Microeconomics

Week 8: Producer Theory

1
Outline of Chapter 6

6.1 The Ownership and Management of Firms.

6.2 Production.
6.3 Short-Run Production.
6.4 Long-Run Production.
6.5 Returns to Scale.
6.6 Productivity and Technical Change.

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.

3
Private, Public, and Nonprofit
Firms
• (For-profit) Private sector – firms owned by individuals
or other nongovernmental entities whose owners try to
earn a profit.
• Public sector – firms and organizations that are owned
by governments or government agencies.
• In 2018, public employment in Denmark reached 28% of total
employment, the third highest among OECD countires
(OECD.org)
• Nonprofit or not-for-profit sector – organizations
neither government-owned nor intended to earn a
profit.

4
Ownership of For-Profit Firms

• Sole proprietorships are firms owned and run by a

single individual.
• Partnerships are businesses jointly owned and
controlled by two or more people operating under a
partnership agreement.
• Corporations are owned by shareholders who own the
firm’s shares (stock).
• Owners have limited liability - Personal assets of
corporate owners cannot be taken to pay a corporation’s
debts even if it goes into bankruptcy.

5
 % of Net Incom e
% of Fir m s , US % of R evenue, US
Corporation
Corporation Corporation Sole Proprietorship
Sole Proprietorship Sole Proprietorship Partnership
Partnership Partnership

15%
10%
18% 29%
4%

61%
10%
81%

72%

Using data from 2018, I checked the distribution of firms of Denmark and found that the
fraction of sole-proprietors was noticeably smaller – in the mid 40% range. Part of this
explanation may be due to forms of limited liability that are easier to enter in Denmark
relative to the US (very raw check – no conditioning on economic activity,etc)

6
 What Owners Want (1 of 2)

• Main assumption: A firm’s owners try to maximize profit.

• Profit: Revenue R minus C.

• What if firms don’t maximize profit?

• Recall that we are assuming perfectly competitive market – in short, they would be
driven from the market, a result we will see a bit later

7
What Owners Want (2 of 2)

• 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.

8
Efficiency and Profit
maximization
Efficiency is a necessary condition

Profit Maximizing Efficient

The level of output that Implies Can not produce
maximizes profit more output given
fixed level of inputs

But not a sufficient one

Efficient Profit Maximizing

Can not produce Need not imply The level of output that
more output given maximizes profit
fixed level of inputs

9
 Production
• A firm uses a technology or production process to transform
inputs or factors of production into outputs.
• Capital services (K) – use of long-lived inputs such as land,
buildings (factories, stores), and equipment (machines, trucks).
• Labor services (L) – hours of work provided by managers, skilled
workers (architects, economists, engineers, plumbers), and less-
skilled workers (custodians, construction laborers, assembly-line
workers).
• Materials (M) – natural resources and raw goods (oil, water,
wheat) and processed products (aluminum, plastic, paper, steel).

10
Production Function (1 of 2)

• 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.

11
 Production Function (2 of 2)

• Formally,

q f L, K 
where q units of output are produced using L units of labor services and
K units of capital.
• The production function “uses” inputs efficiently: the level of output , q, is the
most output that can be produced from a given level of L and K in this case.
• The production function summarizes the technologically efficient production
processes that are available 12
Varying Inputs Over Time

• 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
practically vary in the short run.
• Variable input - a factor of production that the firm can
easily vary during the relevant time period.
• Long run - a lengthy enough period of time that all
factors of production can be varied.

13
 Short-Run Production
• In the short run, the firm’s production function is


q f L, K 
• where q is output, L is the amount of labor, and is the fixed
number of units of capital.

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

14
 Marginal Product of Labor1
• Marginal product of labor (MPL ) - the change in total output, q,
resulting from using an extra unit of labor, L,
holding other factors (capital) constant:

q
MPL 
L
Using calculus, we can define the marginal product of labor at a point . In the short
run, we can’t change capital, and thus we consider a constant. Thus the MP is just
the simple derivative
𝑑𝑓 (𝐿, 𝐾 )
𝑀𝑃 𝐿 =
𝑑𝐿

Using calculus, we can define the marginal product of labor at a point . In the long
run, we can change capital and the MP is the partial derivative

𝜕 𝑓 ( 𝐿, 𝐾 )
𝑀𝑃 𝐿 =
𝜕𝐿 15
 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:
q
APL 
L
What does this measure help us answer?
If I double labor, by how much will output change?
• If I double labor and output does not increase as much, i.e. it does not
double, then we have:

•  Average productivity falls

16
Total Product, Marginal Product, and
Average Product of Labor with Fixed
Capital
Table 6.1 Total Product, Marginal Product, and Average Product of Labor with
Fixed Capital

17
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?

18
 Solved Problem 6.1: Answer
Given: q = f(L, K) = 2L + K, capital
fixed at 100
1. Set k 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

𝑑𝑞 df ( 𝐿 , 𝐾 )
𝑀𝑃 𝐿 = = =2
𝑑𝑙 𝑑𝐿

19
Total Product, Marginal Product, and
Average Product of Labor with Fixed
Capital
Table 6.1 Total Product, Marginal Product, and Average Product of Labor with
Fixed Capital

20
Figure 6.1 (a)
C

Output, q, Units per day

110

Production 90 B

Relationships with
Variable Labor 56 A

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

Output increases more relative to labor up until L=6,

then output increase less relative to output –
compare slope of black and blue line in the top
graph
21
Diminishing returns vs. diminishing marginal returns
 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.
• Malthus: land fixed, population grows exponentially, not enough food can
be produced

• If we also change technology or increase other factors, need

not have diminishing marginal returns:
• Malthus missed this!
• To produce 100 Bushels of corn today requires only 2.5% of the
amount of labor needed in 1850

Norman Borlaug led the

Green Revolution: drought
and insect resistant crops,
etc. 22
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 )

23
 Output Produced with Two
Variable Inputs
Table 6.2 Output Produced with Two Variable Inputs

blank blank blank Labor, L blank blank blank

Capital, K 1 2 3 4 5 6
1 10 14 17 20 22 24
2 14 20 24 28 32 35
3 17 24 30 35 39 42
4 20 28 35 40 45 49
5 22 32 39 45 50 55
6 24 35 42 49 55 60

24
Figure 6.2 Family of Isoquants
K, Units of capital per day

6 a
d
e c f
b

b
3

e c f
2
q = 35

d
1 q = 24

q = 14

0 1 2 3 6 L, Workers per day

25
Properties of Isoquants
1. The farther an isoquant is from the origin, the
greater the level of output.
If not, the firm would not be producing efficiently at the higher
level of input – it’s wasting labor. If the marginal product of
labor is negative , the firm would not operate
2. Isoquants do not cross.
By definition of crossing, the same level of L and K are used to
make two different levels of q. One of these curves would
necessarily correspond to a production function that is not
efficient
3. Isoquants slope downward.
This would imply that the same output is produced with less
inputs, again against efficiency

26
Figure 6.3: Substitutability of
Inputs (1 of 2)

(a) (b)
y, Idaho potatoes per day

Boxes per day

q=3
q=3

q=2
q=2

q=1 q= 1
45 ° line

x, Maine potatoes Cereal per day

per day
Only black points are on the isoquants- if
isoquants could have inefficient production, the
isoquants would be right angles.
27
Figure 6.3: Substitutability of
Inputs (2 of 2)
(c)

K, Capital per unit of time

q= 1

L, Labor per unit of time

28
Application: A Semiconductor
Integrated Circuit Isoquant
Any linear combination of
the Aligners and Wafer-
handling stepper….firms
would not use

29
 Substituting Inputs
• Marginal rate of technical substitution (MRTS) – the extra
units of one input needed to replace one unit of another
input that enables a firm to keep the amount of output it
produces constant.

change in capital K
MRTS  
change in labor L

Slope of Isoquant!

30
Figure 6.4 How the Marginal Rate of
Technical Substitution Varies Along an
Isoquant
K, Units of capital per day

a
16

DK = –6

b
10
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, Workers per d ay
31
 Substitutability of Inputs and
Marginal Products
• Along an isoquant q 0, or:

We saw this same

concept in
consumer theory-
there were derived
the result by totally
differentiating the
utility function.
Here you would
totally differentiate
the production
function
• or
MPL K
  MRTS
MPK L
32
Cobb-Douglas Production
Function  
q  AL K What is ?
𝛼 −1 𝛽
𝑀𝑃 𝐿 =𝛼 𝐴 𝐿 𝐾

𝛼 𝛽
𝛼 𝐴𝐿 𝐾
𝑀𝑃 𝐿 =
𝐿
𝑞 What is ?
𝑀𝑃 𝐿 =𝛼
𝐿

• the marginal rate of technical substitution along an

isoquant that holds output fixed is
MPL q / L K
MRTS    .
MPK q / K  L
33
Returns to Scale

• How much does output change if a firm increases all its

inputs proportionately?

• If I triple all my inputs, will I get triple the output?

• Less than triple?
• More than triple?

• The answer helps a firm determine its scale or size in

the long run.

34
 𝑓 ( 𝐾 , 𝐿)=𝑞

¿𝑎𝑞
𝑓 ( 𝑎𝐾 , 𝑎𝐿) Decreasing returns to scale
If I double the number of factories and employees, top
management has a harder time overseeing productivity, workers
better able to slack, output does not double

𝑓 ( 𝑎𝐾 , 𝑎𝐿)¿𝑎𝑞 Constant returns to scale

Cookie cutter technology – I can just duplicate exactly what I’m

doing and get exactly the same results

¿𝑎𝑞
𝑓 ( 𝑎𝐾 , 𝑎𝐿) Increasing returns to scale
Instead of doubling output by doubling the factory, perhaps I
can more than double output by building one larger factory and
allow for more specialization.
35
Solved Problem 6.3
Under what conditions does a Cobb-Douglas production
 
function (Equation 6.4, q  AL K )
exhibit decreasing, constant, or increasing returns to scale?
𝛼 𝛽
𝐴 𝐿 𝐾 =𝑞
What happens to q if instead of L and K units of capital, I increase
both by a multiplicatively?
𝛼
¿ 𝐴 (𝑎 𝐿) ¿
𝛼 𝛼 𝛽 𝛽
¿ 𝐴𝑎 𝐿 𝑎 𝐾
𝛼 +𝛽 𝛼 𝛽
¿𝑎 𝐴 𝐿 𝐾
𝛼 +𝛽
¿𝑎 𝑞
If
If =SCALE
If 36
Application: Returns to Scale in
Various Industries (1 of 4)

37
Application: Returns to Scale in
Various Industries (2 of 4)

38
Application: Returns to Scale in
Various Industries (3 of 4)

39
Application: Returns to Scale in
Various Industries (4 of 4)

40
Figure 6.5 Varying Scale
Economies
K, Units of capital per year

d
8

q= 8

c ® :dDecreasing returns to scale

c
4

q= 6
b
2 b ® :cConstant returns to scale
a
1 q= 3
q= 1 a ® :bIncreasing returns to scale
0 1 2 4 8 ,L Work hours per year

41
Productivity and Technical
Change
• Productivity may differ across firms – produce different
amounts of output with a given amount of inputs.
• technical or managerial innovation, a firm can produce more
today from a given amount of inputs than it could in the past.
• Unions, government regulations, discrimination
• The level of competition in a market may affect
productivity – be productive of be driven out!
𝛼 𝛽
𝐴 𝐿 𝐾 = 𝑓 ( 𝐿 , 𝐾 ) =𝑞

42
Innovations (1 of 2)

• 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.

Progress, increases to :

43
Innovations (2 of 2)

• Neutral technical change – a firm can produce more

output using the same ratio of inputs.
• “same ratio of inputs” shape of isoquants unaffected
• The example we just looked at: increases to , nothing else
affected

• Non-neutral technical changes are innovations that

alter the proportion in which inputs are used.
• Technological progress could be capital saving or labor
saving.
• This will change the shape (slope) of the isoquants

44
• Technical progress refers to an increase in the productivity of inputs and can
be represented by a shift toward the origin of the isoquant for any output
level. This means that any level of output can be produced with fewer​inputs,
or more output can be produced with the same inputs.

• Technical progress can be classified as​neutral, or in the case of non-neutral

change, as labor-saving, or​labor-using, depending on whether the increased
in the same​proportion, greater​proportion, or lesser proportion than the :

• Classifying the type of technical change:

• If increased in the same proportion as the technical change is neutral.

• If increased in a greater proportion than the technical change is​labor-saving.
• If increased in a lesser proportion than the technical change is​labor-using.

45
Example: Consider two production​functions:

We can determine the type of technical change by comparing the proportionate

change in the to the proportionate change in the .

First, let’s remember, the form of the marginal product in the Cobb Douglas case:

46
Example continued:
Consider two production​functions:

Let’s assume we are operating at

,

Now let’s look a the proportionate change in the marginal product of labor:

As we just saw, in the case of Cobb Douglas , we have: and

So proportional change in

So proportional change in The marginal

productivity of
capital decreased
proportionately
less than labor, so
this is a labor
saving technology

47
Two main steps firms must perform to figure out how to efficiently
produces a given level of output:

1. Create “the menu” of technologically efficient input combinations

• The production functions captures these possibilities. It captures a
menu of sorts: choose your level of output, and the technologically
efficient combinations of inputs is provided.
• What we covered in Chapter 6
• Note that we never said anything about the cost of these inputs, or
which combination of inputs should be chosen

2. Choose from “the menu” of technologically efficient input combinations

• Will choose the option from the menu that is economically efficient
(in addition to technologically efficient)
• In other words, will choose the least costly combination of inputs
need to produce a given level of output using knowledge of it’s
production function and input prices
48
Outline of Chapter 7

7.1 The Nature of Costs.

7.2 Short-Run Costs.
7.3 Long-Run Costs.
7.4 Lower Costs in the Long Run.
7.5 Cost of Producing Multiple Goods.

49
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.

50
Opportunity Costs

• Economic cost or opportunity cost - the value of the

best alternative use of a resource.
• “There is no such thing as a free lunch”
• The economic or opportunity cost includes both explicit
and implicit costs.
• If a firm purchases a an input and uses it immediately,
that input’s opportunity cost is the amount the firm
paid for it. If it does not use the input, the opportunity
cost is price the firm could get by selling it
• Do you really save a lot of money by cleaning your
apartment?
51
 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? What is her explicit cost
of attending the derivatives talk?

52
 Solved Problem 7.1: Answer
• 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.
• The explicit cost is $0

53
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.
• We use the rental rate per period of time to capture
the opportunity cost of capital: if I’m not using my
truck, I can rent it out
• If no rental rate is available: can calculate the
opportunity cost of the truck as the depreciation
rate + the return I could have made had I invested
the cost of the truck.
54
Sunk Costs
• Sunk cost – a past expenditure that cannot be recovered.
• Sunk cost is not relevant to a firm when deciding how much to
produce now.
• If an expenditure on a fixed input is sunk, it is not an opportunity
cost.
• “No use crying over spilled milk”
• Example:
• Buy land at 300,000DKK
• Land depreciated to 200,000DKK
• If you build on the land it is worth 240,000DKK. Is it profitable to build or not?
• One should ignore sunk costs in decision making
• The 100,000 depreciation in land value is not recoverable, it is sunk.
• Net benefit of building: 240,000-200,000>0
• If instead, you considered the initial purchase price, you would have mistakenly
come up with a negative net value of building

55
Short-Run Costs
Fixed cost (F): a production expense that does not vary with
output.
• Costs of inputs that can not be changed in the short run. Typically
land, capital

Variable cost (VC): a production expense that changes with

the quantity of output produced.

Cost (total cost, C): the sum variable cost VC and F.

The sharing economy has created a way by which firms can

rent capital equipment for short periods, implying that all
inputs are variable, even in the short run
56
 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
• Since only variable cost changes with output:

VC
MC 
q

57
 Marginal Cost, with calculus
• Marginal cost (MC): the amount by which a firm’s cost
changes if the firm produces one more unit of output.

MC
• Since only variable cost changes with output:

MC

58
 Average Costs
• Average fixed cost (AFC) – the fixed cost divided by the units of
output produced:
F
AFC  .
q
• Average variable cost (AVC) – the variable cost divided by the
units of output produced:
VC
AVC  .
q
• Average cost (AC) – the total cost divided by the units of output
produced:
C
AC 
q
AC  AFC  AVC.
59
 Variation of Short-Run Cost with
Output (1 of 2)
Table 7.1 Variation of Short-Run Cost with Output

Fixed Variable Total Marginal Average Average Average

Output, q Cost, F Cost, VC Cost, C Cost, MC Fixed Cost, Variable Cost,
Cost,
F VC C
AFC  . AVC  . AC 
q q q
0 48 0 48 blank blank blank blank
1 48 25 73 25 48 25 73
2 48 46 94 21 24 23 47
3 48 66 114 20 16 22 38
4 48 82 130 16 12 20.5 32.5
5 48 100 148 18 9.6 20 29.6
6 48 120 168 20 8 20 28

60
 Variation of Short-Run Cost with
Output (2 of 2)
Table 7.1 Variation of Short-Run Cost with Output [Table 7.1 Continued]

Fixed Variable Total Marginal Average Average Average

Output, q Cost, F Cost, VC Cost, C Cost, MC Fixed Cost, Variable Cost,
Cost,
F VC C
AFC  . AVC  . AC 
q q q
7 48 141 189 21 6.9 20.1 27
8 48 168 216 27 6 21 27
9 48 198 246 30 5.3 22 27.3
10 48 230 278 32 4.8 23 27.8
11 48 272 320 42 4.4 24.7 29.1
12 48 321 369 49 4.0 26.8 30.8

61
 (a)

Cost, $
400

Figure 7.1 Short- C

Run Cost Curves VC

27
A 1
216
Fixed Variable Total 20
Output, q
Cost, F Cost, VC Cost, C B
1
120
0 48 0 48
1 48 25 73 48 F

2 48 46 94
0 2 4 6 8 10
3 48 66 114 Quantity, q, Units per day
(b)
4 48 82 130

Cost per unit, $

60
5 48 100 148
MC
6 48 120 168
7 48 141 189
8 48 168 216
AC
28 a
9 48 198 246 27 AVC
b
10 48 230 278 20

11 48 272 320
8
12 48 321 369 AFC

0 2 4 6 8 10
Quantity, q, Units per day

62
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

63
Figure 7.2 Variable Cost and Total Product of
Labor

The production function determines the firms

shape of a firm’s cost curves
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, $

In the short run when only labor is variable, firm will eventually hit diminishing
64
marginal returns to labor
 Shape of the Marginal Cost
Curve
VC
MC 
q
• But in the short run,
VC w L
• Therefore,
w L
MC 
q
• Recall that the marginal product of labor is:
q
MPL
L

• Therefore, Shape of MC is proportional to

w
MC  the inverse of the marginal
MP L
product of labor 65
Relationship between MC and MPL in
the short run w
MC 
MP L
If one additional unit of labor increases output more than before, the cost of producing
one more unit of output will decrease.

Example:
• Case 1: , an additional worker created one more unit of the good
• Case 2: an additional worker creates two more units of a good

Case 1:
• To produce another unit of the good, we need to hire one more worker.
• The cost of one more worker is 10
• Therefore the cost of the additional unit is 10,
Case 2
• To produce another unit of the good, we need to hire 2 more workers
• The cost of two more workers is 20
• Therefore the additional unit is 20,

Example illustrates that the marginal cost decreases as the marginal product increases.

66
Shape of the Average Cost
Curves
VC
AVC 
q
• But in the short-run, with only labor as an input:
VC wL
AVC  
q q
q
• And since  APL , then
L
VC w
AVC  
q APL

Shape of AVC is proportional to the inverse of the average

product of labor
67
Application: A Beer Manufacturer’s
Short-Run Cost Curves

68
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved
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.

69
Figure 7.3 Effect of a Specific
Tax on Cost Curves
Costs per unit, $ A $10.00 tax shifts MCa = MCb + 10
both the AC and
MC by exactly MCb
$10…

$10
ACa = ACb + 10

37
$10 ACb

27

0 8
q, Units per d ay

(although it doesn’t look it, the MC should shift up by 10 at each q) 70

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.)

71
Solved Problem 7.2: Answer

72
Summing up
Three cost-level curves:
1. Total Cost (C)
2. Fixed Cost (FC)
3. Variable Cost (VC)

Four cost-per-unit curves:

4. Average Total Cost (AC)
5. Average Fixed Cost (AFC)
6. Average Variable Cost (AVC)
7. Marginal Cost (MC)

73
 Summing up
1. Variable costs come from inputs that can be adjusted in the short
run, costs that come from factors that can not adjust are fixed
costs

2. If the price of inputs are constant , shape of all cost functions but
fixed are inherited from the production function

3. Diminishing marginal returns of variable input  increasing costs

at an increasing rate

4. Relationship between marginal and average

• If MC>AC AC is increasing
• If MC<ACAC is decreasing
• If MC>AVCAVC is increasing
• If MC<AVCAVC is decreasing
• The above implies that MC crosses both the ATC and AVC at their minimum74
points
Long-Run Costs
• Fixed costs are avoidable in the long run.
• This is because all inputs are variable.
• There is a mistake in your text on page 218. A
subsection says “All Costs Are Avoidable in the Long
Run”. This is clearly wrong and should read “All 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
• As firms are not constrained in the long run, long
run costs are lower than short run costs

75
Two main steps firms must perform to figure out how to efficiently
produces a given level of output:

1. Create “the menu” of technologically efficient input combinations

• The production functions captures these possibilities. It captures a
menu of sorts: choose your level of output, and the technologically
efficient combinations of inputs is provided.
• What we covered in Chapter 6
• Note that we never said anything about the cost of these inputs, or
which combination of inputs should be chosen

2. Choose from “the menu” of technologically efficient input combinations

• Will choose the option from the menu that is economically efficient
(in addition to technologically efficient)
• In other words, will choose the least costly combination of inputs
need to produce a given level of output using knowledge of it’s
production function and input prices
76
 • The firm’s total cost equation is:
C wL  rK .

• Isocost line - all the combinations of inputs that require the same (iso) total expenditure (cost).

• 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
k  L
r r

77
 Bundles of Labor and Capital
That Cost the Firm $200
Table 7.2 Bundles of Labor and Capital That Cost the Firm $200

Labor Cost, Capital Cost, Total Cost,

Bundle Labor, L Capital, K
wL = $10L rK = $20K wL + rK
a 20 0 $200 $0 $200
b 14 3 $140 $60 $200
c 10 5 $100 $100 $200
d 6 7 $60 $140 $200
e 0 10 $0 $200 $200

78
Figure 7.4 A Family of Isocost
Lines (1 of 3)
For each extra unit of Isocost Equation
K, Units of capital per year

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
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
L, Units of labor per year

79
Figure 7.4 A Family of Isocost
Lines (2 of 3)
Isocost Equation
K, Units of capital per year

C - w L
$200 K= r
15 =
$20 r
An increase in C….
$200 e C = $300
10 =
$20 w = $10
r = $20

$200 isocost $300 isocost

a
$200 $300
= 20 = 30
$10 $10
L, Units of labor per year
80
Figure 7.4 A Family of Isocost
Lines (3 of 3)
Isocost Equation
K, Units of capital per year

C - w L
K= r
15 =
$200
$20
r
A decrease in C….
$200 e
C = $100
10 =
$20 w = $10
r = $20
$100
5=
$20

$100 isocost $200 isocost $300 isocost

a
$100 $200 $300
= 10 = 20 = 30
$10 $10 $10
L, Units of labor per year
81
 Combining Cost and Production
Information
• The firm can choose any of three equivalent approaches
to minimize its cost (keeping level of output constant):
• 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.

82
Figure 7.5 Cost Minimization (1 of
2)
Isocost Equation
K, Units of capital per hour

Which of these three

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
possible cost? MPL
- = MRTS
$2,000
MPK
isocost

Initial Values
$1,000 q = 100
isocost
w = $24
r = $8

0 50 L, Units of labor per hour

83
Figure 7.5 Cost Minimization (2 of
2)
Isocost Equation
K, Units of capital per hour

q = 100 isoquant C - w L
K= r r
$3,000
isocost
Isoquant Slope
MPL
303
y - = MRTS
$2,000
MPK
isocost

Initial Values
$1,000 q = 100
isocost
100
x w = $24
r = $8
z
28

0 24 50 116
L, Units of labor per hour
84
 Cost Minimization
• At the point of tangency, the slope of the isoquant
equals the slope of the isocost. Therefore,
w
MRTS 
r
MPL
MRTS 
MPK
MPL w

MPK r
MPL MPK

w r
85
Figure 7.6 Change in
Factor Price Minimizing Cost Rule
K, Units of capital per hour

q = 100 isoquant
Original MPL MPK
isocost,
$2,000 A decrease in w…. w = r
Initial Values
q = 100
C = $2,000
New isocost,
$1,032
w = $24
x
r = $8
100
w2 = $8
52
v C2 = $1,032

0 50 77 L, Workers per hour

86
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.

87
Figure 7.7(a) Expansion Path
and Long-Run Cost Curve

K, Units of capital per hour

$4,000
isocost

$3,000
isocost

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, Workers per hour
88
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

89
Figure 7.8 Long-Run Cost Curves

90
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved
Economies of Scale

• Economies of scale - property of a cost function

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

91
 Returns to Scale and Long-Run
Costs
Table 7.3 Returns to Scale and Long-Run Costs

Cost, Returns to
Output, Q Labor, L Capital, K Average Cost,
C = wL + rK Scale
C
AC 
q
1 1 1 24 24 blank
3 2 2 48 16 Increasing
6 4 4 96 16 Constant
8 8 8 192 24 Decreasing

92
 Shape of Average Cost Curves in
Canadian Manufacturing
Table 7.4 Shape of Average Cost Curves in Canadian
Manufacturing
Scale Economies Share of Manufacturing
Industries, %
Economies of scale: Initially downward- 57
sloping AC
Everywhere downward-sloping AC 18
L-shaped AC (downward-sloping, then flat) 31
U-shaped AC 8
No economies of scale: Flat AC 23
Diseconomies of scale: Upward-sloping AC 14

Source: Data from Robidoux and Lester (1992).

93
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.

94
Figure 7.9 Long-Run Average Cost as
the Envelope of Short-Run Average Cost
Curves
Average cost, $

LRAC
SRAC 3

SRAC 1 SRAC 3 SRAC 2

b
12 d
10
a c

0 q1 q2 q, Output per day

95
Application: A Beer
Manufacturer’s
Long-Run Cost Curves

96
Application: Should You Buy an
Inkjet or a Laser Printer

97
Figure 7.10 Long-Run and
Short-Run ExpansionIn the
K, Capital per day
Paths
long run,
short run,the
thebeer
firm
manufacturer
cannot vary itsincreases
capital, soitsitsoutput
by using more
short-run of both
expansion inputs,
path is so
its long-runatexpansion
horizontal path of
the fixed level is
upward sloping.
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 L, Workers per day

98
The Learning Curve

• Learning by doing – the productive skills and

knowledge that workers and managers gain from
experience.
• Learning curve – the relationship between average
costs and cumulative output.

99
Figure 7.11 Learning by Doing

100
 Cost of Producing Multiple Goods
• Economies of scope - situation in which it is less
expensive to produce goods jointly than separately.

C q1,0   C 0, q2   C q1, q2 

SC 
C q1, q2 

• Production possibility frontier - the maximum amount of

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

101
Figure 7.12 Joint Production

102
Technology Choice at Home
Versus Abroad

103