Micro chapter II & III

1

Theory of Producers’ Behavior

-Production-Cost of Production-Profit Maximizing

Vinashin case

In 3/2003, Vinashin Jacobsen signed a contract of providing machines for diezel factory

From the first operation in 4/2007, there were many times the mentioned factory has to stop working for fixing.

From 10/2009, the diezel factory terminated its work

All equipment sold by Jacobsen are “secondhand” equipment dated back 1995, 1996, from Italy, Germany, Finland, Taiwan, China and also Vietnam

Can you explain about the behavior of people who lead the contract ???

Do they follow the purpose of maximizing profit of all firms?

The way people organize a firm may vary its behaviors

Note:The producers’ behavior may vary if the owner and the administrator are different

Purpose of firm may vary

I. Production

Technology of Production

Production with One Variable Input (Labor)

Production with Two Variable Inputs (Labor and Capital) Returns to Scale

Isoquant

Isocost

9

10

1. Production Decisions of a Firm

a. Production Technology Describe how inputs transformed into outputs

Inputs: land, labor, capital and raw materials Outputs: cars, desks, books, etc.

Firms produce different amounts of outputs using combinations of inputs

b. Cost Constraints Firms consider prices of labor, capital and other

inputs Minimize total production costs partly determined

by input pricesc. Input Choices

Given input prices and production technology, firm chooses how much of each input to use

Given prices of inputs, firm choose combinations of inputs to minimize costs

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Technology of Production

Production Function: Indicates highest output (q) that firm can

produce for every specified combination of inputs

For simplicity, only labor (L) and capital (K) Shows what is technically feasible when

firm operates efficiently Production function for two inputs:

q = F(L,K)

Short Run Period of time in which quantities of

one or more production factors (fixed inputs) cannot be changed

Long Run Time needed to make all production

inputs variable

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2. Production: One Variable Input(Short-run)

Assume capital fixed and labor variable Observations:

1. When labor is zero, output is zero2. With additional labor, output (q) increases

initially3. Beyond this, output declines

More labor becomes counterproductive

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2.1 Definitions

Average Product of Labor - Output per unit of particular product Measures productivity of firm’s labor in terms

of how much, on average, each worker can produce

Marginal Product of Labor – additional output produced when labor increases by one unit

L

q

Input Labor

Output APL

L

q

Input Labor

Output MPL

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At point D, output is maximized.

Labor per Month

Outputper

Month

0 2 3 4 5 6 7 8 9 101

Total Product

60

112

A

B

C

D

Production: One Variable Input

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Average Product

Production: One Variable Input

10

20

Outputper

Worker

30

80 2 3 4 5 6 7 9 101 Labor per Month

E

Marginal Product

•Left of E: MP > AP & AP is increasing•Right of E: MP < AP & AP is decreasing•At E: MP = AP & AP is at its maximum•At 8 units, MP is zero and output is at max

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2.2 Law of Diminishing Marginal Returns

Law of Diminishing Marginal Returns: As input use increases with other inputs fixed, resulting additions to output eventually decrease When labor use is small and capital fixed,

output increases since workers specialize; MP of labor increases When labor use is large, some workers

become less efficient MP of labor decreases

Explains declining marginal product, not necessarily negative one Technology changes cause shifts in total

product curve More output produced with same inputs

Diminishing marginal product

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3.Production: Two Variable Inputs

Firm can produce output by combining different amounts of labor and capital

In long run, capital and labor are both variable

Information can be represented graphically using isoquants Curves showing all possible combinations

of inputs that yield same output Curves are smooth to allow for use of

fractional inputs

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Diminishing Returns

Labor1 2 3 4 5

Increasing labor holding capital

constant (A, B, C) OR

Increasing capital holding labor constant

(E, D, C)

q1 = 55

q2 = 75

q3 = 90

1

2

3

4

5Capital

D

E

A B C

3.1 Isoquant3.1 Isoquant

-A and B bring the same level of quantity to the firm. -A is the combination of more both capital and labor. In comparison with B, A is less efficient.

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Production: Two Variable Inputs

Substituting Among Inputs Producers decide what combination of inputs to

use to produce certain quantity of output Slope of Isoquant shows how one input can be

substituted and keep level of output the same Negative of slope is marginal rate of technical

substitution (MRTS) Amount by which quantity of one input

reduced when one extra unit of another input used, so that output remains constant

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Production: Two Variable Inputs

)( q of level fixed forLKMRTS

InputLaborinChange

InputCapitalinChangeMRTS

LK

LK

As labor increases to replace capital Labor relatively less productive Capital relatively more productive Need less capital to keep output constant Isoquant becomes flatter

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Marginal Rate ofTechnical Substitution (MRTS)

Labor

1

2

3

4

1 2 3 4 5

5Capital

Negative slope measures MRTS; MRTS decreases as move down isoquant curve

1

1

1

1

2

1

2/3

1/3

Q1 =55

Q2 =75

Q3 =90

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MRTS and Marginal Products

Diminishing MRTS occurs because of diminishing returns; implies isoquants are convex

If holding output constant, net effect of increasing labor and decreasing capital is zero

Using changes in output from capital and labor:

LKK

L

KL

KL

MRTSL

K

MP

MP

KMP- LMP

KMP LMP

)(

)(

))(())((

0))(())((

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Isoquants: Special Cases

Two extreme cases show range of input substitution

Perfect Substitutes MRTS constant at all points on isoquant Same output produced with a lot of capital or

of labor or balanced mix Perfect Complements

Perfect fixed proportions production function Output made with only a specific proportion

of capital and labor Cannot increase output unless increase both

capital and labor in specific proportion

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Perfect Substitutes

Laborper month

Capitalper

month

Q1 Q2 Q3

A

B

C

Same output can be reached with mostly capital or mostly labor (A or C) or with equal amount of both (B).

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Perfect Complements

Labor per month

Capitalper

month

L1

K1Q1

A

Q2

Q3

B

C

Same output can only be produced with one set of inputs.

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Returns to Scale

How does firm decide, in long run, best way to increase output? Can change scale of production by

increasing all inputs in proportion If double inputs, output will most likely

increase but by how much? Rate at which output increases as inputs

are increased proportionately

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Increasing Returns to Scale

10

20

•Output more than doubles when all inputs are doubled•e.g., Larger output associated with lower cost (cars)•e.g., One firm more efficient than many (utilities)•Isoquants get closer together

Labor (hours)5 10

Capital(machine

hours)

2

4

31

Constant Returns to Scale

•Output doubles when all inputs doubled•Size does not affect productivity•May have large number of producers•Isoquants are equidistant apart

20

30

Labor (hours)155 10

10

Capital(machine

hours)

2

4

6

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Decreasing Returns to Scale

Labor (hours)

Capital(machine

hours)•Output less than doubles when all inputs doubled•Decreasing efficiency with large size•Reduction of entrepreneurial abilities•Isoquants become farther apart

10

20

10

4

5

2

3.2 Isocost-Equal cost curve

TC = K.R + L.w

K = LR

W

R

TC

- Factors explain Isocost:- R, W constant, TC change shift the

Isocost- TC, R constant, W change will turn the

Isocost- TC, R constant, R change will turn the

Isocost

3.3 Optimum choice

R

MPP

W

MPP

R

W

MPP

MPP

KL

K

L

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Cost Minimizing Input Choice Isocost Line

Line showing all combinations of L and K that can be purchased for same cost

Total cost of production is sum of firm’s labor cost, wL, and capital cost, rK:

C = wL + rK Price of labor: wage rate (w) Price of capital: user cost/rental rate (r)

Rewriting: K = C/r - (w/r)L Slope of isocost:

-(w/r) is ratio of wage rate to rental cost of capital Shows rate at which capital can be substituted

for labor with no cost change

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Producing Given Output at Minimum Cost

Labor per year

Capitalper

year

Isocost C2 shows quantity Q1 can be produced with

combination K2,L2 or K3,L3.However, both

are higher cost combinationsthan K1,L1.

Q1

Q1 is isoquant for output Q1.

There are three isocost lines, of which 2 are possible choices in

which to produce Q1.

C0 C1 C2

AK1

L1

K3

L3

K2

L2

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Input Substitution When an Input Price Change

C2

New combination of K and L is used to produce Q1.

Combination B is used in place of combination A.K2

L2

B

C1

K1

L1

A

Q1

If price of laborrises, isocost curve

becomes steeper due to change in slope -(w/r).

Labor per year

Capitalper

year

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Cost in Long Run

How does isocost line relate to firm’s production process?

K

LLK MPMP- MRTS

LK

rw

LK

lineisocost of Slope

costminimizesfirmwhenrw

MPMP

K

L

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Cost in Long Run

Minimum cost combination can be written:

Minimum cost for given output will occur when each dollar of input added to production process will add equivalent output

Cost minimization with varying output levels For each output level, there is an isocost curve

showing minimum cost Firm’s expansion path shows minimum cost

combinations of labor and capital at each output level

Slope equals K/L

rwKL MPMP

All firms, from Delta Air Lines to your local deli, incur costs as they make the goods and services that they sell.

As we will see in the coming chapters, a firm’s costs are a key determinant of its production and pricing decisions.

Establishing what a firm’s costs are, however, is not as straightforward as it might seem

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A. Cost of Production in Short-run1. FC, VC and TC

a. FC-fixed cost

I. Cost of Production

b. VC-Variable Cost

c. TC-Total Cost:

Give some comments on the relationship between TC and VC

2. Average cost, Marginal costa. Average cost

- AFC (Average Fixed Cost)- AVC (Average Variable Cost)- ATC (Average Total Cost)

Note:

Under the effect of Law of Diminishing Marginal Product, AVC, ATC and MC have U shape.

b. MC (Marginal Cost)

Notes:- MC intersects with AVC at the minimum

point of AVC- MC intersects with ATC at the minimum

point of ATC

1. Long-run Total Cost - LTC

In long-run there is no cost can be considered as fixed cost.

All of the cost are variable

B. Long-run Cost of Production

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Firm’s Expansion Path

Expansion Path

Expansion path illustratesleast-cost combinations of

labor and capital that can be used to produce each level of

output in long-run.

Capitalper

year

25

50

75

100

150

50Labor per year

100 150 300200

A

$2000

200 Units

B

$3000

300 Units

C

$1000

100 Units

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Firm’s Long Run Total Cost Curve

Long Run Total Cost

Output, Units/yr100 300200

Cost/ Year

1000

2000

3000

D

E

F•To move from expansion path to LR cost curve•Find tangency with isoquant and isocost•Determine min cost of producing output level selected•Graph output-cost combination

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Long Run Versus Short Run Cost Curves

In short run, some costs fixed In long run, firm can change

anything including plant size Can produce at lower average cost Capital and labor flexible

Show this by holding capital fixed in short run and flexible in long run

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Capital is fixed at K1.To produce Q1, min cost at K1,L1.If increase output to Q2, min cost

is K1 and L3 in short run.

Inflexibility of Short Run Production

Long-RunExpansion Path

Labor per year

Capitalper

year

L2

Q2

K2

D

C

F

E

Q1

A

BL1

K1

L3

PShort-RunExpansion Path

In LR, can change capital and min costs falls to K2 and L2.

54

Production with Two Outputs – Economies of Scope

Firms produce multiple products that are linked Advantages:

1. Both use capital and labor2. Firms share management resources3. Same labor skills and types of machinery

Alternative quantities produced illustrated using product transformation curves Product transformation curves negatively sloped since

to get more of one output, must give up some of other Product transformation curves are concave if joint

production has advantages

2.Long-run Average Total Cost - LATC

- The shape of LATC depends on the

return on scale of each production process

Q

LTCLATC

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Long Run VersusShort Run Cost Curves

Long-Run Average Cost (LAC) Determinant of shape of LAC and LMC is

relationship between scale of firm’s operation and cost-minimizing inputs

1. Constant Returns to Scale If input doubled, output doubles AC cost is constant at all levels of output

2. Increasing Returns to Scale If input doubled, output more than doubles AC decreases at all levels of output

3. Decreasing Returns to Scale If input doubled, output less than doubles AC increases at all levels of output

LATC

C

Q

Increasing returns to scale

LATC

C

QDecreasing returns to scale

C

Q

LATC

Constant returns to scale

3. Long-run Marginal Cost (LMC)-Definition:- Calculation

)(' QLTCQ

LTCLMC

LATC

C

Q

LMC

Increasing Returns to Scale

LATC

C

Q

LMC

Decreasing Returns to Scale

C

Q

LATC≡LMC

Constant Returns to Scale

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Long Run Average and Marginal Cost

Output

Cost($ per unitof output)

LAC

LMC

A

•If LMC < LAC, LAC will fall•If LMC > LAC, LAC will rise•LMC = LAC at the minimum of LAC•In special case where LAC is constant, LAC and LMC are equal

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Long Run Costs

As output increases, firm’s AC of producing is likely to decline

1. On larger scale, workers specialize2. Scale can provide flexibility, managers organize

production effectively3. Quantity discounts for inputs, lower prices lead to

different input mix At some point, AC begins to increase

1. Factory space and machinery make it difficult for efficient work

2. Managing larger firm may become more complex and inefficient as tasks increase

3. Limited input availability may cause price increases

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Long Run Costs

Economies of scale reflects input proportions that change as firm changes production level

Economies of Scale Increase in output greater than increase in

inputs Diseconomies of Scale

Increase in output less than increase in inputs

U-shaped LAC shows economies of scale for relatively low output levels and diseconomies of scale for higher levels

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Long Run Costs

Economies of scale measured in terms of cost-output elasticity, EC

EC is percentage change in production cost resulting from 1-percent increase in output

EC is equal to 1, MC = AC Costs increase proportionately with output Neither economies nor diseconomies of scale

EC < 1 when MC < AC Economies of scale Both MC and AC are declining

EC > 1 when MC > AC Diseconomies of scale Both MC and AC are rising

ACMC

QQCCEC

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Long Run Cost with Economiesand Diseconomies of Scale

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Long Run Cost withConstant Returns to Scale

What is firm’s long run cost curve? Firms can change scale to change output

in long run Long run cost curve represents minimum

cost for any output level Firm choose plant that minimizes

average cost of production Long-run average cost curve envelops

short-run average cost curves LAC curve exhibits economies of scale

initially but diseconomies at higher output levels

1. Definitions

a. Profit There are some circumstances

that the enterprise does not want to have profit

IV. Profit

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Marginal Revenue, Marginal Cost, and Profit Maximization

Can study profit maximizing output for any firm, whether perfectly competitive or not Profit () = Total Revenue - Total Cost

If q is output of firm: Total Revenue (R) = Pq Total Cost (C) = C(q)

Firm selects output to maximize difference between revenue and cost

)()()( qCqRq

73

Marginal Revenue, Marginal Cost, and Profit Maximization Slope of revenue curve is marginal revenue

Change in revenue from one-unit increase in output

Slope of total cost curve is marginal cost Additional cost of producing additional

unit of output Profit is negative to start since revenue is

not large enough to cover fixed and variable costs

As output rises, revenue rises faster than costs

74

Profit Maximization – Short Run

0

Cost,Revenue,

Profit($s per

year)

Output

C(q)

R(q)A

B

(q)q0 q*

Profits are maximized where MR (slope at A) and MC (slope at B) are equal

Profits are maximized where R(q) – C(q) is maximized

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Marginal Revenue, Marginal Cost, and Profit Maximization

Profit maximized at point at which additional increment to output leaves profit unchanged

MCMR

MCMRq

C

q

R

q

CR

0

b. Accounting and Economic Profit- Accounting profit- Economic profit

c. MR (Marginal Revenue)

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Exercise

Josh, a second year MBA student, takes three hours off one evening and uses his car to go to a movie with a friend. A ticket to the movie costs Josh $5, gasoline for the trip costs $1, and Josh passed up tutoring a student that night at $10 an hour. He could also have used the three hours to work as a grader for a professor at $15 an hour. What is Josh’s economic cost of going to the movie?

2. Profit maximizingMR = MC

3. Total revenue maximizingMR = 0

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Production with Two Outputs – Economies of Scope

Degree of economies of scope (SC) measured by percentage of cost saved producing two or more products jointly:

C(q1) is cost of producing q1 C(q2) is cost of producing q2 C(q1,q2) is joint cost of producing both products

Interpretation: If SC > 0 Economies of scope If SC < 0 Diseconomies of scope Greater value of SC, greater economies of scope

)qC(q

)qC(q)C(q)C(q SC

,

,

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