Lesson 3: Firm behavior.

1. Firm profits: revenues and costs.

The objective for firms is to maximize profits. Their problem is about choosing the combination of
imputs that minimize the cost of producing on output. Let us consider a firm that produces good x,
and sells it in the market at a price P. The firm obtains revenues (R(x)). Producing x implies a cost
(C(x)). Then, the maximization problem of the firm is: Max R( x )− C ( x )
Revenues are: R(x )=P ( x ) x . It isn't so simple because the price of a good depends on the
market structure a firm is competing in (in a monopoly, the firm has more power chossing the price
than in a perfect competitive market).

2. Technology. Returns to scale.

The production set.
The production set of a firm is given by:
– Factors of production: which are the inputs to production. Factors of production are usually
classified into categories. In our analysis, we will exclusively consider two inputs: L (labor)
and K (capital). Capital goods are those inputs to production that are themselves produced
goods
– Production function: f (·). Nature imposes technological constraints on firms: Only certain
combinations of inputs are feasible ways to produce, and the firm must limit itself to
technologically feasible production plans.
The production set is the set of all combinations of inputs and outputs that comprise a
technologically feasible way to produce. To say that the point (z, x) is in the production set means
that it is technologically possible to produce x amount of output if you have z amount of input. The
production set shows the possible technological choices facing a firm. The function describing the
boundary of this set is known as the production function. It measures the maximum possible output
that the firm can get from a given amount of input z.

Difference between the short run and the long run.

We distinguish between the production plans that are immediately feasible and those that are
eventually feasible.
– In the short run (S/R), there will be some factors of production that are fixed at some levels.
– On the other hand, in the long run (L/R), all factors can be changed.
Marginal product and average product.
∂x
Marginal product of factor L: MPL=
∂L
Average product or productivity: is the total output divided by the number of units of factor of
production we use. Productivity is determined by the technology.
 x
Average product of factor L (Productivity): APL= Productivity=
L
The Law of Diminishing Marginal Product is an economic principle that states that while increasing
one input and keeping other inputs at the same level may initially increase output, further increases
in that input will have a limited effect, and eventually no effect or a negative effect, on output. That
is, there is always a cutoff point such that beyond that point, the marginal product of that input starts
to decrease. This means that beyond that point, the production function turns concave. It is because
during the way of the function, the derivative of the MPL changes (that is the second derivative of
the function with respect to L). There are three cases if:
– d 2x dL 2> 0 ⇒ convex technology, MPL increasing.
2x 2
– d dL =0 ⇒ linear technology, MPL constant.
2x 2
– d dL < 0 ⇒ concave technology, MPL decreasing.

Production function in the short run.

In the short run, the firm has only one factor that can vary (L), representing the technology:
x= f ( L , K )
Production function in the long run.
In the long run, all the factors of production can be varied. The production function f (L,K )
measures the maximal amount of output x that the firm could get if it had L units of labor and K
units of capital.
– Isoquant: it is the set of all possible combinations of inputs L and K that are just sufficient to
produce a given amount of output x.
– Technical rate of substitution (TRS) between L and K : it measures the rate at which the firm
is willing to substitute one input for another in order to keep output constant. The technical
rate of substitution is the slope (in absolute value) of the isoquant. It has a negative slope
because a positive one, don't make sense because with more capital of both imputs you must
produce more, not the same.

∂ x( L, K)
∂L dK
TRS= =
∂ x ( L , K ) dL
∂K

0=∆ x=MPL· ∆ L+ MPK · ∆ K

− ∆ K MPL
=
∆L MPK

− dK MPL
TRS= =
dL MPK
The COBB-DOUGLAS production function.

x= f ( L , K )=Lα K b , 0< α< 1

Then, the Cobb-Douglas isoquants have the nice, well-behaved shape that the Cobb-Douglas
indifference curves have. The Cobb-Douglas production function presents some characteristics:
∆ x ∂ x(L , K ) a −1 b
– Marginal product: MPL= = MPL=a L K
∆L ∂L
MPL' =a (a−1) La−2 K b
• MPL' > 0 when a > 1 ⇒ MPL increasing ⇒ convex technology.
• MPL' = 0 when a = 1 ⇒ MPL constant ⇒ linear technology.
• MPL' < 0 when a < 1 ⇒ MPL decreasing ⇒ concave technology.
– Elasticity: We define elasticity of L as the elasticity of the output x to the use of the imput L.
∂x L a−1 b L a−1 b L (a−1+ 1−a)
E= ⋅ E=a L K =a L K a b =a L =a
∂L x x L K
So, if I increases L in 1%, x is going to increases in a%.
– Returns to scale: If we increases in 1 unit the factors of production, what happen to the total
production? It is similar to the MPL, but for the long run. But I dont change L or K, I change
both in the same proportion. In conslusion, it is important to distinguishes between two
concepts:
• Marginal product: it tells us how much more output we get when we increase in one
marginal unit the use of one factor of production.
• Returns to scale: it tells us how much more output we get when we increase the use of
all factors of production in the same scale.
We are going to call the increase in L and K, “t”. So there are three cases:
• Constant returns to scale: ∀ t> 1 f (t L , tK )=t f ( L , K )
When you increases your size you are better off (specialization, division of work,
efficiency gains...)
• Increasing returns to scale: ∀ t> 1 f (t L , tK )> t f ( L , K )
It is the most common.
• Decreasing returns to scale: ∀ t> 1 f (t L , tK )< t f (L , K )
When you increases your size you are worse off (monotoring and control becomes more
difficult).

3. Derived factor demands.

Cost minimization in the short run.
We will break up the profit maximization problem into two pieces:
– First, we will look at the problem of how to minimize the cost of producing any level of
output.
– Then, we will look at how to choose the most profitable level of output.
The minimum cost function: it is the minimum cost necessary to achieve a given level of output,
C(x). The firm wants to know the minimum cost necessary to achieve a desired level of output. In
the short run there is only one factor of production that the firm can change, L. So the problem is as
follows:
– min wL+ rK
– s.t. x= f ( L , K )
Where w and r are the prices of L and K. In the short run, the level of capital is fixed (we denote it
by K). Then, all it has to do is to solve for L in: x= f ( L , K )
The choices of inputs that yield minimal costs for the firm in the short run is called the conditional
factor demand or derived factor demand in the short run:
LD( x , K ) K D =K
Once we know the conditional factor demand, obtaining the (minimum) cost of producing x in the
short run is straightforward.
C min s /r ( w , r , x , K )=wL D (x , K )+ rK

Cost minimization in the long run.

The firm wants to know the minimum cost necessary to achieve a desired level of output x, having
now full flexibility to vary any of its factors of production L and K. We can write this problem as:
– min wL+ r K
– s.t. x= f ( L , K )
The graphical representation of this problem in the long run i composed of:
– Isoquant: combinations of inputs L and K that are just sufficient to produce a given amount
of output x.
– Isocost: combinations of inputs L and K that imply a given level of cost C, where:
C=wL+ r K
In order to depict an isocost line, we solve for K:
C w
K= − L
r r
This is a straight line with a slope of − w/r and a vertical intercept of C/r. As we let the number C
vary, we get the whole family of isocost lines. The problem of cost minimization in the long run
implies to find the point in the isoquant that has the lowest associated isocost curve:

At the optimal position (L*, K * ) the isoquant and the isocost are tangent. This means:
∂x
∂ L MPL w
TRS= = = x= f ( L∗, K ∗)
∂ x MPK r
∂K
The choices of inputs that yield minimal costs for the firm will in general depend on the input prices
and the level of output that the firm wants to produce. These are called the conditional factor
demand or derived factor demand in the long run.
D D
L ( w , r , x) K (w , r , x)
Then, the (minimum) cost of producing x in the long run is:
C min l /r (w , r , x)=wL D (w , r , x )+ r K D (w , r , x )

4. Cost curves in the short and the long run.

There are two types of costs:
– Fixed costs (FC): costs that must be paid regardless of what level of output the firm
produces.
– Variable costs (VC(x)): are costs that change when output changes.
While in the short run there are both, in the long run there are no fixed costs.
Cost curves in the short run.
The total cost (or costs) of a firm in the short run can always be written as the sum of the variable
costs and the fixed costs: C (x )=FC + V C ( x)
There are some important definitions:
– Average cost (AC(x)): measures the cost per unit of output.
– Average fixed cost (AFC(x)): measures the fixed costs per unit of output. This is always
decreasing.
– Average variable cost (AVC(x)): measures the variable costs per unit of output.
C ( x ) FC VC ( x)
AC ( x)= = + = AFC ( x)+ AVC ( x)
x x x
– Marginal cost (MC(x)): measures the change in costs when output increases in one marginal
unit.
dC ( x) dFC dVC ( x) dVC ( x )
MC (x )= = + =
dx dx dx dx
Relationship between the MC(x) and the AC(x).
x* is the level of output that minimizes the average cost of producing a certain good x. At x* we
have that:
dVC (x ) FC + VC ( x)
MC ( x )= = = AC (x )
dx x
That is, at the level of production x* that minimizes the average cost, the marginal cost is equal to
the average cost. We can prove that at the level of production x* that minimizes the average
variable cost, the marginal cost is equal to the average variable cost. Additionally, since x* is the
minimum of the average cost AC (x*), it also holds:
dAC⋅( x)
– ∀x < x* : < 0 ⇒MC ( x)< AC ( x )
dx
dAC⋅( x)
– ∀x > x* : > 0 ⇒MC ( x)> AC ( x )
dx
The average cost function, AC (x), first decreases (due to the existence of decreasing average fixed
costs), and then increases (due to the existence of increasing average variable costs). The marginal
cost function, MC (x) crosses both the average cost function, AC (x), and the average variable cost
function, AVC (x), at their minimum.
Cost curves in the short run and the marginal product of labor.
We analyze the relationship between the production function (thus the marginal product of the
variable factor of production) and the cost curves in the short run. Both, the cost curves and the
production function, represent the technology of the firm. Hence, there is a close relationship
between these concepts:

If the production function is convex in L ⇒ The cost function is concave in x:

If the production function is lineal in L ⇒ The cost function is lineal in x:

If the production function is concave in L ⇒ The cost function is convex in x:

If the production function is convex (MPL increasing) ∀L ≤ L and concave (MPL decreasing) ∀L ≥
L ⇒ The cost function is concave ∀x ≤ x and convex ∀x ≥ x.

Cost curves in the long run.

In the long run, all the factors of production can be varied. There are no fixed costs. Thus, the least
profits a firm can make in the long run are zero profits. There are differents costs:
– Long run total cost (c(x)): is the total cost of producing an output level x, given that the firm
is allowed to adjust its plant size optimally.
– Long run average cost (ac(x) = c(x) x ): is the long run total cost per unit of output.
– Long run marginal cost (mc(x) = dc(x) d x ): is the change in the long run total cost when
output increases in one marginal unit.
Let us consider a firm that, in the short run, has a plant size of K =K . The short run costs are:
Cs/r (x, K). For any given level of output, there will be some plant size that is the optimal size to
produce that level of output. The long run cost function of the firm is just the short run cost function
evaluated at the optimal choice of the fixed factors: Cl/r (x, K'(x)). If we pick some level of output
x, the optimal plant size for that level of output is K' (x). When, K' (x) = K , then:
Cs/r (x , K )=Cl /r ( x , K ' ( x))
We say that the long run cost curve is the lower envelope of the short run cost curves.
The long run average cost curve is the lower envelope of the short run average cost curves.

Cost curves in the L/R and returns to scale.

There is a close relationship between the long run average cost curve and the returns to scale. It is
the following:
– Constant returns to scale ⇒ ACl/r (x) constant.
– Increasing returns to scale ⇒ ACl/r (x) decreasing.
– Decreasing returns to scale ⇒ ACl/r (x) increasing.