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Part 2: Producer behavior

Topic 4: Technology, cost and profit
4.1. Technology
- Technological constraints – 19.2, 19.3
- Properties of technology – 19.4, 19.5
- Technical rate of substitution – 19.6, 19.7, 19.8
- Long run and short run – 19.9
- Return to scale – 19.10
4.2. Cost minimization
- Cost minimization - 21.1.
- Short run and long run costs 21.4
- Returns to scale and cost functions 21.3
4.3. Cost curves
- Average costs, marginal costs, variable costs – 22.1, 22.2, 22.3
- Long-run costs 22.5, 22.6, 22.7
4.4. Profit maximization
- Profit maximization in short run 20.1, 20.6, 20.7
- Profit maximization in the long run 20.8
- Discussion
1

4.1. Technology
4.1.1. Technological constraints – 19.2, 19.3
• Production transforms a set of inputs into a set of outputs
• Inputs/factors of production:
• labor, land, raw materials, capital
• Measured in flows
• Output:
• The amount of goods and services produces by the firm is the firm’s output.
• In flow too

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Technology

• What is technology?
• Technology refers to all alternative methods of combining inputs to produce
outputs. It does not refer to a specific new invention like the tablet computer. The
firm will search for the production technology that allows it to produce the desired
level of output at the lowest cost.
• ...determines the quantity of output that is feasible to attain for a given set of
inputs.

• What is a "technological constraint"?

• Technological constraints imply that a given amount of output can be produced only
with certain combination of inputs.

Technological constraints

1.Production set: all combinations of inputs

and outputs that are technically feasible.
2.Production function: upper boundary of
production set.
C
1. The production function tells us the maximum
possible output that can be attained by the y1
B (x1, y1)
firm for any given (combination) of inputs.
3.Examples (input, output):
1. A (9 hrs of studying per week, final grade of 4)
in PS but not efficient (below PF).
2. B (9 hrs of studying per week, final grade of A
10) not in PS (i.e. not feasible).
3. (9 hrs of studying per week, final grade of 8) in
PS and on PF (feasible and efficient).
x1 4

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Production Functions
• Production function: measure maximum possible output that firm can get from
a given amount of input
y  f ( x1 ,, xn )
• q = f(L, K)
• q = output (note that book uses y for output)
• K = Capital
• L = Labor
• Examples:
• q=f(L,K)=L+K
• q=f(L,K)=L×𝐾
• q=f(L)= 𝐿 .
• q=f(L,K)=min{L,K/0.5}
• Remember: every input and output is expressed in units per unit of time.

Isoquants: Đường đẳng lượng

• Ex: 𝑓(𝑥 , 𝑥 ) measure the maximum amount of output y that could
get if we had x1 units of factor 1 and x2 units of factor 2
• Set of all possible combinations of inputs 1 and 2 that are just
sufficient to produce a given amount of output: An isoquant
• Isoquants: represent all the combinations of inputs that produce a
constant level of output.
• Isoquants are like indifference curves for preferences, except
"isoquants" describe technology not preferences.
• Isoquants are labeled with the amount of output they can produce: labeling of
isoquants is fixed by the technology and doesn’t have the kind of arbitrary nature
that the utility labeling has.
• Warning: a monotonic transformation of f(K,L) does not give the same technology!

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Examples of technology: Fixed proportions

Function: f(x1, x2) = min{x1, x2}

• Producing holes: Input factor: one man,

one shovel. One extra shovels aren’t worth
anything, and neither one extra man.
•  Total number of holes can produce:
minimum of the number of men and the
number of shovels have.

• Function: y=min {man, shovel}

(Like the case of perfect complements in

consumer theory)
7

Examples of technology: Perfect substitutes

Function: f(x1, x2) = x1 +x2

• Harvesting fruits and the inputs are red

harvesting machine and blue harvesting
machine .
• The amount of fruits harvested depends
only on the total number of machines

(Like the case of perfect substitutes in

consumer theory)

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Examples of technology: Cobb-Douglas

Function: f(x1, x2) = 𝑨𝒙𝒂𝟏 𝒙𝒃𝟐 x2 All isoquants are hyperbolic,

asymptoting to, but never
• A: scale of production: How much output we touching any axis.
would get if we used 1 unit of each input
• a, b: Measure how the amount of output
responds to changes in the input y  x1a1 xa2 2
y" > y'
• Simplify: usually assume A = 1, and a+b=1
• Cobb-Douglas isoquants have the same nice, a a
x1 1 x 2 2  y"
well-behaved shape that the Cobb-Douglas
indifference curves have x1a1 xa2 2  y'
x1

4.1.2. Properties of technology

A well-behaved technology is:

• Monotonic: more inputs produce more output

• Convexity: averages produce more than extremes

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Well-Behaved Technologies - Monotonicity

• Monotonicity: More of any input generates more output.
y y

monotonic

not
monotonic

x x
11

Well-Behaved Technologies
x2
higher output

A B C
40
y

y y

10 20 40 x1

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Well-Behaved Technologies - Convexity

• Convexity: If the input bundles x’ and x” both provide y units of output then the
mixture tx’ + (1-t)x” provides at least y units of output, for any 0 < t < 1.
x2

x'2
tx'1  (1  t)x"1, tx'2  (1  t)x"2 

y
x"
2
y

x'1 x"
1 x1 13

Marginal Products
• Using more input x1, keeping factor x2 fixed. How much more output will get per
additional unit of factor 1?
• Marginal production of factor 1: 𝑴𝑷𝟏 (𝒙𝟏 𝒙𝟐 )

• Marginal product is a rate: the extra amount of output per unit of extra input

• Marginal utility: ordinal nature

• Marginal product: physical output - specific number - can be observed.

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Diminishing marginal product

• Farming example: Considered changing input of nitrogen fertilizer applied in

1 hectare of paddy field, holding the land and other input fixed.
• Apply 60 kg nitrogen fertilizer on 1 hectare of land: Produce 4000kg of rice
• Apply 70kg nitrogen fertilizer on 1 hectare of land: Produce 4100kg of rice
• Apply 80kg nitrogen fertilizer on 1 hectare of land: Produce 4400kg of rice
• Apply 90kg nitrogen fertilizer on 1 hectare of land: Produce 5000kg of rice
• Apply 100kg nitrogen fertilizer on 1 hectare of land: Produce 5200kg of rice
• Apply 110kg nitrogen fertilizer on 1 hectare of land: Produce 5300kg of rice
• Apply 120kg nitrogen fertilizer on 1 hectare of land: Produce 5200kg of rice
• Apply 130kg nitrogen fertilizer on 1 hectare of land: Produce 4900kg of rice

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Nitrogen fertilizer (kg/ha) Rice (kg) MP

60 4000
70 4100 10
80 4400 30
90 5000 60
100 5200 20
110 5300 10
120 5200 -10
130 4900 -30

Diminishing marginal product: marginal product of a factor will diminish as

we get more and more of that factor (Δy/Δx1) 16

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4.1.3. Technical rate of substitution

• Suppose input bundle (x1, x2)
• Same amount of y, How much extra of factor 2, Δx2, do we need if we
are going to give up a little bit of factor 1, Δx1?
• Slope of the isoquant = the technical rate of substitution (TRS)
• TRS measures the tradeoff between two inputs in production

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Diminishing technical rate of substitution

𝑲 𝐢𝐧𝐢𝐭𝐢𝐚𝐥 𝐓𝐑𝐒
𝐓𝐑𝐒 =  = 𝑺𝒍𝒐𝒑𝒆 𝒐𝒇 𝒊𝒔𝒐𝒒𝒖𝒂𝒏𝒕
𝑳
• Increase the amount of factor 1, and adjust
factor 2 so as to stay on the same isoquant,
the technical rate of substitution declines. 𝐝𝐢𝐦𝐢𝐧𝐢𝐬𝐡𝐢𝐧𝐠 𝐓𝐑𝐒
• slope of an isoquant must decrease in
absolute value as we move along the isoquant
in the direction of increasing x1, and it must
increase as we move in the direction of
increasing x2.
 isoquants will have the same sort of convex
shape that well-behaved indifference curves
have 18

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Technical rate of substitution and marginal products

• The assumptions of a diminishing TRS and MP are closely related but

are not exactly the same.

• Diminishing MP is an assumption about how the MP changes as we

increase the amount of one factor, holding the other factor fixed.

• Diminishing TRS is about how the ratio of the marginal products—the

slope of the isoquant—changes as we increase the amount of one
factor and reduce the amount of the other factor so as to stay on
the same isoquant.

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4.1.4. Long run and short run – 19.9

• Short run: Some factors of production are fixed at predetermined levels
• Example: Our farmer might only consider production plans that involve a fixed amount of land, if that is all
he has access to. It may be true that if he had more land, he could produce more corn, but in the short run
he is stuck with the amount of land that he has.

• Long run: All factors of production can be varied. No fixed factors

• How long is the long run? It depends on specific type of production
• For automobile manufacturer it can take years to change size of plant. For travel agency - months.

/ /
• 𝑦=𝑥 𝑥 is the long-run production function (both x1 and x2 are variable).
/
• 𝑦=𝑥 is the short-run production function when x2 fixed and = 1

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function for the short run is f(𝑥 , 𝑥 )

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4.1.5. Return to scale – 19.1 0 Lợi suất theo quy mô

• Let’s consider a different kind of experiment. Instead of increasing the amount
of one input while holding the other input fixed, let’s increase the amount of all
inputs to the production function. In other words, let’s scale the amount of all
inputs up by some constant factor: for example, use twice as much of both
factor 1 and factor 2.
• If we use twice as much of each input, how much output will we get?
• Output: twice  Constant returns-to-scale
• Output: Less than twice  Diminishing returns-to-scale
• Output: More than twice  Increasing returns-to-scale

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4.1.5. Return to scale

Constant returns-to-scale
• two times each input gives two times output
f(2x 2x )=2f(x x )  f(𝒌𝒙𝟏 , k𝒙𝟐 ) = kf(𝒙𝟏 , 𝒙𝟐 ) k>1

Diminishing returns-to-scale
• two times each input gives less than two times output
f(2x 2x ) = 1.5f(x x )  f(𝒌𝒙𝟏 , k𝒙𝟐 ) > kf(𝒙𝟏 , 𝒙𝟐 ) k>1

Increasing returns-to-scale
• two times each input gives more than two times output
f(2x 2x )=3f(x x )  f(𝒌𝒙𝟏 , k𝒙𝟐 ) < kf(𝒙𝟏 , 𝒙𝟐 ) k>1

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4.1.5. Return to scale – 19.1 0 Lợi suất theo quy mô

• Marginal products describe the change in output level as a single input level
changes.
• Returns-to-scale describes how the output level changes as all input levels
change in direct proportion (e.g. all input levels doubled, or halved).

Level of Y
x1 x2 y increased returns-to-scale
Original input factor 2 2 6

Doubling input factor 4 4 12 2 Constant returns-to-scale

4 4 15 2.5 Increasing returns-to-scale

4 4 9 1.5 Diminishing returns-to-scale

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• A single technology can ‘locally’ exhibit different returns-to-scale

Output Level

y = f(x)
Increasing
returns-to-scale
Decreasing
returns-to-scale

x
Input Level
25

Question 1: Following functions exhibit constant, increasing

or decreasing returns-to-scale?

a. The perfect-substitutes production function is

y = 𝑎 𝑥 + 𝑎 𝑥 +⋯+𝑎 𝑥

b. The perfect-complements production function is

y = min 𝑎 𝑥 + 𝑎 𝑥 + ⋯ + 𝑎 𝑥

c. The Cobb-Douglas production function is

y = 𝑥 𝑥 …𝑥

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a. The perfect-substitutes production function is

y = f(x) = 𝒂𝟏 𝒙𝟏 + 𝒂𝟐 𝒙𝟐 + ⋯ + 𝒂𝒏 𝒙𝒏

Step 1: Expand all input levels proportionately by k.

 The output level becomes:
f(kx) = 𝑎 (𝑘𝑥 )+ 𝑎 (𝑘𝑥 ) + ⋯ + 𝑎 (𝑘𝑥 )
= k(𝑎 𝑥 + 𝑎 𝑥 + ⋯ + 𝑎 𝑥 )
= k.y = k.f(x)

 f(kx) = kf(x)
 The perfect-substitutes production function exhibits constant returns-to-scale.

27

b. The perfect-complements production function is

y = 𝐦𝐢𝐧 𝒂𝟏 𝒙𝟏 + 𝒂𝟐 𝒙𝟐 + ⋯ + 𝒂𝒏 𝒙𝒏

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c. The Cobb-Douglas production function is

y = 𝒙𝒂𝟏 𝒂𝟐 𝒂𝒏
𝟏 𝒙𝟐 … 𝒙𝒏

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Question 2: Can a technology exhibit increasing returns-to-scale even if

all of its marginal products are diminishing? Take an example?

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So a technology can exhibit increasing returns-to-scale even if all of its marginal

products are diminishing. Why?
• A marginal product is the rate-of-change of output as one input level increases,
holding all other input levels fixed.
• Marginal product diminishes because the other input levels are fixed, so the
increasing input’s units have each less and less of other inputs with which to work.
• When all input levels are increased proportionately, there need be no diminution
of marginal products since each input will always have the same amount of other
inputs with which to work. Input productivities need not fall and so returns-to-
scale can be constant or increasing.

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Summary
1. The technological constraints of the firm are described by the production set, which depicts all the
technologically feasible combinations of inputs and outputs, and by the production function, which
gives the maximum amount of output associated with a given amount of the inputs.
2. Another way to describe the technological constraints facing a firm is through the use of
isoquants—curves that indicate all the combinations of inputs capable of producing a given level of
output.
3. We generally assume that isoquants are convex and monotonic, just like well–behaved preferences.
4. The marginal product measures the extra output per extra unit of an input, holding all other inputs
fixed. We typically assume that the marginal product of an input diminishes as we use more and more
of that input
5. The technical rate of substitution (TRS) measures the slope of an isoquant. We generally assume
that the TRS diminishes as we move out along an isoquant—which is another way of saying that the
isoquant has a convex shape.
6. In the short run some inputs are fixed, while in the long run all inputs are variable.
7. Returns to scale refers to the way that output changes as we change the scale of production. If we
scale all inputs up by some amount t and output goes up by the same factor, then we have constant
returns to scale. If output scales up by more that t, we have increasing returns to scale; and if it scales
up by less than t, we have decreasing returns to scale.
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Review question
1. Consider the production function f(x1, x2) = 𝑥 𝑥 . Does this exhibit constant, increasing,
or decreasing returns to scale?
/ /
2. Consider the production function f(x1, x2) = 4𝑥 𝑥 . Does this exhibit constant,
increasing, or decreasing returns to scale?
3. The Cobb-Douglas production function is given by f(𝑥 , 𝑥 ) = A𝑥 𝑥 . It turns out that the
type of returns to scale of this function will depend on the magnitude of a + b. Which values
of a + b will be associated with the different kinds of returns to scale?
4. The technical rate of substitution between factors 𝑥 and 𝑥 is −4. If you desire to produce
the same amount of output but cut your use of 𝑥 by 3 units, how many more units of 𝑥 will
you need?
5. True or false? If the law of diminishing marginal product did not hold, the world’s food
supply could be grown in a flowerpot.
6. In a production process is it possible to have decreasing marginal product in an input and
yet increasing returns to scale?
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4.2. Cost minimization

Study the behavior of profit-maximizing firms
• Minimize the cost of producing a given level of out put
• How to choose the most profitable level of output

4.2. Cost minimization - 21.1.

4.2.1. Cost minimization
4.2.2. Short run and long run costs 21.4
4.2.3. Returns to scale and cost functions 21.3

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4.2.1. Cost minimization

• 2 input factors: Amount: 𝑥 , 𝑥
Price: 𝑤 , 𝑤
• To figure out the cheapest way to produce a given level of output: y

• Production function: y= f(𝑥 , 𝑥 )

 𝑚𝑖𝑛 = 𝑤 𝑥 + 𝑤 𝑥

The minimum costs necessary to achieve the desired level of output—will depend
on w1, w2, and y, so we write it as c(w1, w2, y)

cost function is defined as the minimum cost of achieving a given level of output
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4.2.1. Cost minimization

• cost function c(w1, w2, y): measures the minimal costs of producing y units
of output when factor prices are (w1, w2).
• Combinations of input that have some given level of cost, C:
𝑪 = 𝒘𝟏 𝒙 𝟏 + 𝒘 𝟐 𝒙 𝟐
• In order to understand the solution to this problem, let us depict the costs
and the technological constraints facing the firm on the same diagram

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4.2.1. Cost minimization

x2 Slopes = -w1/w2.
• Iso-cost line
At some level of cost: c”  w1x1+w2x2
𝒘𝟏 𝒙𝟏 + 𝒘𝟐 𝒙𝟐 = 𝑪

 Rearrange: 𝒙𝟐 = −
𝒘𝟏
𝒙𝟏 +
𝒄 c’  w1x1+w2x2
𝒘𝟐 𝒘𝟐
𝒘𝟏
Slope is −
𝒘𝟐
• Isocost line: Every point on an isocost curve
c’ < c”
has the same cost, C
• Higher isocost lines are associated with
higher costs. 37
x1

4.2.1. Cost minimization

x2The y’-Output Unit Isoquant x2

x2*
f(x1,x2)  y’ f(x1,x2)  y’
x1 x1* x1
Cost-minimization problem can be rephrased as: find the point on the isoquant
that has the lowest possible isocost line associated with it 38

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4.2.1. Cost minimization

Tangent condition cost-minimizing:
• slope of the isoquant must be equal
to the slope of the isocost curve.
(The technical rate of substitution must
equal the factor price ratio)

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EXAMPLE: Minimizing Costs for Specific Technologies

• perfect complements technology: f(x1, x2) = min{x1, x2}.
• To produce y units of output  need y units of x1 and y units of x2.
• Minimal costs of production will be:
c(w1, w2, y) = w1y + w2y = (w1 + w2)y.

• Perfect substitutes technology: f(x1, x2) = x1 + x2

• Firm will use whichever is cheaper.
• Thus the minimum cost of producing y units of output will be w1y or w2y,
whichever is less:
• c(w1, w2, y) = min{w1y, w2y} = min{w1, w2}y.

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EXAMPLE: Minimizing Costs for Specific Technologies

• Cobb-Douglas technology:

• Cost function will have the form

Check Appendix

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4.2.3 Returns to scale and cost functions

• Average Total Production Costs: For positive output levels y, a firm’s average
total cost of producing y units is:

• The returns-to-scale properties of a firm’s technology determine how average

production costs change (AC) with output level.
• Our firm is presently producing y’ output units.
• How does the firm’s average production cost change if it instead produces 2y’ units of
output?

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4.2.3 Returns to scale and cost functions

Constant Returns-to-Scale
• doubling its output level from y to 2y requires doubling all input levels.
• Total production cost doubles.
• Average production cost does not change.

Decreasing Returns-to-Scale
• doubling its output level from y to 2y requires more than doubling all input levels.
• Total production cost more than doubles.
• Average production cost increases.

Increasing Returns-to-Scale
• doubling its output level from y to 2y requires less than doubling all input levels.
• Total production cost less than doubles.
• Average production cost decreases 43

4.2.3 Returns to scale and cost functions

$/output unit doubling its output level from y to 2y

• Requires more than doubling all input levels.
decreasing r.t.s. • Total cost more than doubles
• Average cost increases
AC(y)
• Requires doubling all input levels.
• Total production cost doubles
constant r.t.s. • Average cost does not change

• Requires more than doubling all input levels.

increasing r.t.s. • Total cost less than doubles
• Average cost decrease

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y

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4.2.2. Short run and long run costs 21.4

• cost function is defined as the minimum cost of achieving a given level of
output
• The short-run cost function is defined as the minimum cost to produce a given level of
output, only adjusting the variable factors of production.

• The long-run cost function gives the minimum cost of producing a given level of output,
adjusting all of the factors of production.

• Suppose:
• Factor 1: 𝑥 free to vary in both long run and short run
• Factor 2: fixed at 𝑥 in short run, but free to vary in long run
• Write cost function in shun run and long run?

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Short-run cost function Long-run cost function

Cost function

factor demands

Cost function

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Review question
1. Prove that a profit-maximizing firm will always minimize costs.
2. If a firm is producing where MP1/w1 > MP2/w2, what can it do to reduce costs
but maintain the same output?
3. Suppose that a cost-minimizing firm uses two inputs that are perfect substitutes.
If the two inputs are priced the same, what do the conditional factor demands
look like for the inputs?
4. The price of paper used by a cost-minimizing firm increases. The firm responds
to this price change by changing its demand for certain inputs, but it keeps its
output constant. What happens to the firm’s use of paper?

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4.3. Cost curves

Cost curve is used to depict graphically the cost
function to determine optimal output choices

4.3.1. Average costs, marginal costs, variable costs – 22.1, 22.2, 22.3
4.3.2. Long-run costs 22.5, 22.6, 22.7

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4.3.1. Average costs, marginal costs, variable costs

Average costs
• Total cost function: C(y) = F + 𝑪𝒗 (𝒚)
• C(y): Cost function: minimum cost to produce y output (prices of input factor
(w1, w2) are fixed)
• Fixed cost: F the firm’s fixed cost, does not vary with output level (cost to short-
run fixed inputs)
• Variable costs: 𝑪𝒗 𝒚 Costs change when output change:

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4.3.1. Average costs, marginal costs, variable costs

Average costs
Average cost function: Measure cost per unit of output:
𝑪(𝒚) 𝑪𝒗 (𝒚) 𝑭
𝐀𝐂 𝐲 = = + = 𝑨𝑽𝑪 𝒚 + 𝑨𝑭𝑪(𝒚)
𝒚 𝒚 𝒚
• AVY(y): Average variable costs to produce y output
𝑪𝒗 (𝒚)
• 𝑨𝑽𝑪 𝒚 =
𝒚
• AFC(y): Average fixed costs to produce y output
𝑭
• 𝑨𝑭𝑪(𝒚)=
𝒚

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Construction of the average cost curve

(A) The average fixed costs decrease as output is increased.

(B) The average variable costs eventually increase as output is increased.
(C) The combination of these two effects produces a U-shaped average cost curve
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Marginal costs
• Marginal cost curve: measures change in costs for a given change in output.
𝐶(𝑦) 𝐶 𝑦 + 𝑦 − 𝐶(𝑦)
MC y = =
𝑦 𝑦

• Marginal cost in term of the variable cost function:

𝐶 (𝑦) 𝐶 𝑦 + 𝑦 − 𝐶 (𝑦)
MC y = =
𝑦 𝑦

• F don’t change as y changes

• MC is the slope of both the variable cost and the total cost functions.

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$
c(y)
c( y )  F  c v ( y )
cv(y)
F

F
y

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Marginal costs and cost curve

• Range: AVC is decreasing
 MC<AVC
• cost of each additional unit
produced is les than average up
to that point

• Range: AVC is increasing

 MC>AVC

• MC=ACV: MC curve must

intersect the AVC curve at its
minimum point.
55

Prove MC curve pass through the minimum of the AC curve?

𝐶(𝑦)
𝐴𝐶 =
𝑦
𝑀𝐶 = 𝐶′(𝑦)
AC achieve minimum point if and only if AC’ = 0
( )y − C(y)
 =0 → = 0 → 𝐶′(𝑦)y − C(y) = 0
( )
𝐶′(𝑦) = < ---- > MC = AC at minimum point

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Sum up
• The average variable cost curve may initially slope down but need
not. However, it will eventually rise, as long as there are fixed factors
that constrain production.
• The average cost curve will initially fall due to declining average fixed
costs but then rise due to the increasing average variable costs.
• The marginal cost and average variable cost are the same at the first
unit of output.
• The marginal cost curve passes through the minimum point of both
the average variable cost and the average cost curves.

57

Marginal costs and Variable costs

C (y) = [C (1) - C (0)] + [C (2) - C (1)] + … +

[C (y - 1) - C (y – 2)]+ [C (y) - C (y - 1)]

𝐂𝐯 (y) = MC(0) + MC (1) + …+ MC(y-2) + MC(y-1)

𝐂𝐯 (y) = MC(y-1) + MC(y-2) + … + MC(0)

Variable cost: The area under the marginal

cost curve gives the variable costs y

a b c d

1 2 3 4

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Example 1: Specific cost curve

Eg: cost function: c(y) = 𝑦 + 1

VC, FC, AVC, AFC, AC, MC = ?

• variable costs: cv(y) = 𝑦

• fixed costs: cf(y) = 1
• average variable costs: AV C(y) = =𝑦
• average fixed costs: AFC(y) = 1/y
• average costs: =𝑦+
• marginal costs: MC(y) = 2y

59

Example 2: Marginal Cost Curves for Two Plants

• Suppose two plants that have two different cost functions, c1(y1) and c2(y2).
• Produce y units of output in the cheapest way.
• How much should you produce in each plant?

optimal division of
output between the two
plants we must have:
MC1 = MC2

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4.3.2. Long-run costs 22.5, 22.6, 22.7

The Concept of the Long Run
• The long run refers to that time period for a firm where it can vary all
the factors of production
• “fixed” factors in short run no longer fixed in long run
 the long run consists of variable inputs only, and the concept of fixed
inputs does not arise.
long-run variable cost = long-run total cost

61

Long-run cost function

• Suppose fixed factor:
k=𝑥 = size of the plant
• short-run cost function
denoted by:
𝐶 (y, k)
• Long run firm can change the size of its plant depends
on expected level of output
• optimal plant size to produce y level of output: k(y)
The long-run cost function: is the short-run cost
function evaluated at the optimal choice of the fixed
factors: C(y) = 𝐶 (y, k(y)).
• k∗ = k(y∗): optimal plant size for y*.
• The short run cost function 𝐶 (y, k∗), and the
• Long-run cost function: C(y) = 𝐶 (y, k(y))
C(y) ≤ 𝐶 (y, k∗)
• y∗ the optimal choice of plant size is k∗. So at y∗, the
long-run costs and the short-run costs are the same:
C(y∗) = 𝑪𝒔 (y∗, k∗)
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Long-run cost function

• If the short-run cost is always
greater than the long-run cost and
they are equal at one level of
output
 short-run and the long-run
average costs have the same
property:
AC(y) ≤ ACs(y, k∗) and
AC(y∗) = ACs(y∗, k∗)
• short-run average cost curve
always lies above the long-run
average cost curve and that they
touch at one point, y∗.

63

Long-run cost function

Suppose we pick outputs y1, y2, . . . , yn
and accompanying plant sizes k1 = k(y1),
k2 = k(y2), . . . , kn = k(yn )

The long-run average cost curve is the

envelope of the short-run average cost
curves.

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Discrete Levels of Plant Size

• Previous discussion: assumed can choose a
continuous number of different plant sizes.
Each different level of output has a unique
optimal plant size associated with it.

what happens if there are only a few

different levels of plant size to choose from?
• Suppose we have four different choices, k1,
k2, k3, and k4.
• Long-run average cost curve will be the
lower envelope of the short-run average four different average cost curves
costs
associated with these plant sizes
65

Long-Run Marginal Costs

• For each level of output, see
which short-run average cost
curve firms are operating on and
then look at the marginal cost
associated with that curve.
• discrete levels of the fixed
factor: the firm will choose the
amount of the fixed factor to
minimize average costs.
 Thus the long-run marginal cost
curve will consist of the various
segments of the short-run
marginal cost curves associated
with each different level of the
fixed factor.
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The relationship between the long-run and the short-run marginal costs with
continuous levels of the fixed factors. 67

Review question
1. Which of the following are true? (1) Average fixed costs never increase
with output; (2) average total costs are always greater than or equal to
average variable costs; (3) average cost can never rise while marginal costs
are declining.
2. A firm produces identical outputs at two different plants. If the marginal
cost at the first plant exceeds the marginal cost at the second plant, how can
the firm reduce costs and maintain the same level of output?
3. True or false? In the long run a firm always operates at the minimum level
of average costs for the optimally sized plant to produce a given amount of
output.
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4.4. Profit maximization

4.4.1. Profit maximization in short run 20.1, 20.6, 20.7
• Profits
• Suppose firm produces n outputs (𝑦 ,… 𝑦 ); prices of the output
goods: (𝑝 ,… 𝑝 )
• uses m inputs (𝑥 ,… 𝑥 ); prices of the inputs: (𝑤 , . . . , 𝑤 )


The profits the firm receives, π = revenues – cost

69

Accounting Cost vs. Economic Cost

• Accounting cost and economic cost
Accounting costs represent anything your business has paid for
Implicit cost: cost that exists without the exchange of cash and is not recorded for
accounting purposes (opportunity cost)
Economic cost = Accounting cost + implicit cost

• Accounting profit and economic profit: Profit requires that we value all inputs
and outputs at their opportunity cost.
Accounting profit = revenue – accounting cost
Economic profit = revenue – economic cost

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Short-Run Profit Maximization

• Production function y= f(𝑥 , 𝑥 ),

• p: price of output;
• 𝑤 and 𝑤 : prices of the two inputs
• input 2 is fixed at some level 𝑥
• Then the profit-maximization: (revenues – cost)  Max
𝒎𝒂𝒙 𝒑𝒇 𝒙𝟏 , 𝒙𝟐 − 𝒘𝟏 𝒙𝟏 − 𝒘𝟏 𝒙𝟐
𝒙𝟏
Profit max when: 𝑝𝑓 𝑥 , 𝑥 − 𝑤 = 0
𝑝𝑀𝑃 𝑥 ∗ , 𝒙𝟐 = 𝑤
71

Short-Run Profit Maximization

• 𝑥 ∗ is the profit-maximizing choice of factor 1
𝑝𝑀𝑃 𝑥 ∗ , 𝒙𝟐 = 𝑤

If the value of marginal product exceeds its cost, then profits can be increased by
increasing input 1.
If the value of marginal product is less than its cost, then profits can be increased by
decreasing the level of input 1
 at a profit-maximizing choice of inputs and outputs, value of the marginal
product of a factor should equal its price

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Isoprofit line: Đường đẳng lợi nhuận

• Profit:

• Isoprofit:

• Slope and intercept of isoprofit line?

 higher levels of profit will be associated

with isoprofit lines with higher vertical
intercepts

Isoprofit lines: all combinations of the input goods and

the output good that give a constant level of profit, π

Profit maximization
Profit-maximization: point
(𝑥 ∗ 𝑦 ∗ ) on the production
function that has the highest
associated iso-profit line
Tangency condition: the
slope of the production
function should equal the
slope of the isoprofit line

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Comparative Statics – text book page 370

75

4.4.2.Profit maximization in the long run 20.8

• In the long run the firm is free to choose the level of all inputs. Thus
the long-run profit-maximization problem can be posed as

• basically the same as the short-run problem described above, but

now both factors are free to vary
• condition describing the optimal choices

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Review questions
1. In the short run, if the price of the fixed factor is increased, what will
happen to profits?
2. If a firm had everywhere increasing returns to scale, what would happen
to its profits if prices remained fixed and if it doubled its scale of operation?
3. If a firm had decreasing returns to scale at all levels of output and it
divided up into two equal-size smaller firms, what would happen to its
overall profits?
4. A gardener exclaims: “For only $1 in seeds I’ve grown over $20 in
produce!” Besides the fact that most of the produce is in the form of
zucchini, what other observations would a cynical economist make about
this situation?

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5. Is maximizing a firm’s profits always identical to maximizing the

firm’s stock market value?
6. If pMP1 > w1, then should the firm increase or decrease the amount
of factor 1 in order to increase profits?
7. Suppose a firm is maximizing profits in the short run with variable
factor x1 and fixed factor x2. If the price of x2 goes down, what
happens to the firm’s use of x1? What happens to the firm’s level of
profits?
8. A profit-maximizing competitive firm that is making positive profits
in long-run equilibrium (may/may not) have a technology with constant
returns to scale.
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