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CHAPTER 3: FIRM THEORY

Nguyen Thi Minh Thu

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Chapter outline

1. Long-run production
2. Long run cost
3. Firm objectives
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1. Production function

Key definitions
- Production is the process that transforms inputs into
outputs, i.e. goods and services, to satisfy human wants.
- Common types of inputs

Capital (K) : machines and building

Labour (L) : human services

Material (M): raw inputs and processed products

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Production function

 Production function is a mathematic

representation of the relationship between
quantities of inputs used and maximum quantity
of output that can be produced given the current
technology.
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Production function

 Production function with two inputs

Q = f (K, L)
Where
Q: output quantity
K: physical capital
L: labour
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PRODUCTION FUNCTION

 Cobb- Douglas production function

Q = A K αL β
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Production function

 Short run: The period of time during which at

least one input is fixed

 Long run: the period of time which is lengthy

enough for all inputs to vary
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Production function

 returns to scale Rate at which output increases as

inputs are increased proportionately.
 increasingreturns to scale Situation in which output
more than doubles when all inputs are doubled.
 constantreturns to scale Situation in which output
doubles when all inputs are doubled.
 decreasing returns to scale Situation in which output
less than doubles when all inputs are doubled.
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PRODUCTION WITH TWO
VARIABLE INPUTS

 isocost line Graph showing all possible

combinations of labor and capital that can
be purchased for a given total cost.
• TC = wL + rK
K = - w/r L + TC/ r

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PRODUCTION WITH TWO

VARIABLE INPUTS
• If only production K
cost changes, the
TC/r
Isocost curve shifts
parallel.
• If interest rate or
wage changes, the
Iso-cost curve pivots

ISOCOST

0 TC/w L
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VARIABLE INPUTS

Isoquant Curve showing all possible combinations of

inputs that yield the same output.

isoquant map Graph combining a number of

isoquants, used to describe a production function.

Assumption: The firm operates efficiently (MP >0)

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PRODUCTION WITH TWO
VARIABLE INPUTS
• marginal rate of technical substitution (MRTS)
Amount by which the quantity of one input can be
reduced when one extra unit of another input is used, so
that output remains constant.

• The slope of the isoquant at any point measures the

marginal rate of technical substitution—the ability of the
firm to replace capital with labor while maintaining the
same level of output.

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PRODUCTION WITH TWO

VARIABLE INPUTS
• ΔK* MPK + ΔL* MPL = 0 K

ΔK/ΔL = - MPL / MPK

 MRTS = MPL/ MPK

KA A
ΔK
KB B
ΔL
0 LA LB L
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VARIABLE INPUTS
K

30

20
10

0 L
14When a firm’s production process exhibits constant returns to
scale, the isoquants are equally spaced as output increases
proportionally.
+PRODUCTION WITH TWO
VARIABLE INPUTS
K

30
20
15 10

0 L
However, when there are increasing returns to scale as shown in the
diagram, the isoquants move closer together
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VARIABLE INPUTS
K

30

20
10

0 L

16
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VARIABLE INPUTS
Isoquants When Inputs Are Perfect
Substitutes
 When the isoquants are
K straight lines, the MRTS
is constant. Thus the rate
at which capital and labor
can be substituted for
each other is the same no
matter what level of
inputs is being used.

0 L
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VARIABLE INPUTS
fixed-proportions
production function K
Production function with
L-shaped isoquants, so
that only one combination
of labor and capital can
be used to produce each
level of output.

0 L
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VARIABLE INPUTS
Optimal baskets: producing a
given output at the minimum
cost or producing the K
maximum quantity with a
given cost
- w/r = - MPL/ MPK M
K*
MPK/r = MPL/w
ISOQUANT

TC

0 L* L
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2. Production cost

Economic cost versus accounting cost

- Explicit costs are input costs that require a direct
outlay of money by the firm
- Implicit costs are input costs that do not require an
outlay of money by the firm.
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2. Production cost

- Total Accounting cost is the sum of explicit costs that

a firm incur.
- Total Economic cost is the sum of both implicit and
explicit costs.
 Economic cost is often greater than accounting cost.
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Production cost

 Sunk costs are costs that a firm have already

incurred and cannot be recovered
 Sunk cost fallacy
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Production cost

2.2 Short run production cost

 Fixed costs (FC) are those costs that do not vary with
the output level.
 Variable cost( VC) are those costs that do vary with
the output level.
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Production cost

 Total cost (TC) is the sum of both fixed costs and

variable costs
 TC = FC +VC
 The vertical distance between total cost curve and
variable cost curve remains constant.
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Production cost

C
TC
VC
FC

FC
FC

0 Q
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Production cost

 Average fixed cost is the fixed cost of each typical

unit of product
 Average variable cost is the variable cost of each
typical unit of product.
 Average total cost is the total cost of each typical
unit of product.
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Production cost

TC = FC + VC
 ATC = AFC + AVC
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Production cost

 Relationship between AVC and APL

 As average product falls, average variable cost will

rise substantially
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Production cost

 Relationship between MC and MPL

 MP first rises and then falls

L

MC first declines and then goes up

MC curve is U- shaped
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Production cost

 Relationship between MC and AVC

MC > AVC : AVC 
MC < AVC : AVC 
MC = AVC : AVC min
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Production cost
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Production cost

 Relationship between MC and ATC

MC > ATC : ATC 
MC < ATC : ATC 
MC = ATC : ATC min
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Production cost

MC
MC,P

ATC

ATCmin AVC

AVCmin

AFC
0
Q
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Long run cost
• In the long run, all factors are variable as
the firm have time to build new factory, to
install new machines, etc.
• Long run cost is the minimum cost to
produce a given level of output

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LÝ THUYẾT CHI PHÍ

Production
K expansion curve C
LTC

TC3

M3
TC2
M2 Q3
TC1
M1
Q1 Q2
TC3
TC1 TC2

0 L 0 Q1 Q2 Q3 Q
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Expansion path: The curve that traces the

minimum-cost combinations of two factors
as output increases.
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PRODUCTION COST
• Production with two variable inputs can save more money than
production with on variable input.

K TC2
TC1

K2 M2
M3
K1 Q2
M1

Q1

37
0 L1 L 2 L3 L
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- Long run average cost curve shows how

average cost varies with output on the
assumption that all factors are variable and
the least-cost combinations of inputs will be
chosen for each output.
- Long-run marginal cost: the extra cost of
doing one more unit of output assuming that
all factors are variable.

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The relationship between the long-run and
short-run average cost curves

AC
SACK1 SACK3
SACK2
LAC

0
Q1 Q2 Q

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Economies of scale: LRAC decreases as

output increases
 Additional unit cost less than the average
 LRMC lies below the LRAC curve,
pulling it down
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 Diseconomies of scale: LRAC increases as

output increases
 Additional unit costs more than the
average
 LRMC lies above the LRAC curve,
pulling it up
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 Economies of scale are often measured in terms of a cost-

output elasticity, EC. EC is the percentage change in the cost of
production resulting from a 1-percent increase in output:

EC  (C / C )/(q / q)

 To see how EC relates to our traditional measures of cost,

rewrite equation as follows:

EC  (C / q)/(C / q)  MC/ AC

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Firm objectives

 Traditional Goal: Profit maximization

Q* : π = TR – TC max
π’ (Q) =0

TR’ (Q) – TC’ (Q) =0

MR – MC = 0
MR = MC
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Profit maximization

MC
P

P*

D
MR
0 Q
Q*
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Firm objectives
 The traditional objective of the owner-managed
firm is assumed to be short-run profit
maximization.
 Difficulties in maximizing profit
- Lack of information: unlikely to know precisely
the demand and MR.
- Time period: Demand and costs of firm are not
static over time.
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Firm objectives
 In modern corporation, there is a divorce between
ownership and control  the Principal- Agent
problem
 An alternative objective can be sales revenue
maximization in the short run subject to a profit
constraint:
- Managers’ salaries, power and prestige may
depend on sales revenue.
- Sufficient profit is to keep shareholders happy.
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TC

TR2
TR 1

FC TR
π0
0 Q1 Q2 Q
-FC
π
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