MICROECONOMICS

SEM II
 RECAP
 OBJECTIVES OF A PRODUCER : • MINIMIZE COSTS
• MAXIMIZE OUTPUT

 SHORT RUN VS LONG RUN?

 WHY DOES TOTAL PRODUCTIVITY OF A PRODUCTION PROCESS FALL?

 WHAT IS MRTS? HOW DOES IT RELATE TO PRODUCTIVITY?

 WHAT IS THE PRACTICAL RELEVANCE OF AN ISOQUANT?

RETURNS TO SCALE VS DIMINISHING
MARGINAL RETURNS

• A B :Diminishing
Marginal Returns to labour

• B C : Diminishing
Marginal Returns to Labour

• A D : Returns to Scale
TECHNOLOGICAL PROGESS: same output
with lesser units of input
• Every production
process would ideally
want to undergo
technological progress

• Lesser inputs gives

you more output
TECHNOLOGICAL PROGRESS:

 Firm achieves more from a given combination of

inputs. Isoquant shifts upwards in this case
• Neutral: lesser units of
labor and capital are
needed to produce a
given output , but the
shift leaves MRTS
unchanged .
CASE I
 Barcodes are graphical representations of data that are printed on
products or packaging, typically in the form of parallel lines with
varying widths.
 Labor Neutrality: Don't inherently favor labor over capital or vice
versa. While barcodes automate tasks like inventory management and
checkout processes, they also create new job opportunities in
barcode scanning, data analysis, and system maintenance. Retail and
logistics companies may need to invest in barcode scanners and
related infrastructure, but the overall impact on labor and capital is
balanced.

 Capital Neutrality: Implementing barcode technology doesn't require

substantial capital investment compared to its potential benefits.
Labor-saving technological progress
 The isoquant becomes flatter,
indicating that the MRTSL,K is less
than it was before

 MRTSL,K decreases such that marginal

product of capital increases more
rapidly than the marginal product of
labor

 Technical advances in capital

equipment, robotics, or computers
increase the marginal productivity of
capital relative to the marginal
productivity of labor.
 CASE II
Introduction of automated manufacturing processes in industries. This
can include the implementation of robotic arms in assembly lines,
which can perform tasks that were previously done manually by human
workers. By automating these tasks, companies can increase efficiency,
reduce labor costs, and improve product consistency. This technological
progress not only saves time and effort but also allows human workers
to focus on more skilled and creative aspects of production, leading to
overall productivity gains.
Capital Saving Technological Progress
 Here, as an isoquant
shifts inward, MRTSL,K
increases, indicating
that the marginal
product of labor
increases more rapidly
than the marginal
product of capital.
CASE III
Development and implementation of 3D printing (also known as additive manufacturing)
technology.

Traditionally, manufacturing processes often required significant capital investment in

specialized machinery, molds, and tooling for mass production. However, 3D printing
enables the creation of objects layer by layer directly from digital designs, without the
need for expensive molds or tooling.

This technology allows for the rapid prototyping and production of customized parts and
products with minimal setup costs. It eliminates the need for large inventories of spare
parts by enabling on-demand manufacturing, reducing capital tied up in inventory storage.
Suppose a firm’s production function initially
took the form Q = 500(L + 3K). However, as a result of a manufacturing innovation , its production function is now
Q = 1,000(0.5L + 10K).
a) Show that the innovation has resulted in technological progress in the sense defined in the text.

B) Is the technological progress neutral, labor saving, or capital saving? (HINT : calculate MRTS)
When a production function has a diminishing marginal rate of technical substitution of labor for capital, it must also have diminishing
marginal products of capital and labor.

Show that this is not true, using the production function

Q = KL, with the corresponding marginal products MPK= L and MPL = K.

 MRTSL,K = MPL/MPK = K/L, which diminishes as L increases and K falls as we move along an
isoquant. So the marginal rate of technical substitution of labor for capital is diminishing.
 However, the marginal product of capital MPK is constant (not diminishing) as K increases
(remember, the amount of labor is held fixed when we measure MPK). Similarly, the marginal
product of labor is constant (again, because the amount of capital is held fixed when we measure
MPL).
 This exercise demonstrates that it is possible to have a diminishing marginal rate of technical
substitution even though both of the marginal products are constant. The distinction is that in
analyzing MRTSL,K, we move along an isoquant, while in analyzing MPL and MPK, total output can
change

 (Refer to 6.2)
APPLICATION OF MRTS HIGH TECH WORKERS VS LOW TECH
WORKERS

Using data on employment and computer usage over the period 1988–1991, Frank Lichtenberg

has estimated the extent to which computer equipment and computer-oriented personnel

have contributed to output in U.S. businesses.12 As part of this study, Lichtenberg estimated

the marginal rate of technical substitution of high- tech labor—computer and information

systems personnel—for low-tech labor— workers employed in activities other than information

systems and technology. If we hold a typical U.S. firm’s output fixed, and also assume that its

stock of computer equipment remains fixed, then the MRTS of high-tech labor for low-tech

labor is about 6. That is, once the firm has determined its stock of computers, one high-tech

worker can be substituted for six low tech workers and output will remain unchanged.
Cost concepts for MANAGERIAL DECISION MAKING
Opportunity Costs: The value of the next best alternative that is foregone when
another alternative is chosen.

CASE I : Kaiser operated two aluminum smelters (giant plants used to manufacture raw
aluminum ingots) near the cities of Spokane and Tacoma,Washington. The production
of aluminum requires a substantial amount of electric power, so one of the most
important determinants of the cost of producing aluminum is the price of electricity.
In 2000, Kaiser was purchasing electricity at about $23 per megawatt-hour under a
long-term contract with the Bonneville Power Administration (BPA). Kaiser signed the
contract with BPA in 1996 when the spot market price (the current price on the open
market) was low. However, in late 2000 and early 2001, the spot market price of
electricity skyrocketed, on some days averaging over $1,000 per megawatt-hour.
The contract with BPA gave it the right to resell the electricity if market prices
escalated. (The BPA had offered this option to induce Kaiser to sign a long-term
contract in the first place.
What is the opportunity cost of Kaiser in this case?
Suppose that in the 21st century the production of semiconductors
requires two inputs: capital (denoted by K) and labor (denoted by L).
The production function takes the form Q = √KL.
However, in the 23rd century, suppose the production function for
semiconductors will take the form Q = K. In other words, in the 23rd
century it will be possible to produce semiconductors entirely with
capital (perhaps because of robots).
 a) Does this change in the production function change the returns to
scale?
 b) Is this change in the production function an illustration of
technological progress?
 Explicit costs: direct monetary outlays . Example: insurance premium,
car payment, gasoline, grocers bill
 Implicit costs: do not involve monetary outlays. Example: Owned
airline, property, flat.

 Economic costs: sum of all relevant implicit and explicit costs.

 Accounting costs: costs that appear on accounting statements and are
sum of all explicit costs.
 Sunk costs: Costs that are already incurred and cannot be recovered.
 Non sunk costs: Costs that are incurred only if a particular decision is
made
 A computer-products retailer purchases laser printers from a manufacturer at a price of
$500 per printer. During the year the retailer will try to sell the printers at a price higher
than $500 but may not be able to sell all of the printers. At the end of the year, the
manufacturer will pay the retailer 30 percent of the original price for any unsold laser
printers. No one other than the manufacturer would be willing to buy these unsold printers
at the end of the year.

a) At the beginning of the year, before the retailer has purchased any printers, what is the
opportunity cost of laser printers?

b) After the retailer has purchased the laser printers, what is the opportunity cost associated
with selling a laser printer to a prospective customer? (Assume that if this customer does
not buy the printer, it will be unsold at the end of the year.

c) 7.1(290)
C) Suppose that at the end of the year, the retailer still has a large inventory of
unsold printers. The retailer has set a retail price of $1,200 per printer. A new
line of printers is due out soon, and it is unlikely that many more old printers
will be sold at this price. The marketing manager of the retail chain argues that
the chain should cut the retail price by $1,000 and sell the laser printers at
$200 each. The general manager of the chain strongly disagrees, pointing out
that at $200 each, the retailer would “lose” $300 on each printer it sells. Is the
general manager’s argument correct?
ISOCOST LINE
• Combinations of labor and
capital that yield the same
total cost for the firm.

• w = 10 per labor-hour, r = 20
per machine hour, and TC =
$1 million per year. The $1
million isocost line is
described by the equation
• 1,000,000 = 10L + 20K, which
can be rewritten as K =
1,000,000/20 − (10/20)L.
OPTIMUM OUTPUT COST COMBINATION
 Point G is off the Q0 isoquant altogether.
Using it the firm would be wasting inputs
(i.e.,point G is technically inefficient). This
point cannot be optimal because input
combination A also produces Q0 units of
output but uses fewer units of labor and
capital.

 Points E and F are technically efficient, but

they are not cost-minimizing because they
are on an isocost line that corresponds to a
higher level of cost than the isocost line
passing through the cost-minimizing point A.

 Moving from point E to A or from F to A, the

firm can produce the same amount of
output, but at a lower total cost.

 The slope of the isoquant at the cost-

minimizing point A is equal to the slope of
the isocost line.
 the cost-minimizing condition occurs when:
slope of isoquant = slope of isocost line
-MRTSL,K = -
=
ratio of marginal products = ratio of input prices

At point E, the slope of the isoquant is more negative than the slope of
the isocost line. Therefore, −(MPL/MPK) < −(w/r), or MPL/MPK > w/r, or
MPL/w > MPK/r.
APPLICATION
 Suppose that the firm’s production function is of the form Q = .
The equations of the marginal products of labor and capital are
MPL = 30 √K/L and MPK = 30 √L/K.
Suppose, the price of labor w is $15 per unit and the price of
capital r is $60 per unit. What is the cost minimizing input
combination if the firm wants to produce 1,000 units per year?
COST CURVES
 TOTAL COSTS: all costs incurred in production, both fixed and variable. As output
increases, total costs typically increase due to the additional resources (both fixed
and variable) required for production.
 Variable costs: Expenses that vary in direct proportion to the level of production or
output. These costs increase as production increases and decrease as production
decreases.
 Examples: Raw materials, direct labor costs (wages paid to workers directly
involved in production), utilities (electricity, water) directly related to production,
and shipping costs.
 FIXED COSTS: Fixed costs are expenses that do not vary with the level of production
or output. They remain constant within a certain range of activity or time period.
Here are some examples of fixed costs: Salaries and Wages of Permanent Staff
 TC = TVC +TFC
 AC= AFC +AVC
 Fixed cost FC does not vary with output—it is shown as a horizontal line at $50.

 Variable cost VC is zero when output is zero and then increases continuously as output
increases. The total cost curve TC is determined by vertically adding the fixed cost
curve to the variable cost curve. Because fixed cost is constant, the vertical distance
between the two curves is always $50.
 Total fixed cost is $50, the average fixed cost curve AFC falls continuously from $50
when output is 1, toward zero for large output.
 Whenever marginal cost lies below average cost, the average cost curve falls.
Whenever marginal cost lies above average cost, the average cost curve rises.

 When average cost is at a minimum, marginal cost equals average cost.

  When the firm produces 1 million televisions
LONG-RUN TOTAL COST CURVE per year, the cost-minimizing input
combination occurs at point A.

 At this input combination, the firm is on an

isocost line corresponding to TC1 dollars of
total cost, where TC1 = wL1 + rK1.

 Increases output from 1 million to 2 million

televisions per year, its isocost line shifts to
the northeast, and its cost-minimizing input
combination moves to point B, with L2 units
of labor and K2 units of capital (TC2 > TC1).

 Because the cost minimizing input

combination moves us to higher isocost
lines, the long-run total cost curve must be
increasing in Q. We also know that when Q =
0, long-run total cost is 0.
Q = 50 √LK
 (a) How does minimized total cost depend
on the output Q and the input prices w and
r for this production function?
 (b)What is the graph of the long-run total
cost curve when w = 25 and r = 100?
(LEARNING-BY-DOING EXERCISE 8.1)
Long run TC curve
 The price of each
input increases by
10 percent.
 Panel (a) shows that
the cost-minimizing
input combination
remains the same
(at point A), because
the slope of the
isocost line is
unchanged.
 Panel (b) shows that
the total cost curve
shifts up by the
same 10 percent.
Total cost , average cost and marginal cost
 At any particular output level, the
long-run average cost is equal to
the slope of a ray from the origin
to the point on the long-run total
cost curve corresponding to that
output Thus, at point A the average
cost is equal to the slope of ray
0A, or $1,500/50 units = $30 per
unit.
 Marginal cost at point A is the slope
of the line BAC (the line tangent to
the total cost curve at A); the
slope of this line is 10, so the
marginal cost when output is 50
units per year is $10 per unit.
 If average cost is decreasing as quantity is increasing, then average cost is
greater than marginal cost: AC(Q) > MC(Q).
 If average cost is increasing as quantity is increasing, then average cost is less
than marginal cost: AC(Q) < MC(Q).
 If average cost is neither increasing nor decreasing as quantity is increasing,
the average cost is equal to marginal cost: AC(Q) = MC(Q).
Q = 50√LK when the price of labor L is w = 25 and
the price of capital K is r = 100: TC(Q) = 2Q.
 Whatare the long-run average and marginal cost
curves associated with this long-run total cost
curve?
 Economies of Scale: characteristic of production in which average cost
decreases as output goes up.

 Diseconomies of scale: A characteristic of production in which

average cost increases as output goes up.
The unique case of hospital
mergers in the US
NETFLIX PASSWORD CRACKDOWN
SHORT RUN TC CURVES
 more constraints and less time
More costs in the short run

 Fixed inputs
 Initially, The firm wants to
produce 1 million television
sets per year. In the long
run, when it is free to vary
both capital and labor, it
minimizes total cost by
operating at point A, using
L1 units of labor and K1
units of capital.

 In the short run, its usage of

capital must remain fixed at
K1 .In that case, the firm
would operate at point B,
using L3 units of labor and
the same K1 units of capital.
SHORT RUN AVERAGE COST AND MARGINAL COST
 SAC(Q) = [STC(Q)]/Q and
 SMC(Q) = (ΔSTC)/(ΔQ).
 Average cost into two pieces:
 Average variable cost (AVC) and
average fixed cost (AFC): SAC = AVC +
AFC.
 AFC = TFC/Q.
 AVC = TVC/Q.
 The average fixed cost curve decreases
everywhere and approaches the
horizontal axis as Q becomes very large.
This reflects the fact that as
output increases, fixed capital costs are
“spread out” over an increasingly large
volume of output, driving fixed costs per
unit downward toward zero.
Because AFC becomes smaller and
smaller as Q increases, the AVC(Q) and
SAC(Q) curves get closer and closer
together.
 The short-run marginal cost curve SMC(Q)
intersects the short-run average cost
curve and the average variable cost curve
at the minimum point of each curve.
LONG RUN AND SHORT RUN AVERAGE AND MARGINAL
COST CURVES
 Long-run average cost curve forms a
boundary (or envelope) around the
set of short-run average cost curves
corresponding to different levels of
output and fixed input.

 Short-run average cost curve

corresponding to any level of fixed
capital lies above the long-run
curve except at the level of output
for which the fixed capital is
optimal (points A, B, and D in the
figure).
 fixed capital were K1, but if it
expanded its output to 2 million or
3 million TVs, it would minimize
costs if its level of fixed capital
were K2 or K3, respectively.
 K represents plant size, the firm’s
high short-run average cost of $110
to produce 2 million TVs using fixed
capital K1 might reflect reductions in
the marginal product of labor
resulting from crowding too many
workers into a small plant. To
achieve the minimal average cost of
$35, the firm would have to increase
its plant size to K2.)
LONG RUN AND SHORT RUN COST
 If the firm is required to
BEHAVIOUR produce 1 million units, in the
long run it would choose a plant
size K1. Therefore, if the firm
has a fixed plant of size K1,
the combination of inputs it
would use to produce 1 million
units in the short run is the
same as the combination it
would choose in the long run.
 At an output of 1 million units
not only are SAC1(Q) and AC(Q)
equal (at point A), but also
SMC1(Q) and MC(Q) are equal
(at point G).
 At point A, SAC1(Q) and AC(Q) are equal, and
they are both downward sloping.
 The minimum of SAC1(Q) occurs at point C,
where SMC1(Q) equals SAC1(Q).

 at point D, SAC3(Q) and AC(Q) are equal and

have the same upward slope. SAC3(Q) must
be rising because SMC3(Q) lies above SAC3(Q).
The minimum of SAC3(Q) occurs at point F,
where SMC3(Q) equals SAC3(Q).

 Point B, SAC2(Q) and AC(Q) are equal, and

they both achieve a minimum. SAC2(Q) must
have a slope of zero because SMC2(Q) passes
through SAC2(Q) at B
APPLICATION OF COST CURVES