Part 2: Producer behavior

Topic 4: Technology, cost and profit

4.1. Technology
- Technological constraints – 19.2, 19.3
- Properties of technology – 19.4, 19.5
- Technical rate of substitution – 19.6, 19.7, 19.8
- Long run and short run – 19.9
- Return to scale – 19.10
4.2. Cost minimization
- Cost minimization - 21.1.
- Short run and long run costs 21.4
- Returns to scale and cost functions 21.3
4.3. Cost curves
- Average costs, marginal costs, variable costs – 22.1, 22.2, 22.3
- Long-run costs 22.5, 22.6, 22.7
4.4. Profit maximization
- Profit maximization in short run 20.1, 20.6, 20.7
- Profit maximization in the long run 20.8 1
 4.1. Technology
4.1.1. Technological constraints – 19.2, 19.3
• Production transforms a set of inputs into a set of outputs
• Inputs/factors of production:
• labor, land, raw materials, capital
• Measured in flows
• Output:
• The amount of goods and services produces by the firm is the firm’s output.
• In flow too

2
Technology

• What is technology?
• Technology refers to all alternative methods of combining inputs to produce
outputs. It does not refer to a specific new invention like the tablet computer. The
firm will search for the production technology that allows it to produce the
desired level of output at the lowest cost.
• ...determines the quantity of output that is feasible to attain for a given set of inputs.

• What is a "technological constraint"?

• Technological constraints imply that a given amount of output can be produced
only with certain combination of inputs.

3
 Technological constraints

1.Production set: all combinations of inputs

and outputs that are technically feasible.
2.Production function: upper boundary of
production set.
1. The production function tells us the maximum C
possible output that can be attained by the firm for y1
any given (combination) of inputs. B (x1, y1)

3.Examples (input, output):

1. A (9 hrs of studying per week, final grade of 4) in
PS but not efficient (below PF).
2. B (9 hrs of studying per week, final grade of 10) A
not in PS (i.e. not feasible).
3. (9 hrs of studying per week, final grade of 8) in PS
and on PF (feasible and efficient).
x1 4
 Technology Sets
Output Level

Technically
y’ efficient plans

The technology set

Technically
y”
inefficient
plans

x’ x
Input Level
5
 Production Functions
• Production function: measure maximum possible output that firm can get from a given
amount of input
y  f ( x1 , , xn )
• q = f(L, K)
• q = output (note that book uses y for output)
• K = Capital
• L = Labor
• Examples:
• q=f(L,K)=L+K
• q=f(L,K)=L×
• q=f(L)=
• q=f(L,K)=min{L,K/0.5}
• Remember: every input and output is expressed in units per unit of time.

6
Isoquants: Đường đẳng lượng
• Ex: measure the maximum amount of output y that could get if we had
x1 units of factor 1 and x2 units of factor 2
• Set of all possible combinations of inputs 1 and 2 that are just sufficient
to produce a given amount of output: An isoquant
• Isoquants: represent all the combinations of inputs that produce a constant
level of output.
• Isoquants are like indifference curves for preferences, except "isoquants"
describe technology not preferences.
• Isoquants are labeled with the amount of output they can produce: labeling of
isoquants is fixed by the technology and doesn’t have the kind of arbitrary nature that
the utility labeling has.
• Warning: a monotonic transformation of f(K,L) does not give the same technology!
7
 Examples of technology: Fixed proportions

Function: f(x1, x2) = min{x1, x2}

• Producing holes: Input factor: one man, one

shovel. One extra shovels aren’t worth
anything, and neither one extra man.
•  Total number of holes can produce:
minimum of the number of men and the
number of shovels have.

• Function: y=min {man, shovel}

(Like the case of perfect complements in

consumer theory)
8
 Examples of technology: Perfect substitutes

Function: f(x1, x2) = x1 +x2

• Harvesting fruits and the inputs are red

harvesting machine and blue harvesting
machine .
• The amount of fruits harvested depends
only on the total number of machines

(Like the case of perfect substitutes in

consumer theory)

9
 Examples of technology: Cobb-Douglas

Function: f(x1, x2) = x2 All isoquants are hyperbolic,

asymptoting to, but never
• A: scale of production: How much output we touching any axis.
would get if we used 1 unit of each input
• a, b: Measure how the amount of output
responds to changes in the input y  x1a1 x a2 2
y" > y'
• Simplify: usually assume A = 1, and a+b=1
• Cobb-Douglas isoquants have the same nice, x1a1 x a2 2  y"
well-behaved shape that the Cobb-Douglas
a1 a 2
indifference curves have x1 x 2  y'
x1

10
4.1.2. Properties of technology
A well-behaved technology is:

• Monotonic: more inputs produce more output

• Convexity: averages produce more than extremes

11
Well-Behaved Technologies - Monotonicity
• Monotonicity: More of any input generates more output.
y y

monotonic

not
monotonic

x x
12
Well-Behaved
Technologies
x2
higher output

A B C
40
yº200

yº50 yº100

10 20 40 x1

13
 Well-Behaved Technologies - Convexity
• Convexity: If the input bundles x’ and x” both provide y units of output then the
mixture tx’ + (1-t)x” provides at least y units of output, for any 0 < t < 1.
x2

x'2
 tx'1  ( 1  t ) x"1 , tx'2  ( 1  t ) x"2 

yº120
x"
2
yº100

x'1 x"
1 x1 14
 Marginal Products
• Using more input x1, keeping factor x2 fixed. How much more output will get per
additional unit of factor 1?
• Marginal production of factor 1:

• Marginal product is a rate: the extra amount of output per unit of extra input

• Marginal utility: ordinal nature

• Marginal product: physical output - specific number - can be observed.
15
4.1.3. Technical rate of substitution
• Suppose input bundle (x1, x2)
• Same amount of y, How much extra of factor 2, Δx2, do we need if we
are going to give up a little bit of factor 1, Δx1?
• Slope of the isoquant = the technical rate of substitution (TRS)
• TRS measures the tradeoff between two inputs in production

16
Diminishing marginal product

• Farming example: Considered changing only the labor input, holding

the land and raw materials fixed.
• 1 man on 1 hectare of land: Produce 100kg of corn
• 2 man on 1 hectare of land: Produce 200kg of corn MP = 100
• 3 man on 1 hectare of land: Produce 290kg of corn MP = 90
• After 4 or 5 people are added the additional output per worker will drop to
90, 80, 70,…n
• Diminishing marginal product: marginal product of a factor will
diminish as we get more and more of that factor (Δy/Δx1)

17
Diminishing technical rate of substitution

• Increase the amount of factor 1, and adjust factor 2 so as to stay on

the same isoquant, the technical rate of substitution declines.
• TRS = Δx2/Δx1
• slope of an isoquant must decrease in absolute value as we move
along the isoquant in the direction of increasing x1, and it must
increase as we move in the direction of increasing x2.
•  isoquants will have the same sort of convex shape that well-
behaved indifference curves have

18
 4.1.4. Long run and short run – 19.9
• Short run: Some factors of production are fixed at predetermined levels
• Example: Our farmer might only consider production plans that involve a fixed amount of land, if that is all
he has access to. It may be true that if he had more land, he could produce more corn, but in the short run
he is stuck with the amount of land that he has.

• Long run: All factors of production can be varied. No fixed factors

• How long is the long run? It depends on specific type of production
• For automobile manufacturer it can take years to change size of plant. For travel agency - months.

• is the long-run production function (both x 1 and x2 are variable).

• is the short-run production function when x 2 fixed and = 1

19
function for the short run is f()

20
4.1.5. Return to scale
• Marginal products describe the change in output level as a single input
level changes.
• Returns-to-scale describes how the output level changes as all input levels
change in direct proportion (e.g. all input levels doubled, or halved).

21
Constant returns-to-scale
f (kx 1 , kx 2 ,  , kx n )  kf ( x 1 , x 2 ,  , x n )
E.g. (k = 2) doubling all input levels doubles the output level.

Output Level
y=
2y’
f(x)

y’

x’ 2x’ x
Input Level 22
Diminishing returns-to-scale.
f (kx 1 , kx 2 ,  , kx n )  kf ( x 1 , x 2 ,  , x n )
E.g. (k = 2) doubling all input levels less than doubles the output level.
Output Level

2f(x’) y = f(x)

f(2x’) Decreasing
returns-to-scale
f(x’)

Input Level

x’ 2x’ x 23
Increasing returns-to-scale
f (kx 1 , kx 2 ,  , kx n )  kf ( x 1 , x 2 ,  , x n )
E.g. (k = 2) doubling all input levels, get more than doubles the output level.

Output Level
Increasing
y = f(x)
returns-to-scale
f(2x’)

2f(x’)
f(x’)

x’ 2x’ x
Input Level 24
• A single technology can ‘locally’ exhibit different returns-to-scale.

Output Level

y = f(x)
Increasing
returns-to-scale
Decreasing
returns-to-scale

x
Input Level
25
Question 1: Following functions exhibit constant, increasing
or decreasing returns-to-scale?

a. The perfect-substitutes production function is

y  a 1 x 1  a 2x 2    a n x n .
b. The perfect-complements production function is
y  min{ a 1 x 1 , a 2x 2 ,  , a n x n }.
c. The Cobb-Douglas production function is
a1 a 2 an
y  x1 x 2  xn .

Question 2: Can a technology exhibit increasing returns-to-scale even if

all of its marginal products are diminishing? Take an example?
26
Examples of Returns-to-Scale
The perfect-substitutes production function is
y  a 1 x 1  a 2x 2    a n x n .

Expand all input levels proportionately by k. The output level becomes

a1 (kx1 )  a 2 (kx 2 )    an (kxn )
 k ( a1x1  a 2x 2    anxn )
 ky.

The perfect-substitutes production function exhibits constant returns-to-scale.

27
The perfect-complements production function
is
y  min{ a 1 x 1 , a 2x 2 ,  , a n x n }.

Expand all input levels proportionately by k. The output level becomes

min{ a1 (kx1 ), a 2 (kx 2 ),  , an (kxn )}

 k (min{ a1x1 , a 2x 2 ,  , anxn })
 ky.

The perfect-complements production function exhibits constant returns-to-scale.

28
The Cobb-Douglas production function is
a1 a 2 an
y  x1 x 2  xn .

Expand all input levels proportionately by k. The output level becomes

(kx1 ) a1 (kx 2 ) a 2 (kxn ) an The Cobb-Douglas technology’s

 k a1k a 2 k an x a1 x a 2 x an returns-to-scale is:
 constant if a1+ … + an = 1
a1  a 2  an a1 a 2 an
k x1 x 2  xn  increasing if a1+ … + an > 1
 decreasing if a1+ … + an < 1.
a1  an
k y.

29
Returns-to-Scale
• Q: Can a technology exhibit increasing returns-to-scale even if all of its marginal
products are diminishing?
• A: Yes.
• E.g.
2/ 3 2/ 3 4
y  x1 x 2 . a1  a 2   1
3

30
So a technology can exhibit increasing returns-to-scale even if all of its marginal
products are diminishing. Why?
• A marginal product is the rate-of-change of output as one input level increases,
holding all other input levels fixed.
• Marginal product diminishes because the other input levels are fixed, so the
increasing input’s units have each less and less of other inputs with which to work.
• When all input levels are increased proportionately, there need be no diminution
of marginal products since each input will always have the same amount of other
inputs with which to work. Input productivities need not fall and so returns-to-
scale can be constant or increasing.

31
Review question
1. Consider the production function f(x1, x2) = . Does this exhibit constant, increasing, or
decreasing returns to scale?
2. Consider the production function f(x1, x2) = . Does this exhibit constant, increasing, or
decreasing returns to scale?
3. The Cobb-Douglas production function is given by f(x1, x2) = It turns out that the type of
returns to scale of this function will depend on the magnitude of a + b. Which values of a + b will
be associated with the different kinds of returns to scale?
4. The technical rate of substitution between factors x2 and x1 is −4. If you desire to produce the
same amount of output but cut your use of x1 by 3 units, how many more units of x2 will you
need?
5. True or false? If the law of diminishing marginal product did not hold, the world’s food supply
could be grown in a flowerpot.
6. In a production process is it possible to have decreasing marginal product in an input and yet
32
increasing returns to scale?
 Solution
1. Consider the production function f(x1, x2) = . Does this exhibit constant, increasing, or
decreasing returns to scale?
2. Consider the production function f(x1, x2) = . Does this exhibit constant, increasing, or
decreasing returns to scale?
3. The Cobb-Douglas production function is given by f(x1, x2) = It turns out that the type of returns
to scale of this function will depend on the magnitude of a + b. Which values of a + b will be
associated with the different kinds of returns to scale?
4. The technical rate of substitution between factors x2 and x1 is −4. If you desire to produce the
same amount of output but cut your use of x1 by 3 units, how many more units of x2 will you need?
5. True or false? If the law of diminishing marginal product did not hold, the world’s food supply
could be grown in a flowerpot.
6. In a production process is it possible to have decreasing marginal product in an input and yet
increasing returns to scale? 33
Topic 4: Technology, cost and profit
4.1. Technology
- Technological constraints – 19.2, 19.3
- Properties of technology – 19.4, 19.5
- Technical rate of substitution – 19.6, 19.7, 19.8
- Long run and short run – 19.9
- Return to scale – 19.10
4.2. Cost minimization
- Cost minimization - 21.1.
- Short run and long run costs 21.4
- Returns to scale and cost functions 21.3
4.3. Cost curves
- Average costs, marginal costs, variable costs – 22.1, 22.2, 22.3
- Long-run costs 22.5, 22.6, 22.7
4.4. Profit maximization
- Profit maximization in short run 20.1, 20.6, 20.7
- Profit maximization in the long run 20.8 34
4.2. Cost minimization
- Cost minimization - 21.1.
- Short run and long run costs 21.4
- Returns to scale and cost functions 21.3

Study the behavior of profit-maximizing firms

• Minimize the cost of producing a given level of out put
• How to choose the most profitable level of output

35
 4.2.1. Cost minimization
• A firm is a cost-minimizer if it produces any given output level y ³ 0 at smallest
possible total cost.
• c(y) denotes the firm’s smallest possible total cost for producing y units of output.
• c(y) is the firm’s total cost function.
• input prices w = (w1,w2,…,wn)
the total cost function will be written as:
C(w1,…,wn,y)  Minimize

36
4.2.1. Cost minimization
• 2 input factors: Amount: x1, x2
Price: w1, w2;
Production function: y= f(x1, x2)

 cost function:
Combinations of input that have some given level of cost, C:

37
 Iso-cost Lines (Đường đẳng phí)
x2 Slopes = -w1/w2.
• Every point on an isocost curve has the
same cost, C,
• Higher isocost lines are associated with c” º w1x1+w2x2
higher costs.
• Generally, given w1 and w2, the equation
of the $c iso-cost line is c’ º w1x1+w2x2
w 1x 1  w 2 x 2  c
w1 c
x2   x1  . c’ < c”
w2 w2

• Slope is - w1/w2.
38
x1
 The Cost-Minimization Problem
x2 The y’-Output Unit Isoquant
x2

x2*
f(x1,x2) º y’ f(x1,x2) º y’
x1 x1* x1

All input bundles yielding y’ units of output. Which is the cheapest?

39
 The Cost-Minimization
Problem
 If isoquant is a nice smooth curve,
conditions of cost-minimizing point
(tangency):
(a) f(
(b) slope of isocost = slope of isoquant

w1 MP1
  TRS   at ( x*1 , x*2 ).
w2 MP2

40
 Total cost function
• Conditional factor demand functions or derived factor demands:
• x1(w1, w2, y)
• x2(w1, w2, y)
• Function measures how much of each factor would the firm use if it wanted to
produce a given level of output in the cheapest way.
• EXAMPLE: Minimizing Costs for Specific Technologies (See textbook)
• perfect complements: f(x1, x2) = min{x1, x2}
 c(w1, w2, y) = w1y + w2y = (w1 + w2)y
• perfect substitutes technology, f(x1, x2) = x1 + x
 c(w1, w2, y) = min{w1y, w2y} = min{w1, w2}y.
• Cobb-Douglas technology, f(x1, x2) =

41
Cost function of Cobb-Douglas technology
• Example: A firm’s Cobb-Douglas production function

• Input prices are w1 and w2.

• What are the firm’s conditional input demand functions?
• What is the firm’s total cost function?

• Hint: Take a bundle satisfy conditional cost-minimizing point

Conditional demand Function from: x1(w1, w2, y); x2(w1, w2, y)
Total cost function form C(w1,w2,y)

42
A Cobb-Douglas: conditional input demand functions
 At the input bundle (x1*,x2*) which minimizes the cost of producing y output units:
(a)
(b) Slope isoquant = slope isocost:

 =
Replay to function (a):
 Firm’s conditional demand for input 1: =
 Firm’s conditional demand for input 2: =
 So the cheapest input bundle yielding y output units is

x*1 ( w1 , w 2 , y ), x*2 ( w1 , w 2 , y )
  w  2/ 3  2w  1/ 3 
  2 y,  1 y .
  2w 1   w2 
  43
 
A Cobb-Douglas: total cost function
So the firm’s total cost function is
c( w 1 , w 2 , y )  w 1x*1 ( w 1 , w 2 , y )  w 2x*2 ( w 1 , w 2 , y )
2/ 3 1/ 3
 w2   2w 1 
 w1   y  w2  y
 2w 1   w2 
2/ 3
 
1
  w 11/ 3 w 22/ 3 y  21/ 3 w 11/ 3 w 22/ 3 y
 2
1/ 3
 w 1w 2 
2
 3  y.
 4 

44
A Perfect Complements Example of Cost
Minimization
• The firm’s production function is y  min{ 4 x 1 , x 2 }.

• Input prices w1 and w2 are given.

• What are the firm’s conditional demands for inputs 1 and 2?
• What is the firm’s total cost function?

45
The firm’s production function is y  min{ 4 x 1 , x 2 }

* y
x1 ( w 1 , w 2 , y ) 
The conditional input demands are 4
x*2 ( w 1 , w 2 , y )  y .
So the firm’s total cost function is c( w 1 , w 2 , y )  w 1x*1 ( w 1 , w 2 , y )
 w 2x*2 ( w 1 , w 2 , y )
y  w1 
 w1  w 2y    w 2  y.
4  4 

46
A Perfect Complements Example of Cost Minimization
x2
4x1 = x2

x2* = y min{4x1,x2} º y’

x1* x1
= y/4

Where is the least costly input bundle yielding y’ output units? 47

4.2.2. Short run and long run costs 21.4
• The short-run cost function is defined as the minimum cost to produce a
given level of output, only adjusting the variable factors of production.

• The long-run cost function gives the minimum cost of producing a given
level of output, adjusting all of the factors of production.

48
Short-run cost function
• Short run factor 2 is fixed at some predetermined level

• Short-run factor demands as

• Example: if the building size is fixed in the short run, then the number of
workers that a firm wants to hire at any given set of prices and output choice
will typically depend on the size of the building.
• Cost short-run function:

49
 Long-run cost function
• long-run cost function both factors are free to vary :

• Long-run costs depend only on the level of output that the firm wants
to produce along with factor prices
• Long-run factor demands: x1 = x1(w1, w2, y)
x2 = x2(w1, w2, y)
• Long-run cost function

50
 4.2.3 Returns to scale and cost functions
• Average Total Production Costs: For positive output levels y, a firm’s average
total cost of producing y units is:

• The returns-to-scale properties of a firm’s technology determine how average

production costs change with output level.
• Our firm is presently producing y’ output units.
• How does the firm’s average production cost change if it instead produces 2y’ units of
output?

51
Constant Returns-to-Scale
• If a firm’s technology exhibits constant returns-to-scale then doubling its output
level from y’ to 2y’ requires doubling all input levels.
• Total production cost doubles.
• Average production cost does not change.

Decreasing Returns-to-Scale
• If a firm’s technology exhibits decreasing returns-to-scale then doubling its
output level from y’ to 2y’ requires more than doubling all input levels.
• Total production cost more than doubles.
• Average production cost increases.
52
 Increasing Returns-to-Scale
$/output unit

• If a firm’s technology exhibits

increasing returns-to-scale then AC(y)
doubling its output level from y’ to decreasing r.t.s.
2y’ requires less than doubling all
input levels. constant r.t.s.
• Total production cost less than
doubles.
increasing r.t.s.
• Average production cost decreases.

53
 Review question
1. Prove that a profit-maximizing firm will always minimize costs.
2. If a firm is producing where MP1/w1 > MP2/w2, what can it do to reduce costs
but maintain the same output?
3. Suppose that a cost-minimizing firm uses two inputs that are perfect substitutes.
If the two inputs are priced the same, what do the conditional factor demands
look like for the inputs?
4. The price of paper used by a cost-minimizing firm increases. The firm responds
to this price change by changing its demand for certain inputs, but it keeps its
output constant. What happens to the firm’s use of paper?

54
4.3. Cost curves
- Average costs, marginal costs, variable costs – 22.1, 22.2, 22.3
- Long-run costs 22.5, 22.6, 22.7
4.4. Profit maximization
- Profit maximization in short run 20.1, 20.6, 20.7
- Profit maximization in the long run 20.8
- Discussion

55
 4.3. Cost curves
4.3.1. Average costs, marginal costs, variable costs

Average costs
• Cost function: c(w1, w2, y)
• Suppose prices of input factor are fixed
Cost function: C(y)
• Fixed cost (F): the firm’s fixed cost, does not vary with output level
(cost to short-run fixed inputs)
• Variable costs: Costs change when output change:
Total cost: C(y) = F +
56
Average cost function: Measure cost per unit of output:

AVY(y): Average variable costs

AFC(y): Average fixed costs

57
$
c(y)
c( y )  F  c v ( y )
cv(y)
F

F
y

58
 Construction of the average cost curve

(A) The average fixed costs decrease as output is increased.

(B) The average variable costs eventually increase as output is increased.
(C) The combination of these two effects produces a U-shaped average cost curve
59
Marginal costs
• Marginal cost curve: measures change in costs for a given change in
output.

• Marginal cost in term of the variable cost function:

• F don’t change as y changes

• MC is the slope of both the variable cost and the total cost functions.

60
Marginal costs and cost curve

• Rage: AVC is decreasing

 MC<AVC
• cost of each additional unit
produced is les than average up to
that point
• Range: AVC is increasing
 MC>AVC
• MC=ACV: MC curve must
intersect the AVC curve at its
minimum point.

AVC decreasing AVC increasing

61
MC<AVC MC>AVC
Sum up
• The average variable cost curve may initially slope down but need
not. However, it will eventually rise, as long as there are fixed factors
that constrain production.
• The average cost curve will initially fall due to declining average fixed
costs but then rise due to the increasing average variable costs.
• The marginal cost and average variable cost are the same at the first
unit of output.
• The marginal cost curve passes through the minimum point of both
the average variable cost and the average cost curves.

62
 Marginal costs and Variable costs
(y) = [(1) - (0)] + [(2) - (1)] + … +
[(y - 1) - (y – 2)]+ [(y) - (y - 1)]

(y) = MC(0) + MC (1) + …+ MC(y-2) + MC(y-1)

= MC(y-1) + MC(y-2) + … + MC(0)

The area under the marginal cost curve gives

the variable costs y

a b c d

1 2 3 4
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 Example: Specific cost curve
cost function c(y) = + 1
VC, FC, AVC, AFC, AC, MC = ?

• variable costs: cv(y) =

• fixed costs: cf(y) = 1
• average variable costs: AV C(y) =
• average fixed costs: AFC(y) = 1/y
• average costs:
• marginal costs: MC(y) = 2y

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 Marginal Cost Curves for Two Plants
• Suppose that you have two plants that have two different cost functions, c1(y1) and
c2(y2). Produce y units of output in the cheapest way. How much should you
produce in each plant?

65
 4.3.2. Long-run costs 22.5, 22.6, 22.7
The Concept of the Long Run
• The long run refers to that time period for a firm where it can vary all the
factors of production  firm can choose the level of its “fixed” factors—
they are no longer fixed
 the long run consists of variable inputs only, and the concept of fixed
inputs does not arise.
long-run variable cost = long-run total cost

66
Long-run cost function
• fixed factor = size of the plant
• short-run cost function denoted by cs(y, k) (k =
• long run firm can change the size of its plant depends on expected level of
output
 denote plant size = k(y) (firm’s conditional factor demand for plant size)
• the long-run cost function of the firm will be given by cs(y, k(y))
• The long-run cost function of the firm is just the short-run cost function
evaluated at the optimal choice of the fixed factors:
c(y) = cs(y, k(y)).
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Long-run cost function
• Pick some level of output y∗, and let k∗ = k(y∗) be the optimal plant size for that
level of output
• short run cost function for a plant of size k∗ will be given by cs(y, k ∗)
• long-run cost function will be given by c(y) = cs(y, k(y))
• short-run cost to produce output y must always be at least as large as the long-run
cost to produce y.
c(y) ≤ cs(y, k∗) for all level of y
at one particular level of y, namely y∗:
c(y∗) = cs(y∗, k∗).
y∗ the optimal choice of plant size is k∗. So at y∗, the long-run costs and the short-
run costs are the same
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 Long-run cost function
• If the short-run cost is always greater
than the long-run cost and they are
equal at one level of output, then
this means that the short-run and
the long-run average costs have the
same property:
AC(y) ≤ ACs(y, k∗) and
AC(y∗) = ACs(y∗, k∗)
• short-run average cost curve always
lies above the long-run average cost
curve and that they touch at one
point, y∗.
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 Long-run cost function
Suppose we pick outputs y1, y2, . . . , yn
and accompanying plant sizes k1 = k(y1),
k2 = k(y2), . . . , kn = k(yn )

The long-run average cost curve is the

envelope of the short-run average cost
curves.

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 Discrete Levels of Plant Size
• Previous discussion: assumed can choose a
continuous number of different plant sizes.
Each different level of output has a unique
optimal plant size associated with it.

what happens if there are only a few

different levels of plant size to choose from?
• Suppose we have four different choices, k1,
k2, k3, and k4.
• Long-run average cost curve will be the
lower envelope of the short-run average four different average cost curves
costs associated with these plant sizes
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 Long-Run Marginal Costs
• For each level of output, see
which short-run average cost
curve firms are operating on
and then look at the marginal
cost associated with that curve.
• discrete levels of the fixed
factor: the firm will choose the
amount of the fixed factor to
minimize average costs.
 Thus the long-run marginal
cost curve will consist of the
various segments of the short-run
marginal cost curves associated
with each different level of the
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fixed factor.
The relationship between the long-run and the short-run marginal costs with
continuous levels of the fixed factors. 73
 Review question
1. Which of the following are true? (1) Average fixed costs never increase
with output; (2) average total costs are always greater than or equal to
average variable costs; (3) average cost can never rise while marginal costs
are declining.
2. A firm produces identical outputs at two different plants. If the marginal
cost at the first plant exceeds the marginal cost at the second plant, how can
the firm reduce costs and maintain the same level of output?
3. True or false? In the long run a firm always operates at the minimum level
of average costs for the optimally sized plant to produce a given amount of
output.
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 4.4. Profit maximization
4.4.1. Profit maximization in short run 20.1, 20.6, 20.7
• Profits
• Suppose firm produces n outputs (y1, . . . , yn)
• uses m inputs (x1, . . . , xm).
• prices of the output goods: (p1, . . . , pn)
• prices of the inputs: (w1, . . . , wm)
• The profits the firm receives, π = revenues – cost

75
 Accounting Cost vs. Economic Cost
• Accounting cost and economic cost
• Accounting costs represent anything your business has paid for
• Implicit cost: cost that exists without the exchange of cash and is not recorded for
accounting purposes (opportunity cost)
• Economic cost = Accounting cost + implicit cost
• Accounting profit and economic profit: Profit requires that we value all inputs
and outputs at their opportunity cost.
• Accounting profit = revenue – accounting cost
• Economic profit = revenue – economic cost

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Short-Run Profit Maximization
• Production function y= f(x1, x2), p: price of output; w1 and w2: prices of
the two inputs. input 2 is fixed at some level
• Then the profit-maximization problem facing the firm can be written:

• is the profit-maximizing choice of factor 1

If the value of marginal product exceeds its cost, then profits can be increased by
increasing input 1.
If the value of marginal product is less than its cost, then profits can be increased by
decreasing the level of input 1
 at a profit-maximizing choice of inputs and outputs, value of the marginal
product of a factor should equal its price
77
 Isoprofit line: Đường đẳng lợi nhuận
• Profit:

• isoprofit lines: all combinations of the input goods and the output good that give a
constant level of profit, π
• slope of w1/p
• vertical intercept:

• Fixed costs are fixed  isoprofit line move to another depend on level of profits.
 higher levels of profit will be associated with isoprofit lines with higher vertical intercepts
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Profit maximization
Profit-maximization: point ()
on the production function
that has the highest
associated iso-profit line
Tangency condition: the
slope of the production
function should equal the
slope of the isoprofit line

79
Comparative Statics – text book page 370

80
4.4.2.Profit maximization in the long run
20.8
• In the long run the firm is free to choose the level of all inputs. Thus
the long-run profit-maximization problem can be posed as

• basically the same as the short-run problem described above, but

now both factors are free to vary
• condition describing the optimal choices

81
Review questions
1. In the short run, if the price of the fixed factor is increased, what will
happen to profits?
2. If a firm had everywhere increasing returns to scale, what would happen to
its profits if prices remained fixed and if it doubled its scale of operation?
3. If a firm had decreasing returns to scale at all levels of output and it
divided up into two equal-size smaller firms, what would happen to its overall
profits?
4. A gardener exclaims: “For only $1 in seeds I’ve grown over $20 in
produce!” Besides the fact that most of the produce is in the form of
zucchini, what other observations would a cynical economist make about this
situation?
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5. Is maximizing a firm’s profits always identical to maximizing the firm’s
stock market value?
6. If pMP1 > w1, then should the firm increase or decrease the amount
of factor 1 in order to increase profits?
7. Suppose a firm is maximizing profits in the short run with variable
factor x1 and fixed factor x2. If the price of x2 goes down, what happens
to the firm’s use of x1? What happens to the firm’s level of profits?
8. A profit-maximizing competitive firm that is making positive profits in
long-run equilibrium (may/may not) have a technology with constant
returns to scale.
83