CHAP 5: THE THEORY OF FIRM BEHAVIOR

1. Theory of production

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

• Cobb – Douglas function ( example of Production function )

Exercise

• Short run or long run depends on number of variable inputs & fixed inputs
+ Short run: variable inputs, at least 1 fixed input
+ Long run: all variable inputs, no fixed input
Exercise
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?
1.2. Producing in short run

Assumption: Capital ( K) is fixed, Labor ( L) is variable

=> Production function in the 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)

• 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)

or MPL = Q’L ( when change in L is close to 0 )

★ MPL and Q:

Example:
Keep hiring
more
workers
( K remain)
Analyze:
- L = 0 : Nothing is produced to sell => Q = 0
- L = 1 : First laborer => many space to work => high Productivity => highly Increase Q
- L = 2 : Two laborer share their work => high Productivity => highly Increase Q
- L = 3 - 7 : Not many space => Q increase but the production speed decrease
- L = 8 : The 8th laborer has nothing to do because the prior 7 do all the job
- L = 9 - 10 : Two many laborer,
=> some do nothing and even distract the other laborers => Q decrease

• The Diminishing Marginal Product

is the property whereby the marginal product of an input declines
as the quantity of the input increases.

★ MPL and APL :

 COMPARISON

1.3. Producing in long run

• No fixed inputs → all variable inputs : Labor (L) & Capital ( K)

Production function:
Q = f(K,L)
• Average Product (AP):

• Marginal Product (MP):

Isoquant - đường đẳng lượng: shows all combinations of factors that produce a certain
output ( similar properties with indifferent curve )
 ❖ Downward-sloping
❖ Do not cross
❖ Higher isoquants are preferred to lower ones
❖ Bowed inward → Marginal rate of technical substitution (MRTS)

tỷ lệ thay thế kỹ thuật cận biên - hay tỷ lệ thay thế kỹ thuật

số lượng của một đầu vào phải giảm đi khi sử dụng thêm một đơn vị đầu vào khác
để đầu ra không đổi

• 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

MRTSLK = -2 :
=> To keep the equal output, decreasing 2K => increasing 1L
 Relationship of MRTS and MPL, MPK:

MRTSLK = -MPL/MPK
=> ∆K/∆L = -MPL/MPK

Isocost shows all combinations of factors that cost the same amount
( kinda the same as budget constraint )

• Isocost equation:

• Slope of isocost: -PL/PK

At optimal combination ( Kết hợp sản xuất tối ưu ) :

E: Minimizing cost ( Điểm tối thiểu hóa chi phí ) = tangent of Isoquant & Isocost
Exercise
2.Theory of cost

2.1. Costs in the short run

Fixed cost + Variable cost = Total cost
2.2.1. 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

TC = FC + VC
Exercise

2.2.2. Average cost

• Average fixed cost (AFC): Fixed cost divided by the quantity of output
AFC = FC/Q

• Average variable cost (AVC): Variable cost divided by the quantity of output
AVC = VC/Q
• Average total cost (ATC): Total cost divided by the quantity of output
ATC = TC/Q = AFC + AVC

2.2.3. Marginal cost

• Marginal cost (MC): The increase in total cost that arises from an extra unit of production:

MC = ∆TC/∆Q = ∆TVC/∆Q
 or
MC = (TC)’Q = (TVC)’Q

U shape : Lúc đầu resource nhiều, lúc sau thì thiếu dần

2.2.4. Shape of AC curve and MC curve

2.2.5. AC and MC
Exercise
2.2. Costs in the long run

❖ 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

❖ Long-run marginal cost (LMC)

LM is the additional cost of producing an extra unit of the output in the long run

LMC = ∆LTC/∆Q

❖ LAC and LMC

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

E.g: Book vé xem phim vào CN tốn 400k nhưng vào CN lại có việc bận

• Explicit costs - chi phí nổi: input costs that require an outlay of money by the firm

E.g: 5tr tiền nhà + 5tr tiền ăn = 10tr ( Ex.cost tháng đó là 10tr )
• Implicit costs - chi phí chìm : input costs that do not require an outlay of money by the
firm

E.g: Đi hát thì kiếm đc 1 tỷ / Đi học

=> Đi học thì mất 1 tỷ ( Im.cost )

• Total opportunity costs = Explicit costs + Implicit cost

3. Theory of profit

3.1. Definition

• Profit is the firm’s total revenue minus its total cost:

Π = TR – TC
Π (Q) = TR(Q) – TC(Q)

• Accounting profit = Total revenue – explicit cost

• Economic profit = Total revenue – explicit cost - implicit cost

Exercise:

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:

Πmax ⇔ Marginal Revenue = Marginal Cost

Exercise
TR = P.Q