1. Business Firm
An entity that employs factors of
production (resources) to produce goods
and services to be sold to consumers,
other firms, or the government.

2. Managerial Coordination and
Business Firms
The process in which managers direct
employees to perform certain tasks.

3. Why Do Business Firms Arise in the
First Place?
Firms are formed when benefits can be
obtained from individuals working as a
team.

4. Problem of and Solutions for
“Team” Work
Problem: Shirking - The behavior of a worker who
is putting forth less than the agreed to effort.
Solution: Monitor – Person (manager) in a business
firm who coordinates team production and
reduces shirking.
Problem: Monitor shirking
Solution: Make the monitor a Residual Claimants Persons who share in the profits of a business
firm.

5. Markets: Inside and Outside the Firm
 Economics is largely about trades or exchanges; it is
about market transactions.
 In supply-and-demand analysis, the exchanges are
between buyers of goods and services and sellers of
goods and services.
 In the theory of the firm, the exchanges take place at two
levels: (1) at the level of individuals coming together to
form a team and (2) at the level of workers “choosing” a
monitor.

6. Firm’s Objective: Maximizing Profit
The difference between total revenue and
total cost.
Profit = Total revenue - Total cost

7. Explicit and Implicit Cost
 Explicit Cost - A cost incurred when an
actual (monetary) payment is made.
 Implicit Cost - A cost that represents the
value of resources used in production for
which no actual (monetary) payment is
made.

8. Accounting, Economic and Normal
Profit I
 Accounting Profit - The difference
between total revenue and explicit costs.
 Economic Profit - The difference
between total revenue and total cost,
including both explicit and implicit
costs.
 Normal Profit - Zero economic profit. A
firm that earns normal profit is earning
revenue equal to its total costs (explicit
plus implicit costs). This is the level of
profit necessary to keep resources
employed in that particular firm.

9. Accounting, Economic and Normal
Profit II

10. Production and Cost:
Fixed and Variable Inputs
 Fixed Input - An input whose quantity
cannot be changed as output changes.
 Variable Input - An input whose quantity
can be changed as output changes.

11. Production and Cost:
Short and Long Run
 Short Run - A period of time in which
some inputs in the production process are
fixed.
 Long Run - A period of time in which all
inputs in the production process can be
varied (no inputs are fixed).

12. Marginal Physical Product (MPP)
 Marginal Physical Product (MPP) - The
change in output that results from
changing the variable input by one unit,
holding all other inputs fixed

13. Production in the Short Run and the Law
of Diminishing Marginal Returns
 In the short run, as additional units of a
variable input are added to a fixed input,
the marginal physical product of the
variable input may increase at first.
 Eventually, the marginal physical product
of the variable input decreases.
 The point at which marginal physical
product decreases is the point at which
diminishing marginal returns have set in.

14. Law of Diminishing Marginal
Returns
Law of Diminishing Marginal Returns As ever-larger amounts of a variable input
are combined with fixed inputs,
eventually, the marginal physical product
of the variable input will decline.

15. Production in the Short Run and the Law
of Diminishing Marginal Productivity

16. Fixed, Variable, Total and Marginal
Cost
 Fixed Costs (FC) - Costs that do not vary with
output; the costs associated with fixed inputs.
 Variable Cost (VC) - Costs that vary with
output; the costs associated with variable inputs.
 Total Cost (TC) - The sum of fixed costs and
variable costs. TC = TFC + TVC
 Marginal Cost (MC) - The change in total cost
that results from a change in output: MC =
ΔTC/Δ Q.

17. Marginal Physical Product and
Marginal Cost I

18. Marginal Physical Product and Marginal Cost II
 The marginal physical product of labor curve is derived
by plotting the data from columns 2 and 4 in the exhibit.
 The marginal cost curve is derived by plotting the data
from columns 3 and 8 in the exhibit. See next slide.

19. Notice that as the
MPP curve rises,
the MC curve falls;
and as the MPP
curve falls, the MC
curve rises.

20. Average Productivity
Q = Output
L = Number of units of labor

21. Average Fixed, Variable and Total
Cost
 Average Fixed Cost (AFC) - Total fixed
cost divided by quantity of output:
AFC = TFC / Q.
 Average Variable Cost (AVC) - Total
variable cost divided by quantity of
output: AVC = TVC / Q.
 Average Total Cost (ATC), or Unit Cost Total cost divided by quantity of output:
ATC = TC / Q.

22. Total, Average & Marginal Costs I

23. Total, Average & Marginal Costs II

24. Average-Marginal Rule
When the marginal magnitude is above
the average magnitude, the average
magnitude rises; when the marginal
magnitude is below the average
magnitude, the average magnitude falls.

25. Average and Marginal Cost Curves

26. Tying Production to Costs
What happens in terms of production (MPP rising or
falling) affects MC, which in turn eventually affects AVC
and ATC.

27. Production and Costs in the Long Run
 In the short run, there are fixed costs and
variable costs; therefore, total cost is the
sum of the two.
 A period of time in which all inputs in the
production process can be varied (no
inputs are fixed). In the long run, there are
no fixed costs, so variable costs are total
costs.

28. Long-Run Average Total Cost
(LRATC) Curve
A curve that shows the lowest (unit) cost
at which the firm can produce any given
level of output.

29. Long-Run Average Total Cost
Curve (LRATC )
 There are three
short-run average
total cost curves for
three different plant
sizes.
 If these are the only
plant sizes, the longrun average total
cost curve is the
heavily shaded, blue
scalloped curve.

30. Long-Run Average Total Cost
Curve (LRATC )
 The long-run average
total cost curve is the
heavily shaded, blue
smooth curve.
 The LRATC curve is
not scalloped because it
is assumed that there
are so many plant sizes
that the LRATC curve
touches each SRATC
curve at only one point.

31. Economies of Scale I
 Economies of Scale exist when inputs are
increased by some percentage and output
increases by a greater percentage, causing unit
costs to fall.
 Constant Returns to Scale exist when inputs are
increased by some percentage and output
increases by an equal percentage, causing unit
costs to remain constant.
 Diseconomies of Scale exist when inputs are
increased by some percentage and output
increases by a smaller percentage, causing unit
costs to rise.

32. Why Economies of Scale?
Up to a certain point, long-run unit costs of
production fall as a firm grows. There are
two main reasons for this:
 Growing firms offer greater opportunities
for employees to specialize.
 Growing firms can take advantage of highly
efficient mass production techniques and
equipment that ordinarily require large
setup costs and thus are economical only if
they can be spread over a large number of
units.
 2/3 rule

33. Why Diseconomies of Scale?
In very large firms,
managers often find it
difficult to coordinate
work activities,
communicate their
directives to the right
persons in satisfactory
time, and monitor
personnel effectively.

34. Economies of Scale II
The lowest output level
at which average total
costs are minimized.

35. Shifts in Cost Curves
A firm’s cost curves will shift if there is a
change in:
Taxes
Input prices
Technology.

36. Isoquants
An isoquant is a graph that shows all the
combinations of capital and labour that
can be used to produce a given amount of
output.
36

37. Properties of Isoquant Maps
There are an infinite number of combinations of labour and
capital that can produce each level of output.
Every point lies on some isoquant.
The slope of an isoquant is equal to:
MPlabour / MPcapital = - MPL / MPK = ΔK / ΔL
The slope of the isoquant is called the marginal rate of
technical substitution which can be defined as the rate at
which a firm can substitute capital for labour and hold
output constant.
37
-

38. Isoquants Showing All Combinations of Capital
and Labour That Can Be Used to Produce 50, 100,
and 150 Units of Output
38

39. The Slope of an Isoquant Is Equal
to the Ratio of MPL to MPK
39

40. Isocosts
An isocost is a graph that shows all the
combinations of capital and labour
available for a given cost.
40

41. Isocost Lines Showing the Combinations of
Capital and Labour Available for $5, $6, & $7
41

42. Isocost Line Showing All Combinations of
Capital and Labour Available for $25
The slope of an
isocost line is equal
to -
PL / PK.
The simple way to
draw an isocost is to
calculate the
endpoints on the line
and connect them.
42

43. The Cost Minimizing Equilibrium
Condition
Slope of isoquant = - MPL / MPK
Slope of isocost = - PL / PK
For cost minimization we set these equal
and rearrange to obtain:
MPL / PL = MPK / PK
43

44. Finding the Least-Cost Combination of Capital and Labour
to Produce 50 Units of Output
Profit-maximizing firms
will minimize costs by
producing their chosen
level of output with the
technology represented by
the point at which the
isoquant is tangent to an
isocost line.
Point A on this diagram
44

45. Minimizing Cost of Production
for qx = 50, qx = 100, and qx = 150
Plotting a series of
cost- minimizing
combinations of
inputs - shown here
as A, B and C enables us to derive a
cost curve.
45

46. A Cost Curve Showing the Minimum Cost
of Producing Each Level of Output
46

47. Review Terms & Concepts
isocost line
isoquant
marginal rate of technical
substitution
47

48. The Cobb-Douglas Production
Function
Y = AK L
α (1-α)

49. History
Developed by Paul
Douglas and C.
W. Cobb in the
1930’s
The Cobb-Douglas
Production Function

50. History
Developed by Paul
Douglas and C.
W. Cobb in the
1930’s
Douglas went on to
be professor at
Chicago and U.S.
Senator
Cobb - ??
The Cobb-Douglas
Production Function

51. The General Problem
An increase in a nation’s capital stock or
labor force means more output.
Is there a mathematical formula that relates
capital, labor and output?
The Cobb-Douglas
Production Function

52. The General Form
α 1−α
t
t
Yt = At K L
The Cobb-Douglas
Production Function

53. Increasing Capital
Yo = AK L
α
o
1−α
o
Y = A(2 K o ) L
α
The Cobb-Douglas
Production Function
1−α
o

54. Increasing Capital
Yo = AK L
α
o
1−α
o
Y = A(2 K o ) L
α
α
α
o
1−α
o
2 AK L
The Cobb-Douglas
Production Function
1−α
o
=
= 2 Yo
α

55. Increasing Capital
Yo = AK L
α
o
1−α
o
Y = A(2 K o ) L
α
α
α
o
1−α
o
2 AK L
=
= 2 Yo
Diminishing returns to proportion
The Cobb-Douglas
Production Function
1−α
o
α

56. Increasing Labor
Yo = AK L
α
o
α
1−α
o
Y = AK o (2 Lo )
The Cobb-Douglas
Production Function
1−α

57. Increasing Labor
Yo = AK L
α
o
α
1−α
o
Y = AK o (2 Lo )
1−α
2
The Cobb-Douglas
Production Function
α
o
1−α
o
AK L
1−α
=
= 2 Yo
1−α

58. Increasing Labor
Yo = AK L
α
o
1−α
o
α
Y = AK o (2 Lo )
1−α
2
α
o
1−α
o
AK L
1−α
= 2 Yo
Diminishing returns to proportion
The Cobb-Douglas
Production Function
=
1−α

59. Increasing Both
Yo = AK L
α
o
1−α
o
Y = A(2 K o ) (2 Lo )
α
The Cobb-Douglas
Production Function
1−α

60. Increasing Both
Yo = AK L
α
o
1−α
o
Y = A(2 K o ) (2 Lo )
α
α
o
1−α
o
2 AK L
The Cobb-Douglas
Production Function
1−α
= 2 Yo
=

61. Increasing Both
Yo = AK L
α
o
1−α
o
Y = A(2 K o ) (2 Lo )
α
α
o
1−α
o
2 AK L
1−α
= 2 Yo
Constant returns to scale
The Cobb-Douglas
Production Function
=

62. Substitution
Yo = AK L
α
o
1−α
o
Y = A(2 K o ) ( xLo )
α
Capital and Labor Can be Substituted
The Cobb-Douglas
Production Function
1−α
= Yo

63. An Illustration
Yt = At K L
1/ 2
t
The Cobb-Douglas
Production Function
1/ 2
t

64. An Illustration
Y = AK L
1/ 2
The Cobb-Douglas
Production Function
1/ 2

65. An Illustration
Y = A KL
The Cobb-Douglas
Production Function

66. An Illustration
A =3
L =10
Y = A KL
K
=10
The Cobb-Douglas
Production Function

67. An Illustration
Y = 3 (10)(10) = 3 100 = 30
The Cobb-Douglas
Production Function

68. Doubling Capital
Y = 3 (20)(10) = 3 200 =
30 2 ≅ 42
The Cobb-Douglas
Production Function

69. Constant Returns to Scale
Y = 3 (20)(20) = 3 400 = 60
The Cobb-Douglas
Production Function

70. Substitution
Y = 3 (20)( x) = 30
x=5
The Cobb-Douglas
Production Function

71. Estimation
Yt = At K L
α
t
1−α
t
log(Yt ) = log( At ) + α log( K t )
+ (1 − α ) log( Lt )
The Cobb-Douglas
Production Function

72. Estimation
log(Yt ) = C + t + β1 log( K t )
+ β 2 log( Lt ) + ε t
The Cobb-Douglas
Production Function

73. Estimation
log(Yt ) = α + β1 log( K t )
+ β 2 log( Lt ) + ε t
Statistical issues abound!
The Cobb-Douglas
Production Function

74. Factor Payments
α = % of Income going to owners
of capital
1-α =
% of Income going to workers
The Cobb-Douglas
Production Function

75. How well does it work?
Yt = At K L
α
t
β
t
You can’t beat something
with nothing
The Cobb-Douglas
Production Function

76. Leontief Production Function
K
L
The Cobb-Douglas
Production Function

77. Leontief Production Function
K = aY
L = bY
K
L
The Cobb-Douglas
Production Function

78. Leontief Production Function
K = aY
L = bY
K
L
The Cobb-Douglas
Production Function

79. Leontief Production Function
K
K = aY
L = bY
σ=0
L
The Cobb-Douglas
Production Function

80. Leontief Production Function
K = aY
L = bY
K
Doesn’t work.
We can and do
substitute labor
for capital all the
time
The Cobb-Douglas
Production Function
L

81. Other Factors?
Yt = At K L LND
α
t
The Cobb-Douglas
Production Function
β
t
1−α − β
t

82. And in Conclusion…
α 1−α
t
t
Yt = At K L
The Cobb-Douglas
Production Function