PRODUCTION AND COSTS THE PROFIT-MAXIMIZING ASSUMPTION. Why is any firm in business? Most people would immediately answer

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1 which add to their costs, but do not earn revenue. These programs she can still sell as many pizzas as she can make, she goes on change as output changes. In other words, she needs more of them change as output increases. very useful assumption. It is the basis on which we can predict strive to earn the highest possible profits possible. This is a make a profit. Economists generally assume that businesses answer, clearly, is no. Some businesses are run as non-profit as she increases production. He store and equipment or plant (ovens, cash register, etc.) are fixed resources. They do not But is maximum profit always the objective of all businesses? The and what types of workers they will employ, and how they will determine the quantity of resources firms will purchase, how many determine their production output. firm depends on making profits and avoiding losses. baking the pizzas. As a result of this elementary division of support the objectives of good customer or employee relations, in inputs always ensure an increase in output? Let s investigate product - producing 295 pizzas a day. uses as she increases production are variable resources. They The production function refers to the relationship between a firm s The workers (and the additional ingredients, toppings, etc.) Petra by considering a hypothetical firm - THE PRODUCTION FUNCTION Profit, therefore is not the only business objective. However, no stability, and long-term growth. Other businesses that do aim to make a profit may also offer enterprises, which aim to earn only enough revenue to cover costs. other words, based on the profit-maximizing assumption, we can Pizza Parlour. Petra s Pizza Parlour is a take-out pizza outlet producing only one tasks. One takes the orders and cash, boxes the hot pizzas, and hiring additional workers until she has 11 employees and is worker. Each worker is then able to specialize in particular At first, Petra hires one worker who is able to produce and sell 30 cm. pizzas with pepperoni, pineapple, and anchovies. scholarships, support for the arts, or employee day-care services inputs (or factors of production) and its output. Does an increase pizzas a day. Knowing that she can sell more, Petra hires a second make in terms of what, how, and for whom they will produce. In - to 75 THE PROFIT-MAXIMIZING ASSUMPTION Why is any firm in business? Most people would immediately answer Petra s PRODUCTION AND COSTS business behaviour, it tells us what decisions businesses will business can ignore the need to make a profit. The survival of the gives them to the customer; the other specializes in preparing and labour, Petra s total daily output increases to 70 pizzas. Since

2 page 2 TOTAL, MARG I NAL, AND AVERAGE PRODUCT Study the table below. NUMBER OF WORKERS OR TOTAL QUANTITY PRODUCED NUMBER OF PIZZAS AVERAGE NUMBER OF PIZZAS UNITS CF A VARIABLE OR TOTAL PRODUCT PRODUCED BY EACH PRODUCED DY EACH WORKER FACTOR OF PRODUCTION) {Q) ADDITIONAL WORKER OR OR AVERAGE PRODUCT (N) MARGINAL PRODUCT (AP) (MP) D B IC 29) Ii 295 Column 2 shows that as more workers are hired, the total number of pizzas produced, or the total product, also increases. The additional output that comes from each addition of a variable resource (such as labour) is known as the marginal product. The marginal product is calculated by the following formula: Marginal Change ( ) in quantity oroduced (0) Product = Change (4 ) in the variable factor (MP) of production (N) MP = (A )0 (4)N Calculate the Marginal Product for each additional worker added by Petra. You will notice that with two extra workers, output increases to 70 pizzas, as the one extra worker accounts for an additional 40 pizzas. With three workers, the extra worker accounts for SO additional pizzas. The fourth worker accounts for 60 additional pizzas. The marginal product for Petra s Pizza Parlour rises at an increasing rate up to four workers. After four workers, however, it decreases - declining from 40 pizzas with the fifth worker to 2 pizzas with the eleventh worker.

3 product, average product the variable factor) product is less than product is positive, the product will fall. marginal average product, average negative greater than average will rise. When marginal When marginal product is worker up to the fourth worker. Then, it begins to decline. We can see that the average product also increases with each new Calculate the Average Product for each additional worker added by decreasing. product must be Petra. the increasing. When total product is total product must be As long as the marginal AP=Q Average Product CAP) = Total Product (0) The average product is the total product per worker (or per unit of Number or workers (N) page 3 pizza per day will appear on the y-axis. Pizza. Number of workers will appear on the x-axis and output of Create a graph of total, marginal, and average product for Petra s Marginal Product and Average Product - Marginal Product and Total Product - RELATIONSHIP AMONG MARGINAL, TOTAL, AND AVERAGE PRODUCT worker declines. product continues to rise, the marginal product of each additional and the ovens, for example. Efficiency decreases and though total each other s way. They will have to wait to use the cash register added (in this case after four workers), they will start to get in continue forever. After a certain point, as still more workers are marginal product of each additional worker rises. But this cannot As more workers are added to an under-staffed pizza take-out, the the variable resource will decline. point the marginal product attributable to each additional unit of resource (in this case, capital, plant, and equipment), beyond some variable resource (in Petra s case, labour) are added to a fixed The law of diminishing returns state that as additional units of a N LAW OF DIMINISHING RETURNS

4 Figure 7.1 Total, average, and marginal product C t I 0 a 0 curves for Petra s Pizza Total product Point of diminishing 50 marginal productivity Point of diminishing average productivfty Ii Average product 0-50 Marginal product Number of workers This figure shows the information in Table 7.1 graphic ally. The marginal product curve rises up to four workers and then declines, reflecting the law of diminishing returnsr Th margipal product curve cro avera e roduct curve at the oint where avera e production is at a maximum. is is I e of maximu e iciede77whrre the four workers together make the best use of the plant and equipment. The total product curve continues to rise as long as the marginal product is greater than zero. a a0 C NN a

5 (N) (Q) Factor of Production) Output (or units of a Variable Produced or Total Number of Workers Total Quantity Number of Pizzas Average Number of Produced By Each Pizzas Produced By (MP) CAP) Additional Worker or Each Worker or Marginal Product Average Product PETRA S PIZZA PARLOUR

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