Topic 5: Production, Costs and Decisions in a Perfectly Competitive Market

In the last lecture, we discussed how market prices are arrived at, and for that we needed to know
the how decision making in the household is done, and therefore come up with a market demand,
which tells how what market demand would be like at different prices. In order to know what
would be the price that would prevail in the market, we found what each individual producer would
supply at different prices, and came up with a market supply curve. An interaction of market
demand and market supply gave us the equilibrium price at which goods were traded in the market.
However, a lot of simple assumptions were made when we were doing decision making of a firm.
All that the firm had to choose was a level of output given the price prevailing in the market, once
the level of output was decided upon, the amount of input required was no issue since output
required only one input and there was a one to one correspondence.

We now relax the assumption that output may be produced by only one input, and allow for two
inputs to be used in the production of an output. We start with the simplest technology, the fixed
coefficients technology, which dictates that fixed amounts of each input go into the production
process. Let us think of the output as requiring a units of labor and b units of capital to make a unit
of the output. Let there be L0 units of labor K0 units of capital available in the economy. Then it is
apparent that the amount of output y, that can be produced in the economy will be either L0/a, or
K0/b, whichever is less. Therefore the amount of output that can be produced in the economy is
given by:

y = min[L0/a, K0/b]

The above technology is referred to as fixed coefficients technology in the literature. Notice that
for any amount of labor and capital available in the economy, one of the inputs may not get fully
utilized even if the maximum level of output is being produced unless L0/K0 = a/b. Usually in
countries like India, labor might remain unemployed, even when the maximum level of output is
produced. Combinations of labor and capital that produce a certain level of output can also be
shown in a diagram as in Figure 5.1. In Figure 5.1, any combination with b units of capital and a,
or more than a units of labor will produce an output equal to one. Similarly any combination of a
units of labor and b or more than b units of capital will produce one unit of output. Locus of all
such points which produce one unit of output will be called an isoquant, and in this case the
isoquant will be an L shaped curve.

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 Figure 5.1: Isoquants with fixed inputs of production

Capital
y=1

K0 y = K0/b

b y=1

a y = aK0/b L0 Labor

Given L0 units of labor and K0 units of capital, the maximum output that can be produced is given
by y = K0/b if L0/a > K0/b which is shown by the higher isoquant in figure 36. Therefore an amount
(L0 – aK0/b) would be left unutilized within the system. Also note that isoquants are very similar
to indifference curves as discussed earlier, however the former is much more concrete. It may be
much easier to draw an isoquant for a production process than to draw the indifference curve for a
household.

It will be of concern to any economy if its resources either labor or capital lie wasted. This can be
offset by the introduction of more number of fixed coefficients technologies. For example, let two
fixed coefficients technologies be available, one which uses 2 units of labor and 1 unit of capital
to produce a unit of output, and the other uses 1 unit of labor and 2 units of capital to produce a
unit of output. If there exists 3 units of labor and 3 units of capital in the economy, then availability
of just any one of the technologies would mean either labor or capital going waste, but by using

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both of them, the society is able to produce 2 units of output. Both these technologies are
represented by their respective isoquants to produce one unit of output in Figure 5.2. Please note
that if 3 units of labor and 3 units of capital are able to produce 2 units of output

Figure 5.2: Isoquants representing two fixed coefficient technologies

Capital

2 A

1
B

1 2 Labor

using both technologies, 1.5 units of labor and 1.5 units of capital will also be able to produce 1
unit of labor. It is apparent that 1.5 units of labor and 1.5 units of capital lie on the line AB in
Figure 5.2, and it can be shown that all points on the line AB will be able to produce 1 unit of
output. Points on the line AB are said to be convex combinations of the points A and B. Therefore
with the availability of new technologies, the isoquant of y = 1 becomes modified to CABD as
shown in Figure 5.3. If two more fixed coefficient technologies were made available, one which
uses labor and capital at point E to produce a unit of output, and the other at point F; the technology
E will not be utilized since convex combinations of technologies A and B would use lower levels
of both labor and capital to produce a unit of output. So the isoquant gets revised to CAFBD

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 Figure 5.3: Isoquants with the impact of new technology

Capital

2 A E

1
F
B D

1 2 Labor

If we were to look at Table 5.1, we see that capital is constant at 2 units and labor is being
progressively increased by one unit. Output increases from 5/3 to 6/3 and does not increase after
that, so we witness diminishing marginal productivity of labor.

Table 5.1: Diminishing Marginal Productivity of Labor

Marginal Product of
Labor Capital Output Labor
3 2 5/3 1/3
4 2 6/3 0
5 2 6/3

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This occurs since the shape of the isoquant is convex, in fact if the isoquant is strictly convex and
smooth; the shape of the isoquant will be as given in Figure 5.4.

Figure 5.4: Marginal Rate of Technical Substitution

L
This will imply there are numerous possibilities of production, and the proportion in which labor
and capital is present is not a problem, one can find an appropriate technology to use up both
resources and produce more output. The slope at any point say A gives us what is called the
marginal rate of technical substitution which is the extent by which capital can be reduced for
every extra unit of labor used, output remaining constant. This concept is very similar to that of
the marginal rate of substitution discussed in the context of indifference curve. Notice also that we
have diminishing marginal rate of technical substitution as we move from point A to point B. This
is due to the fact that both labor and capital are essential for production. When more labor is being
used and less and less of capital can be withdrawn since it is an essential input in the production
process.

Till now we were discussing situations where we had a finite amount of labor and capital and
wanted to make the best use of it by producing the maximum possible output given our technology
constraints. Such an optimization is true for some firms like a farmer who may use his land and
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family labor or of small business units that generally rely on family labor and have free access to
some capital inputs. Such an optimization exercise will not be true for firms which buy inputs from
the market. For such firms the decision on how much to produce would depend on the profit which
may be earned at each level of output, which in turn depends on the cost of production at each
level of output. Therefore for the maximum profit to be earned at each level of output, we need to
know the minimum cost at which each level of output can be produced. When there are two or
more than two inputs used, the same output can be produced at varying levels of cost, we therefore
need to know the minimum cost at which each level of output can be produced. This is provided
by what we call a cost function; this gives us the minimum cost at which each level of output can
be produced. Once we have the cost function, we can compute the profit that we can obtain at each
level of output, and then we can select the optimum output level that gives us the maximum profit.

How do we go about selecting the input combination of labor and capital which will give us the
minimum cost to produce a particular level of output? To get started, let us assume an output y0 is
produced with L0 amount of labor and K0 amount of capital. Let labor cost w per unit and capital
cost r per units. Therefore the current cost is C0 = wL0 + rK0. The output level, the amount of
inputs used as well as the current cost can be represented in a diagram as in Figure 5.5.

Figure 5.5: Input equilibrium with two inputs of production

A
K
C0/r P
C1/r
B
K0

*
K
Q0
C

R
*
L0 L C1/w C0/w
L

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In Figure 5.5, any combination along the isoquant ABC will produce an output Q0. The cost to
produce at B will be C0 = wL0 + rK0. We will like to find out the costs to produce Q0 for every
feasible combination of L and K, and then choose the combination which results in minimum costs.
Once minimum costs are achieved, profit is maximized if that level of output is to be produced.
We have to repeat this exercise for every level of output Q to get the costs schedule. All (L, K)
bundles along the line PBR cost C0 form an iso-cost line. The slope of the iso-cost line is w/r, that
is the opportunity cost of buying labor. However output Q0 can be produced at least cost using the
labor capital combination L*, K*. At this optimum combination slope of the isoquant is equal to
the slope of the isocost line. That is Marginal rate of technical substitution MRTS is equal to the
input price ratio w/r.

Our next attempt will be to try and derive the cost function for a fixed coefficients technology, the
one that we have discussed so far. If we are given a fixed coefficients technology y = min[a1x1,
a2x2], it implies that we need 1/a1 of input 1, and 1/a2 of input 2 to produce a unit of output. Let
the cost of input x1 be w1 per unit and that of x2 be w2 per unit. If the optimum amount of x1 and x2
are used to produce the output, then it must be the case that y = a1x1* = a2x2*, where x1* and x2*
refer to the optimal amounts of x1 and x2 used for the production of y units of output, optimal in
the sense that it minimizes the cost of production of y units of output, given the input prices.
Therefore the cost function to produce a level of output y given input prices w1 and w2 for a fixed
coefficients technology is given by C(w1, w2, y) = w1x1* + w2x2* = w1y/a1 + w2y/a2.

A feature of the fixed coefficients technology is that we choose the same input combination to
produce a particular level of output irrespective of the ratio of input prices. Consider the situation
in figure 5.6, the initial input price ratio or the opportunity cost of labor was w’/r’, even when labor
became relatively more expensive with the input price ratio w’’/r’’, one did not have the possibility
to substitute labor x1 with x2.

Figure 5.6: Fixed cost technology and change in input prices

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 x2

C’’/r’’

C’/r’

C’’/w’’ C’/w’ x1

This however may not be the case with all kinds of technology. Think of a linear technology for
instance, where y = a1x1 + a2x2. One can imagine that such will be the case if the output y is say
amount of clothes washed. One can choose to have clothes washed by a maid who charges w1 per
hour or with a washing machine where a rental charge for a wash of one lot is w2 per load. If this
were the problem, we would compute the cost of washing clothes for an equal amount of clothes
washed by a maid as well as by a washing machine, and whichever is cheaper we opt for that one
only. In case we wish to use only x1, our input requirement to produce y will be y/a1, and in case
we wish to use only x2, our input requirement will be y/a2. Therefore the cost function for such a
technology will be

C(w1, w2, y) = w1x1* + w2x2* = w1y/a1 if w1y/a1 < w2y/a2

= w2y/a2 if w1y/a1 > w2y/a2

= any x1*, x2* that satisfies y = a1x1* + a2x2* if w1y/a1 = w2y/a2

Therefore in this situation we have a corner solution, it may be possible to substitute one input
completely with the other, given input prices. Figure 5.6 shows the optimal choices with different
input prices. AB represents the isoquant; that is the various x1, x2 combinations that produce at

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output level y. With input prices w1’ and w2’, only x1 is used to produce y, with input prices w1’’
and w2’’ only x2 is used to produce y.

Figure 5.7: Optimal choices with different input prices

x2

A
C’’/w2’’=y/a2

C’/w2’

B
C’’/w1’’ C’/w1’=y/a x1
1

The fixed coefficients technology and the linear technology are two extremes; in one there is no
change in the input use to produce a particular level of output as input prices change in a fixed
coefficients technology, in linear technology there is a huge change in the sense that one of the
inputs will be completely dispensed off with, if input prices were to change substantially. The
situation is something in between for a Cobb Douglas Technology. The Cobb Douglas Technology
is given by

y = x1a1x2a2

Let a1= a2= 0.5. This will imply that x1x2 = y2, therefore the indifference curve is a rectangular
hyperbole. Figure 5.8 show the different optimum input choices at A and B with different input
prices.

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 Figure 5.8: Equilibrium points with different input prices

x2

C’’/r’’

B
C’/r’

C’’/w’’ C’/w’ x1

It can be shown that the cost function for a Cobb Douglas Technology will be

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C(w1, w2, y) = 2w10.5w20.5y

However, it may not always be possible to use optimum amounts of inputs given input prices. It is
said in the short run, one may be forced to buy a certain amount of input, and one may not be able
to increase or decrease input use with output. For example, we may hire labor at the beginning of
a period, and cannot fire them before the contract term is over. It may also happen with capital,
our particular vintage may not allow for different amount of capital use. In such situations the
optimum amount of input use for cost minimization to produce a particular level of output becomes
different. Given the constraints one operates in the short run, the short run cost function is always
at least as high as the long run cost function, if the optimal input choice in the short run happens
to be different from that in the long run, the short run cost will be higher than the long run cost to
produce the same output. This is illustrated in Figure 5.9.

Figure 5.9: Short and Long run Cost Functions

C2/r
Q1
C1/r

Q0

C0/r

K1

K0

L0 L1 C0/w L2 C1/w C2/w

In Figure 5.8, L1, K1 are the optimal amounts of labor and capital needed to produce an output Q1.
In the short run, capital is fixed at K0, and therefore the input choice L2, K1 produces the same
output, but at a higher cost C2 rather than C1.

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We have till now only considered inputs costs which are essentially variable costs that is costs
that vary with the level of output. These usually include material costs. We also have fixed costs
like rent for factory premises which do not vary with the level of output. In the case of a car for
example, fixed costs include the costs of a car, while variable costs include fuel costs which depend
on the amount of kilometers covered which is essentially the output of from a car. If we have a
choice between a petrol car which has low fixed costs and high variable costs and a diesel car
which has high fixed costs and low variable costs, which one should we choose? Obviously it will
depend on the amount of distance we need to cover. Private vehicles normally tend to be petrol
driven cars, while taxis and trucks usually run on diesel, since they travel larger distances, and it
is more economical for them to run on diesel rather than petrol. The entry of fixed and variable
costs adds a new dimension. There will now be a level of output at which unit costs will be least
which we will call the minimum efficient scale. We will demonstrate that shortly. Different
technologies will have different fixed and variable costs, so will have different minimum efficient
scale of production. Whether a market can support many firms or one firm will depend not only
on the minimum efficient scale but also on the level of demand. To illustrate how we may arrive
at the minimum efficient scale, let us consider a hypothetical data given in Table 5.2. It is apparent
that we have diminishing marginal productivity from labor, wage rate is 10 units per laborer and
factory rent is 10 units.

Table 5.2: Total cost for varying levels of inputs (workers) and outputs
Total Total Fixed
No. of Average Fixed Average Average
Output Variable Cost Cost (Factory
workers Cost Variable Cost Total Cost
(Wages) Rent)
1 10 10 10 1 1 2
2 18 20 10 0.56 1.11 1.67
3 22 30 10 0.45 1.36 1.81

Figure 5.10 & 5.11: Relationship between output, number of workers, and
wages

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 Output 30
22 Wages
18 20
10 10

1 2 3 10 18 22
No. of workers Output

The relationship between the output and the number of workers, and wages and output is shown
in Figure 5.10 and 5.11 respectively. Given that fixed costs does not vary with output, average
fixed costs which are fixed costs divided by the level of output will decrease as output increases.
This is illustrated in figure 5.12.

Figure 5.12: Average fixed cost curve with increasing output

Average
Fixed
Cost

Output
Now wages are essentially variable costs as mentioned before, and therefore if variable costs
increase at an increasing rate as in figure 5.11, we will have average variable costs increasing at
an increasing rate as in figure 5.13.

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 Figure 5.13: Average variable cost curve with increasing output

Average
Variable
Cost

Output

Therefore Total Costs = Fixed Costs + Variable Costs

Or Average Total Costs = Average Fixed Costs + Average Variable Costs

Given that average fixed cost is decreasing with output and average variable cost is increasing with
output, average total cost first decreases then increases as illustrated in Table 5.2. That is why
average total cost is said to have a U shape as shown in figure 5.14.

Figure 5.14: Average Total Cost Curve with increasing Output

Average
Total
Cost
Curve

Output
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Let us now introduce another variable marginal cost, which is the increase in cost arising from a
unit increase in production. To illustrate the relationship between average total cost and marginal
cost, let us introduce another dataset given in Table 5.3.

Table 5.3: Marginal Cost for varying level of output

Average Average Average

Fixed Variable Total Fixed Variable Total Marginal
Output Cost Cost Cost Cost Cost Cost cost
1 10 10 20 10 10 20 14
2 10 24 34 5 12 17 20
3 10 44 54 3.33 14.67 18

The general relationship between average total cost and marginal cost is shown in Figure 5.15

Figure 5.15: Minimum Efficient Scale Output

Costs
Marginal Average
Cost Total
Cost
Curve

Efficient Scale Output

It should be noted both from figure 5.15 and from Table 5.3 that whenever marginal cost is less
than average total cost, average cost is falling and marginal cost is more than average total cost,

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average cost is rising. The marginal cost crosses the average total cost curve at the minimum of
the average total cost. The efficient scale is the quantity of output that minimizes average total
cost.

If firms want to increase their output, they might have to build another plant as the existing plant
may not have the required capacity to increase output. However, the cost of producing a larger
output may fall with the coming up of the new plant, however it may not continue if output size is
too large. This is where the concept of returns to scale is important to the firm. Returns to scale
are of three types: increasing, constant and decreasing returns to scale. When outputs increase in a
greater proportion than that of inputs, it is termed as increasing returns to scale. When output
increases in the same proportion as inputs, it is termed as constant return, whereas when output
decreases as inputs increase, it is termed as decreasing returns to scale. In a similar way, economies
of scope is defined when the cost of producing two or more items together is less than the cost of
producing them individually. In other words, C(x,y) < C(x) + C(y), then there is economies of
scope. Otherwise, there exists diseconomies of scope.

Now that we have analyzed, production conditions and the cost structure, we will be able to
comment on firm behavior in a perfectly competitive market. In a perfectly competitive market,
there are many buyers and sellers in the market, no individual can influence prices, so each person
is a price taker. The goods offered by the various sellers are roughly the same. Firms can enter or
exit the market freely.

Table 5.4: Profit maximizing output by the firm

Marginal Marginal
Output Price Revenue Costs Profit
Revenue Cost
1 4 4 2 2 4 3
2 4 8 5 3 4 4
3 4 12 9 3 4 5
4 4 16 14 2 4 6
5 4 20 20 0 4

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 Table 5.5: Profit maximizing output with an increase in prices

Marginal Marginal
Output Price Revenue Costs Profit
Revenue Cost
1 5 5 2 3 5 3
2 5 10 5 5 5 4
3 5 15 9 6 5 5
4 5 20 14 6 5 6
5 5 25 20 5 5

Let us again recapitulate the output that a firm would produce at any given price. We notice from
Table 5.4 and 5.5, that at the profit maximizing output, the price is equal to the marginal cost at
the profit maximizing output. Therefore, if we have the marginal cost schedule, we will get the
profit maximizing output at any price. This is what is demonstrated in Figure 5.16, and the amount
of profit earned is shown by the area within the dotted lines.

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 Figure 5.16: Optimal Output and total profit generated

Costs

Marginal Average
Cost Total
Cost
P* Curve
Profit

Q* Output

Therefore the marginal cost curve is also said to be the firm’s supply curve at any price, but there
are certain qualifiers. The question is does it make sense for the firm to produce output if the price
is less than the minimum of the average total cost, which means the firm makes economic losses.
Yes, it does as long in the short run, as long as the price is above the average variable cost. This
would imply, although we are having economic losses, we can minimize our losses by earning a
revenue more than the variable cost, which means that a part of the fixed costs are also covered.
Therefore the part of the marginal cost curve relevant for the firm’s supply decision is the part
which is above the average variable cost of the firm as shown in Figure 5.17. Once the supply
schedules of all firms are known, we can work out the market supply schedule at different prices,
by adding up the supplies of each firm at every price and we obtain the market supply schedule.

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 Figure 5.17: Market Supply Curve of the firm

0 Quantity
The three main conditions are:

Shut down if Total Revenue < Variable Cost

Shut Down if Total Revenue/Output < Variable Cost/Output

Shut down if Price < Average Variable Cost

Depending on the level of the profit/loss generated by the firms in the industry, there would be
entry and exit. If profits are positive, there will be an increase in the number of firms, this will
push supply up, which will then push down prices to the perfect competitive level.

Long run Equilibrium

On observing the profits/losses in an industry, firms enter or leave accordingly. In essence, if firms
in a perfect competitive industry are making profits, there will be an entry of new firms into the
market, thereby increasing the supply of firms producing the goods. Conversely, if the firms are
in a loss making situation, then the firms already in the market start to leave. This decreases the
supply in the industry. However, in the long run, process of entry and exit will drive the price in
perfectly competitive markets to the zero-profit point at the bottom of the AC curve, where
marginal cost crosses average cost. The mechanism through which this functions is as follows:

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Let’s say that the product’s demand increases, and with that, the market price goes up. The existing
firms in the industry are now facing a higher price than before, so they will increase production to
the new output level where P = MR = MC.

This will temporarily make the market price rise above the average cost curve, and therefore, the
existing firms in the market will now be earning economic profits. However, these economic
profits attract other firms to enter the market. Entry of many new firms causes the market supply
curve to shift to the right. As the supply curve shifts to the right, the market price starts decreasing,
and with that, economic profits fall for new and existing firms. As long as there are still profits in
the market, entry will continue to shift supply to the right. This will stop whenever the market
price is driven down to the zero-profit level, where no firm is earning economic profits.

Short-run losses will fade away by reversing this process. Say that the market is in long-run
equilibrium. This time, instead, demand decreases, and with that, the market price starts falling.
The existing firms in the industry are now facing a lower price than before, and as it will be below
the average cost curve, they will now be making economic losses. Some firms will continue
producing where the new P = MR = MC, as long as they are able to cover their average variable
costs. Some firms will have to shut down immediately as they will not be able to cover their
average variable costs, and will then only incur their fixed costs, minimizing their losses. Exit of
many firms causes the market supply curve to shift to the left. As the supply curve shifts to the
left, the market price starts rising, and economic losses start to be lower. This process ends
whenever the market price rises to the zero-profit level, where the existing firms are no longer
losing money and are at zero profits again. Thus, while a perfectly competitive firm can earn profits
in the short run, in the long run the process of entry will push down prices until they reach the
zero-profit level. Conversely, while a perfectly competitive firm may earn losses in the short run,
firms will not continually lose money. In the long run, firms making losses are able to escape from
their fixed costs, and their exit from the market will push the price back up to the zero-profit level.
In the long run, this process of entry and exit will drive the price in perfectly competitive markets
to the zero-profit point at the bottom of the AC curve, where marginal cost crosses average cost.
Figure 5.18, panel A shows the firm level equilibrium, while panel B shows the market level
equilibrium in the long run.

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 Figure 5.18: Firm and Market level equilibrium in a perfectly competitive industry

MC

AC 𝑃∗

𝑃∗ P=MR=AR

𝑞∗ 𝑄∗

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 Additional Questions

1. A firm has access to two technologies, A and B. Technology A requires 2 units of labor L
and 3 units of capital K to produce a unit of final output. Technology B requires 3 units
of labor L and 2 units of capital K to produce a unit of final output. Labor costs w1 per
unit and capital costs w2 per unit. Find the long run cost function when there is no
constraint on the availability of any input? Find the short run function cost if the amount
of capital available in the short run is less than and equal to 4.

2. A firm has access to two technologies, A and B. Technology A requires 4 units of labor L
or 1 units of capital K to produce a unit of final output. Technology B requires 1 units of
labor L or 4 units of capital K to produce a unit of final output. Find out the maximum
output that the firm can produce if the firm is endowed with 2 units of labor and 5 units
of capital. Comment on whether the same combination (2 units of labor and 5 units of
capital) can be an optimal combination if labor and capital had to be purchased from
outside to produce the same output if the cost of labor is 2 per unit and that of capital is 3
per unit.

3. There are two technologies available to a producer, technology 1 can be represented by y

= x1 + x2 and technology 2 by y = min(4x1, 4x2), where y represents the output and x1 and
x2, represents the two inputs. The price of x1 is w1 and that of x2 is w2. Determine under
what situation the producer will use technology 1 and under what situation he will use
technology 2.

4. Consider a perfectly competitive industry with a large number of firms, all of which have
identical cost functions c(y)= y2 + 1, for y>0 and c(0)=0. Suppose the initial demand
curve for the industry is D(p) = 52 – p. In the long run, what will be the equilibrium
price, output produced by any firm and the number of firms in the industry?

5.

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