PRODUCERS

Business Organization, Costs and Production, Strategic Behavior and Game Thoery

THEORY OF THE FIRM

Any organization that turns inputs into outputs.

Every household is a firm.

Child care, home maintenance

Profit-maximizing firm

Business: organization of the firm

(proprietorship, partnership, corporation

Economics:
Boundaries of firms : make vs buy
Separation of ownership and control

THEORY OF THE FIRM

Goal: maximize long-term value of the firm
N

Value
t 1

Profit
(1 i ) t

N
t 1

Total Revenue - Total Cost

(1 i )t

PROFIT:
Accounting vs. economic profit

Normal rate of return

THEORY OF THE FIRM

ECONOMIC
PROFIT
OPPORTUNITY COST

REVENUE
EXPLICIT COST

EXPLICIT COST

IMPLICIT COST

REVENUE

ACCOUNTING
PROFIT

THEORY OF THE FIRM

Economic profits or losses exist when:

a)

Barriers to entry : monopoly profit

b)

Unexpected changes in demand and supply : frictional

profit

c)

Successful invention or innovation : Schumpeterian

profit

d)

Extraordinary success in meeting customer needs,

maintaining efficient operations : compensatory profit

THEORY OF THE FIRM

Do firms maximize profits?
Optimize vs. Satisfice
Separation of management and ownership

Internal market discipline

Optimal contract: fixed wage plus profit-contingent compensation

Labor market discipline

poor performance creates bad reputation for managers

Product market discipline

firms are likely to go under if profit is not maximized.

Capital market discipline

Vulnerability to corporate raid or takeover (when value of firm is lower

than its potential)

PRODUCTION
Production set is the set of all combinations of

inputs (FACTORS OF PRODUCTION) and outputs that

are technologically feasible.
B

PRODUCTION FUNCTION
q = f(x1, x2)

J
X1 0

x1

PRODUCTION
Technology
Fixed proportions

x1 x2
q = f (x1, x2 ) = min ,
a b

Perfect substitutes

q = f (x1, x2 ) = ax1 + bx2

Cobb-Douglas

q = f (x1, x2 ) = Ax1a x2b

PRODUCTION
X2

Downward sloping
Higher isoquants represent higher output

Do not cross
Convex
A

ISOQUANT
X1

PRODUCTION
X2

q = f (x1 , x2 ) = ax1 +bx2

q a
x2 = - x1
b b

X1

PRODUCTION
X2

b
a

x1 x2
q = f (x1 , x2 ) = min ,
a b

X1

PRODUCTION
X2 = CAPITAL

x1 x2
q = min ,
a b

b d
>
a J c B
J is capital-intensive;
B is labor-intensive

B
a

x1 x2
q = min ,
c d

X1 = LABOR

PRODUCTION
X2 = CAPITAL

R
d

(.75a +.25c, .75b +.25d)

B
a

X1 = LABOR

PRODUCTION
q
B

Dq f (x1 + Dx1, x2 ) - f (x1, x2 )

MP1 =
=
Dx1
Dx1
LAW OF DIMINISHING
MARGINAL PRODUCT

x1

PRODUCTION

Let x1 = labor; x2 = capital.

MARGINAL PRODUCT

MP1 =

Dq f (x1 + Dx1, x2 ) - f (x1, x2 )

=
Dx1
Dx1

How many units will be added to production if an additional

worker is hired?

AVERAGE PRODUCT

q f (x1, x2 )
AP1 = =
x1
x1

How many units of output is typically produced by one

worker?

PRODUCTION
OUTPUT ELASTICITY

%Dq Dq / q
Dq x1
MP
Eqx1 =
=
=
= 1
%Dx1 Dx1 / x1 Dx1 q
AP1

PRODUCTION
No. of
workers

Output

0
1
2
3
4
5
6

0
3
8
12
14
14
12

Marginal
Average
product of product of
labor
labor

3
5
4
2
0
-2

3
4
4
3.5
2.8
2

Output
elasticity
of labor

1
1.25
1
0.57
0
-1

PRODUCTION
Total output

No. of workers
MP of labor
AP of labor

No. of workers

PRODUCTION
X2

q = f ( x1, x2 )
Dq = MP1Dx1 + MP2 Dx2

Dq = 0
Dx2 MP1
=
Dx1 MP2

q = 100

TECHNICAL RATE OF
SUBSTITUTION (TRS)

LAW OF
DIMINISHING TRS
X1

PRODUCTION
Long run (LR) vs short run (SR)
All factors of production are variable in the long run.

Returns to Scale (RTS)

How much is the change in output if ALL inputs change by
some proportion k?

INCREASING RTS
Change in output is MORE than k

DECREASING RTS
Change in output is LESS than k

CONSTANT RTS
Change in output is EQUAL TO k

PRODUCTION
For some production functions:

q = f (x1, x2 )

f (kx1, kx2 ) = k t f (x1, x2 )

t > 1 INCREASING RTS
t < 1 DECREASING RTS
t = 1 CONSTANT RTS
EXAMPLE:

q = x12 x22

qNEW = ( kx1 ) ( kx2 ) = k 4 x12 x22 = k 4 q

2

INCREASING RTS

PRODUCTION
In general,

EXAMPLE:

q = f (x1, x2 )
f (kx1, kx2 ) > kf (x1, x2 )

INCREASING RTS

f (kx1, kx2 ) < kf (x1, x2 )

DECREASING RTS

f (kx1, kx2 ) = kf (x1, x2 )

CONSTANT RTS

q = x12 x22 + x2
qNEW = ( kx1 ) ( kx2 ) + kx2
2

Let x1 = 1, x2 = 2, k = 2.

q=6

qnew = 68 > 2(6) =12

INCREASING RTS

PRODUCTION
X2

B
3

6
J

Q=200

Q=300

CONSTANT RTS

X1

6
3

Q=150

Q=100

Q=100

X1

INCREASING RTS

Q=100
3

X1

DECREASING RTS

COST
Cost is OPPORTUNITY COST = explicit + implicit costs
Fixed vs. variable cost
Fixed = does not vary with output
Ex. rent

Variable = depends on the output produced

Ex. wage of production worker

COST
FIXED COST
Fixed vs. quasi-fixed
Quasi-fixed = independent of output level, but incurred
only with positive amount of output
Fixed vs. sunk
Sunk = non-recoverable

Example:
Office rent
Rent of machine (short-term contract)
Interest of a loan
Computer (purchase price = P80,000; resale value after 5
years = P20,000)

COST
TOTAL COST = variable + fixed

C = VC + FC
C = VC(q) + FC
Variable cost
Unit variable cost x no. of units produced
Unit variable cost may be constant or increasing
with output
Increasing unit variable cost due to diminishing
marginal product presence of fixed factor

COST
C VC FC
AC = =
+
q
q
q

AC = AVC + AFC
C

C
AVC
AC

AFC

COST
MES = minimum efficient scale

q* = MES

COST
Let x1 = labor; x2 = capital (fixed).
MARGINAL COST

DC DVC
MC =
=
Dq Dq

How much does it cost to increase production by one

unit?

AVERAGE COST

C
AC =
q

How much does it usually cost to produce one unit?

COST
Output
0
1

FC
60
60

VC
0
20

C
60
80

AFC
60

AVC
20

AC
60

MC
20

2
3

60
60

30
45

90
105

30
20

15
15

45
35

10
15

4
5

60
60

80
135

140
195

15
12

20
27

35
39

35
55

COST
C

q
AC, MC, AVC

COST
MC =

DC DVC VC(q + Dq) -VC(q)

=
=
Dq
Dq
Dq

Let q = 0, q = 1.
MC(1) =

VC(1)-VC(0)
=VC(1)
1

MC is the derivative of VC.

VC is the area under derivative of MC.

MC = AVC when AVC is minimum.

MC = AC when AC is minimum.

COST
Example:

VC = q 2

C(q) = q 2 +1

FC =1

AVC = q AFC = 1
q

AC = q +

MC = AVC when AVC is minimum.

q = 2q

only if q = 0.

MC = AC when AC is minimum.

q+

1
= 2q
q

q= 1

1
q

MC = 2q

COST

MC

AC
AVC

COST
In the long-run, all costs are variable.

LRC(q) = SRC(q, k *(q))

where k* is optimal fixed factor (say, plant size).

LRC(q) SRC(q, k(q))

LAC(q) SAC(q, k(q))
LAC is the envelope of SAC.

COST

k =1
k =4

k =2

q1

k =3

q2

q3

COST
0 < q < q1 INCREASING RTS

q1 q q2 CONSTANT RTS
q2 < q

q1

q2

DECREASING RTS