Question

1.Define and draw the firm’s production function.
1a. What determinants allow a firm to expand.
1b. Explain why a profit maximizing competitive firm would produce up to the point where price equals marginal costs.

Answer 1

The production function of a firm shows the level of output that can be obtained using the combination of inputs like labor and capital. It is an equation that shows the relationship between the level of output and the units of factors of production like labor and capital used for obtaining it. It is given by the following formula:

Q = f (L,K)  

This equation shows that the level of output is a function of the inputs used for production.

Here, Q is the level of output

L is labor employed

K is the capital used

This is the diagram of the production function.

1a.

The determinants that allow a firm to expand are:

a. Market power: The firm should have some market power in a way that it can change the prices of the goods being sold to increase its profit margin. An increase in profit helps the firm to expand.

b. Inelastic demand: If the demand for the good is inelastic, then the price increase/decrease won't much affect the quantity demanded and the profits will increase.

c. Business strategies to increase the market share of the goods will lead to the expansion of the firm.

d. Government aid: In the form of subsidies or tax cuts that can help the firm to expand.

e. Lower cost of raw materials: When the raw materials are available at an affordable cost then the firm will increase their purchase and that will lead to increase in the output level which will expand the firm.

1b.

The profit-maximizing level of output is determined at the point where the Marginal revenue = Marginal cost. Marginal revenue is the additional revenue obtained from an extra unit of output sold. Marginal cost is the additional cost incurred from an extra unit of output produced. When MR>MC, the additional revenue>additonal cost incurred for the product, and thus it will be profitable to increase the output to the level where MR=MC. When MC>MR, the additional cost incurred>additional revenue generated for the product, and thus it will be profitable to decrease the output to the point where MR=MC. Thus, MR=MC is the only point that maximizes profit.

In perfect competition, price=average reveue= marginal revenue. Hence, the profit-maximizing level of output is obtained at the point where the Price =marginal revenue = marginal cost.