Lecture 6 - Theory of The Firm

LECTURE 6:
Firms and
Production
Topics
1. The Ownership and Management of Firms.
2. Production Function.
3. Short-Run Production.
4. Long-Run Production.
5. Returns to Scale.
6. Productivity and Technical Change.
Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-2

The Ownership and Management
of Firms
• Firm - an organization that converts inputs

such as labor, materials, energy, and capital
into outputs, the goods and services that it
sells.
– Private sector (For Profit)
• Sole proprietorships;
• General partnerships;
• Corporations
– Public sector
– Nonprofit or not-for-profit sector

What Owners Want
• Main assumption: firm’s owners try to

maximize profit!
• Profit (p) - the difference between the

revenue, R, and the cost, C:
p=R–C

What Owners Want (cont.)
• To maximize profit a firm must produce as

efficiently as possible.
• A firm engages in efficient production

(achieves technological efficiency) if it
cannot produce its current level of output
with fewer inputs, given existing knowledge
about technology and the organization of
production.

Production Function
• A firm uses a technology or production process to

transform inputs or factors of production into
outputs.
• Capital (K) - long-lived inputs.
– land, buildings (factories, stores), and equipment
(machines, trucks).
• Labor (L) - human services.
– managers, skilled workers (architects, economists,
engineers, plumbers), and less-skilled workers (custodians,
construction laborers, assembly-line workers).
• Materials (M) - raw goods (oil, water, wheat) and
processed products (aluminum, plastic, paper, steel).

Production Function (cont.)
• Production function - the relationship

between the quantities of inputs used and
the maximum quantity of output that can be
produced, given current knowledge about
technology and organization.

Production
Inputs Function Output
(L, K) q = f(L, K) q
• Formally,
q = f(L, K)
– where q units of output are produced using L

units of labor services and K units of capital.

• Short run - a period of time so brief that at

least one factor of production cannot be
varied practically.
– Fixed input - a factor of production that cannot

be varied practically in the short run.
– Variable input - a factor of production whose

quantity can be changed readily by the firm during
the relevant time period.
• Long run - a lengthy enough period of time

that all inputs can be varied.

Short-Run Production
• In the short run, the firm’s production

function is
q = f(L, M, K)
– where q is output, L is the amount of labor, and K

and M are the fixed number of units of capital and
raw materials.

Table 6.1 Total Product, Marginal Product,
and Average Product of Labor with Fixed
Capital

Total Product of Labor
• Total product of labor- the amount of

output (or total product) that can be
produced by a given amount of labor.

Marginal Product of Labor
• Marginal product of labor (MPL ) - the

change in total output, Dq, resulting from
using an extra unit of labor, DL, holding other
factors (capital) constant:

Solved Problem 6.1
• For a linear production function q = f(L, K)

= 2L + K, what is the short-run production
function given that capital is fixed at capital
equals to 100? What is the marginal product
of labor?

Solved Problem 6.1: Answer
1. Set = 100. The short-run production function is:

q = 2L + 100.
2. Determine the marginal products of labor by showing how q

changes as L is increased by ΔL units.
Δq = (2[L + ΔL] + 100) – (2L + 100) = 2ΔL.
Thus, the marginal product of labor is MPL = Δq/ΔL = 2.

Average Product of Labor
• Average product of labor (APL ) - the ratio

of output, q, to the number of workers, L,
used to produce that output:

(a)
Output, q, Units per day

C
110
90 B
Figure 6.1 Production

Relationships with
56 A
Variable Labor
0 4 6 11
Diminishing Marginal (b)
L, Workers per day
Returns sets in! a
APL, MPL
20
b
15
Average product, APL
Marginal product, MPL
c
0 4 6 11
L, Workers per day

Law of Diminishing Marginal
Returns
If a firm keeps increasing an input, holding all

other inputs and technology constant, the
corresponding increases in output will
become smaller eventually.
– That is, if only one input is increased, the

marginal product of that input will diminish
eventually.

Long-Run Production
• In the long run both labor and capital are

variable inputs.
• It is possible to substitute one input for the
other while continuing to produce the same
level of output .

Isoquants
• Isoquant - a curve that shows the efficient

combinations of labor and capital that can
produce a single (iso) level of output
(quantity).
• Equation for an isoquant:
q = f (L, K).

Table 6.2 Output Produced with
Two Variable Inputs

Figure 6.2 Family of Isoquants
d
Units of capital peray
6 a
d
e c f
b
a
,K
b
3
e c f
2
q = 35
d
1 q = 24
q = 14
0 1 2 3 6 L, Work
ers per day

Properties of Isoquants
1. The farther an isoquant is from the origin,

the greater the level of output.
2. Isoquants do not cross.
3. Isoquants slope downward.

Substituting Inputs
• Marginal rate of technical substitution

(MRTS) - how many units of capital the
firm can replace with an extra unit of labor
while holding output constant.
change in capital K
MRTS  
change in labor L
Slope of Isoquant!

Figure 6.4 How the Marginal Rate of
Technical Substitution Varies Along an
Isoquant
MRTS in a Printing and Publishing Firm
Units of capital peray
d
a
16
DK = –6
b
10
,K
DL = 1
–3
1 c
7
–2 1 d
5 e
4 –1
1 q = 10
0 1 2 3 4 5 6 7 8 9 10
L, Work
ers per day
Substitutability of Inputs and
Marginal Products
• Along an isoquant Dq = 0, or:
Extra units Extra units
of labor of capital
(MPL x ΔL) + (MPK x ΔK) = 0.

Increase in Increase in
q per extra q per extra
– or unit of labor unit of
capital
MPL DK
- = = MRTS
MPK DL

Cobb-Douglas Production
Function
• Cobb-Douglas Production function
q = ALaKb
• the marginal rate of technical substitution

along an isoquant that holds output fixed is

Returns to Scale
• How much does output change if a firm

increases all its inputs proportionately?
• The answer helps a firm determine its scale

or size in the long run.

Types of Returns to Scale
• Constant Returns to scale: Property of a production

function whereby when all inputs are increased by a
certain percentage, output increases by that same
percentage.
• Increasing Returns to scale: Property of a

production function whereby output rises more than in
proportion to an equal increase in all inputs.
• Decreasing Returns to scale: Property of a

production function whereby output increases less than
in proportion to an equal percentage increase in all
inputs.
Solved Problem 6.3
• Under what conditions does a Cobb-Douglas

production function (Equation 6.4, q = ALaKb)
exhibit decreasing, constant, or increasing
returns to scale?

Application: Returns to Scale in
Various Industries

Various Industries

Various Industries (cont.)

Various Industries (cont.)

Figure 6.5 Varying Scale
Economies
K, Units of capital per year
d
8
q=8
c ® d : Decreasing returns to scale
c
4
q=6
b
2 b ® c : Constant returns to scale
a
1 q=3
q=1 a ® b : Increasing returns to scale
0 1 2 4 8 L , Work hours per year

Productivity and Technical
Change
• Productivity may differ across firms –
produce different amounts of output with a
given amount of inputs.
• After a technical or managerial innovation, a
firm can produce more today from a given
amount of inputs than it could in the past.

Innovations
• Technical progress - an advance in

knowledge that allows more output to be
produced with the same level of inputs.
• Better management or organization of the

production process similarly allows the firm
to produce more output from given levels of
inputs.

Innovations (cont.)
• Neutral technical change – a firm can

produce more output using the same ratio of
inputs.
• Non-neutral technical changes are

innovations that alter the proportion in
which inputs are used.

Organizational Change
• Organizational change may also alter the

production function and increase the amount
of output produced by a given amount of
inputs.

Chapter 7
Costs
Topics
1. The Nature of Costs.
2. Short-Run Costs.
3. Long-Run Costs.
4. Lower Costs in the Long Run.
5. Cost of Producing Multiple Goods.

The Nature of Costs
• Economists measure all relevant costs.

– Explicit costs – direct, out-of-pocket payments
for inputs to its production process within a given
time period
– Implicit costs – reflect only a forgone opportunity
rather than an explicit, current expenditure.
• Accountants measure costs in ways that are
more consistent with tax laws and other
laws.

Opportunity Costs
• Economic cost or opportunity cost - the

value of the best alternative use of a
resource.
• The economic or opportunity cost includes

both explicit and implicit costs.

Solved Problem 7.1
• Meredith’s firm sends her to a conference for

managers and has paid her registration fee.
Included in the registration fee is free admission to
a class on how to price derivative securities such as
options. She is considering attending, but her most
attractive alternative opportunity is to attend a talk
by Warren Buffett about his investment strategies,
which is scheduled at the same time. Although she
would be willing to pay $100 to hear his talk, the
cost of a ticket is only $40. Given that there are no
other costs involved in attending either event, what
is Meredith’s opportunity cost of attending the
derivatives talk?
• To calculate her opportunity cost, determine the

benefit that Meredith would forgo by attending
the derivatives class.
• Because she incurs no additional fee to attend
the derivatives talk, Meredith’s opportunity cost
is the foregone benefit of hearing the Buffett
speech. Because she values hearing the Buffett
speech at $100, but only has to pay $40, her
net benefit from hearing that talk is $60 (=
$100 – $40). Thus, her opportunity cost of
attending the derivatives talk is $60.

Costs of Durable Inputs
• Durable good – a product that is usable for

years.
• Two issues may arise in measuring the cost
of durable goods:
– How to allocate the initial purchase cost over
time.
– What to do if the value of the capital changes
over time.

Sunk Costs
• Sunk cost – a past expenditure that cannot

be recovered.
• Sunk cost is not relevant to a manager

when deciding how much to produce now.
• If an expenditure is sunk, it is not an

opportunity cost.

Short-Run Costs
• Fixed cost (F) – a production expense that

does not vary with output.
• Variable cost (VC) – a production expense

that changes with the quantity of output
produced.
• Cost (total cost, C) – the sum of a firm’s

variable cost and fixed cost:
C = VC + F

Marginal Cost
• Marginal cost (MC) – the amount by

which a firm’s cost changes if the firm
produces one more unit of output.
C
MC 
q
– And since only variable cost changes with
output:
VC
MC 
q

Average Costs
• Average fixed cost (AFC) – the fixed cost

divided by the units of output produced:
AFC = F/q.
• Average variable cost (AVC) – the

variable cost divided by the units of output
produced:
AVC = VC/q.
• Average cost (AC) – the total cost divided

by the units of output produced:
AC = C/q
AC = AFC + AVC.

Table 7.1 Variation of Short-Run
Cost with Output

(a)
Cost, $
400
VC
27
Figure 7.1 Short-Run 216
A 1
Cost Curves
20
1
B
120
48 F
0 2 4 6 8 10
Quantity, ,qUnits per day
(b)
Cost per unit, $

60
MC
AC
28 a
27 AVC
b
20
8
AFC
0 2 4 6 8 10
Quantity, ,qUnits per day

Relationship Between Average
and Marginal Cost Curves
Cost per unit, $
60
When MC is and when MC is
lower than AC, MC
When andlarger
whenthan
MCAC,
is
ACMCis is AC is increases
lower than larger than AVC,
decreasing…
AVC, AVC is AVC is increases
decreasing…
AC
28 a …so MC = AC, at the
27 AVC lowest point of the
b
20 AC curve!
…so MC = AVC, at
the lowest point of
8 the AVC curve!
0 2 4 6 8 10
Quantity, ,q Units per d
ay

Figure 7.2 Variable Cost and
Total Product of Labor
Quantity, q, Units per day
Total product,
d
13 Variable cost
c
10
b
5
a
1
0 5 20 46 77 , L
Hours of labor per day
50 200 460 770 VC =wL
, Variable cost, $

Shape of the Marginal Cost
Curve
MC = DVC/Dq.
• But in the short run,
DVC = wDL
– Therefore,
MC = wDL/Dq
• The additional output created by every additional

unit of labor is:
Dq/ DL = MPL
– Therefore,
MC = w/ MPL

Shape of the Average Cost
Curves
AVC = VC/q.
– But in the short-run, with only labor as an input:
AVC = VC/q = wL/q
– And since q/L = APL, then
AVC = VC/q = w/APL

Application: Short-Run Cost
Curves for a Beer Manufacturer

Effects of Taxes on Costs
• Taxes applied to a firm shift some or all of

the marginal and average cost curves.
• For example, suppose that the government

collects a specific tax of $10 per unit of
output from the firm.

Figure 7.3 Effect of a Specific
Tax on Cost Curves
Costs per unit, $ A $10.00 tax shifts MC a = MC b + 10

80
both the AC and
MC by exactly MC b
$10…
$10
AC a = AC b + 10
37
$10 AC b
27
0 5 8 10 15
,qUnits per d
ay

Solved Problem 7.2
• What is the effect of a lump-sum franchise

tax on the quantity at which a firm’s after
tax average cost curve reaches its
minimum? (Assume that the firm’s before-
tax average cost curve is U-shaped.)


Long-Run Costs
• Fixed costs are avoidable in the long run.

– In the long-run, F = 0.
– As a result, the long-run total cost equals:
C = VC

Isocost Line
• Isocost line - all the combinations of inputs

that require the same (iso-) total
expenditure (cost).
• The firm’s total cost equation is:
C = wL + rK.
Capital
Labor Costs
Costs

Isocost Line (cont.)
• The firm’s total cost equation is:

C = wL + rK.
– We get the Isocost equation by setting the

costs at a particular level:
C = wL + rK.
– And then solving for K (variable along y-axis):
C - w L
K= r r

Table 7.2 Bundles of Labor and
Capital That Cost the Firm $200

Figure 7.4 A Family of Isocost
Lines
For each extra unit of Isocost Equation
year
Units of capital per
capital it uses, the

C - w L
firm must use two K= r
fewer units of labor r
to hold its cost Initial Values
constant.
$200 e C = $200
10 =
$20 w = $10
,K
7.5
d
r = $20
c
5 Slope = -1/2 = w/r
DK = 2.5 b
2.5
DL = 5 $200 isocost
a
5 10 15 $200
= 20
$10
, LUnits of labor per
year

Lines (cont.)
Isocost Equation
year
C - w L
$200 K= r
15 =
$20 r
An increase in C….
$200 e C = $300
10 =
$20 w = $10
,K
r = $20
$200 isocost $300 isocost
a
$200 $300
= 20 = 30
$10 $10
year

Lines (cont.)
Isocost Equation
year
C - w L
K= r
15 =
$200
$20
r
A decrease in C….
$200 e
C = $100
10 =
$20 w = $10
,K
r = $20
$100
5=
$20
$100 isocost $200 isocost $300 isocost
a
$100 $200 $300
= 10 = 20 = 30
$10 $10 $10
year

Combining Cost and Production
Information
• The firm can choose any of three equivalent

approaches to minimize its cost:
– Lowest-isocost rule - pick the bundle of
inputs where the lowest isocost line touches the
isoquant.
– Tangency rule - pick the bundle of inputs
where the isoquant is tangent to the isocost
line.
– Last-dollar rule - pick the bundle of inputs
where the last dollar spent on one input gives
as much extra output as the last dollar spent on
any other input.

Figure 7.5 Cost Minimization
of capital per hour
Which of these three Isocost Equation

Isocost would allow C - w L
the firm to produce K= r r
$3,000 the 100 units of
isocost output at the lowest Isoquant Slope
MPL
, Units
possible cost?
- = MRTS
K
$2,000
MPK
isocost
Initial Values
$1,000 q = 100
isocost
w = $24
r = $8
0 50 , Units
L of labor per hour

Figure 7.5 Cost Minimization
of capital per hour
Isocost Equation
q= 100 isoquant C - w L
K= r r
$3,000
isocost
Isoquant Slope
MPL
, Units
y - = MRTS
K
303
$2,000
MPK
isocost
Initial Values
$1,000 q = 100
isocost
100
x C = $2,000
w = $24
z
28 r = $8
0 24 50 116
, Units
L of labor per hour

Cost Minimization
• At the point of tangency, the slope of the

isoquant equals the slope of the isocost.
Therefore,
w
MRTS   last-dollar rule: cost is
r minimized if inputs are
MPL chosen so
MRTS  
MPK that the last dollar spent
MPL w on labor adds as much
 extra output as the last
MPK r
dollar spent on capital.
MPL MPK

w r
Figure 7.5 Cost
Minimization Initial Values
of capital per hour q = 100
MPL = 0.6q/L C = $2,000
q= 100 isoquant MPK = 0.4q/K w = $24
r = $8
$3,000
isocost
MPL MPK 1.2 0.4
= = 0.05
, Units
= =
y w r 24 8
K
303
$2,000
isocost
Spending one more dollar on
labor at x gets the firm as much
extra output as spending the
$1,000
isocost same amount on capital.
x
100
z
28
0 24 50 116
, Units
L of labor per hour

Figure 7.5 Cost Initial Values
Minimization q = 100
of capital per hour C = $2,000
MPL = 0.6q/L w = $24
q= 100 isoquant MPK = 0.4q/K r = $8
if So
the…the
firm shifts
firm one
$3,000 MPL 2.5 dollar
shouldfrom
shift
capital to
isocost = 24 = 0.1
w labor,
evenoutput
more falls by
, Units
MPK 0.017
resources
becausefromthere is
y
0.13
K
303
r = 0.017
8 =
less
capital
capital
to labor—
but also
$2,000
isocost increases
which increases
by 0.1 the
because
marginalthere
product
is more
labor
of capital
for a net
andgain of
$1,000 0.083
decreases
more the
output at
isocost themarginal
same cost….
product
x
100
of labor.
z
28
0 24 50 116
, Units
L of labor per hour

Solved Problem 7.3
• Use the tangency rule to determine the

cost-minimizing bundles of labor and
capital for a general Cobb-Douglas
production function, q = ALαKβ, and for the
specific beer production function that
underlies Figure 7.5, q = 1.516L0.6K0.4,
where w = 24 and r = 8.


Figure 7.6 Change in Factor
Price
of capital per hour
Minimizing Cost Rule

q= 100 isoquant
Original MPL MPK
isocost,
$2,000 A decrease in w…. w = r
Initial Values
q = 100
, Units
C = $2,000
K
Ne
w isocost,
$1,032
w = $24
x
r = $8
100
w2 = $8
52
v C2 = $1,032
0 50 77 ers per hour

L, Work
Solved Problem 7.4
• If a firm manufactures at home, it faces

input prices for labor and capital of wˆ and
rˆ and produces qˆ units of output using
Lˆ units of labor and Kˆ units of capital.
Abroad, the wage and cost of capital are
half as much as at home. If the firm
manufactures abroad, will it change the
amount of labor and capital it uses to
produce qˆ? What happens to its cost of
producing qˆ?

• Determine whether the change in factor

prices affects the slopes of the isoquant or
the isocost lines.
• Using a rule for cost minimization,
determine whether the firm changes its
input mix.
• Calculate the original cost and the new cost
and compare them.

The Long-Run Expansion Path
and the Long-Run Cost Function
• Expansion path - the cost-minimizing

combination of labor and capital for each
output level.

Figure 7.7(a) Expansion Path
and Long-Run Cost Curve
of capital per hour

$4,000
isocost
$3,000
isocost
, Units
K
Expansion path
$2,000
isocost
z
200
y
150
x
100
q = 200 Isoquant
q = 150 Isoquant
q = 100 Isoquant
0 50 75 100 L,Work
ers per hour

Figure 7.7(b) Expansion Path
and Long-Run Cost Curve
Long-run cost curve

C, Cost, $
4,000 Z
3,000 Y
2,000 X
0 100 150 200 q

, Units per hour

Solved Problem 7.5
• What is the long-run cost function for a

fixed-proportions production function
(Chapter 6) when it takes one unit of labor
and one unit of capital to produce one unit
of output? Describe the long-run cost curve.
• Answer:
– Multiply the inputs by their prices, and sum to
determine total cost.

Figure 7.8 Long-
Run Cost Curves
• The shape of long run

cost curves is
determined by the
production function
relationship between
output and inputs.

Economies of Scale
• Economies of scale - property of a cost

function whereby the average cost of
production falls as output expands.
• Diseconomies of scale - property of a cost
function whereby the average cost of
production rises when output increases.

Table 7.3 Returns to Scale and
Long-Run Costs

Table 7.4 Shape of Average Cost
Curves in Canadian Manufacturing

Lower Costs in the Long Run
• In its long-run planning, a firm chooses a

plant size and makes other investments so
as to minimize its long-run cost on the basis
of how many units it produces.
– Once it chooses its plant size and equipment,
these inputs are fixed in the short run.
• Thus, the firm’s long-run decision
determines its short-run cost.

Figure 7.9 Long-Run Average Cost as
the Envelope of Short-Run Average
age cost, $ Cost Curves
LRAC
Aver
SRAC 3
SRAC 1 SRAC 3 SRAC 2
b
12 d
10
a c
0 q1 q2 ,qOutput per ay
d

Application: Long-Run Cost
Curves in Beer Manufacturing

Application: Choosing an Ink-Jet
or a Laser Printer

Figure 7.10 Long-Run and
Short-Run Expansion Paths
K, Capital per day In the short run, the firm cannot
vary its capital, so its short-run
expansion path is horizontal at
the fixed level of output.
$4,616
Long-run expansion path

$4,000
$2,000
z
200
x y Short-run
100 expansion path
200 isoquant
100 isoquant
0 50 100 159 ,LWorkers per day

Figure 7.10 Long-Run and
Short-Run Expansion Paths (Contd.)
K, Capital per day
In the long run, the beer
manufacturer increases its
output by using more of both
inputs, so its long-run
$4,616 expansion path is upward
sloping.
Long-run expansion path

$4,000
$2,000
z
200
x y Short-run
100 expansion path
200 isoquant
100 isoquant
0 50 100 159 ,LWorkers per day

The Learning Curve
• Learning by doing - the productive skills

and knowledge that workers and managers
gain from experience.

Figure 7.11 Learning by Doing

Why Costs Fall over Time
• Technological or organizational progress

may increase productivity.
• Operating at a larger scale in the long run
may lower average costs due to increasing
returns to scale.
• The firm’s workers and managers may
become more proficient over time due to
learning by doing.

Cost of Producing Multiple
Goods
• Economies of scope - situation in which it
is less expensive to produce goods jointly
than separately.
• Production possibility frontier - the

maximum amount of outputs that can be
produced from a fixed amount of input.

Figure 7.12 Joint Production

Technology Choice at Home
Versus Abroad

Lecture 6 - Theory of The Firm

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LECTURE 6:

1. The Ownership and Management of Firms.

6. Productivity and Technical Change.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-2

• Firm - an organization that converts inputs

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-3

• Main assumption: firm’s owners try to

• Profit (p) - the difference between the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-4

• To maximize profit a firm must produce as

• A firm engages in efficient production

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-5

• A firm uses a technology or production process to

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-6

• Production function - the relationship

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-7

– where q units of output are produced using L

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-8

• Short run - a period of time so brief that at

– Fixed input - a factor of production that cannot

– Variable input - a factor of production whose

• Long run - a lengthy enough period of time

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-9

• In the short run, the firm’s production

– where q is output, L is the amount of labor, and K

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-10

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-11

• Total product of labor- the amount of

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-12

• Marginal product of labor (MPL ) - the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-13

• For a linear production function q = f(L, K)

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1. Set = 100. The short-run production function is:

2. Determine the marginal products of labor by showing how q

Thus, the marginal product of labor is MPL = Δq/ΔL = 2.

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• Average product of labor (APL ) - the ratio

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Output, q, Units per day

Figure 6.1 Production

Returns sets in! a

Marginal product, MPL

L, Workers per day

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If a firm keeps increasing an input, holding all

– That is, if only one input is increased, the

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• In the long run both labor and capital are

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• Isoquant - a curve that shows the efficient

• Equation for an isoquant:

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1. The farther an isoquant is from the origin,

2. Isoquants do not cross.

3. Isoquants slope downward.

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• Marginal rate of technical substitution

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(MPL x ΔL) + (MPK x ΔK) = 0.