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Chapter 7_Micro - Chapter 7 The Production Process The...

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7 Chapter The Production Process: The Behavior of Profit-Maximizing Firms
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2 Overview The Behavior of Profit Maximizing Firms Profits and Economic Costs Short-Run versus Long-Run Decisions Choices of Firms Assumptions of Perfect Competition The Bases of Decisions The Production Process Production Functions Choice of Technology
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3 THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS All firms take raw materials, labor, electricity, machines, land, etc (inputs) and uses and/or transform these to make another good or service (output). Goal of firm: To maximize profits.
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4 THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS profit (economic profit) The difference between total revenue and total (economic) cost. Total Revenues: The amount received from the sale of the product =P*q total (total economic) cost: 1. out-of-pocket costs (Explicit Costs/Accounting Costs) refer to costs of labor, materials, machinery, interest on loans etc 2. opportunity cost of factors of production that do not involve direct out of pocket costs (Implicit costs) The term profit will from here on refer to economic profit which is total revenues –total economic costs.
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5 THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS Opportunity costs of factors of production (Implicit Costs) Example: If a restaurant employs three family members who are not being paid a wage, must include the wages they could have earned if they were working elsewhere. Example: If you own your own building and use it for your business, must also include what you could have earned if you rented it out Example: If you had to invest some of your own money in buying equipment, machinery, buildings, you want to include what your investment would have earned if it had been invested in the next best alternative of comparable risk. Opportunity cost of capital is calculated as a normal rate of return on capital.
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6 THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS normal rate of return A rate of return on capital that is just sufficient to keep owners and investors satisfied. The normal rate of return depends on the riskiness of the investment. Riskier investments are required to promise a greater return. For relatively risk-free firms, the normal rate of return should be nearly the same as the interest rate on risk-free government bonds.
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7 THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS Example (calculating normal rate of return): If you invested $100,000 to start a small restaurant. Assuming that the rate of return of an equally risky investment was 12%, a normal return on the investment is 12%*$100,000=$12,000. This should be included in part of the total economic costs.
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8 THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS Example 7.1: Sue and Ann decide to start a business selling belts at the mall. Their business venture requires an initial investment in a pushcart which costs $20,000. An equally risky investment would earn an annual return of 10%.
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