses the technology that minimizes the cost of production,
given the prices of inputs and various production techniques.

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Exercise
Review Questions
Q.1 Discuss the features of a perfectly competitive market structure. Why are the firms in a
perfectly competitive industry called “Price-Takers”?

Q.2 Why is normal rate of return to capital added while calculating total economic costs?

Q.3 What is the law of diminishing returns?. In the table given below determine whether
there is a case of diminishing returns.

Labor units Total Output

0 0
1 6
2 13
3 19
4 23
5 26

Q.4 Draw curves for total product, marginal product and average product. Illustrate the
relation between average product and marginal product.

Q.5 what does the choice of the cost-minimizing production technique depend on.

Multiple Choice Questions

Q.1 Features of perfect competition are:

a. There are a large number of sellers.

b. All the firms produce homogeneous products.
c. There is no restriction on the entry and exit of the firms.
d. All of the above.

Q.2 Which one out of the following is included to calculate the total economic costs:

a. Revenue.
b. Profit.
c. Price of the output.
d. Normal rate of return to capital.

Q.3 Which one of the following represents short run:

a. 4 months.
b. 6 months to a year.
c. The time period where all the inputs are variable.
d. The time period where one or more of the inputs are fixed.

Q.4 The law of diminishing returns states that:

a. When additional units of a variable input are used with fixed inputs, the marginal
product of that variable input declines.

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b. When additional units of a variable input are used with fixed inputs, the marginal
product of that variable input rises.
c. When additional units of a variable input are used with fixed inputs, the marginal
product of that variable input becomes constant.
d. None of the above.

Q.5 While choosing the production technology, the profit-maximizing firm should keep in
mind:

a. Input-prices.
b. Available production techniques.
c. Market price of output.
d. All of the above.

Correct Answers/Options for the Multiple Choice Questions

Question Number Option
Q.1 d
Q.2 d
Q.3 d
Q.4 a
Q.5 d

Justification for the Correct Answers for Multiple Choice Questions

Answer 1. The characteristics of a perfectly competitive industry include a large number of
firms, these firms sell identical products and there is no restriction on the entry and exit of
firms.

Answer 2. The opportunity cost of capital are accounted for by including the normal rate of
return to capital in the total economic costs.

Answer 3. Short-run is the time period where one or more of the inputs are fixed.

Answer 4. The law of diminishing returns state that when additional units of a variable input
are used with fixed inputs, the marginal product of that variable input declines.

Answer 5. The choice of production technology by a profit-maximizing firm depends on input

prices, available production technology and the market price of output.

Feedback for the Wrong Answers for Multiple Choice Questions

Answer 1. All the options for question 1 are correct hence the answer is option d.

Answer 2. Option a is incorrect, revenue is not included in the total economic costs. Option
b is also not correct, profit is calculated by deducting costs from revenue. Option c is
incorrect since price of the output is used in calculating the revenue earned by a firm.

Answer 3. Option a and b are incorrect, short-run is not earmarked by months or years.
Option c defines the long-run.

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Answer 4. Option b is incorrect, the law states that as more and more units of variable input
are used with fixed inputs, the marginal product of the variable input declines. Option c is
incorrect for the same reason. Option d is ruled out.

Answer 5. All the options for question 5 are correct.

Glossary

Average Product: average product is the ratio of total product to the total units of the
variable input. It is the average product produced by each unit of variable input.

Capital-Intensive Technology: The production technology that uses greater number of units
of capital relative to the units of labor.

Labor-Intensive Technology: The production technology that uses greater number of units
of labor relative to the units of capital.

Marginal Product: The additional units of output produced by an additional unit of variable
input employed.

Homogeneous Products: The goods that are identical to each other in terms of quality and
characteristics.

References
Case, Karl E. and Fair, Ray C. (2007), “Principles of Economics”, Ch.7, 8 th edition, Pearson
Education Inc.

Web Link
http://www.econlib.org/library/Enc/bios/Ricardo.html

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Appendix
Introduction to Isocosts and Isoquants

Table A.1 Various Combinations of Capital (K) and Labor (L) which can be used to produce
output units 75, 150 and 225.
Output = 75 Output=150 Output=225
K L K L K L
A 1 9 2 10 3 11
B 2 6 3 7 4 8
C 3 4 4 5 5 6
D 6 3 8 3 9 4

Table A.1 shows various combinations of capital and labor that can be used to produce three
different levels of output of good x. These levels of output are 75 units, 150 units and 225
units. A curve that shows different combinations of inputs, capital and labor, to produce a
given level of output is called an isoquant. Figure A.1 shows isoquants for three different
levels of output, using the data shown in the table A.1. Each isoquant represents infinite
combinations of inputs that can be used to produce the corresponding level of output. There
can be several isoquants corresponding to several levels of output. The higher the isoquant
greater is the level of output attached to it.

Figure A.1 : Isoquants showing combinations of labor and capital to produce levels of output
Q1 = 75, Q2 = 150 and Q3 = 225

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Figure A.2 shows the slope of the isoquant, where the isoquant has been drawn for the level
of output 75 units. Points F and G represent two points on the isoquant. When one moves
from point F and G, the capital employed falls and the units of labor rise. The output lost
due to fall in the number of units of capital employed is given by multiplied by . The
marginal product of capital is the number of additional units of output produced by
employing another unit of capital. To keep the level of output constant along the isoquant,
this loos in output must be made up by the addition to the output by employing more units
of labor. This addition to the output is similarly calculated as multiplied by .

So, the slope of the isoquant is given by

The ratio of marginal product of labor to the marginal product of capital is called the
marginal rate of technical substitution. It measures the rate at which a firm can substitute
capital in place of labor, keeping the level of output fixed.

Figure A.2 : Slope of an Isoquant

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Isocosts
A curve that shows several combinations of capital and labor to produce output at a given
cost, is called an isocost line. Like isoquants, isocost lines are infinite in number. Figure A.3
shows lines. If the price of labor is and the price of capital is , the isocost line is given
by the equation:

The lowest isocost line represents the combinations of capital and labor corresponding to
the lowest cost of production. Suppose the price of labor is Rs.1 and the price of capital is
Rs.1, figure A.3 shows three isocost lines corresponding to total cost of Rs.4, Rs.5 and Rs.6.

Figure A.3 : Iso cost lines

In the figure A.4 slope of isocost line has been shown for total cost Rs.16, = Rs.1 and
= Rs.2. The isocost line shows several combinations of capital and labor that can be
purchase for a total cost of Rs.16. to draw the isocost line the endpoints can be marked.

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 Behavior Of Profit Maximizing Firms And The Production Process

Point A of the isocost line is given by i.e. 8 units of capital. Similarly point B is

given by i.e. 16 units of labor. The slope of the isocost line is given by:

This formula gives out the slope for the above isocost line, which is -1/2.

Figure A.4 : Slopes of Isocost line

Finding the Cost Minimizing Production Technology

Suppose the firm that we are considering, functions in a perfectly competitive setup. This
firm wants to maximize its profit by minimizing the cost incurred in production. Let’s
consider an isoquant which corresponds to the level of production of 100 units of good X.
Suppose = Rs.1 and = Rs.1, now 100 units of good X can be produced at a cost of
Rs.7 using 4 units of capital and 3 units of labor, this is shown by point C in the figure A.5.
The same level of output can also be produced by using 6 units of capital and 2 units of
labor, represented by point D which will cost Rs.8. 100 units of output can also be produced
at point B by using 2 units of capital and 6 units of labor which again costs Rs.8. As shown
in the figure the minimum cost at which 100 units of good X can be produced is Rs.7. A firm
that wants to maximize its profit and minimize its cost will produce at point C which
represents the cost minimizing technology for given level of output. The cost minimizing
technology to produce a given level of output is represented by the point where the isocost
line and the isoquant for that particular level of output are tangent to each other.

Figure A.5 : Least cost combination for 100 units of good x

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Let’s draw another diagram with three isoquants showing different levels of output, i.e. 100,
150 and 200 units of good X. Figure A.6 shows the cost minimizing production technology
for these levels of output. We maintain that = Rs.1 and = Rs.1. The minimum cost of
producing 100 units of good X is represented by the isocost line with total cost of Rs.4, for
150 units of good X is shown by the isocost line with total cost of Rs.5 and for 200 units of
good X is shown by the isocost line with total cost of Rs.6.

Figure A.6 : Cost minimizing production technology for Q1 = 100, Q2 = 150 & Q3 = 200

Equilibrium Condition to Reach the Cost Minimizing Production Technique

The equilibrium point is reached where the isocost line is tangent to the isoquant. As shown
in Figure A.6, points A, B and C are points of equilibrium or points of tangency. At the point
of equilibrium the slope of isoquant is equal to the slope of isocost line.
The equilibrium condition is: or

The same condition can be written as:

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This is the firm’s cost-minimizing condition. Left side is the output produced by the last
rupee spent on labor and the right side is the output produced by the last rupee spent on
capital. If these two measure are not equal, the firm can lower the cost by substituting
more labor for capital or vice versa. Figure A.7 shows the total cost curve that represents
the minimum cost to produce different levels of output.

Figure A.7 : Minimum cost of producting different levels of output

Summary of Appendix
A few important points discussed in the appendix that need to be reviewed are:
 An isoquant represents infinite combinations of inputs that can be used to produce
the corresponding level of output.
 The slope of the isoquant is given by: . The ratio of marginal product
of labor to the marginal product of capital is called the marginal rate of technical
substitution. It measures the rate at which a firm can substitute capital in place of
labor, keeping the level of output fixed.
 A curve that shows several combinations of capital and labor to produce output at a
given cost, is called an isocost line. The slope of the isocost line is given by:

 The point of equilibrium where the slope of isoquant is equal to the slope of isocost
line shows the cost-minimizing technology of production for a given level of output.
The equilibrium condition is: or . The same condition can

be written as:

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Exercise for Appendix

Review Questions
Q.1 Draw the isocost line, when the total cost is Rs.200, the price of labor is Rs.5 and the
price of capital is Rs.10. How will the isocost line change if the price of labor becomes Rs.10
while the price of capital is Rs.5. Give the slope of the isocost line in both the cases.

Q.2 Give the equilibrium condition for the cost-minimizing production technique.

Multiple Choice Questions

Q.1 The isocost line shows:

a. The different combinations of inputs that can be used to produce output at a given
total cost.
b. The budget of the consumer.
c. The different combinations of inputs to produce a given level of output.
d. The combinations of two goods that leave a consumer equally satisfied.

Q.2 Higher the isoquant:

a. Higher the level of output corresponding to it.

b. Higher the level of utility attached to it.
c. Higher the cost attached to it.
d. All of the above.

Q.3 The cost-minimizing production technique is the one wherein:

a. The profit is the lowest.

b. The isocost line and the isoquant curve for the given level of output are tangent.
c. The isocost line and the isoquant curve for the given level of output intersect.
d. The tangency of isocost line and isoquant is not needed.

Correct Answers/Options for the Multiple Choice Questions

Question Number Option
Q.1 a
Q.2 a
Q.3 b

Justification for the Correct Answers for Multiple Choice Questions

Answer 1. The isocost line shows the different combinations of inputs that can be used to
produce output at a given total cost.

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Answer 2. Higher the isoquant, higher is the level of output that it represents.

Answer 3. The cost-minimizing production techniques is given by the point where the slopes
of the isocost line and the isoquant curve for the given level of output are the same. So, it is
the point where they are tangent.

Feedback for the Wrong Answers for Multiple Choice Questions

Answer 1. Option b is incorrect, the budget of the consumer is given by the budget line.
Option c is incorrect as it defines an isoquant. Option d defines an indifference curve.

Answer 2. Option b discusses a concept related to indifference curves, isoquants do not

show utility. Option c states a characteristic of the isocost lines. Option d is ruled out.

Answer 3. Option a is incorrect, the cost-minimizing technique corresponds to maximum

profit. Option c is wrong, equilibrium cost minimizing technique is characterized by tangency
of isocost line and the isoquant curve for the given level of output. If the two intersect, the
firm can move along the isoquant down to the point where the cost is minimum and the
slopes of the two curves are equal. Option d is therefore incorrect because tangency is
needed.

Glossary for Appendix

Isocost line: A line that shows several combinations of inputs to be used for production for a
given total cost.

Isoquant: A curve that shows several combinations of inputs to produce a given level of
output.

Marginal rate of technical substitution: The rate at which capital can be substituted in place
of labor by the firm, holding the level of output fixed.

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