Concepts from the Theory of the Firm

Daniel Kirschen
University of Manchester

2006 Daniel Kirschen

Production function

y = f ( x1,x 2 )
y:

output

x1 , x2:

factors of production

x2 fixed

x1 fixed

x1

x2

Law of diminishing marginal products

2006 Daniel Kirschen

Long run and short run

Some factors of production can be adjusted
faster than others
Example: fertilizer vs. planting more trees

Long run: all factors can be changed

Short run: some factors cannot be changed
No general rule separates long and short run

2006 Daniel Kirschen

Input-output function
y = f (x 1 ,x2

x 2 fixed

The inverse of production function is the

input-output function

x 1 = g ( y ) for x 2 = x 2

Example: amount of fuel required to produce a

certain amount of power with a given plant

2006 Daniel Kirschen

Short run cost function

c SR ( y ) = w 1 x 1 + w 2 x 2 = w 1 g ( y ) + w 2 x 2

w1, w2: unit cost of factors of production x1, x2

c SR ( y )

2006 Daniel Kirschen

Short run marginal cost function

c SR ( y )

Convex due to law

of marginal returns

y
dc SR ( y )
dy

Non-decreasing function

y
2006 Daniel Kirschen

Optimal production
Production that maximizes profit:

max { y c SR ( y ) }
y

d { y c SR ( y ) }
dy

dc SR ( y )
dy

2006 Daniel Kirschen

=0

Only if the price does not depend

on y perfect competition
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Costs: Accountants perspective

In the short run, some costs are

variable and others are fixed

Variable costs:
labour
materials

Production cost []

fuel
transportation

Fixed costs (amortised):

equipments
land
Overheads

Quasi-fixed costs

Quantity

Startup cost of power plant

Sunk costs vs. recoverable costs

2006 Daniel Kirschen

Average cost

c( y ) = c v ( y ) + c f
c( y ) c v ( y ) c f
AC ( y ) =
=
+
= AVC ( y ) + AFC ( y )
y
y
y

Production cost []

2006 Daniel Kirschen

Quantity

Average cost [/unit]

Quantity

Marginal vs. average cost

MC

AC

/unit

Production
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When should I stop producing?

Marginal cost = cost of producing one more unit
If MC > ! next unit costs more than it returns
If MC < ! next unit returns more than it costs
Profitable only if Q4 > Q2 because of fixed costs
Average cost [/unit]

Marginal
cost
[/unit]

Q1
2006 Daniel Kirschen

Q2

Q3

Q4
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Costs: Economists perspective

Opportunity cost:
What would be the best use of the money spent to make the
product ?
Not taking the opportunity to sell at a higher price represents a
cost

Examples:
Growing apples or growing kiwis?
Use the money to grow apples or put it in the bank where it
earns interests?

Includes a normal profit

Selling at cost does not mean no profit
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Perfect competition
Perfect competition
The volume handled by
each market participant is
small compared to the
overall market volume

Price

Extra-marginal

No market participant can

influence the market price
by its actions
All market participants act
like price takers

supply

Inframarginal

demand
Quantity

Marginal producer

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Imperfect competition
One or more competitors can influence the
market price through their actions
Strategic players
Participants with a large market share
Can influence the market price

Competitive fringe
Participants with a small market share
Take the market price

Cournot and Bertrand models of competition

2006 Daniel Kirschen

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Cournot model in a duopoly

Competition on quantity
Problem for firm 1: max ( y 1 + y 2 ) y 1 c ( y 1 )
y
e

y 1 = f 1 ( y e2 )
Similar problem for firm 2

y2 = f 2 ( y )
e
1

y1 = f 1 ( y 2 )
*

Cournot equilibrium:

y 2* = f 2 ( y 1* )

Neither firm has any incentive to deviate from the equilibrium

2006 Daniel Kirschen

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Cournot model in an oligopoly

Total industry output:
Firm i:

Y = y 1 +L + y n

max { y i ( Y ) c ( y i ) }
yi

d
dy i

{ y i (Y ) c ( y i ) } = 0

Difference with
perfect competition

d ( Y ) dc ( y i )
(Y ) + y i
=
dy i
dy i
y i Y d ( Y ) dc ( y i )

( Y ) 1 +
=
Y dy i (Y )
dy i

si
( Y ) 1

(Y )
2006 Daniel Kirschen

dc ( y i )
=

dy i
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Cournot model in an oligopoly

si
( Y ) 1

(Y )

dc ( y i )
=

dy i

<1
Strategic player operates at a marginal cost less than the
market price
Ability to manipulate prices is a function of:
si = y i Y
Market share
Elasticity of demand
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Bertrand model in a duopoly

Competition on price
Firm that sets the lowest price captures the
entire market
No firm will bid below its marginal cost of
production because it would sell at a loss
At equilibrium, both firms sell at the same price,
which is the marginal cost of production
Equivalent to competitive equilibrium!
Not a realistic model!
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