Firms and Markets Lecture 7 8 Final
Firms and Markets Lecture 7 8 Final
Firms and Markets Lecture 7 8 Final
Price
Demand Curve Price
Demand Curve
Supply
Supply
w/o
w/o
A C subsidy
A subsidy
B
Supply
Supply
with
with
subsidy
subsidy
Quantity
Quantity
APPROACH
Consumers
maximize
their levels
Opportunity of
Costs satisfaction
• Time, Money, and other
resources are scarce
• We make choices in • While we do so, we
Markets allow
presence of this scarcity account for opportunity interaction of
costs the two and
we obtain an
equilibrium
Scarcity
Producers
maximize
their profits
Firms use a technology (production function) to transform inputs (factors of production) into
outputs. The inputs of a firm can be broadly categorized into three categories:
Capital (K): Land, Buildings (factories, stores), and equipment (machines, trucks)
Labour (L): labourers (construction workers, assembly-line workers) , skilled workers (architects, engineers,
plumbers, economists), and managers
Materials (M): Raw goods (oil, water, wheat), and processed goods (aluminium, paper, plastic, steel)
Production function is the relationship between the quantities of inputs used and maximum
quantity of output that can be produced given the current knowledge about technology and
organization
INPUTS
Fixed input is an input whose input does not vary with the production for some time.
The costs for the input do not vary with the level of production
Short run is the time in which at least one factor of production cannot be varied
practically
Long run is a lengthy enough period of time that all inputs can be varied
MORE ON DIMINISHING MARGINAL PRODUCTIVITY…
SHORT RUN PRODUCTION
1 10 14 17 20 22 24
4 20 28 35 40 45 49
Isoquant
q = f ( K , L)
q=14
Isoquants slope downward
CAPITAL
Slope of the isoquant is the marginal rate of
technical substitution (MRTS)
ΔK MPL
MRTS = =-
ΔL MPK
ISOCOSTS
Capital Input (K) All the input combinations that require the
same (iso) total expenditure (cost)
C = wL + rK
w
-
Slope of the line is given by r
Cost Minimization occurs when the
Isoquant is tangent to Isocost. At this
point, the following condition exists similar
to that of consumer’s utility maximization
MPL MPK
=
=100
units w r
At point A, the firm will spend more than it
0 will at B, but produce the same as in point
B
Labor Input (L)
Optimal Input Substitution in Action
Capital Input (K)
I
New cost-minimizing
point due to higher wage
F
B
Initial point of cost minimization
A
H J
0 G Labor Input (L)
SUMMARY
MPL MPK
=
w r
SHORT RUN COSTS
Fixed Costs (FC) are the costs that do not change with changes in output
Variable Costs (VC) are the costs that change with the changes in output
Total Costs (TC) are the sum of fixed and variable costs
SHORT RUN COSTS
(5)=20000*(2
(1) (2) (3) (4)=50000*(1) ) (6)=(4)+(5)
Capital Variable Total
(K) Labour (L)Output (Q) Fixed Costs Costs Costs TOTAL COSTS
2 0 0 100000 0 100000
2 1 76 100000 20000 120000
VARIABLE COSTS
2 2 248 100000 40000 140000
2 3 492 100000 60000 160000
FIXED COSTS
2 4 784 100000 80000 180000
2 5 1100 100000 100000 200000
2 6 1416 100000 120000 220000
2 7 1708 100000 140000 240000
2 8 1952 100000 160000 260000 QUANTITY
2 9 2124 100000 180000 280000
2 10 2200 100000 200000 300000
SHORT RUN COSTS
Identical Products
Full Information
Two Decisions
Output Decision : What is the optimal level q* which maximizes the firms profits?
Shutdown Decision: Is it more profitable to produce q* or to shut down and produce no output?
p
Profit
Rs.
Loss
0 q
SHUT DOWN DECISION
Fixed Cost
Loss if produce
0 q
SHORT RUN FIRM SUPPLY CURVE
MARKET SUPPLY CURVE
LONG RUN AVERAGE TOTAL COST CURVE
LRAC (Rs.)
0 Output
LONG RUN ENTRY AND EXIT
LONG RUN COMPETITIVE EQUILIBRIUM
ECONOMIES OF SCALE
Economies of scale
Portion of the long-run average cost curve where long-run average costs decline as
output increases
Diseconomies of scale
Portion of the long-run average cost curve where long-run average costs increase
as output increases
Economies of scope
Exist when the total cost of producing and together is less than the total cost of producing each of
the type of output separately.
Cost complementarity
Exist when the marginal cost of producing one type of output decreases when the output of another
good is increased.
RETURNS TO SCALE
Constant Returns to Scale – When all the inputs are increased by a certain
percentage the output increases by same percentage
fαK , ) =αf K( L, )
( αL
Increasing Returns to Scale – The output increases more than in proportion to equal
increase in inputs
fαK , ) >αf K( L, )
( αL
Decreasing Returns to Scale – The output increases less than in proportion to equal
increase in inputs
fαK , ) <αf K( L, )
( αL
COBB DOUGLAS PRODUCTION FUNCTION
q = ALα K β
The returns to scale of a cobb-douglas production function will depend on the sum
of the powers of labour and capital function