Diploma Preparatory Course: Microeconomics

Mikhail Safronov

ms2329@cam.ac.uk

Lecture 3

Producer’s Choice

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Producer Theory

The decision making unit is a firm that converts a number of

inputs (e.g., wood, nails, labour) into an output (e.g., chairs).

The firm freely chooses the quantities of each input. Money

spent on these is the cost of production.

The output is sold at the market. Money generated from these

sales is the revenue.

The firm maximises

Profit = Revenue − Cost of Production

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Production function

What made a consumer himself was his preferences.

What defines a firm is its production function, which describes

how much output the firm can produce with a given amount of
inputs.

For example, if firm produces apples using land and labour,

then with the two kinds of inputs
I amount of land, denoted by x1 ,
I amount of labour, denoted by x2 ,
its production function f (x1 , x2 ) is the amount of apples
produced with x1 units of land and x2 units of labour.

Another word for input is factor.

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Characterizing a production function

f captures the firm’s technology, i.e., its ability to convert

inputs into outputs.

Understanding the properties of f helps to understand firm’s

optimal choice.

A safe assumption is that f is weakly increasing in each input.

(Having more of some input doesn’t hurt production.)

But how does increasing inputs change the level of production?

We will look now at two exercises that help to characterize f .

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Returns to scale

A key concept for a firm’s technology (i.e., production function)

concerns its ability to scale up production.

For example, what would be the effect of doubling the amount

of all inputs?

More generally, if t > 1, what is the relationship between

f (x1 , x2 ) and f (tx1 , tx2 )?

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Three special cases

Decreasing returns to scale:

f (tx1 , tx2 ) < tf (x1 , x2 ) for t >1

Constant returns to scale:

f (tx1 , tx2 ) = tf (x1 , x2 ) for t >1

Increasing returns to scale:

f (tx1 , tx2 ) > tf (x1 , x2 ) for t >1

It is likely that whichever property holds will depend on t

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Returns to scale

In reality, most firms seem to have increasing returns to scale

for small amounts of inputs, but decreasing returns to scale
once the firm grows beyond a certain size.
Returns to scale determine the size and number of firms in a
market. Increasing returns to scale usually lead to a market
with a few large firms or a monopolist; decreasing returns to
scale can often result in a market with many small firms.

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Marginal Product

Another key concept for a production function is the marginal

product of a single factor.

Instead of looking at how production scales up, let’s ask how

production increases when we increase only one of the inputs.
Marginal product of the first input at the point where the firm is
using (x1 , x2 ) is the partial derivative:

∂f
MP1 (x1 , x2 ) = (x1 , x2 ) = f1 (x1 , x2 )
∂x1

The marginal product of the second input, denoted MP2 , is

defined analogously.

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Diminishing marginal product

In practice, for most production functions, the marginal product

of an input is eventually (beyond a certain level of production)
diminishing.

If that’s the case, the function f1 (x1 , x2 ) is decreasing in x1 .

To put it formally, we say the marginal product of x1 is

diminishing if
f11 (x1 , x2 ) < 0

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An example: Cobb-Douglas production function

Let f (x1 , x2 ) = x1α1 x2α2 where α1 , α2 > 0. Then

f (tx1 , tx2 ) = (tx1 )α1 (tx2 )α2 = t α1 +α2 x1α1 x2α2 = t α1 +α2 f (x1 , x2 )

If α1 + α2 < 1, then f has decreasing returns to scale.

If α1 + α2 = 1, then f has constant returns to scale.

If α1 + α2 > 1, then f has increasing returns to scale.

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Some features of Cobb-Douglas production
f (x1 , x2 ) = x1α1 x2α2 . How about marginal products?
The marginal product of x1 is

∂f
= α1 x1α1 −1 x2α2
∂x1
Look at the second partial derivative, i.e., f11 :

∂2f
= α1 (α1 − 1)x1α1 −2 x2α2
∂x12

If α1 < 1, then f11 < 0 , i.e., the marginal product of x1 is diminishing.

Likewise, the marginal product of x2 is diminishing if α2 < 1.

Let α1 = α2 = 23 . Both marginal products are diminishing. However,

the production has increasing returns to scale!
Question. If we fix α1 = 23 , for which values of α2 all the above
properties hold?

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Returns to scale and marginal product

It is possible for a firm to exhibit decreasing marginal product in

each input but to have constant or increasing returns to scale.
(example: Cobb-Douglas).
When you increase x1 then production goes up, but the size of
this increase is limited by the fact that x2 is being kept fixed.
The marginal product of x1 is decreasing in x1 . But it could be
that the marginal product of x1 is increasing in x2 .
When we check for returns to scale we increase both x1 and x2 ,
and this causes two effects to operate on this marginal product:
the effect of greater x1 (which reduces this marginal product)
and the effect of greater x2 (which might increase this marginal
product). The same logic applies to the marginal product of x2 .

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Isoquants

Suppose f is a production function with two inputs (factors).

Indifference curves were useful to illustrate a consumer’s

preferences over bundles (x1 , x2 ).

A similar idea is that of isoquants.

The q-isoquant of f is the set of all input bundles (x1 , x2 ) with

which the firm produces exactly q units of the output:

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Factor substitution
The q-isoquant is described by
f (x1, x2) = f (x1 +∆1, x2 +∆2) = q

x2
Note that:
• ∆2 is a function of ∆1
• ∆1 and ∆2 have opposite signs

x2 + ∆ 2

x1 x1+∆1

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Technical Rate of Substitution (TRS)

On the q-isoquant,

f (x1 , x2 ) = f (x1 + ∆1 , x2 + ∆2 ) = q

and as ∆1 → 0, the ratio ∆2 /∆1 captures the firm’s rate of

substitution of factor x2 for x1 .

MP1 (x1 , x2 )
TRS1,2 (x1 , x2 ) = −
MP2 (x1 , x2 )

→ the slope of the line tangent to the isoquant at (x1 , x2 ).

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Optimal choice of inputs and TRS
Suppose the firm is free to choose the amount of each factor.

Say the unit price of factor i is wi .

Which factor offers a better deal per £?

MP1 MP2
That is, which of the following two is bigger: or ?
w1 w2

A non-corner point (x1 , x2 ) cannot be optimal if these values

are different.

Thus, if the firm’s optimal choice of inputs are x1∗ , x2∗ > 0, then

MP1 (x1∗ , x2∗ ) w1

TRS1,2 (x1∗ , x2∗ ) = − = −
MP2 (x1∗ , x2∗ ) w2

Question: Assume MP 1 (x1 ,x2 ) w1

MP2 (x1 ,x2 ) < w2 , and x1 > 0, x2 > 0. Show
that the firm can increase its profit by changing x1 , x2 . 16/50
Question

w1
Suppose TRS1,2 (a1 , a2 ) = − .
w2

Is (a1 , a2 ) the cheapest bundle of inputs to produce f (a1 , a2 )

units of output?

Not necessarily!

Depends on the “shape” of f .

(a1 , a2 ) could be the most expensive bundle of inputs to

produce q = f (a1 , a2 ) units of goods.

Or it could be neither the most expensive nor the least

expensive!

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An isoquant f (x1 , x2 ) = q
x2

T RS1,2(A) = −w1/w2, but A is neither the most

nor the least expensive bundle producing q units.

T RS1,2(B) = −w1/w2, and B is

the most expensive bundle pro-
ducing q units

C x1
C is the cheapest bundle producing q
units, but T RS1,2(C) 6= −w1/w2.
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Another way of putting it
The profit function of the firm is

pf (x1 , x2 ) − (w1 x1 + w2 x2 )

where p is the unit price of the output, and wi is the unit price of
input i.

Assume p does not depend on quantity sold (BIG

ASSUMPTION!). Partially differentiating with respect to xi ,

pfi (x1 , x2 ) − wi = 0

Suppose the firm buys one more unit of xi . It spends wi . The

revenue increases by pfi .
In other words, the marginal revenue of factor i, pfi , equals its
cost, wi .
Hence, if the equation failed, the firm would adjust xi . For
example, if pfi (x1 , x2 ) − wi > 0 - the firm would increase xi . 19/50
 pfi (x1 , x2 ) − wi = 0
Hence, at the optimum,

pfi (x1∗ , x2∗ ) = pMPi (x1∗ , x2∗ ) = wi .

or,
MP1 MP2 1
= =
w1 w2 p
Can use this to find the firm’s optimal solution.

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Case of only one factor
There may be cases when the firm chooses only one factor.
Say, x1 . Respectively, the production function is f (x1 ).
Then, the profit is π(x1 ) = pf (x1 ) − w1 x1 . Same condition for
the optimum: pf 0 (x1∗ ) = w1 .
Can represent it on the picture: draw f (x1 ) - determines
production set, and iso-profit lines: pq − w1 x1 = const.
q

π = π3
π = π2
q = f (x1)
π = π1

x1
x∗1

Need to choose x1 to maximize profit. π = π1 is not optimal.

π = π3 is not feasible. π = π2 - optimal. 21/50
Some comparative statics
Note that on the graph the function f (x1 ) is concave.
Decreasing marginal product!
Isoprofit lines: pq − w1 x1 = const
Can look at what happens if, say, price p of the final product
decreases. New isoprofit lines (red) are steeper, optimal choice
x1∗ decreases.
q

π = π2
q = f (x1)

x1
xnew
1 x∗1

Note we assumed that price p does not depend on q! 22/50

Cost Minimisation

Profit maximisation is closely linked with cost minimisation.

What is the minimal cost of producing q units of good?

That is,

min w1 x1 + w2 x2 such that f (x1 , x2 ) = q

Denote this cost as c(q) - the cost function.

The cost function c(q) will influence the firm’s optimal choice of
production q ∗ .
Certainly, c(q) depends on prices w1 , w2 of inputs, but let’s drop
them from notation.

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Cost minimization - picture
For any level of production q, to determine cost-minimizing
choice (x1 , x2 ), need to find the lowest isocost line that achieves
q.
x2

w1x1 + w2x2 = const

q-isoquant
x1

With diminishing TRS, and assuming interior solution, use

MP1 w1
MP2 = w2 , and f (x1 , x2 ) = q.

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Cost minimization - example

For example, let production function be Cobb-Douglas:

1/3 2/3
f (x1 , x2 ) = x1 x2 .
Assume prices on factors are w1 = 2, w2 = 1. What is the
cost-minimizing way to produce q units of a good?
2/3 1/3
MP1 (1/3)x2 x2 x2
Use MP2 = 2/3 1/3 = 2x1 = 2. Hence, x2 = 4x1 .
x1 (2/3)x1

Substitute into the production function:

1/3
f (x1 , x2 ) = x1 (4x1 )2/3 = 42/3 x1 = q. Hence, the
cost-minimizing choice is x1∗ = q/(42/3 ), x2∗ = 4x1∗ = 41/3 q, and
the cost function is c(q) = w1 x1∗ + w2 x2∗ = [3/(21/3 )]q.
We got a linear cost function. Any relation to production
function?

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Constant returns to scale
Let’s see how the cost function depends on returns to scale.
Let’s first look at a CRS production function:

f (tx1 , tx2 ) = tf (x1 , x2 ) for all t > 1

What is c(q), i.e., the cheapest way of producing q > 1 units?

Constant returns to scale means

f (qx1 , qx1 ) = qf (x1 , x2 ),

which means the firm can produce q units at a cost of qc(1).

Could it do cheaper? No!

Thus c(q) = qc(1) for a CRS technology.

−→ a linear cost function.
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How about increasing returns to scale?

The cost function will grow slower than linearly, because

increasing output by q > 1 times requires less than scaling
inputs up by q times:

c(q) < qc(1)

For example, f (1) = 1, f (2) = 4, w = 1, then c(q = 1) = 1,

c(q = 4) = 2 < 4c(q = 1).

The similar logic implies that in the case of decreasing returns

to scale we must have

c(q) > qc(1).

I.e., the cost of production grows faster than linearly in output.

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Average cost

We can rephrase these statements in terms of average costs.

The firm’s average cost function AC(q) is simply

c(q)
AC(q) = .
q

So, for a constant returns to scale firm, AC is constant and is

equal to c(1).
For an increasing returns to scale firm, we have that AC(q)
decreases with q. For example, if f (1) = 1, f (2) = 4, w = 1,
then AC(1) = 1 > AC(4) = 12 .
Likewise, for a decreasing returns to scale firm, we have that
AC(q) increases with q.

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An Example

Exercise.
√ Consider a production function with a single input:
f (x) = x. The unit price of the input is w = 1.

Does f (x) exhibit increasing or decreasing returns to scale?

Derive its average cost function, AC(q). Is AC(q) increasing or

decreasing?

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“Fixed” costs of production
Spent regardless of how much the firm produces.

These might include

(1) One-off costs necessary for the firm to operate at all

(searching for an appropriate location, legal costs, etc.)

(2) Factors which are not permanently fixed, but might have to
be fixed for a certain while.
(i) E.g., for any production to begin, some machinery might
have to be in place, which means capital spending has to
be above some fixed level K before the firm can produce
anything.
(ii) Or some factors cannot be adjusted quickly, and “in the
short run” the firm might have to hold them constant while
adjusting other factors in response to changes in the
economic environment.
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Fixed Costs vs Variable Costs
In some cases, it is possible and useful to write “fixed costs”
separately from “variable costs":

c(q) = cv (q) + F where cv (0) = 0 and F is a constant

so cv is the variable cost and F is the fixed cost.

The marginal cost function keeps track of the cost of producing

additional units as q varies:

MC(q) = c 0 (q) = cv0 (q)

F has no bearing on the marginal cost.
The average cost at q is the per-unit cost of production, when the
production level is q:

cv (q) F
AC(q) = +
q q

Fixed cost =⇒ AC is relatively high when q is “small”.

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Marginal and average costs

There is an important relation between MC and AC.

Let’s think of a story. Imagine 5 students go on a trip. They
gather all their belongings - which weigh 35 kg - and split the
weight equally among themselves.
Hence, each student carries 7 kg.
Now, imagine that a new student, Bob, joins the trip, and brings
own belongings. The students split the (increased) total weight
equally among the 6 of them.
Did the weight that each student carries, increase or decrease?
Depends on how much Bob brought: if above 7 kg - the weight
increased, if below 7 kg - decreased.
Similar story with MC and AC. AC - how much students were
carrying before Bob. MC - weight of Bob’s belongings.

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MC and AC - picture
The marginal cost always “pulls” the average cost towards it.
On the picture, the AC is initially larger than MC due to high
fixed costs.
MC has a U-shape: marginal product first increases, then
decreases.
Thus, at the point where AC attains its minimum value, the MC
curve intersects the AC curve.

AC, MC

MC
AC

min AC

q
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Average variable costs
Recall the formula for AC:
AC(q) = cv q(q) + Fq
If we do not include fixed costs, the rest is what average
variable cost is:
cv (q)
AVC(q) =
q
AVC lies below AC, and is pulled towards MC. MC crosses AVC
at its minimum. Note: AVC=MC for q = 0 (the first unit).

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An example: f (K , L) = K 1/2 L1/2 with K = 1 fixed
Say wK = wL = 1, and K is fixed at 1.

L units of labour produce f (1, L) = L1/2 units.

For q units of output, the firm needs q 2 units of labour.

1 + q2 1
The average cost function is AC(q) = = + q
q q |{z}
|{z} AVC
AFC

AFC is decreasing, whereas AVC is increasing.

Differentiate AC to get a better feel its behaviour:


d(AC) 1 < 0 until q = 1
=− 2 +1
dq q > 0 after q = 1

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AC, AVC, MC curves for the example

Can we find the firm’s optimal level of output using this graph?

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Short run vs Long run

Before we formulated the cost function c(q), we assumed the

firm optimally chose inputs to minimise cost of production
subject to the condition of producing q units.

In reality a firm’s ability to adjust some inputs may be limited

(e.g., capital), as opposed to other inputs which are easier to
adjust (e.g., labour).

Looking into a firm’s decision making under such

circumstances is sometimes called a short-run analysis.

Respectively, when we say long-run analysis, we consider all

factors being variable.
Long-run AC curve is lower or equal than any short-run AC
curve. There is a connection between them.

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Semi-flexible K : discrete levels of K
Say the firm can choose from only four different levels of K in
the long run:
K ∈ {K 1 , K 2 , K 3 , K 4 }

Still fully flexible to choose L.

Can draw four SAC (short-run AC) curves for all K i .

In the long-run, for any q, firm would choose both K and L.

Say, in the long-run, to produce 10 units of good, the firm

optimally chooses K ∗ = K 1 , L∗ = 5. Now, suppose the firm is
forced to have K 1 and has to produce 10 units. What is the
optimal choice of L∗ ? L∗ = 5.
Hence, at q = 10 units we have same costs for long-run curve
and short-run curve for K = K 1 .
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Short run and long run

Hence, we have that the SAC curve with fixed level of K i

touches the unrestricted LAC curve at all points q when K = K i
is chosen in the long-run.

So, the firm’s actual LAC curve will involve different parts of the
four SAC curves.

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Of the four costs possible, the firm will choose the minimum
one for every q.

 
The  actual cost curve (the “semi-flexible LAC”) is the lower
envelope
  of the four curves. It is marked in bold.
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 This is what would happen if the firm could adjust capital
smoothly:
 

  41/50
An exercise
Suppose that a firm has production technology
√
f (K , L) = KL

1. Assume that prices on K , L equal r = 2, w = 1,

respectively. Derive firm’s cost function, c(q);
2. Now assume that the firm cannot buy capital from outside.
Instead, the firm can produce capital
√ using labor, with
production technology K (L) = L. That is, when the firm
hires labor, it uses part of it to produce capital, and then
uses this capital with the rest of labor to produce the final
good. Derive firm’s cost function c(q) of producing the final
good;
3. Now assume that the firm can both buy capital as in part 1,
and produce it as in part 2. Derive firm’s cost function c(q);

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Buying capital

Part 1. Suppose the firm considers producing q units of the

final good. To find c(q), the firm minimizes 2K + L subject to
√
KL = q

The solution√is interior. Hence,

MPK (1/2) L
√
L√ L p
√
MPL = √ = K = w = 2. Hence, L = 2K = 2q
K (1/2) K

√
c(q) = 2K + L = 2 2q

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Producing capital

Assume the firm hires L1 units of labor to produce capital, and

L2 units of labor to produce the final good.
√ p√ 1/4 1/2
Then one has q = KL2 = L1 L2 = L1 L2
That is, a Cobb-Douglas production; with cost of both L1, L2
equal w = 1.
Solving the cost-minimisation problem, one gets
4/3
L2 = 2L1 = 2q22/3
,
3q 4/3
The final cost is c(q) = L1 + L2 = 22/3
.

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Both options
Let’s derive the minimal cost of having K units of capital.
If the firm produces K1 units of capital using labor, then by
spending small amount dx on labor, the firm hires dx w units of
labor.
√
K1 = L1 , hence the marginal product of producing capital
dx
using labor is √1 = 2K1 1 , that is, the firm produces 2wK units
2 L1 1

of capital.
The firm would stop producing capital with its own labor and
dx
starts buying it from the market once the value 2wK 1
equals
dx dx
r = 2 - that corresponds to additional quantity of capital by
spending dx on the market.
dx
Hence, there is a cutoff value of capital that satisfies 2wK 1
= dx
2 ,
or K1 = 1 - so that the firm produces the first K1 units using
labor, and the rest - buying from the market. The cost c(K ) of
producing K units of capital equals K 2 for K ≤ K1 = 1, and
equals 2K − 1 for K ≥ 1. 45/50
The end

For K ≤ 1, the firm’s solution is the same as in part 2 - when it

does not buy any capital from√the market. The amount
√ of q that
corresponds to K = 1 is q = 2. That is, for q ≤ 2, the cost is
4/3
c(q) = 3q
22/3 .
√
For K ≥ 1, (that is, for q ≥ 2), the firm buys some of capital
from the market, and its solution satisfies the
√ same first-order
conditions as in part 1 - that is, L = 2K = 2q,
The cost function is the same
√as in part 1 except the new cost
for capital: wL + 2K − 1 = 2 2q − 1.

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Reading

Varian, Intermediate Microeconomics, chapters 18, 19, 20, 21.

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Review questions

1. Why, do you think, in reality, many production functions

exhibit decreasing marginal cost to begin with, but
eventually have increasing marginal cost?
2. Construct an example of a cost function which has the
above property.
3. Without appealing to algebra (or any formal model)
evaluate the following statement: “If the marginal cost of a
firm is decreasing in its output, then the firm will always
have an incentive to increase its production.”

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Review questions

Exercise.
√ Consider a production function with a single input:
f (x) = x. The unit price of the input is w = 1. Does f (x)
exhibit increasing or decreasing returns to scale? Derive its
average cost function, AC(q). Is AC(q) increasing or
decreasing?

Exercise. Consider the exercise in the lecture with production

function f (K , L) = K 1/2 L1/2 , and wK = wL = 1:
I Assume in the short run the firm cannot change K . Find
and plot AVC, AC, MC curves for K = 2, K = 3;
I Now assume the long-run problem with the firm being able
to choose both K , L. Find AC, MC;
I Plot on the same graph short-run AC curves for
K = 1, 2, 3, and the long-run AC curve. Comment.

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Question. Suppose that a firm’s long-run cost function is:
1
C(q) = q α+β . Given this cost function, is it possible to say
whether production function has economies or diseconomies of
scale? Explain your answer.
Question. Suppose that a firm only uses labor L to produce
final good of amount Y . Suppose that production is described
as follows L = A + bY , where b > 0, and A > 0 is a ’fixed’
amount of labor needed to start production. Is it possible to say
whether production function has economies or diseconomies of
scale? Explain your answer.

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