FIRMS & MARKETS

LECTURE 7 - PRODUCER THEORY

Prof. THIAGU RANGANATHAN
 Why only 4 liters?

Subsidy with binding quantity

Subsidy with no quantity limit limit

Price
Demand Curve Price
Demand Curve
Supply
Supply
w/o
w/o
A C subsidy
A subsidy
B
Supply
Supply
with
with
subsidy
subsidy

Quantity
Quantity
APPROACH
Consumers
maximize
their levels
Opportunity of
Costs satisfaction
• Time, Money, and other
resources are scarce
• We make choices in • While we do so, we
Markets allow
presence of this scarcity account for opportunity interaction of
costs the two and
we obtain an
equilibrium
Scarcity
Producers
maximize
their profits

• Producers have to be efficient and maximize

profit
Producers • Efficiency depends on cost of factors of
maximize their production. This decision refers to allocation
profits of labour and capital for cost minimization
• Profit maximization depends on market
structure in which the firm is operating. This
decision is about deciding firm’s supply
PRODCUTION FUNCTION

 Firms use a technology (production function) to transform inputs (factors of production) into
outputs. The inputs of a firm can be broadly categorized into three categories:

 Capital (K): Land, Buildings (factories, stores), and equipment (machines, trucks)

 Labour (L): labourers (construction workers, assembly-line workers) , skilled workers (architects, engineers,
plumbers, economists), and managers

 Materials (M): Raw goods (oil, water, wheat), and processed goods (aluminium, paper, plastic, steel)

 Production function is the relationship between the quantities of inputs used and maximum
quantity of output that can be produced given the current knowledge about technology and
organization
INPUTS

 Fixed input is an input whose input does not vary with the production for some time.
The costs for the input do not vary with the level of production

 Variable input is a factor of production whose quantity can be changed readily by

the firm during the relevant time period

 Short run is the time in which at least one factor of production cannot be varied
practically

 Long run is a lengthy enough period of time that all inputs can be varied
MORE ON DIMINISHING MARGINAL PRODUCTIVITY…
SHORT RUN PRODUCTION

K L Total Product Marginal Product Average Product

3 0 0    
3 1 5 5 5
3 2 16 11 8
3 3 31 15 10
3 4 48 17 12
3 5 63 15 13
3 6 75 12 13
3 7 83 8 12
3 8 88 5 11
3 9 90 2 10
3 10 90 0 9
3 11 88 -2 8
3 12 84 -4 7
3 13 78 -6 6
SHORT RUN PRODUCTION

 Production Function in the short run

q = f ( K , L)

 Marginal Product of Labour

Δq
MPL =
ΔL

 Average Product of Labour

q
APL =
L
LONG RUN PRODUCTION

 In the long run, all the inputs are

  Labour, L variable q = f ( K , L)
Capital, K 1 2 3 4 5 6

1 10 14 17 20 22 24

2 14 20 24 28 32 35  Same level of production using very little

capital and lot of labour or using very
3 17 24 30 35 39 42 little labour and a lot of capital

4 20 28 35 40 45 49

5 22 32 39 45 50 55  A lumberyard can produce 200 planks

with 10 workers using handsaws, 4
6 24 35 42 49 55 60 workers using handheld power saws, or
with 2 workers using bench power saws
 ISOQUANTS

 Isoquant
q = f ( K , L)

 Farther the Isoquant is from the origin, more

is the production
LABOUR

q=35  Isoquants do not cross

q=24

q=14
 Isoquants slope downward

CAPITAL
 Slope of the isoquant is the marginal rate of
technical substitution (MRTS)
ΔK MPL
MRTS = =-
ΔL MPK
 ISOCOSTS

Capital Input (K)  All the input combinations that require the
  same (iso) total expenditure (cost)
C = wL + rK
w
  -
   Slope of the line is given by r
   Cost Minimization occurs when the
Isoquant is tangent to Isocost. At this
point, the following condition exists similar
  to that of consumer’s utility maximization
MPL MPK
=
=100
  units w r
 At point A, the firm will spend more than it
0     will at B, but produce the same as in point
B
Labor Input (L)
Optimal Input Substitution in Action
Capital Input (K)
I

New cost-minimizing
point due to higher wage

F
B
  Initial point of cost minimization

A
 
 
H J
0     G Labor Input (L)
SUMMARY

MPL MPK
=
w r
SHORT RUN COSTS

 Fixed Costs (FC) are the costs that do not change with changes in output

 Variable Costs (VC) are the costs that change with the changes in output

 Total Costs (TC) are the sum of fixed and variable costs
 SHORT RUN COSTS

(5)=20000*(2
(1) (2) (3) (4)=50000*(1) ) (6)=(4)+(5)
Capital Variable Total
(K) Labour (L)Output (Q) Fixed Costs Costs Costs TOTAL COSTS
2 0 0 100000 0 100000
2 1 76 100000 20000 120000
VARIABLE COSTS
2 2 248 100000 40000 140000
2 3 492 100000 60000 160000
FIXED COSTS
2 4 784 100000 80000 180000
2 5 1100 100000 100000 200000
2 6 1416 100000 120000 220000
2 7 1708 100000 140000 240000
2 8 1952 100000 160000 260000 QUANTITY
2 9 2124 100000 180000 280000
2 10 2200 100000 200000 300000
 SHORT RUN COSTS

ATC, AVC, AFC  Average Fixed Costs

and MC (Rs.) FC
AFC =
A q

Minimum of ATC  Marginal Costs

ΔTC ( q)
MC =
Δq

 Average Variable Costs

VC (q )
AVC =
q
Minimum of AVC
 Average Total Costs
0 Output
TC (q )
ATC =
q
PERFECT COMPETITION

 Large Number of Buyers and Sellers

 Identical Products

 Full Information

 Negligible Transaction Costs

 Free Entry and Exit

PROFIT MAXIMIZATION

 Two Decisions
 Output Decision : What is the optimal level q* which maximizes the firms profits?
 Shutdown Decision: Is it more profitable to produce q* or to shut down and produce no output?

 Three aspects of profit maximization

 The firm sets its output where profits is maximized or loss is minimized
 The firm sets its output where its marginal profit is zero
 The firm sets its output where its marginal revenue equals its marginal costs

 Shut Down Rule

 The firm shuts down if it can reduce its loss by doing so
 The firm shuts down only if its revenue is less than its avoidable cost
Competition in the Short Run

Rs.  A profit-maximizing competitive firm

produces the amount of output at which
its marginal cost equals the market
price.

p
Profit

 The rectangle between price curve and

the average curve indicates the profit of
0 q the firm
Short Run Loss

Rs.

Loss

0 q
SHUT DOWN DECISION

Loss if shut down

Fixed Cost

Loss if produce

0 q
SHORT RUN FIRM SUPPLY CURVE

 
MARKET SUPPLY CURVE
LONG RUN AVERAGE TOTAL COST CURVE

LRAC (Rs.)
 
   

0   Output
LONG RUN ENTRY AND EXIT
LONG RUN COMPETITIVE EQUILIBRIUM
ECONOMIES OF SCALE
 Economies of scale
 Portion of the long-run average cost curve where long-run average costs decline as
output increases

 Diseconomies of scale
 Portion of the long-run average cost curve where long-run average costs increase
as output increases

 Constant returns to scale

 Portion of the long-run average cost curve that remains constant as output
increases.
ECONOMIES OF SCOPE

  
Economies of scope
 Exist when the total cost of producing and together is less than the total cost of producing each of
the type of output separately.

 Cost complementarity
 Exist when the marginal cost of producing one type of output decreases when the output of another
good is increased.
RETURNS TO SCALE

 Constant Returns to Scale – When all the inputs are increased by a certain
percentage the output increases by same percentage
fαK , ) =αf K( L, )
( αL

 Increasing Returns to Scale – The output increases more than in proportion to equal
increase in inputs
fαK , ) >αf K( L, )
( αL

 Decreasing Returns to Scale – The output increases less than in proportion to equal
increase in inputs
fαK , ) <αf K( L, )
( αL
COBB DOUGLAS PRODUCTION FUNCTION

 Returns to Scale in a Cobb Douglas Function

q = ALα K β

q(aK , aL) = A(aL) α (aK ) β

q(aK , aL) = a α + β ALα K β = a α + β q

 The returns to scale of a cobb-douglas production function will depend on the sum
of the powers of labour and capital function