# MIT - Principles of Microeconomics - Unit 3. Producer Theory - Lec 8. Introduction to Producer Theory

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PROFESSOR: Now what I'm going to do is, I'm going to turn and start producer theory, OK, which will not be in the exam, but be the next subject to the course.

OK, and we're going to spend a little bit longer on this. So what we've been doing so far is saying, look, we introduced the course with supply and demand curves, elasticities, all that. Hint, all that's on the exam too. OK, and all that.

Then we say, well gee, where do supply and demand curves come from? Well, demand curves come from utility maximization. And we talked about how where indifference curves come from, how the tangency with the budget constraints leads to the demand curve.

That's where demand curves come from. We talked about what underlies demand curves is income and substitution effects.

OK, now let's come to supply curves. What underlies supply curves? Now on the one hand, this will be much easier than demand curves, because a lot of the logic is the same. So we can march more quickly through the analysis, because it's basically the same kind of tangency of curves with straight lines that yield supply curves that we've seen with consumer theory.

On the other hand, supply curves are a ton harder, because now we don't just have the price as given to consumers. The suppliers actually make up the price. With consumers, we said the price — you just went to the store. you're given a price. And you choose what to buy at those prices.

Well, who set those prices? Producers do. And that's what determines the underlying supply curve. So life gets a little bit more difficult with producers. And that's why I'll probably spend about twice as many lectures talking about producer theory as we've spent talking about consumer theory.

Now, let's go to the basics.

The basics are, just as we had consumers making decisions, we thought of a consumer as somebody choosing across a bundle of goods, pizza versus movies, now we're going to

think of a producer very simply as a black box, where inputs go in and outputs come out. So think of the firm. Let's think of a firm, a producer, as just some black box.

We're literally thinking a flow chart. You've got inputs that go in and outputs that come out. And that black box, that firm, just as individuals have a simple goal which is to maximize their utility, producers have a simple goal which is to maximize their profits.

And profits are defined as revenue minus cost. OK? Producers are these black boxes, where their goal is to maximize their profits, which is revenue minus cost. And the key to maximizing profits is efficient production.

The key to maximizing profits is going to be to produce goods as efficiently as possible. OK, so profit maximization requires production efficiency. To maximize your profits, you need to produce as efficiently as possible.

Now, you might ask yourself, gee, I can read about all these companies that have executive corporate jets, and the guys in these lavish lifestyles, and that doesn't seem very efficient production. I'll come back to that.

OK, in a couple of lectures, we'll talk about do firms actually maximize profits, and whether they do or not. But for now, let's take as a given that they do. OK, just as it is a given that consumers maximize utility, let's take as a given that firms maximize their profits. OK?

Now, to decide how to efficiently produce goods, we're going to turn and today discuss firm production functions. OK, today, we'll focus on production functions.

OK, and we're going to spend a little bit longer on this. So what we've been doing so far is saying, look, we introduced the course with supply and demand curves, elasticities, all that. Hint, all that's on the exam too. OK, and all that.

Then we say, well gee, where do supply and demand curves come from? Well, demand curves come from utility maximization. And we talked about how where indifference curves come from, how the tangency with the budget constraints leads to the demand curve.

That's where demand curves come from. We talked about what underlies demand curves is income and substitution effects.

OK, now let's come to supply curves. What underlies supply curves? Now on the one hand, this will be much easier than demand curves, because a lot of the logic is the same. So we can march more quickly through the analysis, because it's basically the same kind of tangency of curves with straight lines that yield supply curves that we've seen with consumer theory.

On the other hand, supply curves are a ton harder, because now we don't just have the price as given to consumers. The suppliers actually make up the price. With consumers, we said the price — you just went to the store. you're given a price. And you choose what to buy at those prices.

Well, who set those prices? Producers do. And that's what determines the underlying supply curve. So life gets a little bit more difficult with producers. And that's why I'll probably spend about twice as many lectures talking about producer theory as we've spent talking about consumer theory.

Now, let's go to the basics.

The basics are, just as we had consumers making decisions, we thought of a consumer as somebody choosing across a bundle of goods, pizza versus movies, now we're going to

think of a producer very simply as a black box, where inputs go in and outputs come out. So think of the firm. Let's think of a firm, a producer, as just some black box.

We're literally thinking a flow chart. You've got inputs that go in and outputs that come out. And that black box, that firm, just as individuals have a simple goal which is to maximize their utility, producers have a simple goal which is to maximize their profits.

And profits are defined as revenue minus cost. OK? Producers are these black boxes, where their goal is to maximize their profits, which is revenue minus cost. And the key to maximizing profits is efficient production.

The key to maximizing profits is going to be to produce goods as efficiently as possible. OK, so profit maximization requires production efficiency. To maximize your profits, you need to produce as efficiently as possible.

Now, you might ask yourself, gee, I can read about all these companies that have executive corporate jets, and the guys in these lavish lifestyles, and that doesn't seem very efficient production. I'll come back to that.

OK, in a couple of lectures, we'll talk about do firms actually maximize profits, and whether they do or not. But for now, let's take as a given that they do. OK, just as it is a given that consumers maximize utility, let's take as a given that firms maximize their profits. OK?

Now, to decide how to efficiently produce goods, we're going to turn and today discuss firm production functions. OK, today, we'll focus on production functions.

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