Firm theory

Nguyen Thi Minh Thu

 Chapter outline
1. Production function
2. Production cost
3. Profit maximazation
 1. Production function
1.1 Key definitions
- Production is the process that transforms inputs into
outputs, i.e. goods and services, to satisfy human wants.
- Common types of inputs
Capital (K) : machines and building
Labour (L) : human services
Material (M): raw inputs and processed products
 Production function
 Production function is a mathematic representation of
the relationship between quantities of inputs used
and maximum quantity of output that can be
produced given the current technology.
 Production function
 Production function with two inputs
Q = f (K, L)
Where
Q: output quantity
K: physical capital
L: labour
 Production function
 Short run: The period of time during which at
least one input is fixed
 Long run: the period of time which is lengthy
enough for all inputs to vary
 Production function
1.2 Short-run production
Assumption: Labour is variable while capital is fixed
 Firm can increase output only by using more labour
 Two questions
- How many products that one labour unit can contribute
on average?
- Should the firm hire another labour unit? If so, how many
products this labour can contribute?
 Production function
 Average product of labour, or APL, is the ratio
of total output to the numbers of labour unit
used.

Q
APL =
L
 Production function
 Marginal product labour, or MPL, is the change
in total output resulting from the use of an extra
unit of labour, given the other production factor
(K) held constant
 Production function
 If production function is continuous, the we have

MPL = Q(L
¢)
Q max when MPL = 0
MPL measures the slope of the output curve.
 Production function
 The law of diminishing marginal product
Diminishing marginal product is the property whereby the
marginal product of an input declines as the quantity of
the input increases, holding the other input fixed.
For example, if a firm holds the number of its equipment
constant, hiring more workers would make the capital-
labour ratio fall. Thus, each additional worker would
contribute less and less to the whole production process.
 MPL first rises and then falls.
 Production function
 The relationship between average product of
labour and marginal product of labour
MPL > APL : APL 
MPL < APL : APL 
MPL = APL : APL max
 Production function

æ Q ö¢ Q' L - Q
APL¢ = ç ÷ =
è Lø L 2

Q
Q¢ - L MPL - APL
= =
L L
 Production function
Q
Q = f (L)

0 L1

MPL,APL L
MPL L2

APL max APL

0 L
 2. Production cost
2.1 Economic cost versus accounting cost
- Explicit costs are input costs that require a direct
outlay of money by the firm
- Implicit costs are input costs that do not require an
outlay of money by the firm.
 2. Production cost
- Total Accounting cost is the sum of explicit costs that
a firm incur.
- Total Economic cost is the sum of both implicit and
explicit costs.
 Economic cost is often greater than accounting
cost.
 What are Costs?

 Economic profit
 Total revenue minus total cost
 Including both explicit and implicit costs

 Accounting profit
 Total revenue minus total explicit cost

19
 Profit maximization
 Economic profit is zero  the firm earns
normal profit
 Economic profit is positive  abnormal
profit
 Economic profit is negative  loss
 1

Economists versus accountants

21
 Production cost
2.2 Short run production cost
 Fixed costs (FC) are those costs that do not vary
with the output level.
 Variable cost( VC) are those costs that do vary with
the output level.
 Production cost
 Total cost (TC) is the sum of both fixed costs and
variable costs
 TC = FC +VC
 The vertical distance between total cost curve and
variable cost curve remains constant.
 Production cost
TC
C

VC
FC

FC
FC

0 Q
 Production cost
 Average fixed cost is the fixed cost of each
typical unit of product
 Average variable cost is the variable cost of each
typical unit of product.
 Average total cost is the total cost of each typical
unit of product.
 Production cost
 TC = FC + VC
 ATC = AFC + AVC
 Marginal cost is the change in total cost resulting from
the production of an extra unit of product.
 Production cost
 Relationship between AVC and APL

VC wL w w
AVC= = = =
Q Q (Q/L) APL
 As average product falls, average variable cost will
rise substantially
 Production cost
 Relationship between MC and MPL

 MPL first rises and then falls

MC first declines and then goes up
MC curve is U- shaped
 Production cost
 Relationship between MC and AVC
MC > AVC : AVC 
MC < AVC : AVC 
MC = AVC : AVC min
 Production cost

æ VC ö¢ VC' ´Q - VC
AVC¢ = ç ÷ =
èQø Q 2

MC ´ Q - AVC ´ Q MC - AVC
= =
Q 2
Q
 Production cost
 Relationship between MC and ATC
MC > ATC : ATC 
MC < ATC : ATC 
MC = ATC : ATC min
 Production cost
MC
MC,P

ATC

ATCmin AVC

AVCmin

AFC
0
Q
 Profit maximization
 Total revenue is the amount of money that a
firm receive from the sale of its output.
 Average revenue can be determined by dividing
total revenue by total quantity.
TR
AR =
Q
 Profit maximization
 Marginal revenue is the change in total revenue
resulting from the sale of an extra product.
 Profit maximization
 If the total revenue function is continuous, the we
have
MR = TR’(Q)
 Marginal revenue thus measures the slope of the
total revenue curve
 TR max  MR = 0 (E = -1)
 Profit maximization
P
P = αQ +β
β TR = PQ = αQ2 + βQ
MR = 2αQ +β

E = -1

0 -β/2α -β/α Q

MR
 Profit maximization
 Profit maximization  MR > MC : Increase
Q* : π = TR – TC max output

 π’(Q) =0  MR < MC : Decrease

output
 TR’ (Q) – TC’ (Q) = 0
 MR – MC = 0
 MR = MC : optimal
output level
 MR = MC
 PRACTICE
 Demand is given by P = 55 - 2Q.
 Cost function is TC = 100 - 5Q + Q2.
a. What is the marginal revenue as a function of Q?
b. If the firm wants to maximize profits, what price does it
charge? How much profit and consumer surplus is
generated at this price?
c. If the firm wants to maximize total revenue, what price
does it charge? Calculate quantity and profit.
 Summary
 The goal of firms is to maximize profit, which equals
total revenue minus total cost.
 When analyzing a firm’s behavior, it is important to
include all the opportunity costs of production.
 Some opportunity costs are explicit while other
opportunity costs are implicit.
 Summary
 A firm’s costs reflect its production process.
 A typical firm’s production function gets flatter as the
quantity of input increases, displaying the property of
diminishing marginal product.
 A firm’s total costs are divided between fixed and
variable costs. Fixed costs do not change when the firm
alters the quantity of output produced; variable costs do
change as the firm alters quantity of output produced.
 Summary
 Average total cost is total cost divided by the quantity of
output.
 Marginal cost is the amount by which total cost would rise
if output were increased by one unit.
 The marginal cost always rises with the quantity of
output.
 Average cost first falls as output increases and then rises.
 Summary
 The average-total-cost curve is U-shaped.
 Themarginal-cost curve always crosses the
average-total-cost curve at the minimum of
ATC.