Unit 4 - Business Production Behavior l Factors of Production The three factors of production are: 1.Land (including all natural resources) 2.Labor (manual, managerial, entrepreneurial) 3.Capital goods (machines, equipment, buildings) Microeconomics

Unit 4 - Business Production Behavior l Factor Prices Prices of factors of production are:  Wages (payment for labor, including salaries and commissions)  Rent (payment for the use of land)  Interest (payment for the use of capital goods)  Profits (payment for entrepreneurship) Microeconomics

Unit 4 - Business Production Behavior l Production Functions A production function is a relationship between inputs (factors of production) and outputs (production). Microeconomics

Unit 4 - Business Production Behavior l Production Functions In the table on the next slide, we look at a simple production function. We vary the number of workers, or labor (variable input), and keep the units of machinery constant (fixed input). Microeconomics

Unit 4 - Business Production Behavior Microeconomics LaborUnits of Machinery Production

Unit 4 - Business Production Behavior l Production Functions Marginal production is the additional production per worker. Adding this in the table, we get (see next slide): Microeconomics

Unit 4 - Business Production Behavior LaborUnits of Machinery ProductionMarginal Production

Unit 4 - Business Production Behavior l Production Functions In the table on the previous slide, marginal production decreases after the 3 rd worker. Adding a variable input to a fixed input eventually results in decreasing marginal production. This is the law of diminishing marginal production. Microeconomics

Unit 4 - Business Production Behavior l Production Functions The next slide shows a production function in which the number of workers increases by more than 1. Note that marginal production is the change in total production divided by the change in the number of workers, or: Q / L Microeconomics

Unit 4 - Business Production Behavior LaborUnits of Machinery ProductionMarginal Production

Unit 4 - Business Production Behavior l Production Functions Average production is the production per worker, or total production divided by the number of workers. Question: In the previous table, what is average production when the number of workers is 10? Microeconomics

Unit 4 - Business Production Behavior l Production Functions Answer: Total production = 30, so average production = 30 / 10 = 3 Microeconomics

Unit 4 - Business Production Behavior l Short Run versus Long Run The short run is the period of time during which a firm is unable to change all of its factors of production (it has at least one fixed input). The long run is the period of time during which a firm can change all of its factors of production. Microeconomics

Unit 4 - Business Production Behavior l Production and Costs A firm’s production and costs are directly related. Let’s say that a firm employs 10 workers, and 2 units of machinery, and produces 30 products per week. Each worker costs $500 per week. Each machine costs $800. What are the firm’s total and average costs? Microeconomics

Unit 4 - Business Production Behavior l Production and Costs The cost of labor is 10 x $500 = $5,000. The cost of the machinery is 2 x $800 = $1,600. Total cost is $5,000 + $1,600 = $6,600. Average cost (cost per product) is $6,600 / 30 = $220. Microeconomics

Unit 4 - Business Production Behavior l Production and Costs l See Unit 4, Section 3 for additional examples of the relationship between production and costs. Microeconomics

Unit 4 - Business Production Behavior l Nominal and Real Factor Prices Nominal prices are the actual values charged by the factor supplier. Real prices are adjusted for inflation. For example, if a bank charges 10% interest on a loan, and inflation is 6%, then the real interest rate on the loan is 10% minus 6%, or 4%. Microeconomics

Unit 4 - Business Production Behavior l Factor Prices In a free market, factor prices are determined by the demand for and the supply of the factor of production. For example, interest rates are determined by the demand for and the supply of loans. Microeconomics

Unit 4 - Business Production Behavior l Interest Rates I n the next diagram, the equilibrium interest rate is 8%. Microeconomics

Unit 4 - Business Production Behavior l Interest Rates If the demand for loans increases, then the interest rate increases: Microeconomics

Unit 4 - Business Production Behavior l Interest Rates and Present Value Because of interest, the value of money increases over time. $1,000 today is not the same as $1,000 one year from today. The present value of a future sum of money is: PV = F / (1 + i) Microeconomics n

Unit 4 - Business Production Behavior l Interest Rates and Present Value Example 1 Someone promises to pay you $1,000 one year from today. How much is it worth to you today? Assume that the interest rate is 6%. Answer: PV = F / (1 + i) PV = $1,000 / (1 +.06) = $1,000 / 1.06 = $ Microeconomics n 1

Unit 4 - Business Production Behavior l Interest Rates and Present Value Example 2 Someone promises to pay you $5,000 five years from today. How much is it worth to you today? Assume that the market interest rate is 8%. Answer: PV = F / (1 + i) PV = $5,000 / (1 +.08) = $5,000 / 1.47 = $ Microeconomics n 5

Unit 4 - Business Production Behavior l Interest Rates and Present Value Example 3 Let’s say that a house appreciated in value by 4% each year over the past 80 years. If the house is worth $500,000 now, what was the value 80 years ago? Microeconomics

Unit 4 - Business Production Behavior l Interest Rates and Present Value Example 3 answer: PV = FV / (1 + i) PV 80 years ago = FV (now) / (1 +.04). PV = $500,000 / = $21,692. Microeconomics n 80

Unit 4 - Business Production Behavior l Factor Prices Another factor price is the wage rate. The equilibrium wage is determined by the demand for and the supply of labor. Microeconomics

Price of Labor Quantity of Labor Demand for Labor Supply of Labor $7.00 1,000 Unit 4 - Business Production Behavior

l Factor Prices Some factor prices are determined by the government, not by demand and supply. For example, in the next slide, the market wage is $7, but a minimum wage of $9 is set by the government. Microeconomics

Price of Labor Quantity of Labor Demand for Labor Supply of Labor $7.00 1,000 Unit 4 - Business Production Behavior $9.00 Unemployment

Unit 4 - Business Production Behavior l Factor Prices Advantages of a minimum wage set above the free market wage are:  More income for the minimum wage earners that are able to maintain their job.  More incentive for people to work.  Possibly greater job satisfaction and lower job turnover. Microeconomics

Unit 4 - Business Production Behavior l Factor Prices Disadvantages of a minimum wage set above the market wage:  Decrease in the quantity demanded for labor.  Higher production costs and lower profits.  Higher prices.  Less money for benefits and training.  Decrease in exports due to higher prices. Microeconomics

Unit 4 - Business Production Behavior l Factor Prices Government-set prices that are different from the market price may have social benefits for some groups, but lead to economic inefficiencies (surpluses, shortages, higher prices, unemployment). Microeconomics

Unit 4 - Business Production Behavior l Factor Prices A minimum wage raises the nominal wage, but not the real wage. Question: How can we achieve higher real wages without government intervention? Microeconomics

Unit 4 - Business Production Behavior l Factor Prices Answer: By raising productivity. Question: What raises productivity? Microeconomics

Unit 4 - Business Production Behavior l Factor Prices Answer: An economic system that rewards hard work and innovation. Question: What kind of economic system rewards work and innovation? Microeconomics

Unit 4 - Business Production Behavior l Factor Prices Answer: An economic system in which a government provides essential services (infrastructure, a legal system, defense, and protection of private property), and that has relatively low taxes and limited regulations. This encourages production and innovation. Microeconomics