Class notes for Chapter 1 Introduction and definition1

Chapter 1 presents a brief introduction to microeconomics. The chapter

 Explains the difference between macroeconomics and microeconomics
 Introduce definitions and basic concepts of microeconomics
 introduce the role of prices in microeconomics
 introduce the concept of an economic model

1. Microeconomics vs. Macroeconomics

Economics is the study of the economy and the behaviour of people in the economy.
Traditionally, economics is divided into microeconomics, which studies the behaviour of
individuals and organizations (consumers, firms, and the like) at a disaggregated level, and
macroeconomics, which studies the overall or aggregate behaviour of the economy.

Macroeconomics: Branch of economics that deals with aggregate economic variables, such
as the level and growth rate of national output, interest rates, unemployment, and inflation.

For example, the Bank of Canada increases its overnight interest rate to lower the inflation rate.
What is the impact of this interest-rate cut on inflation, exchange rate, aggregate domestic
consumption, export, and GDP growth?

Microeconomics: Branch of economics that deals with the behavior of individual economic
units—consumers, firms, workers, and governments—as well as the markets that these
units comprise.

2. What is Microeconomics?

Definition: Microeconomics is the study of the allocation of scarce resources by individual

economic units such as consumers, firms and governments.

• Scarcity implies trade-offs. For example:

• Consumers:

Consumers have limited incomes, which can be spent on goods and services, or saved
for the future. (E.g., you got a $1000 scholarship. You will have to make trade-off choices:
a new iPhone, a trip to Mont-Tremblant, or saving for next year’s tuition). Note that the
consumer is not the focus of this course.

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The teaching notes should be only used by the students in the class of Econ2020 taught by Dr. Haozhen Zhang.

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• Firms:

Resources (workers, raw materials, capital, and energy) are available in limited supply.

 Which goods and services should be produced? (trade-off scarce resources)

 How should the firms produce those goods and services? (e.g., production
functions, cost functions, and technology).

Because firms have scarce resources, firms want to maximize profits with given limited
resources and minimize cost for given production (will be explained in Chapters 6 and 7)

 Governments:

Governments provide public goods (e.g. national defence), design tax and social benefit
systems, impose regulations, etc.

 Which goods and services the government will produce? e.g. national defence,
police, lighthouse, road, and other public goods (goods and services are nonrivalrous
and nonexcludable)
 Who gets to consume those goods and services?
 Should the government subsidize, tax, or regulate industries and consumers to
benefit a certain group of individuals or firms (e.g. minimum wage, social
benefits, income taxes, and public health care)?

3. Microeconomics and prices

Microeconomics describes how prices determine resource allocation.

 Prices have effects on three key aspects:

• Which goods should be produced? (prices of product vs. costs)

• How to produce? (cost/prices of inputs and technology, production

function)

• Who are the consumers and how much do they pay? (consumers with
different tastes, preferences and willingness to pay). A change in price
would change the composition and the number of consumers.

 Prices answer these important questions by influencing decision-makers

(consumers, firms, and governments)

• Prices of goods and services are determined in a market.

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  A market is where interactions among consumers, firms, and the government
take place.

This course will focus on firms (producers) and market structures.

4. Economic models

• A model is a description of the relationship between two or more economic

variables. For example, A firm maximizes its production q=f(L, K). subjective to budget
constraint constrain c(L,K) = P1*L+P2*K

 Objectives of the use of models:

 Understand relationships between variables allowing economists to predict how
a change in one variable will affect another variable.
 explain the behaviors of individuals and the economy
 design policies to improve economic performance

• Features of economic models:

• have assumptions that simplify things relative to the real world. Economic
models are simplified versions of a more complex reality. Irrelevant details are
stripped away in the models.
• make theoretical predictions that we can test empirically

• involve maximizing or minimizing something (e.g., maximize firm profits and

minimize costs) subject to constraints

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Class notes for Chapter 6. Firms and production
Definition: A firm is an organization that converts inputs (labor, materials, and capital)
into outputs (e.g. goods and services).

We will examine the following topics in this chapter.

1. The Ownership and Management of Firms: how a firm is owned and managed?
2. Production: how does a firm transform inputs (K and L) into outputs?
3. Short Run Production: One Variable and One Fixed Input
4. Long Run Production: Two Variable Inputs
5. Returns to Scale

1. The Ownership and Management of Firms

a. Firm types:
 Private (for-profit) firms: owned by individuals or other non-governmental entities
trying to earn a profit (e.g. Toyota, Walmart). Responsible for 76% of the U.S. GDP in
2018.
 Public firms: owned by governments or government agencies, e.g. Canadian Crown
corporations, which are enterprises owned by the Crown, or Queen, in the right of
Canada (the federal state) or in the right of a province (a provincial state). Examples:
Canada Post, Air Canada (privatized in 1988), and Canadian National Railway (CN was
government-owned, having been a Canadian Crown corporation from its founding to its
privatization in 1995). Responsible for 11% of the GDP of the US in 2018.

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 Not-for-profit firms: owned by organizations that are neither governments nor
intended to earn a profit, but rather pursue social or public interest objectives (e.g.
Cancer Care Ontario, Child Care Services, etc.). Responsible for 13% of the GDP in the U.S.
in 2018.
 Canadian numbers (note that the classification is different between US and Canada).

CANSIM Table 179-0004. Business ownership in Canada by percentage of total asset

Country of control 2010 2011 2012 2013 2014
Under foreign control 19.2 18.9 18.5 18.3 18.1
Under Canadian control 80.8 81.1 81.5 81.7 81.9
Canadian, private enterprises 71.4 72.6 73 73.5 73.8
Canadian, government business enterprises 9.4 8.5 8.5 8.2 8.1

Legal forms of for-profit firms:

 Sole proprietors hip: firms owned by a single individual who is personally liable for the
firm’s debts.
72% of firms in the U.S., but responsible for 4% of sales in 2012.
 General partnership: businesses jointly owned and controlled by two or more people
who are personally liable for the firm’s debts.
10% of firms in the U.S., but responsible for 15% of sales in 2012.
 Corporation: firms owned by shareholders in proportion to the number of shares or
amount of stock they hold. (e.g. Bestbuy; Apple)
18% of firms in the U.S., but responsible for 81% of sales in 2012.
Corporation owners have limited liability; they are not personally liable for the firm’s
debts even if the firm goes into bankruptcy.

The objective of for-profit firms

We focus on for-profit firms in the private sector in this course. We assume these firms’
owners are driven to maximize profit.

Profit is the difference between revenue (R), what it earns from selling its product, and cost
(C), what it pays for labor, materials, and other inputs.
Profit= revenue - cost where R = pq = price x quantity.

To maximize profits, a firm must produce as efficiently as possible, where efficient

production (technological efficiency) means it cannot produce its current level of output
with fewer inputs.

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2. Production function
Production function: expresses the quantity of good y as a function of an input bundle (z1 ,
z2 ). The various ways that a firm can transform inputs into the maximum amount of output are
summarized in the production function.

Assuming labor (L) and capital (K) are the only inputs, the production function is
q=f(L, K).

Types of production functions:

1. Linear production functions:

For example, q = x + y, x-beef produced in Quebec, y-beef produced in Ontario, q-

ground beef measured in pounds.

2. Fixed proportions production function (Leontief production functions):

 the ratio in which the inputs are used never changes: We need one right shoe and one
left shoe to make a pair of shoes, one piano and one pianist to make music.

Example question: 150 millilitres of apple juice and 100 millilitres of cranberry juice
are needed to make the perfect cranapple drink, This recipe give s rise to the
following fixed-proportion production function: y=min(z1/150, z2/100),

where z1 is a millilitre of apple juice, and z2 is cranberry juice. If you had 600
millilitres of apple juice and 500 millilitres of cranberry juice, how many cranapple
drinks could you make? There is enough apple juice for four drinks (4=600/150) and
enough cranberry juice for five drinks (5=500/100), so you could make just four drinks,
min(5,4)=4, and you would have 100 millilitres of cranberry juice left over.

3. Variable proportion production function:

 the ratio of inputs can vary, i.e., the increased amount of one input can be
substituted for decreased amount of another. For example, the Cobb-Douglas

production function

For example, John owns a firm that produces the output, courier services, measured in
kilometres. In addition to a service truck, John uses two inputs: driver's time (z1
hours) and gasoline (z2 litres).

Assume there is a technological relationship between “kilometre per litre” (km/l) and
speed (s): km/l = 1200/s. Q: What is the production function with inputs z1 and z2?

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y=sz1 (e.g. maximum distance=hours*speed) that is, s=y/z1. Sub it into equation
y=z2*1200/s (e.g. maximum distance=litres of gas* kilometre per litre).

we got y=1200z1*z2/y. y*=(𝟏𝟐𝟎𝟎𝒁𝟏𝒁𝟐)𝟏/𝟐

Cobb-Douglas production function

Y* is the maximum number of kilometres that any input bundle composed of time and gas
will produce. The technologically efficient method for combining z1 and z2: driving the
truck at S*.

3. Production in the short-run

Short-run vs. long-run production
A firm can more easily adjust its inputs in the long run than in the short run.
- The short run is a period of time so brief that at least one factor of production cannot be
varied (the fixed input).
- The long run is a long enough period of time that all inputs can be changed.

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Short Run Production: One Variable and One Fixed Input

In the short run (SR), we assume that capital is a fixed input and labor is a variable input.
SR Production Function:

q is output, also called total product; the short-run production function is also called the
total product of labor

The marginal product of labor is the additional output produced by an additional unit of
labor, holding all other factors constant.

The average product of labor is the ratio of output to the amount of labor employed.

Example. 𝑞 = 0.1𝐿𝐾 + 3𝐿2 𝐾 − 0.1𝐿3 𝐾

1. What is the short-run production function if K is fixed at 10
𝑞 = 0.1𝐿𝐾 + 3𝐿2 𝐾 − 0.1𝐿3 𝐾 = 𝐿 + 30𝐿2 − 𝐿3
2. MPL in the short run?
𝑀𝑃𝐿 = 1 + 60𝐿 − 3𝐿2
3. APL in the short run?
𝐴𝑃𝐿 = 1 + 30𝐿 − 𝐿2

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Interpretations of the graphs of MP and AP in the short run:

Example, 𝑞 = 𝐿 + 30𝐿2 − L3 then 𝑀𝑃𝐿 = 1 + 60𝐿 − 3𝐿2 and 𝐴𝑃𝐿 = 1 + 30𝐿 − 𝐿2

 APL and MPL both first rise and then fall as L increases. Why? Show (the slope of the
MP) =60-6L and (the slope of AP)=30-2L. Note that when the slope is positive, APL or
MPL increases as L increases.
 MP is maximized at 10 when the slope of MP is 0, and AP is maximized at 15 when the
slop of the AP=0
 MP Initially increases due to the specialization of activities; more workers are a good
thing. Eventual declines in MP result when workers begin to get in each other’s way as
they struggle with having a fixed capital stock. For example, lots of workers in a small
restaurant.
 MPL curve first pulls the APL curve up when MPL>APL and then pulls it down when
MPL<APL, thus, MPL intersects APL at its maximum. When MP=AP, L=15.
 The total product of labor curve shows output rises with labor until L=20 when MP=0.

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Law of Diminishing Marginal Returns (LDMR)

The law holds that, if a firm keeps increasing an input, holding all other inputs and
technology constant, the corresponding increases in output will eventually become smaller.
In other words, MP decreases in L when the slope of MP is less than 0.
Occurs at L=10 in the previous graph.

Mathematically:

Note that when MPL begins to fall, the Total product is still increasing until MP=0.
LDMR is really an empirical regularity more than a law.

The production function for healthcare

Additional expenditures on health care (inputs) increase life expectancy (output) along the
production frontier. Points A, B, and C represent points at which inputs are efficiently utilized,
although there are diminishing returns when moving from B to C. Point D is a point of input
inefficiency

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Question: Can labour productivity increase as labour increases if the production process
exhibits diminishing returns to labor?

Technology changes and labour activity

 Labor productivity (output per unit of labor, average product of labour) can
increase if there are improvements in technology, even though any given production
process exhibits diminishing returns to labor.
 As we move from point A on curve O 1 to B on curve O2 to C on curve O3 over time,
labor productivity increases as the input of labor rises.

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4. Long Run Production: Two Variable Inputs

In the long run (LR), we assume that both labor and capital are variable inputs.

The freedom to vary both inputs provides firms with many choices of how to produce
(labor-intensive vs. capital-intensive methods).

Consider a Cobb-Douglas production function where A, a, and b are constants:

Hsieh (1995) estimated such a production function for a U.S. electronics firm:

a. LR Production Isoquants
isoquants: Curve showing all possible combinations of inputs that yield the same output.

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Properties of isoquants:
- The farther an isoquant is from the origin, the greater the level of output.
- Isoquants do not cross.
- Isoquants slope downward (because isoquants only show efficient production)

- Isoquants must be thin.

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The shape of isoquants indicates how readily a firm can substitute between inputs in the
production process.

Types of isoquants:

I. Perfect substitutes (linear production functions): Each isoquant is a straight line

For example, q = x + y, x-beef produced in Quebec, y-beef produced in Ontario, q-
ground beef measured in pounds. Another example, potato in Idaho, Maine

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II. Fixed-proportions: the inputs cannot be substituted at all.

e.g. q = min{g, b}, inputs needed to produce a 1-pound box of cereal in the chart
below (q) are cereal (g) and boxes (b).

The dashed lines show that isoquants are right angles if we included inefficient
production.

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III. Typical isoquants: Imperfect substitution between inputs
-These isoquants are Convex (i.e. curve away from the origin, the middle of the
isoquant is closer to the origin than it would be if the isoquant were a straight line).
- smooth and slop downward
- lie between the extreme cases of perfect substitute and non-substitute.
e.g.

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Substituting inputs
- The slope of an isoquant shows the ability of a firm to replace one input with
another (holding output constant).
- Marginal rate of technical substitution (MRTS) is the slope of an isoquant at a
single point.

- MRTS tells us how many units of K the firm can replace with an extra unit of L (q
constant)
Differentiating

MPL = marginal product of labor; MPK = marginal product of capital

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 Thus, the MRTS is the changes of K relative to the change of L

an increase in L decreases K to keep the same quantity decrease MPl and

increases MPk because of the Law of Diminishing Marginal Returns

- As we move down and to the right along an isoquant, we increase the labor, so we
must decrease capital to stay on the same isoquant.
- The size of MRTS diminishes along a convex isoquant. The more L the firm has,
the harder it is to replace K with L.

For example, if q= 𝑨𝑳𝒂 𝑲𝒃 , then MPl=a𝑨𝑳𝒂−𝟏 𝑲𝒃, MPk= 𝒃𝑨𝑳𝒂 𝑲𝒃−𝟏

MRTS=-MPl/MPk=-aK/bL. The absolute value of MRTS decrease as L increases.

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5. Return to scales
Returns to scale: Rate at which output increases as inputs are increased proportionately,
i.e. how much output changes if a firm increases all its inputs proportionately.
 Constant returns to scale: The production function exhibits constant returns to scale when a
percentage increase in inputs is followed by the same percentage increase in output.
Doubling inputs, doubles output f(2L, 2K) = 2f(L, K)

Recall our example, q = x + y, x-beef produced in Quebec, y-beef produced in Ontario, q-

ground beef measured in pounds. Another example is below.

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 RETURNS TO SCALE

When a firm’s production process exhibits constant returns to scale as shown by a

movement along line 0A in part (a), the isoquants are equally spaced as output
increases proportionally.
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 Production function exhibits increasing returns to scale when a percentage increase in

inputs is followed by a larger percentage increase in output.
Doubling inputs more than doubles output: f(2L, 2K) > 2f(L, K)
Occurs with greater specialization of L and K; one large plant is more productive than
two small plants. One large restaurant produces more foods and services than two small
ones, each of which has only one labor who worked as a cook, waitress and cleaner at the
same time (no specialization advantage).

However, when there are increasing returns to scale as shown

in (b), the isoquants move closer together as inputs are
increased along the line.
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 Production function exhibits decreasing returns to scale when a percentage increase in
inputs is followed by a smaller percentage increase in output.
Doubling inputs less than double output: f(2L, 2K) < 2f(L, K) occurs because of the
difficulty of organizing and coordinating activities as firm size increases.

Question: Is constant, increasing or decreasing return to scale in the following ranges of

labour (e.g. a-b, b-c, and c-d)?

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at a, f(L,K)=1, at b, f(2L,2K)=3>2=2f(L,K), it is increasing return to scale.....

Question: under what conditions, q= 𝑨𝑳𝒂 𝑲𝒃 has decreasing, constant, or increasing return
to scale

Answer: when inputs increase by 2 times, 𝒇(𝟐𝑳, 𝟐𝑲) = 𝑨𝟐(𝒂+𝒃)𝑳𝒂 𝑲𝒃 = 𝟐(𝒂+𝒃)𝒇(𝑳, 𝑲)

If a+b=1 (the sum of inputs’ exponents in a Cob-Douglas function=1), constant return to

scale, because f(2L, 2K) = 2f(L, K)

if a+b>1, increasing return to scale, because f(2L, 2K) > 2f(L, K)

if a+b<1, decreasing return to scale, because f(2L, 2K) < 2f(L, K)

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