1. Theory of Producers’ Behavior
-Production
-Cost of Production
-Profit Maximizing
1

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

3.  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

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

5. Can you explain about the behavior of
people who lead the contract ???
Do they follow the purpose of
maximizing profit of all firms?

6.  The way people organize a firm
may vary its behaviors

8. Note:
The producers’ behavior may vary if the
owner and the administrator are different
 Purpose of firm may vary

9. 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 prices
c. 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
10

11. 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)
11

12.  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

13. 2. Production: One Variable Input
(Short-run)
 Assume capital fixed and labor variable
 Observations:
 When labor is zero, output is zero
 With additional labor, output (q) increases
initially
 Beyond this, output declines
 More labor becomes counterproductive
13

14. 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
Output q
APL = =
Labor Input L
 Marginal Product of Labor – additional
output produced when labor increases by
one unit
∆Output ∆q
MPL = =
∆Labor Input ∆L
14

15. Production: One Variable Input
Output
per
Month D
112
C Total Product
At point D, output is
60 maximized.
B
A
0 1 2 3 4 5 6 7 8 9 10 Labor per Month
15

16. Production: One Variable Input
Output •Left of E: MP > AP & AP is increasing
per •Right of E: MP < AP & AP is decreasing
Worker •At E: MP = AP & AP is at its maximum
•At 8 units, MP is zero and output is at max
30
Marginal Product
E Average Product
20
10
0 1 2 3 4 5 6 7 8 9 10 Labor per Month
16

17. 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
17

18.  Diminishing marginal product
18

19. 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
19

20. Diminishing Returns
Capital 5
Increasing labor holding
capital constant (A, B,
C)
4 OR
Increasing capital
holding labor constant
3 (E, D, C)
A B C
D
2
q3 = 90
1 E q2 = 75
q1 = 55
1 2 3 4 5 Labor
20

21. 3.1 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.

22. 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
22

23. Production: Two Variable Inputs
Change in Capital Input
MRTSLK =−
Change in Labor Input
MRTSLK = − ∆K ( for fixed level of q )
∆L
 As labor increases to replace capital
 Labor relatively less productive
 Capital relatively more productive
 Need less capital to keep output constant
 Isoquant becomes flatter
23

24. Marginal Rate of
Technical Substitution (MRTS)
Capital 5
Negative slope measures MRTS;
2 MRTS decreases as move down
4 isoquant curve
1
3
1
1
2
2/3 1
Q3 =90
1/3 Q2 =75
1 1
Q1 =55
1 2 3 4 5 Labor
24

25. 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:
( MPL )(∆L) + ( MPK )(∆K ) = 0
( MPL )(∆L) = - ( MPK )(∆K )
( MPL ) ∆K
=− = MRTS LK
( MPK ) ∆L
25

26. 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
26

27. Perfect Substitutes
Capital
per A
Same output can be
month reached with mostly
capital or mostly labor (A
or C) or with equal
amount of both (B).
B
C
Q1 Q2 Q3
Labor
per month
27

28. Perfect Complements
Capital
per Same output can
month only be produced
with one set of
inputs.
Q3
C
Q2
B
K1 Q1
A
Labor per
month
L1
28

29. 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
29

30. Increasing Returns to Scale
Capital
(machine •Output more than
hours) doubles when all
inputs are doubled
•e.g., Larger output
associated with
lower cost (cars)
•e.g., One firm more
4 efficient than many
(utilities)
•Isoquants get
closer together
2 20
10
Labor (hours)
5 10
30

31. Constant Returns to Scale
Capital
(machine
hours)
6
30
•Output doubles when
4 all inputs doubled
•Size does not affect
productivity
20 •May have large
number of producers
2 •Isoquants are
equidistant apart
10
Labor (hours)
5 10 15
31

32. Decreasing Returns to Scale
Capital
(machine
hours)
•Output less than
doubles when all inputs
doubled
•Decreasing efficiency
with large size
4 20 •Reduction of
entrepreneurial abilities
•Isoquants become
farther apart
2
10
5 10 Labor (hours)
32

33. 3.2 Isocost-Equal cost curve
TC = K.R + L.w
TC W
K= − L
R R

34. - 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

35. 3.3 Optimum choice
MPPL W
=
MPPK R
MPPL MPPK
=
W R

36. 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 36

37. Producing Given Output at
Minimum Cost
Capital
per Q1 is isoquant for output Q1.
year There are three isocost lines, of
which 2 are possible choices in
which to produce Q1.
K2
Isocost C2 shows quantity
Q1 can be produced with
combination K2,L2 or K3,L3.
However, both
A are higher cost combinations
K1 than K1,L1.
Q1
K3
C0 C1 C2
Labor per year
L2 L1 L3
37

38. Input Substitution When an Input
Price Change
Capital
per If price of labor
year rises, isocost curve
becomes steeper due to
change in slope -(w/r).
New combination of K and L is
used to produce Q1.
B Combination B is used in
K2 place of combination A.
A
K1
Q1
C2 C1
L2 L1 Labor per year
38

39. Cost in Long Run
 How does isocost line relate to
firm’s production process?
MRTSLK = - ∆K = MPL
∆L MPK
Slope of isocost line = ∆K = −w
∆L r
MPL =w when firm minimizes cost
MPK r
39

40. Cost in Long Run
 Minimum cost combination can be written:
MPL = MPK
w r
 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
40

41.  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
41

42. I. Cost of Production
A. Cost of Production in Short-run
2. FC, VC and TC
a. FC-fixed cost

43. b. VC-Variable Cost

44. c. TC-Total Cost:
 Give some comments on the
relationship between TC and VC

45. 2. Average cost, Marginal cost
b. Average cost
- AFC (Average Fixed Cost)
- AVC (Average Variable Cost)
- ATC (Average Total Cost)

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

47. b. MC (Marginal Cost)

48.  Notes:
- MC intersects with AVC at the minimum
point of AVC
- MC intersects with ATC at the minimum
point of ATC

49. B. Long-run Cost of Production
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

50. Firm’s Expansion Path
Capital
per Expansion path illustrates
least-cost combinations of
year
labor and capital that can be
150 $3000 used to produce each level of
output in long-run.
Expansion Path
$2000
100
C
75
B
50 $1000
300 Units
A
25
200 Units
100 Units
Labor per year
50 100 150 200 300
50

51. Firm’s Long Run Total Cost Curve
Cost/
Year
Long Run Total Cost
F
3000 •To move from
expansion path to LR
cost curve
E •Find tangency with
2000 isoquant and isocost
•Determine min cost of
producing output level
D selected
1000 •Graph output-cost
combination
Output, Units/yr
100 200 300
51

52. 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
52

53. Inflexibility of Short Run Production
Capital E Capital is fixed at K1.
per To produce Q1, min cost at K1,L1.
year
C If increase output to Q2, min cost
is K1 and L3 in short run.
In LR, can
Long-Run
change
Expansion Path
A capital and
min costs
falls to K2 and
K2 L2.
Short-Run
P Expansion Path
K1 Q2
Q1
Labor per year
L1 L2 B L3 D F
53

54. Production with Two Outputs –
Economies of Scope
 Firms produce multiple products that are linked
 Advantages:
 Both use capital and labor
 Firms share management resources
 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
54

56. 2.Long-run Average Total Cost -
LATC
LTC
LATC =
Q
- The shape of LATC depends on the
return on scale of each production
process

57. Long Run Versus
Short 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
2. Constant Returns to Scale
 If input doubled, output doubles
 AC cost is constant at all levels of output
3. Increasing Returns to Scale
 If input doubled, output more than doubles
 AC decreases at all levels of output
4. Decreasing Returns to Scale
 If input doubled, output less than doubles
 AC increases at all levels of output
57

58. C Increasing returns to scale
LATC
Q

59. C
LATC
Q
Decreasing returns to scale

60. C
Constant returns to scale
LATC
Q

61. 3. Long-run Marginal Cost (LMC)
-Definition:
- Calculation
∆LTC
LMC = = LTC ' (Q)
∆Q

62. C
Increasing Returns to Scale
LAT
LMC C
Q

63. C LMC
LATC
Q
Decreasing Returns to Scale

64. C Constant Returns to Scale
LATC≡LMC
Q

65. Long Run Average and Marginal
Cost
Cost •If LMC < LAC,
($ per unit LAC will fall
of output) LMC •If LMC > LAC,
LAC will rise
LAC •LMC = LAC at
the minimum of
LAC
•In special case
where LAC is
constant, LAC
A and LMC are
equal
Output
65

66. Long Run Costs
 As output increases, firm’s AC of producing is
likely to decline
1. On larger scale, workers specialize
2. Scale can provide flexibility, managers organize
production effectively
3. 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
66

67. 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
67

68. 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 = ∆C C = MC
∆Q Q AC
 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 68

69. Long Run Cost with Economies
and Diseconomies of Scale
69

70. Long Run Cost with
Constant 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
70

71. IV. Profit
1. Definitions
Profit
a.
 There are some circumstances
that the enterprise does not
want to have profit

72. Marginal Revenue, Marginal Cost,
and Profit Maximization
 Can study profit maximizing output for any
firm, whether perfectly competitive or not
 Profit (π) = Total Revenue - Total Cost
π (q) = R(q) − C (q)
 If q is output of firm:
 TotalRevenue (R) = Pq
 Total Cost (C) = C(q)
 Firm selects output to maximize difference
between revenue and cost
72

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
73

74. Profit Maximization – Short Run
Profits are maximized where MR (slope at
Cost, A) and MC (slope at B) are equal
Revenue,
Profit Profits are
C(q)
($s per maximized
year) where R(q) –
A C(q) is
R(q) maximized
B
0 Output
q0 q*
π(q)
74

75. Marginal Revenue, Marginal Cost,
and Profit Maximization
 Profit maximized at point at which
additional increment to output
leaves profit unchanged
π = R −C
∆π ∆R ∆C
= − = MR − MC = 0
∆q ∆q ∆q
MR = MC
75

76. b. Accounting and Economic Profit
- Accounting profit
- Economic profit
c. MR (Marginal Revenue)

77. 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?
77

78. 2. Profit maximizing
MR = MC
3. Total revenue maximizing
MR = 0

79. 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 ) + C(q2 ) − C(q1 ,q2 )
SC =
C(q1 ,q2 )
 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
79