5 The Firm

Production
The Firm

A firm is an institution that

hires factors of production
and organizes them to
produce and sell goods and
services.

A firm’s goal is to maximize

economic profit.
The firm
Profit Maximization
Economic profit is equal to total revenue minus total cost.
𝝅 = 𝑻𝑹 − 𝑻𝑪

Total revenue is generally the product of price of the good

and total production (or sales) in the market.

Total cost is measured as the opportunity cost of

production.
The Firm’s Economics Problem
Decisions to make
To maximize profit, a firm must make five basic decisions:
1. What to produce and in what quantities
2. How to produce
3. How to organize and compensate its managers and
workers
4. How to market and price its products
5. What to produce itself and what to buy from other firms
Decision Time Frames

The firm makes many decisions to achieve its main

objective: profit maximization.

All decisions can be placed in two time frames:

• The short run
• The long run
Decision Time Frames
The short run is a time frame in which the quantity of one
or more resources used in production is fixed.

• For most firms, the capital, called the firm’s plant, is

fixed in the short run.
• Other resources used by the firm (such as labor, raw
materials, and energy) can be changed in the short run.

The long run is a time frame in which the quantities of all

resources — including the plant size — can be varied.
Product Schedules

Three concepts describe the relationship between output

and inputs:

1. Total product
2. Marginal product
3. Average product
Product Schedules
Total product is the total output produced in a given
period.

The marginal product of an input is the change in

total product that results from a one-unit increase in
the quantity of this input, with all other inputs
remaining the same.

The average product of an input is equal to total

product divided by the quantity of this input.
Economic Example
We assume that
1. There are only two inputs
• Homogeneous labor (l), measured in labor-hours
• Homogeneous capital (k), measured in machine-hours

2. Inputs are hired in perfectly competitive markets

• Firms are price takers in input markets
The Firm’s Production Function

For a particular good (𝑞)

The firm’s production function is given by
𝑞 = 𝑓(𝑘, 𝑙)
using alternative combinations of capital (𝑘) and labor (𝑙)
Here, 𝑞 is the total product.
Isoquant Maps
Isoquant maps
• combinations of 𝑘 and 𝑙 that can produce a given level of
output (𝑞0)
𝑓 𝑘, 𝑙 = 𝑞0

Marginal rate of technical substitution (RTS)

• the rate at which labor can be substituted for capital
• Holding output constant along an isoquant
𝑑𝑘
𝑅𝑇𝑆 𝑙 𝑓𝑜𝑟 𝑘 = − ቤ
𝑑𝑙 𝑞=𝑞
0
Isoquant Maps
The slope of these curves
𝐴&𝐵: 𝑞 2𝑘, 𝑙 = 𝑞 𝑘, 2𝑙 = 10
shows the rate at which 𝑙
can be substituted for 𝑘 k per period
while keeping output
constant.

The negative of this slope is q = 30

A
called the (marginal) rate of kA
technical substitution (RTS). B q = 20
kB q = 10

In the figure, the RTS is

positive and diminishing for lA lB l per period
increasing inputs of labor.
Technical Progress

Methods of production change over time

Following the development of superior production

techniques
• The same level of output can be produced with
fewer inputs
• The isoquant shifts inward
 Technical Progress

k per period Technical progress shifts

the q0 isoquant, labeled
IQ’, toward the origin.

The new q0 isoquant, IQ”,

k2 shows that a given level
k1 IQ’ of output can now be
IQ” produced with less input.
l1 l2 l per period
Marginal Product
Marginal product is
• the additional output that can be produced
• by employing one more unit of that input
• holding other inputs constant
𝑞 = 𝑓(𝑘, 𝑙)
𝜕𝑞
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑀𝑃𝐾 = = 𝑓𝑘
𝜕𝑘
𝜕𝑞
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑀𝑃𝐿 = = 𝑓𝑙
𝜕𝑙
Example
Consider a production function
3 1
𝑄= 4𝐾 4 𝐿4
Computing the partial derivatives,
𝜕𝑄 1 3 3
−1 −
1 1
𝑀𝑃𝐾 = = 4𝐿4 ∙ 𝐾 4 = 3𝐾 4 𝐿4
𝜕𝐾 4
𝜕𝑄 3 1 1 3 3
𝑀𝑃𝐿 = = 4𝐾 4 ∙ 𝐿4 = 𝐾 4 𝐿−4
−1
𝜕𝐿 4
When 𝐾 = 10,000 and 𝐿 = 625, we have
3 1 3 1
𝑄 = 4𝐾 4 𝐿4
= 4(10000)4 (625)4 = 20000
1 1
−4
𝑀𝑃𝐾 = 3(10000) (625)4 = 1.5
3 3
−
𝑀𝑃𝐿 = (10000)4 (625) 4 = 8
Marginal Product
For a given field (keeping the amount of equipment,
fertilizer, and so forth fixed), if we increase the labor
input, what will happen to the labor productivity?
• Marginal product depends on how much of that
input is used.
• Diminishing marginal productivity:
𝜕𝑀𝑃𝑘 𝜕 2 𝑓
= 2 = 𝑓𝑘𝑘 < 0, 𝑓𝑜𝑟 ℎ𝑖𝑔ℎ 𝑒𝑛𝑜𝑢𝑔ℎ 𝑘;
𝜕𝑘 𝜕𝑘
𝜕𝑀𝑃𝑙 𝜕 2 𝑓
= 2 = 𝑓𝑙𝑙 < 0, 𝑓𝑜𝑟 ℎ𝑖𝑔ℎ 𝑒𝑛𝑜𝑢𝑔ℎ 𝑙;
𝜕𝑙 𝜕𝑙
Short-Run Product
Increasing marginal returns arise from increased
specialization and division of labor.
Diminishing marginal returns arises because each
additional worker has less access to capital and less
space in which to work. Diminishing marginal returns
are so pervasive that they are elevated to the status
of a “law.”
The law of diminishing returns:
As a firm uses more of a variable input with a given
quantity of fixed inputs, the marginal product of the
variable input eventually diminishes.
 Short-Run Product Example

2 machines 2 machines 2 machines 2 machines 2 machines 2 machines

0 worker 1 worker 2 workers 3 workers 4 workers 5 workers
Short-Run Product Example

The Table shows a firm’s

product schedules

As the quantity of labor

employed increases:
• Total product increases
• Marginal product
increases initially but
eventually decreases
Increase Decrease
Short-Run Product Example
Product curves
The total product curve in the
Figure shows how total
product changes with the
quantity of labor employed.
The total product curve is
similar to the PPF.
It separates attainable output
levels from unattainable
output levels in the short run.
convex concave
Short-Run Product Example

Marginal Product Curve

This Figure shows the
marginal product of labor
curve and how the
marginal product curve
relates to the total product
curve.
The first worker hired
produces 4 units of output.
Short-Run Product Example
The second worker hired
produces 6 units of output
and total product becomes
10 units.
The third worker hired
produces 3 units of output
and total product becomes
13 units.
And so on.
The curve is the total
product curve.
Short-Run Product Example

The height of each bar

measures the marginal
product of labor.
For example, when labor
increases from 2 to 3, total
product increases from 10
to 13,
so the marginal product of
the third worker is 3 units
of output.
Short-Run Product Example

To make a graph of the

marginal product of labor,
we can stack the bars in the
previous graph side by side.

The marginal product of

labor curve passes through
the mid-points of these bars.
Short-Run Product Example

Almost all production

processes are like the
one shown here and
have
• Increasing marginal
returns initially
• Diminishing marginal
returns eventually
Short-Run Product Example
Increasing Marginal
Returns

Initially, the marginal

product of a worker exceeds
the marginal product of the
previous worker.
The firm experiences
increasing marginal
returns.
Short-Run Product Example
Diminishing Marginal
Returns

Eventually, the marginal

product of a worker is less
than the marginal product
of the previous worker.
The firm experiences
diminishing marginal
returns.
Average Product

• Labor productivity often means average productivity

• Average product of labor:

𝑜𝑢𝑡𝑝𝑢𝑡 𝑞 𝑓(𝑘, 𝑙)
𝐴𝑃𝑙 = = =
𝐿𝑎𝑏𝑜𝑢𝑟 𝑖𝑛𝑝𝑢𝑡 𝑙 𝑙
𝐴𝑃𝑙 also depends on the amount of capital employed
Short-Run Product Example
As the quantity of labor
employed increases:

• Total product increases.

• Marginal product
increases initially but
eventually decreases.
• Average product
increases initially and
then decreases. Increase Decrease
Short-Run Product Example

TP and MP TP and AP
Short-Run Product Example

Average Product Curve

The Figure shows the
average product curve and
its relationship with the
marginal product curve.

When marginal product

exceeds average product,
average product increases.
Short-Run Product Example

When marginal product

is below average
product, average
product decreases.

When marginal product

equals average product,
average product is at its
maximum.
Short-Run Product Example

Mr. A B C D E F G

Marginal height: increase and then decrease

Average height: increase when MH > AH

decrease when MH < AH
Numerical Example

Consider a production function

𝑞 = 𝑓(𝑘, 𝑙) = 600𝑘 2𝑙2 − 𝑘 3𝑙3

To construct 𝑀𝑃𝑙 and A𝑃𝑙 , we must assume a value for 𝑘

Let 𝑘 = 10, then the production function becomes

𝑞 = 60,000𝑙2 − 1000𝑙3
Numerical Example
𝑞 = 60,000𝑙2 − 1000𝑙3
The marginal productivity function is
𝜕𝑞
𝑀𝑃𝑙 = = 120,000𝑙 − 3000𝑙2
𝜕𝑙
– Which diminishes as l increases
– This implies that q has a maximum value when
120,000𝑙 − 3000𝑙2 = 0
40𝑙 = 𝑙2
𝑙 = 40

Labor input beyond 𝑙 = 40 reduces output

Numerical Example
To find average productivity, we hold 𝑘 = 10 and solve
𝑞
𝐴𝑃𝑙 = = 60,000𝑙 − 1000𝑙2
𝑙
𝐴𝑃𝑙 reaches its maximum where
𝜕𝐴𝑃𝑙
= 60,000 − 2000𝑙 = 0
𝜕𝑙
𝑙 = 30
When 𝑙 = 30,
𝐴𝑃𝑙 = 60,000𝑙 − 1000𝑙2 = 900,000
𝑀𝑃𝑙 = 120,000𝑙 − 3000𝑙2 = 900,000
– When 𝐴𝑃𝑙 is at its maximum, 𝐴𝑃𝑙 and 𝑀𝑃𝑙 are equal
Long-Run Product

Returns to Scale

• How does output respond to increases in all inputs

together?

• Suppose that all inputs are doubled, would output double?

Long-Run Cost
The table shows a firm’s
production function.
As the size of the plant
increases, the output that a
given quantity of labor can
produce increases.
But for each plant, as the
quantity of labor increases,
diminishing returns occur.
Long-Run Product

Production function is given by 𝒒 = 𝒇(𝒌, 𝒍)

• Let all inputs are multiplied by the same positive
constant 𝑡 , 𝑡 > 1
• Then we classify the returns to scale of the
production function by

Effect on Output Returns to Scale

𝑓(𝑡𝑘, 𝑡𝑙) = 𝑡𝑓(𝑘, 𝑙) = 𝑡𝑞 Constant
𝑓(𝑡𝑘, 𝑡𝑙) < 𝑡𝑓(𝑘, 𝑙) = 𝑡𝑞 Decreasing
𝑓(𝑡𝑘, 𝑡𝑙) > 𝑡𝑓(𝑘, 𝑙) = 𝑡𝑞 Increasing
Constant Returns to Scale

𝑓(𝑡𝑘, 𝑡𝑙) = 𝑡𝑓(𝑘, 𝑙) = 𝑡𝑞

Example:

Consider 𝑓 𝑘, 𝑙 = 𝐴𝑘 𝛼 𝑙1−𝛼 , 𝐴 and 𝛼 are positive constant.

𝑓 𝑡𝑘, 𝑡𝑙
= 𝐴(𝑡𝑘)𝛼 (𝑡𝑙)1−𝛼
= 𝑡 𝛼 𝑡 1−𝛼 𝐴𝑘 𝛼 𝑙1−𝛼
= 𝑡𝐴𝑘 𝛼 𝑙1−𝛼
= 𝑡𝑓(𝑘, 𝑙)
Decreasing Returns to Scale

𝑓(𝑡𝑘, 𝑡𝑙) < 𝑡𝑓(𝑘, 𝑙) = 𝑡𝑞

Example:

Consider 𝑓 𝑘, 𝑙 = 𝐴𝑘 𝑥 𝑙 𝑦 , where 𝑥 + 𝑦 < 1

𝑓 𝑡𝑘, 𝑡𝑙
= 𝐴(𝑡𝑘)𝑥 (𝑡𝑙)𝑦
= 𝑡 𝑥+𝑦 𝐴𝑘 𝑥 𝑙 𝑦
< 𝑡𝐴𝑘 𝑥 𝑙 𝑦
= 𝑡𝑓(𝑘, 𝑙)
Increasing Returns to Scale

𝑓(𝑡𝑘, 𝑡𝑙) > 𝑡𝑓(𝑘, 𝑙) = 𝑡𝑞

Example:

Consider 𝑓 𝑘, 𝑙 = 𝐴𝑘 𝑥 𝑙 𝑦 , where 𝑥 + 𝑦 > 1

𝑓 𝑡𝑘, 𝑡𝑙
= 𝐴(𝑡𝑘)𝑥 (𝑡𝑙)𝑦
= 𝑡 𝑥+𝑦 𝐴𝑘 𝑥 𝑙 𝑦
> 𝑡𝐴𝑘 𝑥 𝑙 𝑦
= 𝑡𝑓(𝑘, 𝑙)