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CHAPTER 5
The theory of firm behavior

01 Theory of production
02 Theory of cost
03 Theory of profit

01 Theory of production
1.1. Several concepts
1.2. Producing in short run
1.3. Producing in long run

1.1. Several concepts

• Production is the process that transforms inputs into
outputs to satisfy human wants.
• Production function: Q = f(K,L)
Where: K = Capital; L = Labour.
• Short run or long run depends on number of variable
inputs
+ Short run: 1 variable imput
+ Long run: all variable inputs

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1.1. Several concepts

• Production is the process that transforms inputs into
outputs to satisfy human wants.
• Production function: Q = f(K,L)
Where: K = Capital; L = Labour.
• Short run or long run depends on number of variable
inputs
+ Short run: 1 variable imput
+ Long run: all variable inputs

1.1. Several concepts

α β
• Cobb – Douglas function: Q = a.K .L
Trong đó: K: capital, L: labor, α: Capital-output
elasticity, β: Labor-output elasticity

1.1. Several concepts

• Short run or long run depends on the number of fixed inputs
+ Short run: at least 1 fixed input
+ Long run: no fixed inputs
• Ex: Tien An Company uses inputs such as factories and workers to
produce costumes. In the first 2 years, the company needs to hire
more workers, however, the quantity of factories is unchanged. In
the third year, besides hiring more workers, Tien An company
decides to build more factories. Which one is the capital (K)?
Which period is the short and the long run?

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1.2. Producing in short run

• Asumption: ……………….is fixed, ……………is
variable
• Production function in the short run:
Q = f(K, L)

1.2. Producing in short run

• Average Product – AP: Average product output per unit
of input. In short run, the firm can adjust production by
quantity of laborers  Average product of labor (APL)
APL = Q /L

• Marginal Product – MP: the change in output as a

result of one additional unit of input being added to
production. In short run, the firm can adjust production by
quantity of laborers  Marginal product of labor (MPL)
∆Q
MPL =
∆L

1.2. Producing in short run

L Q MPL
0 0 - The diminishing marginal
product is the property whereby
1 3
the marginal product of an input
2 7
declines as the quantity of the
3 12 input increases.
4 16 Relationship of MPL and Q:
5 19 MPL > 0  Q
6 21 MPL = 0  Qmax
7 22 MPL < 0  Q
8 22
9 21
10 15

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1.2. Producing in short run

L Q MPL APL
0 0 - -
1 3
2 7
3 12 Relationship of MPL and APL :
4 16 MPL APL  APL 
5 19 MPL APL  APL max
6 21 MPL APL  APL 
7 22
8 22
9 21
10 15

1.2. Producing in short run

Relationship of MPL and Q:

Q, MPL, APL

MPL > 0  Q
MPL = 0  Qmax
MPL < 0  Q
Relationship of MPL and APL:
MPL APL  APL 
MPL APL  APL max
MPL APL  APL 

1.3. Producing in long run

• …….fixed inputs  ……. variable inputs
• Production function: Q = f(K,L)
• Average product (AP): APL = Q/L; APK = Q/K
• Marginal product (MP): MPL = ∆Q/∆L = Q’L;
MPK = ∆Q/∆K = Q’K

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1.3. Producing in long run

Isoquant: shows all combinations of factors that produce a
certain output
Capital Labor (L)
(K) (1) (2) (3) (4) (5) (6)
(1) 7 10 16 18 19 20
(2) 10 15 20 21 23 25
(3) 14 20 23 25 27 30
(4) 16 21 25 30 33 36
(5) 18 23 27 32 37 42
(6) 20 25 28 34 41 50

1.3. Producing in long run

Đường đẳng lượng

K
 Downward-sloping;
 Do not cross;
Q1 = 20
 Higher indifference curves are
6
5 preferred to lower ones;
 Bowed inward  Marginal rate
3
Q2 = 23 of technical substitution
(MRTS)
L
1 2 3

1.3. Producing in long run

• Marginal Rate of Technical Substitution illustrates
the rate at which one factor must decrease so that
the same level of productivity can be maintained
when another factor is increased.

• MRTSLK = ∆K/∆L: slope of isoquant

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1.3. Producing in long run

Đường đẳng lượng

MRTSLK = -2
6
5  To keep the equal output,
-2
3
decreasing 2K  increasing
Q2 = 23
1L

1.3. Producing in long run

Relationship of MRTS and MPL, MPK:
MRTSLK = -MPL/MPK
∆K/∆L = -MPL/MPK

1.3. Producing in long run

• Isocost shows all combinations of factors that
cost the same amount.

• Isocost equation:
TC PL
P.PK + L.PL = TC  K = – .L
PK PK

• Slope of isocost: -PL/PK

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1.3. Producing in long run

Kết hợp sản xuất tối ưu

At optimal combination:
K
Isoquant ∩ Isocost
P MP
Optimum =
E2 P MP
MP MP
 =
P P
E At optimal combination:
MP MP
=
P P
E1
K.PK+ L.PL = TC
L

02 Theory of cost
2.1. Costs in the short run
2.2. Costs in the long run
2.3. Accounting cost, economic cost,
opportunity cost

2.1. Costs in the short run

2.1. Fixed cost, variable cost, total cost
• Fixed costs (FC): Costs that do not vary with the
quantity of output produced  Incurred even when
producing nothing
• Variable costs (VC): Costs that vary with the quantity
of output produced  More product, paying more
• Total costs (TC): Total amount a firm pays

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$800
Q FC VC TC
$700
0 $100 $0
$600
TC, FC, VC

1 100 70
$500
2 100 120
Costs
$400
3 100 160
$300
4 100 210
$200
5 100 280
$100
6 100 380
$0
7 100 520
0 1 2 3 4 5 6 7
Q

2.2. Average cost, marginal cost

• Average fixed cost (AFC): Fixed cost dived by the
quantity of output  AFC = FC/Q
• Average variable cost (AVC): Variable cost dived by the
quantity of output  AVC = VC/Q
• Average total cost (ATC): Total cost dived by the quantity
of output ATC = TC/Q =…………………
• Marginal cost (MC): The increase in total cost that arises
from an extra unit of production
MC = ∆TC/∆Q = ∆TVC/∆Q

Q TC ATC AFC AVC $200

n/a $175
0 $100 n/a n/a
AC, AVC, AFC

$150
1 170
$125
Costs

2 220
$100
3 260
$75
4 310 $50
5 380 $25

6 480 $0
0 1 2 3 4 5 6 7
7 620
Q

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Q TC MC $200
$175
0 $100
$150
1 170
$125

Costs
2 220
$100
3 260
$75
4 310 $50
5 380 $25

6 480 $0
0 1 2 3 4 5 6 7
7 620
Q
AC, AFC, AVC, MC

$200
$175

AC, AVC, AC is……….. $150

$125
Costs

$100

AFC…………. $75
$50
$25
$0
0 1 2 3 4 5 6 7
Q

MC AVC: Q  AVC
AC, AFC, AVC, MC

$200 MC
$175
MC AVC: AVCmin
$150
MC AVC: Q  AVC $125
Costs

$100 ACmin
MC AC: Q  AC $75
AVCmin
$50
MC AC: ACmin $25

MC AC: Q  AC $0
0 1 2 3 4 5 6 7
Q

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2.2. Costs in the long run

 Long-run total cost (LTC);

 Long-run average cost (LAC);
 Long-run marginal cost (LMC).

Long-run total cost (LTC)

LTC is the cost function

that represents the total
cost of production for all
goods produced.

Long-run average cost (LAC)

LAC is the cost per unit

of output in the long run
LAC = LTC/Q

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Long-run average cost (LAC)

LM is the additional cost of

producing an extra unit of
the output in the long run
LMC = ∆LTC/∆Q

LMC < LAC: q LAC

LMC = LAC: LACmin
LMC > LAC: q  LAC

2.3. Accounting cost, economic cost, opportunity cost

• Sunk cost: a cost that has already been committed and

cannot be recovered  ignoring them when making
decisions
• Explicit costs: input costs that require an outlay of money
by the firm
• Implicit costs: input costs that do not require an outlay of
money by the firm
• Total opportunity costs = Explicit costs
+…………………….

Explicit costs, Implicit costs, Opportunity costs

Cost in the view of the Cost in the view of the

accountant economists

Total
Explicit costs Opportunity costs

(= Explicit costs + Implicit costs

)

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03 Theory of profit
3.1. Definition
3.2. Profit maximization

3.1. Definition
• Profit is the firm’s total revenue minus its total cost:
Π = TR – TC
• Accounting profit = Total revenue – explicit cost
• Economic profit = Total revenue – explicit cost -
……………..

3.1. Definition

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3.1. Definition
Mr. A works at a company with a 120 million VND/year salary. This year, Mr. A quit his
job and opened a cafe for business. To start a business, Mr.A has to do a few things:
Borrow VND 100 million from the bank;
Take out 200 million dongs of savings, which brings in a profit of 16 million VND per
year;
Take back the house, which is rented at the price = 40 million VND per year.
After one year, Mr. A has a revenue of 550 million VND and can list his expenses as
follows:
Cost of raw materials = 60 million VND
Labor costs = 120 million VND
Depreciation = 20 million VND
Operating cost = 20 million VND
Interest expense = 10 million VND
Management cost = 60 million VND
With the data given above, calculate Mr. A's accounting and economic profit.

3.2. Profit maximization

Πmax is the goal of every firm.
Πmax  Π’Q = 0
 TR’(Q) - TC’(Q) = 0
 MR – MC = 0
 MR = MC
The firm maximizes its profit at the output where
Marginal revenue = marginal cost

3.2. Profit maximization

$ $

MC MC

MR
MR
Q Q
MC < MR: Q  II MC < MR: Q  II
MC = MR: IImax MC = MR: IImax
MC > MR: Q  II MC > MR: Q  II

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