Microeconomics 1
Lecture Note 9
Juyoung Cheong
Kyung Hee University
Theory of the Firm
I Firm: Entity that converts inputs into outputs and sells its
output to the market
I Input: Land, Labor, Capital
I Capital: durable goods used in the production of other goods
Theory of the Firm
1. Unlike utility, output is cardinal — 10 units of output is indeed
5 times more than 2 units of output
2. Unlike the consumer, a firm does not have a budget constraint
I We assume that the firm has access to a perfect capital market
— as long as the production is profitable, it can be financed
Production Function
I The production function describes how inputs are turned into
outputs:
I Q = F (L, K )
I Q: Total Product, L: Labor, K : Capital
I Firms produce maximum quantity that can be produced given
L and K
I efficient production: cannot produce more with given input
Short-Run and Long-Run
Short Run Period of time in which the quantity of at least one
input is fixed
(As a convention, we usually call the fixed input
“capital” and the variable input “Labor”)
Long Run Period of time in which the quantities of all inputs are
variable
I Important: Short-run and Long-run are defined by the
variability of inputs, not length of time!
Short-Run Production
I Short-Run
I Assume capital is fixed
I Q = F (L, K )
I If a firm wants to increase production, it has only one option⇒
increase labor
Properties of Short-Run Production Function
I Total Product (TP)
I Total amount of output that factors of production create
I Total product increases with increases in variable factor (up to
a point)
I Marginal Product (MP)
I The change in output that occurs when one additional unit of
an input is added, holding other inputs fixed.
I MPL = ∆Q∆L = ∂L
∂Q
I Average Product (AP)
I Ratio of output to number of workers used to produce that
output
I APL = QL
I Increasing if MP is greater, decreasing if MP is less.
Law of Diminishing Marginal Product (Returns)
I Diminishing marginal product (returns): As ever larger
amounts of an input are added to fixed inputs, eventually the
MP of the variable input will decline.
I As more and more workers are hired at a firm, each additional
worker contributes less and less to production because the firm
has a limited amount of equipment.
I Not necessary to decline right away
I Only holds if holding other factors constant
I Why? If capital is fixed,
I not enough machines for everyone
I getting in each others way
Law of Diminishing Marginal Product (Returns)
I Diminishing marginal product (returns)
I In mathematical terms, it means that MPL (L, K ) is decreasing
in L (given K ) and MPK (L, K ) is decreasing in K (given L)
I Or, the second derivatives FLL (partially differentiate F w.r.t. L
twice) and FKK (partially differentiate F w.r.t. K twice) are
both negative
Marginal Product and Average Product
I MP curve crosses at height of AP curve.
MP, AP: Mathematical Example
I Suppose Q = F (L, K ) = 40KL − K 2 L2
I What are the marginal product of labor and the average
product of labor when K =10?
I Is it observing diminishing marginal products?
MP, AP: Mathematical Example
∂Q
I MPL = ∂L = 40K − 2K 2 L
I If K = 10, MPL = 400 − 200L
I As L increases, MPL always decreases ⇒ diminishing marginal
returns!
Q 40KL−K 2 L2
I APL = L = L = 40K − K 2 L
I If K = 10, APL = 400 − 100L
Long-Run Production Function
I Firms can produce a given level of output (Q) using a variety
of combinations of inputs
I Q = F (L, K )
I Both L and K can vary to produce a certain level of Q = Q̄.
Contour Lines of the Production Function
I Just like the utility function, the production function is a
two-variable function
I So just as we work with indifference curves for consumers, we
would like to work with the contour lines of the production
function
I Contour lines of the production function are called isoquants
I Each isoquant plots the combination of L and K which yields
the same output level
Isoquants
Q3
Q2
Q1
L
Drawing Isoquants
I Suppose the production function is
1 1
F (L, K ) = L 2 K 2
I Then an isoquant is the collection of all points (L, K ) such that
1 1
F (L, K ) = L 2 K 2 = constant
√
I For instance, if we choose the constant to be 2 3, then we
would like to find the points (L, K ) such that
1 1 √
L2 K 2 = 2 3
LK = 12
12
K=
L
Drawing Isoquants
1 1
F (L, K ) = L 2 K 2
10
L
5 10
Drawing Isoquants
K
12
4
3
2
√
1 Q=2 3
L
1 2 3 4 6 12
Drawing Isoquants
2
√
1 √ Q=2 3
Q=2 2 L
1 2 4 8
Drawing Isoquants
K
12.5
2 Q=5
√
√ Q=2 3
Q=2 2 L
2 5 12.5
Properties of Isoquants
1. Further an isoquant is from the origin, the greater the level of
output.
2. Isoquants do NOT cross.
3. Isoquants must slope downward.
I If upward, firms could get the same output with less inputs
⇒Not efficient!
Slope of an Isoquant
I When we want to find the slope of an isoquant, we are asking
the question:
If I change L by a bit, how much does K have to change in
order to remain on the curve?
I On the isoquant, we have
Q = F (L, K ) = constant
it means
∂Q ∂Q
dL + dK = dQ = 0
|∂L{z } |∂K{z }
change in change in
Q due to Q due to
change in L change in
K
Slope of an Isoquant
∂Q ∂Q
dL + dK = 0
|∂L{z } |∂K{z }
change in change in y
Q due to due to
change in L change in
K
∂Q ∂Q
dK = − dL
∂K ∂L
∂Q
dK ∂L
= − ∂Q
dL ∂K
Slope of an Isoquant
∂Q
dK ∂L
= − ∂Q
dL ∂K
If the change in L is very small,
I ∂Q is the Marginal Product of Labor (MPL ), obtained by
∂L
differentiating the production function with respect to L
(holding K as a constant), also denoted as FL (L, K )
I ∂Q is the Marginal Product of Capital (MPK ), obtained by
∂K
differentiating the production function with respect to K
(holding L as a constant), also denoted as FK (L, K )
I dK is the slope of the isoquant, which is known as the
dL
Marginal Rate of Technical Substitution (between L and K )
Marginal Rate of Technical Substitution
I The Marginal Rate of Technical Substitution (MRTS), which is
the slope of the isoquant (at a certain point (L, K )) is given by
MPL (L, K )
MRTS(L, K ) = −
MPK (L, K )
I Or,
∂F (L,K )
MRTS(L, K ) = − ∂F ∂L
(L,K )
∂K
I Intuitively, MRTS shows ability of a firm to replace one input
(capital) with another (labor) while holding output constant.
Diminishing Marginal Rate of Technical Substitution
I Just as in consumer theory, we assume Diminishing Marginal
Rate of Technical Substitution
I That is, along an isoquant, as the amount of L increases, the
absolute value of MRTS decreases
I Intuitively, holding output constant, it is harder to substitute
capital with labor as the capital/labor ratio falls
(or, it is harder to substitute labor with capital as the
capital/labor ratio increases)
I Again this is an “average is better than extreme” type of
assumption
“Non-standard” Isoquants
1. Perfect Substitutes
I One factor could easily replace another.
I e.g. Q = 2K + L
L
Q1 Q2 Q3 Q4
“Non-standard” Isoquants
2. Factors cannot be substituted at all
I Factors must be used in fixed proportions
I e.g. Q = min{K , L}
Q3
Q2
Q1
L
Returns to Scale
I Scale increase: Proportional increase in inputs
I e.g building a second plant
I NOT holding one fixed, or moving along on isoquant as before
I All inputs increases proportionally
I necessarily a Long-Run analysis
Constant Returns to Scale (CRS)
I Proportional increase in all input levels leads to output growth
in the same proportion
I e.g. double all inputs ⇒double output
I F (2L, 2K ) = 2F (L, K ) = 2Q
Increasing Returns to Scale (IRS)
I Proportional increase in all input levels leads to greater than
proportionate output growth
I Also it is called “Economies of Scale”.
I F (2L, 2K ) > 2F (L, K ) = 2Q
I e.g. double all inputs ⇒tripled output
I F (2L, 2K ) = 3F (L, K ) = 3Q > 2Q
I Reasons:
I Greater specialization:
I assembly line vs. one person does all
I Learning by doing:
I correct mistakes made originally
Decreasing Returns to Scale (DRS)
I Proportional increase in all input levels leads to less than
proportionate output growth
I Also it is called “Diseconomies of Scale”.
I F (2L, 2K ) < 2F (L, K ) = 2Q
I e.g. double all inputs ⇒one and half more output
I F (2L, 2K ) = 1.5F (L, K ) = 1.5Q < 2Q
I Reasons:
I Organizational difficulties
I Less efficient resources used
Examples
1. Cobb-Douglas Prodcution Function
I Q1 = ALα K β , where A: Technology
I If doubled input,
I Q2 = A(2L)α (2K )β = 2α+β ALα K β = 2α+β Q1
I If α + β = 1,Q2 = 2Q1 . ∴CRS.
I If α + β < 1,Q2 < 2Q1 . ∴DRS.
I If α + β > 1, Q2 > 2Q1 . ∴ IRS.
Examples
2.Perfect Substitute Production Function
I Q1 = L + K
I If doubled input,
I Q2 = 2L + 2K = 2(L + K ) = 2Q1
I CRS
Examples
3. Production Function
I Q1 = LK
I If doubled input,
I Q2 = 2L2K = 4(LK ) = 4Q1
I IRS
Returns to Scale on Isoquants
Capital
As we travel along any ray
from the origin, the in-
crement of the isoquant
heights tells us about the
returns to scale
Q1
Q2
Q3
Labor
0
Firm’s Decision Problem
I There are two approaches to look at a firm’s production
decision
1. Consider the profit-maximization problem all in one go
2. Break the production decision into two steps:
First find the minimal cost of producing different levels of
output
Next, using the production cost information, find the optimal
level of output
