TM – 1

THE FIRM’S PROBLEM

• The firm wants to MAX PROFIT subject to
a COST CONSTRAINT.
• Equivalently stated, the firm wants to
MINIMIZE COST subject to an OUTPUT
constraint.
• (Ceteris paribus) The FIRM faces GIVEN
resources, PRICES of FACTOR INPUTS
• It operates in 2 markets—goods and factor
markets.
McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.
TM – 2

TOTAL COST (TC)

• FIXED COST + VARIABLE COST = TC
• FIXED COST (FC)-Costs incurred by firm
even if no output is produced. E.G., rent
for space, interest payments on debts, etc.
Also called ”OVERHEAD” or “SUNK”
costs.
• VARIABLE COST (VC)-Costs which vary
as output changes. E.g., materials,
workers, power, etc.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 3

MARGINAL COST
• MARGINAL COST (MC)-the EXTRA cost
of producing one EXTRA unit of output.
• It is measured as the change in TC divided
by the change in Q
• It is the slope of the TC curve.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 4 Chapter 7
Figure 7-2

All Cost Curves Can Be Derived from

the Total Cost Curve

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 5 Chapter 7
Figure 7-1

The Relationship between Total Cost

and Marginal Cost

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 6

AVERAGE COST (AC)

• AVERAGE COST (AC) is Total Cost per
unit of output or UNIT COST.
• It is measured as TC divided by Q.
• It is the SUM of AVERAGE FIXED COST
and AVERAGE VARIABLE COST.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 7

• AVERAGE FIXED COST (AFC) is fixed

cost per unit of output or FC divided by Q.
• It is the ONLY curve that should be
declining continuously as Q rises under a
competitive system. “SPREADING THE
OVERHEAD”
• AVERAGE VARIABLE COST (AVC) is
Variable cost or VC divided by Q.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 8

• When MC > AC, AC is pulled up.

• When MC < AC, AC is pulled down.
• When MC = AC, AC is neither rising nor
falling and is at its MINIMUM. Hence, at
the bottom of a U-shaped AC,
MC=AC=MINIMUM AC.
• REMEMBER story about the average
height of people in a room

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 9

DIMINISHING RETURNS to the

Variable Factor of Production
• The MARGINAL PRODUCT of LABOR
CURVE first rises, then peaks at B and
then starts falling. NOTE that as more and
more units of the VARIABLE FACTOR are
used, its MP starts to fall, i.e., the relatively
abundant factor experiences diminishing
returns (adds less and less to total output)
because other factors of production are
fixed.
McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.
TM – 10 Chapter 7
Figure 7-4a

Diminishing Returns and

U-Shaped Cost Curves

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 11 Chapter 7
Figure 7-4b

Diminishing Returns and

U-Shaped Cost Curves

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 12

• What the two previous graphs show is that

the region of increasing marginal product
corresponds to falling marginal costs,
while the region of diminishing returns
implies rising marginal costs.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 13

What is the significance of having U-

shaped Cost Curves?
• If cost curves did not eventually turn up,
i.e., if they were not U-shaped, perfect
competition would break down. Think of a
firm with a cost curve that declines forever
as more output is produced. That firm
would soon dominate the industry.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 14

EQUILIBRIUM CONDITION
• LEAST-COST RULE-To produce a given
output at least cost, a firm should buy
inputs until it has equalized the MP per
peso of a factor of production with the MP
per peso of any other factor of production.
• MPL/P of labor=MPK/ P of capital etc.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 15

Graphical Representation of
Producer Equilibrium
• We will now use a graphical
representation of producer equilibrium akin
to indifference curves and budget lines for
the utility-maximizing consumer.
• REMEMBER that the producer is trying to
MIN COST subject to an OUTPUT
CONSTRAINT.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 16 Appendix 7A
Figure 7A-1

Equal-Product Curve or
ISOQUANT

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 17

ISOQUANT
• The Equal Product Curve is called an
ISOQUANT. It is analogous to the
indifference curve for the consumer.
• NOTE that on the AXES of the
ISOQUANT are TWO INPUTS or
FACTORS OF PRODUCTION.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 18

ISOQUANT
• NOTE also that the technical recipe
determines the combinations of the two
INPUTS or factors of production able to
produce SAME level of OUTPUT.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 19 Appendix 7A
Table 7A-1

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 20

SHAPE of an ISOQUANT
• The SHAPE of an ISOQUANT is CONVEX
to the origin because of the LAW of
DIMINISHING MARGINAL
PRODUCTIVITY.
• WHY? As one input is increased while all
other inputs are HELD CONSTANT, the
MP of the VARYING INPUT will start
declining after some point.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 21

SLOPE of an ISOQUANT
• The SLOPE of an ISOQUANT is the
MARGINAL RATE OF TECHNICAL
SUBSTITUTION (like MRS in consumer
theory).
• In our example here, it is the ratio of the
MP of labor to the MP of land. (Note that
labor is on the horizontal axis).

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 22

BUDGET or EQUAL COST

LINES
• GIVEN: PRICES of the TWO FACTORS
OF PRODUCTION or INPUTS and TECH.
• How much will it cost to produce a
particular level of output? Note that there
are different combinations of the two
inputs that can be used to produce the
SAME LEVEL of OUTPUT (i.e., This is
what the ISOQUANT tells us).

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 23 Appendix 7A
Figure 7A-2

Equal-Cost Lines

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 24

SLOPE of a BUDGET or EQUAL

COST LINE
• Note that the slope of a Budget or Equal
Cost line is constant. It is equal to the
RATIO of the PRICES OF THE TWO
INPUTS, i.e., PRICE of LABOR / PRICE of
LAND, when labor is on the horizontal
axis.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 25 Appendix 7A
Table 7A-2

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 26

When will the slope of a budget

line change?
• If the price of one factor of production
changes so that the ratio of the factor
prices is no longer the same, the EQUAL
COST LINE will pivot i.e., the slope of a
budget line will change because price of
one input changed and therefore, the ratio
of the prices of the two inputs will be
different from before.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.

TM – 27 Appendix 7A
Figure 7A-3

Least-Cost Input Combination Comes at C

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All Rights reserved.