Production and supply

Applied Microeconomics
Production and supply

Production
- The Technology of Production
- Production with One Variable Input
- Production with Two Variable Inputs
- Returns to Scale

Cost of production
- Measuring Cost: Which Costs Matter?
- Cost in the Short Run
- Cost in the Long Run

Supply in perfectly competitive markets

- Profit Maximization
- Marginal Revenue, Marginal Cost, and Profit Maximization
- Choosing Output in the Short Run
- The Competitive Firm’s Short-Run Supply Curve
- The Short-Run Market Supply Curve
Production
The theory of the firm describes how a firm makes cost-
minimizing production decisions and how the firm’s
resulting cost varies with its output.

• The Production Decisions of a Firm

The production decisions of firms are analogous to the

purchasing decisions of consumers, and can likewise be
understood in three steps:
1. Production Technology
2. Cost Constraints
3. Input Choices
 THE TECHNOLOGY OF PRODUCTION

● factors of production Inputs into the production

process (e.g., labour, capital, and materials).

• The Production Function

q  F (K , L)
● production function Function showing the highest
output that a firm can produce for every specified
combination of inputs.
Remember the following:

- Equation (6.1) applies to a given technology.

- Production functions describe what is technically

feasible when the firm operates efficiently.
 THE TECHNOLOGY OF PRODUCTION

• The Short Run versus the Long Run

● short run Period of time in which quantities of one or

more production factors cannot be changed.

● fixed input Production factor that cannot be varied.

● long run Amount of time needed to make all

production inputs variable.
 PRODUCTION WITH ONE VARIABLE INPUT
Production with One Variable Input (labour) and fixed capital
Amount Amount Total Average Marginal
of labour of Capital (K) Output (q) Product (q/L) Product
(L) 0 10 0 — (∆q/∆
—L)
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 4
10 10 100 10 8

Average product of labour = Output/labour input = q/L

Marginal product of labour = Change in output/change in labour input = Δq/ΔL
 PRODUCTION WITH ONE VARIABLE INPUT (LABOUR)

• The Slopes of the Product Curve

Production with One Variable Input

The total product curve in (a) shows the

output produced for different amounts of
labour input.
The average and marginal products in (b)
can be obtained (using the data from table in
the previous slide) from the total product
curve.
At point A in (a), the marginal product is 20
because the tangent to the total product
curve has a slope of 20.
At point B in (a) the average product of
labour is 20, which is the slope of the line
from the origin to B.
The average product of labour at point C in
(a) is given by the slope of the line 0C.

law of diminishing marginal returns Principle that

as the use of an input increases with other inputs fixed,
the resulting additions to output will eventually
decrease.
 PRODUCTION WITH TWO VARIABLE INPUTS

• Isoquants Production with Two Variable Inputs

labour INPUT
Capital Input 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

● isoquant Curve showing

all possible combinations of
inputs that yield the same
output.
 PRODUCTION WITH TWO VARIABLE INPUTS

• Isoquants
● isoquant map Graph combining a number of
isoquants, used to describe a production function.

Production with Two Variable Inputs

A set of isoquants, or isoquant map,
describes the firm’s production
function.
Output increases as we move from
isoquant q1 (at which 55 units per
year are produced at points such as
A and D),
to isoquant q2 (75 units per year at
points such as B) and
to isoquant q3 (90 units per year at
points such as C and E).
Holding the amount of capital fixed at
a particular level—say 3, we can see
that each additional unit of labour
generates less and less additional
output.
 PRODUCTION WITH TWO VARIABLE INPUTS
• Substitution Among Inputs
● marginal rate of technical substitution (MRTS) Amount by which the quantity of
one input can be reduced when one extra unit of another input is used, so that
output remains constant.
MRTS = − Change in capital input/change in labour input
= − ΔK/ΔL (for a fixed level of q)
Marginal Rate of Technical
Substitution

Like indifference curves,

isoquants are downward sloping
and convex. The slope of the
isoquant at any point measures
the marginal rate of technical
substitution—the ability of the
firm to replace capital with labour
while maintaining the same level
of output.
On isoquant q2, the MRTS falls
from 2 to 1 to 2/3 to 1/3.

(MP ) / (MP )  (K / L)  MRTS

L K
(6.2)
RETURNS TO SCALE

● returns to scale Rate at which output increases as

inputs are increased proportionately.

● increasing returns to scale Situation in which output

more than doubles when all inputs are doubled.

● constant returns to scale Situation in which output

doubles when all inputs are doubled.

● decreasing returns to scale Situation in which output

less than doubles when all inputs are doubled.
 RETURNS TO SCALE
returns to scale Rate at which output increases as inputs are increased proportionately.
increasing returns to scale Situation in which output more than doubles when all inputs are doubled
constant returns to scale Situation in which output doubles when all inputs are doubled
decreasing returns to scale Situation in which output less than doubles when all inputs are doubled

When a firm’s production process exhibits However, when there are increasing
constant returns to scale as shown by a returns to scale as shown in (b), the
movement along line 0A in part (a), the isoquants move closer together as
isoquants are equally spaced as output inputs are increased along the line.
increases proportionally.
MEASURING COST: WHICH COSTS MATTER?

total cost (TC or C) Total economic cost of production, consisting of fixed and
variable costs.

fixed cost (FC) Cost that does not vary with the level of output and that can be
eliminated only by shutting down.

variable cost (VC) Cost that varies as output varies

marginal cost (MC) Increase in cost resulting from the production of one extra
unit of output. Because fixed cost does not change as the firm’s level of output
changes, marginal cost is equal to the increase in variable cost or the increase in
total cost that results from an extra unit of output.

average total cost (ATC) Firm’s total cost divided by its level of output.

average fixed cost (AFC) Fixed cost divided by the level of output.

average variable cost (AVC) Variable cost divided by the level of output.
Marginal and Average Cost

A Firm’s Costs
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Cost Variable Cost Total Cost
(Units (Dollars (Dollars (Dollars (Dollars (Dollars (Dollars (Dollars
per Year) per Year) per Year) per Year) per Unit) per Unit) per Unit) per Unit)
(FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)
(1) (2) (3) (4) (5) (6) (7)

0 50 0 50 -- -- -- --
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
 COST IN THE SHORT RUN
The Determinants of Short-Run Cost
The change in variable cost is the per-unit cost of the extra labour w times
the amount of extra labour needed to produce the extra output ΔL.
Because ΔVC = wΔL, it follows that

The extra labour needed to obtain an extra unit of output is ΔL/Δq = 1/MPL.
As a result,

Diminishing Marginal Returns and Marginal Cost

Diminishing marginal returns means that the marginal product of labour

declines as the quantity of labour employed increases.
As a result, when there are diminishing marginal returns, marginal cost
will increase as output increases.
 COST IN THE SHORT RUN

The Shapes of the Cost Curves

Cost Curves for a Firm

In (a) total cost TC is the

vertical sum of fixed cost
FC and variable cost VC.
In (b) average total cost
ATC is the sum of
average variable cost
AVC and average fixed
cost AFC.
Marginal cost MC
crosses the average
variable cost and average
total cost curves at their
minimum points.
COST IN THE LONG RUN – when we can change both labour and capital

The Isocost Line

● isocost line Graph showing all possible combinations of labour
and capital that can be purchased for a given total cost.

To see what an isocost line looks like, recall that the total cost C of
producing any particular output is given by the sum of the firm’s labour
cost wL and its capital cost rK:

If we rewrite the total cost equation as an equation for a straight line,

we get

It follows that the isocost line has a slope of ΔK/ΔL = −(w/r), which is
the ratio of the wage rate to the rental cost of capital.
 COST IN THE LONG RUN Recall that in our analysis of production
technology, we showed that the marginal
rate of technical substitution of labour for
The Isocost Line capital (MRTS) is the negative of the slope
of the isoquant and is equal to the ratio of
the marginal products of labour and capital:

Producing a Given Output at

Minimum Cost
It follows that when a firm minimizes the
cost of producing a particular output, the
Isocost curves describe the following condition holds:
combination of inputs to
production that cost the
same amount to the firm.
Isocost curve C1 is tangent
to isoquant q1 at A and
shows that output q1 can be
produced at minimum cost
with labour input L1 and
capital input K1.
Other input combinations–
L2, K2 and L3, K3–yield the
same output but at higher
cost.
 PERFECTLY COMPETITIVE MARKETS
The model of perfect competition rests on three basic assumptions:
(1) price taking,
(2) product homogeneity, and
(3) free entry and exit.

Price Taking
Because each individual firm sells a sufficiently small proportion of total
market output, its decisions have no impact on market price.
● price taker Firm that has no influence over market price and thus takes the price
as given.

Product Homogeneity
When the products of all of the firms in a market are perfectly substitutable with
one another—that is, when they are homogeneous—no firm can raise the price of
its product above the price of other firms without losing most or all of its business.

Free Entry and Exit

● free entry (or exit) Condition under which there are no special costs that
make it difficult for a firm to enter (or exit) an industry.
MARGINAL REVENUE, MARGINAL COST,
AND PROFIT MAXIMIZATION
● profit Difference between total revenue and total cost.

π(q) = R(q) − C(q)

● marginal revenue Change in revenue resulting from a one-unit
increase in output.

Profit Maximization in the Short Run

A firm chooses output q*, so that

profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve)
is equal to marginal cost (the
slope of the cost curve).
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0
MR(q) = MC(q)
 Demand and Marginal Revenue for a Competitive Firm

Demand Curve Faced by a Competitive Firm

A competitive firm supplies only a small portion of the total output of all the firms in an
industry. Therefore, the firm takes the market price of the product as given, choosing its
output on the assumption that the price will be unaffected by the output choice.
In (a) the demand curve facing the firm is perfectly elastic, even though the market demand
curve in (b) is downward sloping.

The demand d curve facing an individual firm in a competitive market is both its
average revenue curve and its marginal revenue curve. Along this demand curve,
marginal revenue, average revenue, and price are all equal.

Profit Maximization by a Competitive Firm: MC(q) = MR = P

 CHOOSING OUTPUT IN THE SHORT RUN

The Short-Run Profit of a Competitive Firm

A Competitive Firm Making a

Positive Profit
In the short run, the
competitive firm maximizes
its profit by choosing an
output q* at which its
marginal cost MC is equal to
the price P (or marginal
revenue MR) of its product.

The profit of the firm is

measured by the rectangle
ABCD.

Any change in output,

whether lower at q1 or
higher at q2, will lead to
lower profit.
q*
 CHOOSING OUTPUT IN THE SHORT RUN

The Short-Run Profit of a Competitive Firm

A Competitive Firm Incurring Losses

A competitive firm should

shut down if price is below
AVC.

The firm may produce in

the short run if price is
greater than average
variable cost.

Shut-Down Rule: The firm should shut down if the price of the product is less
than the average variable cost of production at the profit-maximizing output.
 THE COMPETITIVE FIRM’S SHORT-RUN
SUPPLY CURVE

The firm’s supply curve is the portion of the marginal cost curve
for which marginal cost is greater than average variable cost.

The Short-Run Supply Curve for a

Competitive Firm
In the short run, the firm
chooses its output so that
marginal cost MC is equal to
price as long as the firm
covers its average variable
cost.

The short-run supply curve is

given by the crosshatched
portion of the marginal cost
curve.
 THE SHORT-RUN MARKET SUPPLY CURVE

Industry Supply in the Short Run

The short-run industry supply

curve is the summation of the
supply curves of the individual
firms.
Because the third firm has a lower
average variable cost curve than
the first two firms, the market
supply curve S begins at price P1
and follows the marginal cost
curve of the third firm MC3 until
price equals P2, when there is a
kink.
For P2 and all prices above it, the
industry quantity supplied is the
sum of the quantities supplied by
each of the three firms.
Finding a competitive equilibrium:
From firm/household to the market and back

Derive Use the

individual Sum up Find the Find individual firms’
individual equilibrium
firms’ supply equilibrium profits. If profits are:
supply curves price to find
firms price and •Zero: equilibrium (no
to construct the quantity firm entry or exit)
(marginal market
the market supplied by •positive: new firms
costs) quantity at
supply curve each firm enter the market, market
the
intersection supply up, market price
down, profits down until
of the
profits=0 and
Derive market equilibrium
individual Sum up supply and Use the •negative: some firms
households’ individual demand equilibrium exit the market, market
demand demand curves curves price to find supply down, market
curves to construct the quantity price up, profits up until
the market demanded by profits=0 and
demand curve each equilibrium
household