CHAPTER IV:

FIRM
BEHAVIOR

CHAPTER IV: FIRM BEHAVIOR

Learning objectives
By the end of this chapter you should be able to:
 Understand the information given by a production function.
 Define variable inputs and fixed inputs.
 Explain the difference between long-run and short-run production time periods.
 Define and explain the law of diminishing returns.
 Distinguish between economic costs/profits and accounting costs/profits
 Define and draw graphs of different types of costs in the short-run: TC, VC, FC,
ATC, AVC, AFC and the relationships of these variables.
 Determine the profit maximizing rule.

Reading materials
Chapter 13; Principles of Economics (2021), N.Gregory Mankiw; South-Western
Cengage Learning 9th edition
2
 CONTENT

1. PRODUCTION

2. COST

3. PROFIT MAXIMASATION

1. THE PRODUCTION
Some definitions

Production Fixed factor Variable factor

the transformation of inputs an input that cannot be an input that can be
into goods and services in changed within a given time changed within a given time
order to satisfy human wants period period

Short run Long run

a time period during which

a time period during which
at least one factor of
all inputs are varied
production is fixed

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 CHECK POINT:
Billy opened a cafeteria to sell cakes. He hire labor, bought equipment and
ingredients.
After 1 week, the number of customers increased rapidly. Billy decided to
buy more ingredients.
After 1 month, the number of customers continued to increase. In addition
to buy more ingredients, Billy decided to buy some equipment.
After 3 months, the number of customers keep increasing. In addition to
the purchase of additional ingredients and equipment, Billy decided to hire
more workers.

Identify fixed factor, variable factor, short run, long run?

The Production Function

A production function shows the relationship between the
quantity of inputs used to produce a good and the quantity of output
of that good.

• It can be represented by a table, equation, or graph.

• Example 1:
• Farmer Jack grows wheat.
• He has 5 acres of land.
• He can hire as many workers as he wants.

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 EXAMPLE 1: Farmer Jack’s Production Function

L 3,000
Q (bushels
(no. of
of wheat)
workers) 2,500

Quantity of output
0 0 2,000

1 1000 1,500

2 1800 1,000

3 2400 500

4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
7

marginal product is the increase in output that arises from an additional

unit of input.
L
Q (bushels
(no. of
of wheat) MPL(= ∆Q/ ∆L)
workers)

0 0
∆L = 1 ∆Q = 1000 1000
1 1000
∆L = 1 ∆Q = 800 800
2 1800
∆L = 1 ∆Q = 600 600
3 2400
∆L = 1 ∆Q = 400 400
4 2800
∆L = 1 ∆Q = 200 200
5 3000
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 Example 1: MPL = Slope of Production Function
L Q 3,000
(no. of (bushels MPL
workers) of wheat) 2,500

Quantity of output
0 0 2,000
1000
1 1000 1,500
800
2 1800 1,000
600
3 2400 500
400
4 2800 0
200 0 1 2 3 4 5
5 3000
No. of workers
9

Why MPL Diminishes

• Farmer Jack’s output rises by a smaller and smaller amount for each
additional worker. Why?
• As Jack adds workers, the average worker has less land to work with
and will be less productive.
• In general, MPL diminishes as L rises
whether the fixed input is land or capital (equipment, machines, etc.).

The law of diminishing marginal product: the marginal

product of an input declines as the quantity of the input
increases (other things equal).

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 Why MPL Is Important

• Recall one of the Ten Principles:

Rational people think at the margin.
• When Farmer Jack hires an extra worker,
• his costs rise by the wage he pays the worker
• his output rises by MPL
• Basing on w and MPL helps Jack decide whether he
should hire the worker.

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1. If a firm uses labor to produce output, the firm’s production function depicts the
relationship between
a) the number of workers and the quantity of output.
b) marginal product and marginal cost.
c) the maximum quantity that the firm can produce as it adds more capital to a fixed quantity
of labor.
d) fixed inputs and variable inputs in the short run.

2. On a 100-acre farm, a farmer is able to produce 3,000 bushels of wheat when he

hires 2 workers. He is able to produce 4,400 bushels of wheat when he hires 3
workers. Which of the following possibilities is consistent with the property of
diminishing marginal product?
a) The farmer is able to produce 5,600 bushels of wheat when he hires 4 workers.
b) The farmer is able to produce 5,800 bushels of wheat when he hires 4 workers.
c) The farmer is able to produce 6,000 bushels of wheat when he hires 4 workers.
d) Any of the above could be correct.
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 2. COST
Cost is the total amount paid by a firm for the factors of production it
uses in the productive process.
2.1 Economic cost vs. accounting cost
EXPLICIT COSTS IMPLICIT COSTS
are input costs that require an are input costs that do not require
outlay of money by the firm an outlay of money by the firm

ECONOMIC COSTS
are the sum of the explicit costs
and the implicit costs.
ACCOUNTING COSTS
are total explicit costs
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CHECK POINT:
Suppose Billy opened a pizzeria. He used his parents’ house as the
location for his pizzeria. His friend wanted to rent the house at the
price of 10 million dong per month. After 3 months of operation,
Billy sold pizza and earned a revenue of 300 million dong.
However, Billy bought baking ingredients for 100 million dong, paid
out 30 million dong for hiring workers, paid the tax bill of 10 million
dong. Billy directly managed the pizzeria. With his capability and
qualifications, he could go to work elsewhere and could be paid 20
million dong per month. Calculate the total cost of production after
3 months of operation of the pizzeria.

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 Example 1: Farmer Jack’s Costs

• Farmer Jack must pay $1000 per month for the

land, regardless of how much wheat he grows.
• The market wage for a farm worker is $2000 per
month.
• So Farmer Jack’s costs are related to how much
wheat he produces….

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Example 1: Farmer Jack’s Costs

L Q
Total
(no. of (bushels Cost of land Cost of labor
Cost
workers) of wheat)

0 0 $1,000 $0 $1,000

1 1000 $1,000 $2,000 $3,000

2 1800 $1,000 $4,000 $5,000

3 2400 $1,000 $6,000 $7,000

4 2800 $1,000 $8,000 $9,000

5 3000 $1,000 $10,000 $11,000
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 Example 1: Farmer Jack’s Total Cost Curve

$12,000
Q (bushels Total
of wheat) Cost $10,000

0 $1,000 $8,000

Total cost
$6,000
1000 $3,000
$4,000
1800 $5,000
$2,000
2400 $7,000
$0
2800 $9,000
0 1000 2000 3000
3000 $11,000 Quantity of wheat
17

Marginal Cost (MC) is the increase in Total Cost from producing one more unit.

Q Marginal Cost
(bushels Total
of wheat) Cost (MC = ∆TC/∆Q)

0 $1,000
∆Q = 1000 ∆TC = $2000 $2.00
1000 $3,000
∆Q = 800 ∆TC = $2000 $2.50
1800 $5,000
∆Q = 600 ∆TC = $2000 $3.33
2400 $7,000
∆Q = 400 ∆TC = $2000 $5.00
2800 $9,000
∆Q = 200 ∆TC = $2000 $10.00
3000 $11,000
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Example 1: The Marginal Cost Curve

Q $12
(bushels TC MC MC usually rises
of wheat) $10
as Q rises,

Marginal Cost ($)

0 $1,000 as$8in this example.
$2.00
1000 $3,000 $6
$2.50
1800 $5,000 $4
$3.33
2400 $7,000 $2
$5.00
2800 $9,000 $0
$10.00 0 1,000 2,000 3,000
3000 $11,000 Q
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Why MC Is Important

• Farmer Jack is rational and wants to maximize his profit. To

increase profit, should he produce more or less wheat?
• To find the answer, Farmer Jack needs to “think at the margin.”
• If the cost of additional wheat (MC) is less than the revenue he
would get from selling it,
then Jack’s profits rise if he produces more.

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 Fixed and Variable Costs
• Fixed costs (FC) do not vary with the quantity of output produced.
• For Farmer Jack, FC = $1000 for his land
• Other examples: cost of equipment, loan payments, rent
• Variable costs (VC) vary with the quantity produced.
• For Farmer Jack, VC = wages he pays workers
• Other example: cost of materials
• Total cost (TC) = FC + VC

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EXAMPLE 2: Costs
$800 FC
Q FC VC TC $700 VC
TC
0 $100 $0 $100 $600
1 100 70 170 $500
Costs

2 100 120 220

$400
3 100 160 260
$300
4 100 210 310
$200
5 100 280 380
$100
6 100 380 480
$0
7 100 520 620 0 1 2 3 4 5 6 7
Q
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 EXAMPLE 2: Marginal Cost

Q TC MC Recall, Marginal Cost (MC)

is the change in total cost from
0 $100
$70 producing one more unit:
1 170
50 ∆TC
2 220 MC =
∆Q
40
3 260 Usually, MC rises as Q rises, due to
50 diminishing marginal product.
4 310
70 Sometimes (as here), MC falls before
5 380
100 rising.
6 480
140
7 620
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EXAMPLE 2: Marginal Cost

Q TC MC $200
$175
0 $100
$70 $150
1 170
50 $125
Costs

2 220
40 $100
3 260
50 $75
4 310 $50
70
5 380 $25
100
6 480 $0
140
7 620 0 1 2 3 4 5 6 7
Q
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EXAMPLE 2: Average Fixed Cost

Q FC AFC Average fixed cost (AFC)

is fixed cost divided by the quantity of
0 $100 n/a
output:
1 100 $100
AFC = FC/Q
2 100 50
3 100 33.33
Notice that AFC falls as Q rises: The firm is
4 100 25 spreading its fixed costs over a larger and
5 100 20 larger number of units.
6 100 16.67
7 100 14.29

25

EXAMPLE 2: Average Fixed Cost

Q FC AFC $200
0 $100 n/a $175
1 100 $100 $150
2 100 50 $125
Costs

3 100 33.33 $100

4 100 25 $75
$50
5 100 20
$25
6 100 16.67
$0
7 100 14.29
0 1 2 3 4 5 6 7
Q
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 EXAMPLE 2: Average Variable Cost

Q VC AVC Average variable cost (AVC)

0 $0 n/a is variable cost divided by the quantity
of output:
1 70 $70
AVC = VC/Q
2 120 60
3 160 53.33 As Q rises, AVC may fall initially. In
4 210 52.50 most cases, AVC will eventually rise as
output rises.
5 280 56.00
6 380 63.33
7 520 74.29

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EXAMPLE 2: Average Variable Cost

Q VC AVC $200
0 $0 n/a $175

1 70 $70 $150

2 120 60 $125
Costs

$100
3 160 53.33
$75
4 210 52.50
$50
5 280 56.00
$25
6 380 63.33
$0
7 520 74.29 0 1 2 3 4 5 6 7
Q
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EXAMPLE 2: Average Total Cost

Q TC ATC AFC AVC Average total cost (ATC)

equals total cost divided by
0 $100 n/a n/a n/a
the quantity of output:
1 170 $170 $100 $70
ATC = TC/Q
2 220 110 50 60
3 260 86.67 33.33 53.33
Also,
4 310 77.50 25 52.50
5 380 76 20 56.00
ATC = AFC + AVC
6 480 80 16.67 63.33
7 620 88.57 14.29 74.29

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EXAMPLE 2: Average Total Cost

Q TC ATC $200
Usually, as in this example, the ATC
0 $100 n/a $175
curve is U-shaped.
$150
1 170 $170
$125
2 220 110
Costs

$100
3 260 86.67
$75
4 310 77.50
$50
5 380 76 $25
6 480 80 $0
0 1 2 3 4 5 6 7
7 620 88.57
Q
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EXAMPLE 2: Why ATC Is Usually U-Shaped

As Q rises: $200

Initially, $175
falling AFC $150
pulls ATC down. $125

Costs
Eventually, $100
rising AVC $75
pulls ATC up.
$50
Efficient scale: $25
The quantity that $0
minimizes ATC. 0 1 2 3 4 5 6 7
Q
31

EXAMPLE 2: The Various Cost Curves Together

$200
$175
$150
ATC
$125
Costs

AVC
$100
AFC
MC $75
$50

$25
$0
0 1 2 3 4 5 6 7
Q
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EXAMPLE 2: ATC and MC
When MC < ATC, $200 ATC
ATC is falling. MC
$175
When MC > ATC, $150
ATC is rising. $125

Costs
The MC curve crosses $100
the ATC curve at $75
the ATC curve’s $50
minimum.
$25
The MC curve crosses the ATC $0
curve at the efficient scale. 0 1 2 3 4 5 6 7
Q
33

EXAMPLE 2: AVC and MC

When MC < AVC, $200 AVC
AVC is falling. MC
$175
When MC > AVC, $150
AVC is rising. $125
Costs

The MC curve crosses $100

the AVC curve at $75
the AVC curve’s $50
minimum.
$25
$0
0 1 2 3 4 5 6 7
Q
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CHECK POINT: Calculating costs

Fill in the blank spaces of this table.

Q VC TC AFC AVC ATC MC
0 $50 n/a n/a n/a
$10
1 10 $10 $60.00
2 30 80
30
3 16.67 20 36.67
4 100 150 12.50 37.50
5 150 30
60
6 210 260 8.33 35 43.33
35

CHECK POINT:
Fill in the blanks in the following table:

Q TC FC VC AFC AVC ATC MC

0 20 - - - -
1 20
2 15
3 19
4 48
 PROFIT MAXIMASATION

TOTAL REVENUE (TR) TOTAL COSTS (TC)

the firm’s total earnings per period of the total amount paid by a firm
time from the sale of a particular for the factors of production it
amount of output uses in the productive process

TOTAL PROFIT (𝝅)

A firm’s total profit is the difference
between its total sales revenue and
its total costs of production

37

ECONOMIC PROFIT

= total revenue - (explicit costs +

implicit costs)

ACCOUNTING PROFIT

Accounting profit
= total revenue - explicit costs

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1. Economic profit is equal to total revenue minus the
a) opportunity cost of producing goods and services.
b) accounting cost of producing goods and services.
c) implicit cost of producing goods and services.
d) explicit cost of producing goods and services.
2. Economic profit
a) will never exceed accounting profit.
b) is most often equal to accounting profit.
c) is always at least as large as accounting profit.
d) is a less complete measure of profitability than
accounting profit.

3. Total revenue minus only explicit costs is called 4. Total revenue minus only implicit costs is called
a) accounting profit. a) accounting profit.
b) economic profit. b) economic profit.
c) implicit cost. c) opportunity cost.
d) average total cost. d) None is correct.

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Profit - maximizing rule

Profits are maximised

where MC = MR

40
 𝝏(𝑻𝑹(𝑸) 𝑻𝑪 𝑸 )
max  𝝏𝑸
=0

 MR – MC = 0

IF MR > MC  MR = MC IF MR < MC

Firms should Firms should

increase Profit is decrease
outputs maximized outputs

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1. Economists normally assume that the goal of a firm is to

(i) sell as much of its product as possible.
(ii) set the price of the product as high as possible.
(iii) maximize profit.
a) (i) and (ii) only
b) (ii) and (iii) only
c) (iii) only
d) (i), (ii), and (iii)

2. If a competitive firm is currently producing a level of output at which

marginal cost exceeds marginal revenue, then
a) a one-unit decrease in output will increase the firm's profit.
b) a one-unit increase in output will increase the firm's profit.
c) total revenue exceeds total cost.
d) total cost exceeds total revenue.

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