Chapter 4

THE THEORY OF FIRMS

1.Production functions
2.Cost function
3.Profit maximization

1
1. Production functions
1.1. Production function
1.2. Marginal Physical Product
1.3. Marginal Rate of Technical Substitution (RTS)
1.4. Returns to Scale

2
 Production Function
• The firm’s production function for a
particular good (q) shows the maximum
amount of the good that can be produced
using alternative combinations of capital
(k) and labor (l)

q = f(k,l)

3
 Marginal Physical Product
• To study variation in a single input, we
define marginal physical product as the
additional output that can be produced by
employing one more unit of that input
while holding other inputs constant
q
marginal physical product of capital  MPk   fk
k
q
marginal physical product of labor  MPl   fl
l 4
 Diminishing Marginal
Productivity
• The marginal physical product of an input
depends on how much of that input is
used
• In general, we assume diminishing
marginal productivity

MPk  2f MPl  2f
 2  fk k  f11  0  2  fll  f22  0
k k l l
5
 Diminishing Marginal
Productivity
• Because of diminishing marginal
productivity, 19th century economist
Thomas Malthus worried about the effect
of population growth on labor productivity
• But changes in the marginal productivity of
labor over time also depend on changes in
other inputs such as capital
– we need to consider flk which is often > 0
6
 Average Physical Product
• Labor productivity is often measured by
average productivity
output q f (k, l )
APl   
labor input l l

• Note that APl also depends on the amount of

capital employed

7
 A Two-Input Production
Function
• Suppose the production function for
flyswatters can be represented by
q = f(k,l) = 600k 2l2 - k 3l3
• To construct MPl and APl, we must
assume a value for k
– let k = 10
• The production function becomes
q = 60,000l2 - 1000l3 8
 A Two-Input Production
Function
• The marginal productivity function is
MPl = q/l = 120,000l - 3000l2
which diminishes as l increases
• This implies that q has a maximum value:
120,000l - 3000l2 = 0
40l = l2
l = 40
• Labor input beyond l = 40 reduces output9
 A Two-Input Production
Function
• To find average productivity, we hold
k=10 and solve
APl = q/l = 60,000l - 1000l2
• APl reaches its maximum where
APl/l = 60,000 - 2000l = 0
l = 30

10
 A Two-Input Production
Function
• In fact, when l = 30, both APl and MPl are
equal to 900,000

• Thus, when APl is at its maximum, APl and

MPl are equal

11
 Isoquant Maps
• To illustrate the possible substitution of
one input for another, we use an
isoquant map
• An isoquant shows those combinations
of k and l that can produce a given level
of output (q0)

f(k,l) = q0
12
 Isoquant Map
• Each isoquant represents a different level of
output
– output rises as we move northeast
k per period

q = 30
q = 20

l per period
13
 Marginal Rate of Technical
Substitution (RTS)
• The slope of an isoquant shows the rate
at which l can be substituted for k
k per period
- slope = marginal rate of technical
substitution (RTS)
RTS > 0 and is diminishing for
kA
A increasing inputs of labor
B
kB
q = 20

l per period
lA lB 14
 Marginal Rate of Technical
Substitution (RTS)
• The marginal rate of technical substitution
(RTS) shows the rate at which labor can
be substituted for capital while holding
output constant along an isoquant

 dk
RTS (l for k ) 
dl q  q0

15
RTS and Marginal Productivities
• Take the total differential of the production
function:
f f
dq   dl   dk  MPl  dl  MPk  dk
l k
• Along an isoquant dq = 0, so
MPl  dl  MPk  dk
 dk MPl
RTS (l for k )  
dl q  q0 MPk
16
RTS and Marginal Productivities
• Because MPl and MPk will both be
nonnegative, RTS will be positive (or zero)

• However, it is generally not possible to

derive a diminishing RTS from the
assumption of diminishing marginal
productivity alone

17
RTS and Marginal Productivities
• To show that isoquants are convex, we
would like to show that d(RTS)/dl < 0
• Since RTS = fl/fk
dRTS d (fl / fk )

dl dl

dRTS [fk (fll  flk  dk / dl )  fl (fkl  fkk  dk / dl )]


dl ( fk ) 2
18
RTS and Marginal Productivities
• Using the fact that dk/dl = -fl/fk along an
isoquant and Young’s theorem (fkl = flk)
dRTS (fk2fll  2fk fl fkl  fl 2fk k )

dl ( fk )3
• Because we have assumed fk > 0, the
denominator is positive
• Because fll and fkk are both assumed to be
negative, the ratio will be negative if fkl is
positive 19
RTS and Marginal Productivities
• Intuitively, it seems reasonable that fkl = flk
should be positive
– if workers have more capital, they will be more
productive
• But some production functions have fkl < 0
over some input ranges
– when we assume diminishing RTS we are
assuming that MPl and MPk diminish quickly
enough to compensate for any possible negative
cross-productivity effects 20
 A Diminishing RTS
• Suppose the production function is
q = f(k,l) = 600k 2l 2 - k 3l 3
• For this production function
MPl = fl = 1200k 2l - 3k 3l 2
MPk = fk = 1200kl 2 - 3k 2l 3
– these marginal productivities will be
positive for values of k and l for which
kl < 400
21
 A Diminishing RTS
• Because
fll = 1200k 2 - 6k 3l
fkk = 1200l 2 - 6kl 3
this production function exhibits
diminishing marginal productivities for
sufficiently large values of k and l
– fll and fkk < 0 if kl > 200

22
 A Diminishing RTS
• Cross differentiation of either of the
marginal productivity functions yields
fkl = flk = 2400kl - 9k 2l 2

which is positive only for kl < 266

23
 A Diminishing RTS
• Thus, for this production function, RTS is
diminishing throughout the range of k and l
where marginal productivities are positive
– for higher values of k and l, the diminishing
marginal productivities are sufficient to
overcome the influence of a negative value for
fkl to ensure convexity of the isoquants

24
 Returns to Scale
• How does output respond to increases
in all inputs together?
– suppose that all inputs are doubled, would
output double?
• Returns to scale have been of interest
to economists since the days of Adam
Smith

25
 Returns to Scale
• Smith identified two forces that come
into operation as inputs are doubled
– greater division of labor and specialization
of function
– loss in efficiency because management
may become more difficult given the larger
scale of the firm

26
 Returns to Scale
• If the production function is given by q =
f(k,l) and all inputs are multiplied by the
same positive constant (t >1), then

Effect on Output Returns to Scale

f(tk,tl) = tf(k,l) Constant
f(tk,tl) < tf(k,l) Decreasing
f(tk,tl) > tf(k,l) Increasing

27
 Returns to Scale
• It is possible for a production function to
exhibit constant returns to scale for some
levels of input usage and increasing or
decreasing returns for other levels
– economists refer to the degree of returns to
scale with the implicit notion that only a fairly
narrow range of variation in input usage and
the related level of output is being considered

28
 Constant Returns to Scale
• Constant returns-to-scale production
functions are homogeneous of degree
one in inputs
f(tk,tl) = t1f(k,l) = tq
• This implies that the marginal
productivity functions are homogeneous
of degree zero
– if a function is homogeneous of degree k,
its derivatives are homogeneous of degree
k-1 29
 Constant Returns to Scale
• The marginal productivity of any input
depends on the ratio of capital and labor
(not on the absolute levels of these
inputs)
• The RTS between k and l depends only
on the ratio of k to l, not the scale of
operation

30
 Constant Returns to Scale
• The production function will be
homothetic
• Geometrically, all of the isoquants are
radial expansions of one another

31
 Constant Returns to Scale
• Along a ray from the origin (constant k/l),
the RTS will be the same on all isoquants
k per period

The isoquants are equally

spaced as output expands

q=3

q=2
q=1

l per period
32
 Returns to Scale
• Returns to scale can be generalized to a
production function with n inputs
q = f(x1,x2,…,xn)
• If all inputs are multiplied by a positive
constant t, we have
f(tx1,tx2,…,txn) = tkf(x1,x2,…,xn)=tkq
– If k = 1, we have constant returns to scale
– If k < 1, we have decreasing returns to scale
– If k > 1, we have increasing returns to scale 33
 Cobb-Douglas Production
Function
• Suppose that the production function is
q = f(k,l) = Akalb A,a,b > 0
• This production function can exhibit any
returns to scale
f(tk,tl) = A(tk)a(tl)b = Ata+b kalb = ta+bf(k,l)
– if a + b = 1  constant returns to scale
– if a + b > 1  increasing returns to scale
– if a + b < 1  decreasing returns to scale
34
 Cobb-Douglas Production
Function
• The Cobb-Douglas production function is
linear in logarithms
ln q = ln A + a ln k + b ln l
– a is the elasticity of output with respect to k
– b is the elasticity of output with respect to l

35
 CES Production Function
• Suppose that the production function is
q = f(k,l) = [k + l] /   1,   0,  > 0
  > 1  increasing returns to scale
  < 1  decreasing returns to scale
• For this production function
 = 1/(1-)
  = 1  linear production function
  = -  fixed proportions production function
  = 0  Cobb-Douglas production function
36
 Important Points to Note:
• If all but one of the inputs are held
constant, a relationship between the
single variable input and output can be
derived
– the marginal physical productivity is the
change in output resulting from a one-unit
increase in the use of the input
• assumed to decline as use of the input
increases
37
 Important Points to Note:
• The entire production function can be
illustrated by an isoquant map
– the slope of an isoquant is the marginal
rate of technical substitution (RTS)
• it shows how one input can be substituted for
another while holding output constant
• it is the ratio of the marginal physical
productivities of the two inputs

38
 Important Points to Note:
• Isoquants are usually assumed to be
convex
– they obey the assumption of a diminishing
RTS
• this assumption cannot be derived exclusively
from the assumption of diminishing marginal
productivity
• one must be concerned with the effect of
changes in one input on the marginal
productivity of other inputs
39
 Important Points to Note:
• The returns to scale exhibited by a
production function record how output
responds to proportionate increases in
all inputs
– if output increases proportionately with input
use, there are constant returns to scale

40
 2. Cost functions
2.1. Economic Cost
2.2. Short run Cost
2.3. Short run cost and Long run cost relationship

41
 Economic Cost
• The economic cost of any input is the
payment required to keep that input in
its present employment
– the remuneration the input would receive in
its best alternative employment

42
Two Simplifying Assumptions
• There are only two inputs
– homogeneous labor (l), measured in labor-
hours
– homogeneous capital (k), measured in
machine-hours
• entrepreneurial costs are included in capital costs
• Inputs are hired in perfectly competitive
markets
– firms are price takers in input markets
43
 Economic Profits
• Total costs for the firm are given by
total costs = C = wl + vk
• Total revenue for the firm is given by
total revenue = pq = pf(k,l)
• Economic profits () are equal to
 = total revenue - total cost
 = pq - wl - vk
 = pf(k,l) - wl - vk
44
 Economic Profits
• Economic profits are a function of the
amount of capital and labor employed
– we could examine how a firm would choose
k and l to maximize profit
• “derived demand” theory of labor and capital
inputs
– for now, we will assume that the firm has
already chosen its output level (q0) and
wants to minimize its costs
45
 Total Cost Function
• The total cost function shows that for
any set of input costs and for any output
level, the minimum cost incurred by the
firm is
C = C(v,w,q)
• As output (q) increases, total costs
increase

46
 Average Cost Function
• The average cost function (AC) is found
by computing total costs per unit of
output
C (v ,w , q )
average cost  AC (v ,w , q ) 
q

47
 Marginal Cost Function
• The marginal cost function (MC) is
found by computing the change in total
costs for a change in output produced
C (v ,w , q )
marginal cost  MC(v ,w , q ) 
q

48
 Graphical Analysis of
Total Costs
• Suppose that k1 units of capital and l1 units
of labor input are required to produce one
unit of output
C(q=1) = vk1 + wl1
• To produce m units of output (assuming
constant returns to scale)
C(q=m) = vmk1 + wml1 = m(vk1 + wl1)
C(q=m) = m  C(q=1)
49
 Graphical Analysis of
Total Costs
With constant returns to scale, total
Total
costs
costs
are proportional to output
AC = MC
C

Both AC and
MC will be
constant

Output
50
 Graphical Analysis of
Total Costs
• Suppose instead that total costs start
out as concave and then becomes
convex as output increases
– one possible explanation for this is that
there is a third factor of production that is
fixed as capital and labor usage expands
– total costs begin rising rapidly after
diminishing returns set in
51
 Graphical Analysis of
Total Costs
Total C
costs

Total costs rise

dramatically as
output increases
after diminishing
returns set in

Output
52
 Graphical Analysis of
Total Costs
Average
and MC is the slope of the C curve
marginal
costs MC
If AC > MC,
AC AC must be
falling

If AC < MC,
min AC
AC must be
rising
Output
53
 Shifts in Cost Curves
• The cost curves are drawn under the
assumption that input prices and the
level of technology are held constant
– any change in these factors will cause the
cost curves to shift

54
 Short-Run Total Costs
• Short-run total cost for the firm is
SC = vk1 + wl
• There are two types of short-run costs:
– short-run fixed costs are costs associated
with fixed inputs (vk1)
– short-run variable costs are costs
associated with variable inputs (wl)
55
 Short-Run Total Costs
• Short-run costs are not minimal costs for
producing the various output levels
– the firm does not have the flexibility of input
choice
– to vary its output in the short run, the firm
must use nonoptimal input combinations
– the RTS will not be equal to the ratio of
input prices
56
 Short-Run Total Costs
k per period
Because capital is fixed at k1,
the firm cannot equate RTS
with the ratio of input prices

k1

q2
q1

q0

l per period
l1 l2 l3
57
 Short-Run Marginal and
Average Costs
• The short-run average total cost (SAC)
function is
SAC = total costs/total output = SC/q
• The short-run marginal cost (SMC)
function is
SMC = change in SC/change in output = SC/q

58
 Relationship between Short-
Run and Long-Run Costs
SC (k2)
Total SC (k1)
costs C

SC (k0)
The long-run
C curve can
be derived by
varying the
level of k

Output
q0 q1 q2 59
 Relationship between Short-
Run and Long-Run Costs
Costs

SMC (k0) SAC (k0) MC The geometric

AC relationship
SMC (k1) SAC (k1)
between short-
run and long-run
AC and MC can
also be shown

Output
q0 q1 60
 Relationship between Short-
Run and Long-Run Costs
• At the minimum point of the AC curve:
– the MC curve crosses the AC curve
• MC = AC at this point
– the SAC curve is tangent to the AC curve
• SAC (for this level of k) is minimized at the same
level of output as AC
• SMC intersects SAC also at this point
AC = MC = SAC = SMC
61
 Important Points to Note:
• The firm’s average cost (AC = C/q)
and marginal cost (MC = C/q) can
be derived directly from the total-cost
function
– if the total cost curve has a general cubic
shape, the AC and MC curves will be u-
shaped

62
 Important Points to Note:
• All cost curves are drawn on the
assumption that the input prices are
held constant
– when an input price changes, cost curves
shift to new positions
• the size of the shifts will be determined by the
overall importance of the input and the
substitution abilities of the firm
– technical progress will also shift cost
curves 63
 Important Points to Note:
• In the short run, the firm may not be
able to vary some inputs
– it can then alter its level of production
only by changing the employment of its
variable inputs
– it may have to use nonoptimal, higher-
cost input combinations than it would
choose if it were possible to vary all
inputs
64
3. Profit Maximization

65
 Profit Maximization
• A profit-maximizing firm chooses both
its inputs and its outputs with the sole
goal of achieving maximum economic
profits
– seeks to maximize the difference between
total revenue and total economic costs

66
 Profit Maximization
• If firms are strictly profit maximizers,
they will make decisions in a “marginal”
way
– examine the marginal profit obtainable
from producing one more unit of hiring one
additional laborer

67
 Output Choice
• Total revenue for a firm is given by
R(q) = p(q)q
• In the production of q, certain economic
costs are incurred [C(q)]
• Economic profits () are the difference
between total revenue and total costs
(q) = R(q) – C(q) = p(q)q –C(q)

68
 Output Choice
• The necessary condition for choosing
the level of q that maximizes profits can
be found by setting the derivative of the
 function with respect to q equal to zero
d dR dC
 ' (q )   0
dq dq dq

dR dC

dq dq
69
 Output Choice
• To maximize economic profits, the firm
should choose the output for which
marginal revenue is equal to marginal
cost
dR dC
MR    MC
dq dq

70
 Second-Order Conditions
• MR = MC is only a necessary condition
for profit maximization
• For sufficiency, it is also required that
d 2 d' (q )
2
 0
dq q q * dq q q *

• “marginal” profit must be decreasing at

the optimal level of q
71
 Profit Maximization
revenues & costs Profits are maximized when the slope of
the revenue function is equal to the slope of
the cost function
C
R

The second-order
condition prevents us
from mistaking q0 as
a maximum

output
q0 q*
72
 Marginal Revenue
• If a firm can sell all it wishes without
having any effect on market price,
marginal revenue will be equal to price
• If a firm faces a downward-sloping
demand curve, more output can only be
sold if the firm reduces the good’s price
dR d [ p(q )  q ] dp
marginal revenue  MR(q )    pq
dq dq dq
73
 Marginal Revenue
• If a firm faces a downward-sloping
demand curve, marginal revenue will be
a function of output
• If price falls as a firm increases output,
marginal revenue will be less than price

74
 Marginal Revenue
• Suppose that the demand curve for a sub
sandwich is
q = 100 – 10p
• Solving for price, we get
p = -q/10 + 10
• This means that total revenue is
R = pq = -q2/10 + 10q
• Marginal revenue will be given by
MR = dR/dq = -q/5 + 10 75
 Profit Maximization
• To determine the profit-maximizing
output, we must know the firm’s costs
• If subs can be produced at a constant
average and marginal cost of $4, then
MR = MC
-q/5 + 10 = 4
q = 30

76
 Marginal Revenue and
Elasticity
• The concept of marginal revenue is
directly related to the elasticity of the
demand curve facing the firm
• The price elasticity of demand is equal
to the percentage change in quantity
that results from a one percent change
in price
dq / q dq p
eq,p   
dp / p dp q 77
 Marginal Revenue and
Elasticity
• This means that
q  dp  q dp   1 
MR  p   p 1     p1  
dq  p dq   e 
 q ,p 

– if the demand curve slopes downward, eq,p < 0

and MR < p
– if the demand is elastic, eq,p < -1 and marginal
revenue will be positive
• if the demand is infinitely elastic, eq,p = - and
marginal revenue will equal price
78
Marginal Revenue and
Elasticity

eq,p < -1 MR > 0

eq,p = -1 MR = 0

eq,p > -1 MR < 0

79
 The Inverse Elasticity Rule
• Because MR = MC when the firm
maximizes profit, we can see that
 1  p  MC 1
MC  p1   
 e  p eq ,p
 q ,p 

• The gap between price and marginal

cost will fall as the demand curve facing
the firm becomes more elastic
80
 The Inverse Elasticity Rule
p  MC 1

p eq ,p

• If eq,p > -1, MC < 0

• This means that firms will choose to
operate only at points on the demand
curve where demand is elastic

81
 Average Revenue Curve
• If we assume that the firm must sell all
its output at one price, we can think of
the demand curve facing the firm as its
average revenue curve
– shows the revenue per unit yielded by
alternative output choices

82
 Marginal Revenue Curve
• The marginal revenue curve shows the
extra revenue provided by the last unit
sold
• In the case of a downward-sloping
demand curve, the marginal revenue
curve will lie below the demand curve

83
 Marginal Revenue Curve
As output increases from 0 to q1, total
price revenue increases so MR > 0
As output increases beyond q1, total
revenue decreases so MR < 0

p1

D (average revenue)

output
q1

MR 84
 Marginal Revenue Curve
• When the demand curve shifts, its
associated marginal revenue curve
shifts as well
– a marginal revenue curve cannot be
calculated without referring to a specific
demand curve

85