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Introduction toProduction and
Resource Use
Chapter 6
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Topics of Discussion
Conditions of perfect competition
Classification of productive inputs
Important production relationships (Assume one variable input in this chapter)
Assessing short run business costs
Economics of short run production decisions
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Conditions for Perfect CompetitionHomogeneous products
i.e., Corn grain, mined low-sulfur coal
No barriers to entry or exitNo regulatory barriersNo extremely high fixed costs
Large number of sellersHow large is large?
Perfect informationInformation cost is relatively smallNo one firm has access to information that
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Classification of InputsEconomists view the production process
as one where a variety of inputs are combined to produce a single or multiple outputs Cheese plant example
Many inputs: Labor, stainless steel cheese vats, raw milk, energy, starter cultures, cutting and wrapping tables, water, etc.
Multiple outputs: Cheese, dry whey, whey protein concentrates are produced by the plant
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Classification of InputsLand: includes renewable (forests) and
non-renewable (minerals) resourcesLabor: all owner and hired labor
services, excluding managementCapital: Manufactured goods such as
fuel, chemicals, tractors and buildings that may have an extended lifetime
Management: Makes production decisions designed to achieve specific economic goals
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Classification of InputsInputs can also be classified depending
on whether amount of input used changes with production level Fixed inputs: The amount of input used
does not change with output level Up to a point the size of milking parlor does not
change with ↑ milk production/cow or for initial ↑ in herd size
Variable Inputs: The amount of input used changes directly with the level of output Usually the amount of labor supplied is a
variable input (i.e., car assembly plant that ↑ the speed of assembly line to ↑ production/hour
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Production Function
Output = f(labor | capital, land, and management)
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Start withone variable
input
Start withone variable
input
f(•) is general functional notation Could be any functional form
Assume remaining inputsfixed at current levels
Assume remaining inputsfixed at current levels
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“given the level of”
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Point Labor (hr) Output
A 10 1.0
B 16 3.0
C 20 4.8
D 22 6.5
E 26 8.1
F 32 9.6
G 40 10.8
H 50 11.6
I 62 12.0
J 76 11.7
Production FunctionWe can graph the
relationship between output and amount of labor usedKnown as the Total
Physical Product (TPP) curve
Purely a physical relationship, no economics involved X lbs of fertilizer/acre
generates a yield of Y
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Total Physical Product (TPP) Curve
Variable inputVariable input
Maximum Output
Decreasing output
9
Data from previous table
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Other Physical Relationships
The following derivations of the TPP curve play an important role in decision-making
Marginal Physical Product (MPP) =
Average Physical Product (APP) =
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Output
Input
Output Qty
Input Qty
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MPP = Change in output as you change input use
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Production Function
Output
Input
Point Labor[1]
Output[2]
∆Labor[3]
∆Output[4]
MPP [5] = [4]
÷ [3]
A 10 1.0 ----- ----- -----
B 16 3.0 6 2 0.33
C 20 4.8 4 1.8 0.45
D 22 6.5 2 1.7 0.85
E 26 8.1 4 1.6 0.40
F 32 9.6 6 1.5 0.25
G 40 10.8 8 1.2 0.15
H 50 11.6 10 0.8 0.08
I 62 12.0 12 0.4 0.02
J 76 11.7 14 -0.3 -0.0211
↓MPP
↑MPP
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Total Physical Product (TPP) Curve
Input
MPP = 1.8/4.0 = .45Output ↑ from 3.0 to 4.8
units = 1.8Labor ↑ from 16 to 20
units = 4.0
Output
12
4.8
3
Data from previous table
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Law of DiminishingMarginal Returns
Pertains to what happens to the MPP with increased use of a single variable input If there are other inputs their level of use is not
changed
Diminishing Marginal ReturnsThe MPP ↑ with initial use of a variable inputAt some point, MPP reaches a maximum with
greater input useEventually MPP ↓ as input use continues to ↑
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PointLabor
[1]Output
[2]∆Labor
[3]∆Output
[4]
MPP [5] = [4]
÷ [3]∆MPP
A 10 1.0 ----- ----- -----
B 16 3.0 6 2 0.33
C 20 4.8 4 1.8 0.45
D 22 6.5 2 1.7 0.85
E 26 8.1 4 1.6 0.40
F 32 9.6 6 1.5 0.25
G 40 10.8 8 1.2 0.15
H 50 11.6 10 0.8 0.08
I 62 12.0 12 0.4 0.02
J 76 11.7 14 0.3 -0.02
Production Function
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Plotting the MPP Curve
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Change in outputassociated with achange in inputs
Change from A to B on the production function → a MPP of 0.33
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Data from previous table
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Plotting the MPP Curve
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Q of Output
Q of Input0
∆I*
MPP = Slope of the linetangent at a
point (A) on the TPP curve
= ∆Q*/∆I*
A
∆Q*
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Plotting the MPP Curve
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Q of Output
Q of Input0
∆I*
At A, MPP = ∆Q/∆I = 0/∆I* = 0
A
TPP is at a maximumwhen MPP = 0
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PointLabor
[1]Output
[2]∆Labor
[3]∆Output
[4]
APP[6] = [2] ÷
[1]
A 10 1.0 ----- ----- 0.10 -----
B 16 3.0 6 2 0.19
C 20 4.8 4 1.8 0.24
D 22 6.5 2 1.7 0.30
E 26 8.1 4 1.6 0.31
F 32 9.6 6 1.5 0.30
G 40 10.8 8 1.2 0.27
H 50 11.6 10 0.8 0.23
I 62 12.0 12 0.4 0.19
J 76 11.7 14 0.3 0.15
Production Function
Average Physical Product (APP) = Amount of output ÷ amount of inputs used= Output/unit of input used
Average Physical Product (APP) = Amount of output ÷ amount of inputs used= Output/unit of input used
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Total Physical Product (TPP) Curve
APP = .31 (= 8÷26) with labor use = 26
APP = .31 (= 8÷26) with labor use = 26
OutputOutput
InputInput
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Data from previous table
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Plotting the APP Curve
APP = output leveldivided by level of input use
APP = output leveldivided by level of input use
Output dividedby labor use at B (3 ÷ 16) =0.19
Output dividedby labor use at B (3 ÷ 16) =0.19
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Data from previous table
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Plotting the APP Curve
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Q of Output
Q of Input
0
A
Q*
I*
APP = Q*/I* = Slope of the line from
the origin to the pointon the TPP curve
At I**, APP is at a maximum,as line OB is just tangentto the TPP curve
I**
B
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Relationship Between APP and MPP
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MPP
APP
Q of Output
Q of Input0
APP is at a maximum atinput level where APP = MPP
I*
APP*
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Definition of the Three Stages of Production
APP is increasing in Stage I
Stage I: MPP > APP APP is ↑
Stage I: MPP > APP APP is ↑
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Definition of the Three Stages of Production
Stage II: MPP < APP MPP > 0
Stage II: MPP < APP MPP > 0
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Definition of the Three Stages of Production
Stage III: MPP < 0Stage III: MPP < 0
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The Three Stages of Production
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MPP
APP
Stage I Stage II
Stage III
Q of Output
Q of Input0
Stage II starts at input use where APP is at a maximum (pt A)
Stage II ends at input where MPP = 0 (or TPP is at a maximum)
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The Three Stages of Production
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MPP
APP
Stage I Stage II
Stage III
Q of Output
Q of Input0
Why are using the amount of input in Stage I and Stage III of production irrational from the producer’s perspective?
Why are using the amount of input in Stage I and Stage III of production irrational from the producer’s perspective?
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The Three Stages of Production
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MPP
APP
Stage I Stage II
Stage III
Q of Output
Q of Input0
Average productivity is increasing as more inputs are being used so why stop if the average return is greater than cost?
Average productivity is increasing as more inputs are being used so why stop if the average return is greater than cost?
Can increase output by using
less inputs: →More output and less cost
Can increase output by using
less inputs: →More output and less cost
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The Three Stages of Production
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MPP
APP
Stage I Stage II
Stage III
Q of Output
Q of Input0
The producer’s economic question: What level of input amount contained in Stage II should the I use to maximize profits?
The producer’s economic question: What level of input amount contained in Stage II should the I use to maximize profits?
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Economic DimensionTo answer the above question
We need to account for the price of the product being produced
We also need to account for the cost of the inputs used to produce the above product
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Key Cost Relationships The following cost concepts play key
roles in determining where in Stage II a producer will want to produce Total Variable Cost (TVC) = the total value
of costs that change with the level of output (e.g. energy costs, labor costs, material costs, etc.)
Total Fixed Cost (TFC) = total value of costs that do not changed with the level of output (e.g. property taxes)
Total Costs (TC) = the sum of total variable and fixed costs
TC = TVC + TFC
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Key Cost Relationships The following cost concepts play key roles in
determining where in Stage II a producer will want to produce Marginal Cost (MC) = total cost of
production ÷ output produced as output level changes= variable cost of production ÷ output produced given that total fixed costs by definition do not change with output = ∆TC/∆Q = ∆TVC/∆Q
Average Variable Cost (AVC) = total variable cost of production ÷ total amount of output produced = TVC/Q
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Key Cost Relationships The following cost concepts play key roles
in determining where in Stage II a producer will want to produce Average Fixed Cost (AFC) = total fixed
cost of production ÷ total amount of output produced = TFC/Q
Average Total Cost (ATC) = total cost of production ÷ total amount of output produced = TC/Q = AVC + ATC
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From TPP curve onpage 113
From TPP curve onpage 113
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Fixed costs are$100 no matter
the level ofproduction
Fixed costs are$100 no matter
the level ofproduction
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Total fixed costs (Col. 2)÷ by total output (Col. 1)
Total fixed costs (Col. 2)÷ by total output (Col. 1)
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Costs that varywith level of production
Costs that varywith level of production
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Total variable cost (Col. 4) ÷ by total output
(Col. 1)
Total variable cost (Col. 4) ÷ by total output
(Col. 1)
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Total Fixed Cost (Col. 2) + Total Variable Cost (Col.4)
Total Fixed Cost (Col. 2) + Total Variable Cost (Col.4)
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Change in Total Cost (Col. 4 or 6) associated with a change in output (Col. 1)
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[Total Cost (Col. 6) ÷ by Total Output (Col. (1)] or [Avg. Variable Cost + Avg. Fixed Cost]
[Total Cost (Col. 6) ÷ by Total Output (Col. (1)] or [Avg. Variable Cost + Avg. Fixed Cost]
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Let’s Graph the Above Cost Items Contained in the Previous Table
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Table 6.3 Cost Relationships
0
10
20
30
40
50
60
70
3.0 4.8 6.5 8.1 9.6 10.8 11.6
MC ATC
AVC AFC
MC = min(ATC) and min(AVC)
Vertical distance between ATC and AVC = AFC
Input Use
Cos
t ($
)
43
AFC
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Key Revenue ConceptsThe following revenue concepts play key roles in
determining where in Stage II a producer will want to produceTotal Revenue (TR) =Multiplication of total
amount of output produced by the sale price ($)Average Revenue (AR) = Total revenue ÷ total
amount of output produced ($/unit of output) = TR/Q
Marginal Revenue (MR) = ∆ total revenue ÷ ∆ total amount of output produced = ∆TR ÷ ∆Q How much revenue is generated by one additional
unit of output? Under perfect competition, it is the per unit price
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Now let’s assume this firm can sell its
product for $45/unit
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Remember we are assuming perfect competition The firm takes price as given Price (Col. 2) = MR (Col. 7) What is the AR value?
Key Revenue Concepts
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With perfect competition, where would the firm maximize profit in the above example?
Profit Maximization
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Let’s see this in graphical form
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Profit Maximization
0
10
20
30
40
50
60
70
1 3 4.8 6.5 8.1 9.6 10.8 11.6
MC ATCAVC MR
P=MR=AR
$45
11.2
Profit maximizingOutput where MR=MC
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The previous graph indicated thatProfit is maximized at 11.2 units of outputMR ($45) equals MC ($45) at 11.2 units of outputProfit maximizing output occurs between points G and HAt 11.2 units of output profit would be $190.40. Let’s do the math….
Profit Maximization
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Profit at Price of $45?
28
P =45
$
Q11.2
MC
ATC
AVC
Revenue = $45 11.2 = $504.00Total cost = $28 11.2 = $313.60Profit = $504.00 – $313.60 = $190.40
Since P = MR = ARAverage profit = $45 – $28 = $17Profit = $17 11.2 = $190.40
Revenue = $45 11.2 = $504.00Total cost = $28 11.2 = $313.60Profit = $504.00 – $313.60 = $190.40
Since P = MR = ARAverage profit = $45 – $28 = $17Profit = $17 11.2 = $190.40
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Profit at Price of $45?
28
P =45
$
Q11.2
MC
ATC
AVC
Revenue = $45 11.2 = $504.00Total cost = $28 11.2 = $313.60Profit = $504.00 – $313.60 = $190.40
Since P = MR = ARAverage profit = $45 – $28 = $17Profit = $17 11.2 = $190.40
Revenue = $45 11.2 = $504.00Total cost = $28 11.2 = $313.60Profit = $504.00 – $313.60 = $190.40
Since P = MR = ARAverage profit = $45 – $28 = $17Profit = $17 11.2 = $190.40
$190.40
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P=MR=AR
Zero economic profit if price falls to PBE
Firm would only produce output OBE where AR (MR) ≥ ATC
Zero economic profit if price falls to PBE
Firm would only produce output OBE where AR (MR) ≥ ATC
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Profit at Price of $28?
P=28
45
$
Q11.210.3
MC
ATC
AVC
Revenue = $28 10.3 = $288.40Total cost = $28 10.3 = $288.40Profit = $288.40 – $288.40 = $0
Since P = MR = ARAverage profit = $28 – $28 = $0Profit = $0 10.3 = $0 (break even)
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P=MR=AR
Firm can just cover variable cost if price falls to PSD.
Firm would shut down if price falls below PSD
Firm can just cover variable cost if price falls to PSD.
Firm would shut down if price falls below PSD
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Profit at Price of $18?
28
P=18
45
$
Q11.210.38.6
MC
ATC
AVC
Revenue = $18 8.6 = $154.80Total cost = $28 8.6 = $240.80Profit = $154.80 – $240.80 = –$86
Since P = MR = ARAverage profit = $18 – $28 = –$10Profit = –$10 8.6 = –$86 (Loss)
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Profit at Price of $10?
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P=10
19
45
$
Q11.210.38.6
MC
ATC
AVC
7.0
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30
Revenue = $10 7.0 = $70.00Total cost = $30 7.0 = $210.00Profit = $70.00 – $210.00 = – $140.00
Since P = MR = ARAverage profit = $10 – $30 = –$20Profit = –$20 7.0 = –$140
Average variable cost = $19Variable costs = $19 7.0 = $133.00Revenue – variable costs = –$63Not covering variable costs!!!!!!
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The Firm’s Supply Curve
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10
18
45
$
Q11.210.38.6
MC
ATC
AVC
7.0
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Profit Maximizing Output Levels
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Page 99
We know that so long as P (= MR) > AVC some of the fixed costs can be coveredBetter economic position then shutting down
altogether, WHY?We know that when P (= MR)=MC, the
firm maximizes profitPortion of MC curve defined by output
level that generates the minimum AVC is referred to as the firm’s supply curve
The Firm’s Supply Curve
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The Firm’s Supply Curve
28
18
45
$
Q11.210.38.6
ATC
AVC
Firm Supply CurveMC
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Now let’s look at the demand for a single
input: Labor
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Key Input RelationshipsThe following input-related derivations play
key roles in determining amount of variable input to use to maximize profitsMarginal Value Product (MVP) =
MPP × Product Price MPP → ∆Output ÷ ∆Input Use Product Price → ∆Revenue ÷ ∆Output MVP → ∆Revenue ÷ ∆Input Use
(Additional output value generated by the last increment in input use)
Marginal Input Cost (MIC) = wage rate, rental rate, seed cost, etc. Page 100
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Page 101
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MVP=MPP x Output Price
Wage rate islabor’s MIC
I
D
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Page 101
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Profit maximizing input use ruleUse a variable input up to the
point where Value received from another
unit of input (MVP) Equals cost of another unit of
input (MIC)→ MVP=MIC
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Page 101
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The area below the green lined MVP curve and above the red lined MIC curve represents cumulative net benefit
The area below the green lined MVP curve and above the red lined MIC curve represents cumulative net benefit
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Page 100MVP = MPP × $45MVP = MPP × $4566
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Page 100Profit are maximized where MVP = MICor where MVP =$5 and MIC = $5
Profit are maximized where MVP = MICor where MVP =$5 and MIC = $5
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Page 100
Marginal net benefit (Col. 5) = MVP (Col. 3) – labor MIC (Col. 4) = Value of additional output from last unit of input net of the cost of that input
Marginal net benefit (Col. 5) = MVP (Col. 3) – labor MIC (Col. 4) = Value of additional output from last unit of input net of the cost of that input
=–
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Page 100
The cumulative net benefit (Col. 6) of input use = the sum of successive marginal net benefits (Col. 5) = the grey area in previous graph.
The cumulative net benefit (Col. 6) of input use = the sum of successive marginal net benefits (Col. 5) = the grey area in previous graph.
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Page 100
For example…$25.10 = $9.85 + $15.25$58.35 = $25.10 + $33.25
For example…$25.10 = $9.85 + $15.25$58.35 = $25.10 + $33.25
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Page 100
=–
Cumulative net benefit is maximized where MVP=MIC at $5
Cumulative net benefit is maximized where MVP=MIC at $571
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Page 101
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If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.
If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.
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Page 101
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If you use labor beyond the point where MVP =MIC, you begin incurring losses as the return to another unit of labor is < $5.00, its per unit cost
If you use labor beyond the point where MVP =MIC, you begin incurring losses as the return to another unit of labor is < $5.00, its per unit cost
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A Final ThoughtOne final relationship needs to be made. The levelof profit-maximizing output (OMAX) in the graph on page 99 where MR = MC corresponds directly withthe variable input level (LMAX) in the graph on page 101 where MVP = MIC.
Going back to the production function on page 88,this means that:
OMAX = f(LMAX | capital, land and management)
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In Summary…Features of perfect competitionFactors of production (Land, Labor,
Capital and Management)Key decision rule: Profit maximized at
output MR=MCKey decision rule: Profit maximized
where MVP=MIC
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Chapter 7 focuses on the choice of inputs to use and products to produce….
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