The Theories on Firm’s Behavior

CONTENT
*Theory on production
- Production and Production function
- Short run &Long run
- Economies and diseconomies of scale
*Theory on cost
- Total, average and marginal cost
- Economic, Accounting and Sunk cost
*Theory on profit
- Profit
- Total, average and marginal revenue
- Profit maximization and revenue maximization
1 Copyright © 2014 by Quan Hong NGUYEN
 I. Theory on Production
1. Some definitions
-Production: is the process that transforms inputs into
outputs, i.e. goods and services, to satisfy human wants.
PRODUCTION

INPUTS OUTPUTS

K L Goods Services
(Capital) (Labour) (Tangible) (Intangible)

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 I. Theory on Production
1. Some definitions
- Inputs used to produce commodities to satisfy people’s
needs, including:
+ Capital (K)
 Capital: Physical capital (K) => Interests (i)
 Land: Nature resources => Land tax (r)
+ Labor (L)
 Labor: Human activity (L) => Wage (w)
 Entrepreneurship: The capacity and willingness to develop,
organize and manage a business venture
=> Profit (П)
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 I. Theory on Production
1. Some definitions
Short run and long run
+ Short run: is a period of time in which the quantity of at least
one input is fixed (fixed input) and the quantities of the other
inputs can be varied (variable inputs)
+ Long run: is a period of time in which the quantity of all inputs
can be varied
* No specific time that can be marked on the calendar to
separate the short run from the long run

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 I. Theory on Production
2. Production Decisions of a Firm
- Production Technology
+ Firms can produce different amounts of outputs using
different combinations of inputs
- Cost Constraints
+ Firms must consider prices of labor, capital and other inputs
+ Firms want to minimize total production costs partly
determined by input prices

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 I. Theory on Production
2. Production Decisions of a Firm
- Input Choices
 Given input prices and production technology, the firm must
choose how much of each input to use in producing output
 Given prices of different inputs, the firm may choose different
combinations of inputs to minimize costs
 If labor is cheap, may choose to produce with more labor and less
capital

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 I. Theory on Production
2. Production Decisions of a Firm
- If a firm is a cost minimize, we can also study
 How total costs of production varies with output
 How does the firm choose the quantity to maximize its profits
- We can represent the firm’s production technology in form of a
production function: The maximum quantity of outputs gained
from certain quantity of inputs at current technology
constraint in a certain time period
Q = f (K, L)

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 I. Theory on Production
2. Production Decisions of a Firm
Cobb-Douglas production function

Q = a Kα Lβ,
where:
Q = output
L = labor input
K = capital input
α, β = labour and capital's share of output.

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 I. Theory on Production
3. Short-run production
Assumption: Labor is variable while capital is fixed
 Firm can increase output only by using more labor
 Two questions
- How many products that one labor unit can contribute on
average?
- Should the firm hire another labor unit? If so, how many products
this labor can contribute?

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 I. Theory on Production
3. Short-run production
 Average product of labour, or APL, is the ratio of
total output to the numbers of labour unit used.

Q
APL 
L

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 I. Theory on Production
3. Short-run production

 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

Q
MPL 
L
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 I. Theory on Production
3. Short-run production
 If production function is continuous, the we have

MPL  Q(L
 )
Q max when MPL = 0
MPL measures the slope of the output curve.

 12 Copyright © 2014 by Quan Hong NGUYEN

 I. Theory on Production
3. Short-run production
The law of diminishing marginal returns: occurs when
the marginal product of an additional input (e.g.
worker) is less than the marginal product of previous
input (i.e. previous worker)

* What is the relationship between MP and AP?

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Capital Labour Output APL MPL
(K) (L) (Q)
4 0 0

4 1 70

4 2 150

4 3 75

4 4 288
} 52
4 5

4 6
}
10
4 7 52
Capital Labour Output APL MPL
(K) (L) (Q)
4 0 0 0 -
}
70
4 1 70 70
}
4 2 150 75 80
}
4 3 225 75 75
}
63
4 4 288 72
}
52
4 5 340 68
}
4 6 354 59 14
}
4 7 364 52 10
Marginal Product & Average Product
 When marginal product is greater than the average
product, the average product is increasing
 When marginal product is less than the average product,
the average product is decreasing
 When marginal product is zero, total product (output) is
at its maximum
 Marginal product crosses average product at its maximum

19
Marginal Product & Average Product

 Q  Q ' L  Q
APL    
L
2
L

Q  Q
 L  MPL  APL  0
L L

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 II. Production cost

1. Economic cost, Accounting cost and Sunk cost

Economic cost: Total amount paid for inputs used in
production, includes:

- Explicit cost: Amount paid for inputs that do not

belong to the firm’s owner
- Implicit cost: Amount paid for inputs that belong to
the firm’s owner

Economic Cost = Explicit Cost + Implicit cost

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 II. Production cost

1. Economic cost, Accounting cost and Sunk cost

Accounting cost: Amount paid for inputs used in
production and reported in accounting notes:

Economic Cost = Accounting Cost + Opportunity cost

Sunk cost: Amount paid for inputs used in production

which neither be refundable nor changeable by future
decisions/ actions

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 II. Production cost

2. Cost in short-run
2.1. Fixed cost, variable cost, total cost
- Fixed cost (FC): the cost of a fixed input, independent
with the output level C

FC
FC

Q
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 II. Production cost

2. Cost in short-run
2.1. Fixed cost, variable cost, total cost
- Variable cost (VC): the cost of a variable input, varies
with the output level.
C

VC

Q
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 II. Production cost

2. Cost in short-run C
2.1. Fixed cost, variable cost,
total cost
TC
- Total cost (TC): is the
sum of total fixed cost and
VC
total variable cost
FC FC
TC = VC + FC
=> The vertical distance
between total cost curve
and variable cost curve
remains constant. Q

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 II. Production cost

2. Cost in short-run C

2.2. Average cost

- Average fixed cost (AFC):
is total fixed cost per unit of
output
FC
AFC 
Q
AFC

Q
 II. Production cost

2. Cost in short-run
C
2.2. Average cost
- Average variable cost
(AVC): is total variable cost
per unit of output
AVC
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
Q
 II. Production cost

2. Cost in short-run
C
2.2. Average cost
- Average total cost
(ATC): is total cost per ATC
unit of output
AVC
TC
ATC   AFC  AVC
Q AFC
Note: Average curves
(except AFC) is are U-
shaped Q
 II. Production cost
2. Cost in short-run
2.2. Average cost C ATC
Marginal cost (MC): is the
MC
change in total cost results
from a unit increase in AVC
ATCmin
output

TC
MC   TC '(Q )  VC '(Q )
Q
AVCmin

Q
 II. Production cost

 Relationship between MC and MPL

VC wL w w
MC   
Q Q (Q/L) MPL
MPL first rises and then falls
MC first declines and then goes up
MC curve is U- shaped
 II. Production cost
 Relationship between MC and AVC
MC > AVC : AVC 
MC < AVC : AVC 
MC = AVC : AVC min
 Relationship between MC and ATC
MC > ATC : ATC 
MC < ATC : ATC 
MC = ATC : ATC min
=> MC intersects AVC and ATC at their minimum
points
 II. Production cost

VC  VC' Q  VC

AVC    2
 Q  Q
MC  Q  AVC  Q MC  AVC
 2 
Q Q
 III.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
 III. Profit maximization

 Marginal revenue is the change in total revenue

resulting from the sale of an extra product.

TR
MR 
Q
 III. 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)
 III. Profit maximization

P
P = aQ + b
b TR = PQ = aQ2 + bQ
MR = 2aQ +b

E = -1

0 -b/2a -b/a Q

MR
 III. Profit maximization
 Total revenue is the integral of marginal revenue.
Therefore the whole area below the marginal
curve yields the value of total revenue

Q0 Q0

 MRdQ  TR  TRQ0
0 0

 MR
 III. Profit maximization

 Profit is the firm’s total revenue minus its total cost

Profit = Total revenue - Total cost
 Economic profit versus accounting profit
 Economic profit is zero  the firm earns normal
profit
 Economic profit is positive  abnormal profit
 Economic profit is negative  loss
 III. Profit maximization

 Profit maximization  MR > MC : Increase

Q* : π = TR – TC max output
 π’(Q) = 0  MR < MC : Decrease
 TR’ (Q) – TC’ (Q) = 0 output
 MR – MC = 0
 MR = MC : optimal
 MR = MC
output level
 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.

 The marginal-cost curve always crosses the
average-total-cost curve at the minimum of
ATC, the same with AVC.