Professional Documents
Culture Documents
Key definitions
- Production is the process that transforms inputs into
outputs, i.e. goods and services, to satisfy human wants.
- Common types of inputs
Q = A K αLβ
+
Production function
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+ 12
ISOCOST
0 TC/w L
+ PRODUCTION WITH TWO
VARIABLE INPUTS
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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.
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+ 15
KA A
ΔK
KB B
ΔL
0 LA LB L
+PRODUCTION WITH TWO
VARIABLE INPUTS
K
30
20
10
0 L
16When 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
17 10
0 L
However, when there are increasing returns to scale as shown in the
diagram, the isoquants move closer together
+ PRODUCTION WITH TWO
VARIABLE INPUTS
K
30
20
10
0 L
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+PRODUCTION WITH TWO 19
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
+ PRODUCTION WITH TWO 20
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
+ PRODUCTION WITH TWO 21
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
+
2. Production cost
C
TC
VC
FC
FC
FC
0 Q
+
Production cost
TC = FC + VC
ATC = AFC + AVC
+
Production cost
MC
MC,P
ATC
ATCmin AVC
AVCmin
AFC
0
Q
+
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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Long-run cost
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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+
K TC2
TC1
K2 M2
M3
K1 Q2
M1
Q1
39
0 L1 L2 L3 L
+
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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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+
EC (C / C )/(q / q)
As output increases, the firm’s average cost of producing that output is likely to
decline, at least to a point.
This can happen for the following reasons:
1. If the firm operates on a larger scale, workers can specialize in the
activities at which they are most productive.
2. Scale can provide flexibility. By varying the combination of inputs utilized
to produce the firm’s output, managers can organize the production process
more effectively.
3. The firm may be able to acquire some production inputs at lower cost
because it is buying them in large quantities and can therefore negotiate
better prices. The mix of inputs might change with the scale of the firm’s
operation if managers take advantage of lower-cost inputs.
Economies and Diseconomies of Scale
At some point, however, it is likely that the average cost of production will
begin to increase with output.
There are three reasons for this shift:
1. At least in the short run, factory space and machinery may make it
more difficult for workers to do their jobs effectively.
2. Managing a larger firm may become more complex and inefficient as
the number of tasks increases.
3. The advantages of buying in bulk may have disappeared once certain
quantities are reached. At some point, available supplies of key inputs
may be limited, pushing their costs up.
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Firm objectives
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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The case of Vingroup
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Profit maximization vs Revenue
maximization
- Firms face less risk to be taken over. - Firms may have greater social
influence
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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.
+
TC
TR2
TR 1
FC TR
π0
0 Q1 Q2 Q
-FC
π
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