Economics

(FP0002)

Section 3.1: Markets and Production

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Chapter Three: Firms and Production
Section 3.1: Production

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 Learning Objectives

By the end of this chapter students should be able to:

• Define the production problem of firms.
• Explain the different types of market structure.
• Define the concept of market failure and explain how it arises.
• Define externalities and give real-life examples.
• Define costs (social, private and external) and benefits (social, private and external).
• Explain how governments can intervene to correct market failures.
• Explain what impacts demand and supply in labour markets

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 Learning Objectives

By the end of this section students should be able to:

• Describe production functions for perfect substitutes and fixed proportions
• Form a cost function and describe its sensitivity to changes in factor input costs
• Combine isoquants and isocost lines.

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 Key Concepts

• Profit function
• Production function
• Isoquant
• Isocost line.

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 Introduction

Production :
• production is simpler than consumer choice as we consider the output of a firm (which is
observable) instead of utility (which is not).

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 Profit Mazimization

• Section 7.2.4 of FP0001 Mathematics and Statistics considers an economic application of

optimisation, namely
• Profit maximisation, when a firm wants to determine the level of production which
maximises its profit.
• We define profits as the difference between revenues and costs,
 i.e. profits = revenues – costs.

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 Profit Mazimization
In mathematical notation, we have:
 π = profits
R = revenues
C = costs.
each of these variables will depend on the level of q ( Quantity) . As such, each variable is a
function of q, giving rise to the concepts of a profit function, a revenue function, and a cost
function, where:
π(q) = profit function
R(q) = revenue function
C(q) = cost function.
Therefore, the profit function is defined as: π(q) = R(q) − C(q)

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 Profit Mazimization
Revenue function:
• Assuming perfect competition (formally introduced in Section 3.2) then the firm is
considered to be a price-taker, i.e. the firm’s level of production has no impact on the
market price because it is viewed as being such a small proportion of the total market that
its level of output has negligible impact on the market supply of the good, and hence does
not affect the market price.
• Let the market price be p.
• Under perfect competition, a firm’s total revenue is simply price multiplied by the quantity
it produces.
R(q) =pq
• the profit function is:
π(q) = pq − C(q).

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 Profit Mazimization

• when the firm is a pure monopoly, it is the only firm in the market (so the firm is the
market), and its output directly affects the market price as the demand curve captures the
price consumers are willing to pay for each level of output,
• i.e. we have:
p = pD(q).
• Unlike a perfectly competitive firm, a pure monopoly is a price-setter, or price-maker, such
that price is no longer a fixed constant.
• As a result, the revenue function becomes:
R(q) = qpD(q).
• This then leads to a profit function of:
π(q) = qpD(q) − C(q)
• This profit function is then maximised using differential calculus to determine the profit-
maximising level of output

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 Technology

• All firms face technological constraints, in that ‘nature’ restricts how factor inputs can be combined
to produce a desired output through the available technology.
• A production set shows all possible combinations of inputs and outputs which are technologically
feasible.
• Since factor inputs typically cost the firm money, any firm will want to produce the maximum output
for a particular level of input. As such, a firm will produce at the boundary of the production set.
• A production function (similar to a production possibility frontier) is the function which describes this
boundary.
• Assuming an output amount of q, and an input amount of x, then mathematically the production
function could be represented as:
q = f (x).
• This represents the maximum amount of output, q, for a particular amount of input, x.

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 Technology

Figure 3.1 shows an example of a production set, where the boundary of the set (the production
function) shows that output, q, is an increasing function of an input, x (more of the input is required to
produce more of the output)

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 Technology

• The production function depicted in Figure 3.1 assumed only a single input, x. Of course,
we can extend production analysis to more than one input. Suppose there are two inputs.
We could denote the amounts of these two inputs by x1 and x2 . Mathematically, the
production function is then:
q = f (x1 , x2 ).
• This represents the maximum amount of output, q, for x1 units of input 1 and x2 units of
input 2.

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 Isoquant

• With two inputs, it is straightforward to model production relationships using isoquants.

• An isoquant: is the set of all possible combinations of inputs 1 and 2 which are (just)
sufficient to produce a particular amount of output, q.
• The prefix ‘iso’ means ‘same’, so all points along an isoquant result in the same quantity
being produced.
• Isoquants are similar to indifference curves (along an isoquant there is the same quantity
of output; along an indifference curve there is the same level of utility).
• However, there is a crucial difference. Output is actually observed and quantifiable, and is
subject to the available technology.
• In contrast, utility is an arbitrary value with only ordinal properties

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 Examples of technology

Perfect substitutes:
Suppose you can use pens and/or pencils to write your homework. Let x1 denote the
number of pens, and x2 the number of pencils. As far as writing instruments are concerned,
in practice these are perfect substitutes such that the total amount of homework produced is
determined only by the total number of pens and pencils combined. Here, the production
function can be expressed as:
q = f (x1 , x2 ) = x1 + x2

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Perfect substitutes:
• Production functions for perfect substitutes take the form:
q = f (x1 , x2 ) = ax1 + bx2 .
• In this case a and b are non-negative constants. For such technologies, one unit of output
can be produced using 1/a units of input 1, or using 1/b units of input 2, or any
combination of x1 and x2 such that ax1 + bx2 = 1. This means one factor input can be
substituted for the other at a constant rate, hence why they are perfect substitutes
Note: in order to produce one unit of output, we need a unit of x1 and b unit x2.

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Isoquant

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 Isoquant

• Now suppose the two factor inputs are people and machines, such that to produce output
we need to combine people and machines in fixed proportions, for example one person
operates one machine.
• If there are more people than machines, then the extra people contribute nothing to
production, similarly if there are more machines than people, then the extra machines
contribute nothing to production. So, the total amount of output which can be produced is
the minimum of the number of people and machines.
• The production function is therefore:
q = f (x1 , x2 ) = min {x1 , x2 }.
• Figure 3.3 displays isoquants for the case of fixed proportion inputs. Note that these are
L-shaped just as indifference curves are for perfect complements. .

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 Isoquant

• Figure 3.3 displays isoquants for the case of fixed proportion inputs. Note that these are
L-shaped just as indifference curves are for perfect complements. .

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 Isoquant

• Production functions for inputs used in fixed proportions take the form:
q = f (x1 , x2 ) = min {ax1 , bx2 } ,where a and b are non-negative constants.
• For such technologies, one unit of output can be produced using 1/a units of input 1 and
1/b units of input 2.
• Another way of thinking about it is that q units of output can be produced using q/a units
of input 1 and q/b units of input 2. Additional units of either input (on their own) cannot be
used to boost output.

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 Isoquant

• Cobb-Douglas production functions are also possible and mathematically these have the
general form of:
q = f (x1 , x2 ) = Axa xb 1 2.
• Unlike indifference curves where utility was ordinal, here the values of the parameters A,
a and b matter. The parameter A can be thought of as representing the scale of
production, i.e. the amount of output if one unit of each input was used, because:
q = f (1, 1) = A × 1a × 1b = A.
• The parameters a and b measure the responsiveness of output to changes in the inputs.
Isoquants for Cobb-Douglas production functions resemble the smooth curves seen for
Cobb Douglas indifference curves. An example is shown in Figure 3.4

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Isoquant

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 Cost function

• Earlier, when defining the profit function, we saw that the cost function was one
component of this.
• In the real world, factor inputs are not free (for example, labour and machinery both cost
money), so we need to model the total cost of production, which we do using cost
functions.
• We continue to assume two factor inputs. Suppose the cost (or price) of one unit of input
1 is w1 , and the cost (or price) of one unit of input 2 is w2 , where clearly w1 > 0 and w2
> 0.
• The choice of the letter ‘w’ can be explained by it representing the ‘wage’ of each input.
Mathematically, the firm’s total cost of production, c, when using x1 units of input 1 and x2
units of input 2 is:
c = w1 x1 + w2 x2
• i.e. unit cost times quantity for each input. Note the similarity to the consumer’s total
expenditure seen in Section 2.4.

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 Cost function

• We now rearrange this equation to express x2 as a function of x1 .

x1 x2 = c w2 – w2 w1
• which notice is a linear equation relating x2 and x1 , with an x2 -intercept of c/w2 (here
the y-axis variable is x2 ) and a slope of -w1 /w2 .
• We can draw this as shown in Figure 3.5. At any point along this line, the value of c is the
same, so we call this line an isocost line, remembering that the prefix ‘iso’ means ‘same’
so all points along an isocost line result in the same total cost of production.
• Note the x2 -intercept corresponds to the total cost of production when only input 2 is
used (i.e. when x1 = 0).
• Similarly, the x1 -intercept corresponds to the total cost of production when only input 1 is
used (i.e. when x2 = 0)

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Linear Isocost

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Sensitivity of isocost lines to changes in input costs

• The unit costs of w1 and w2 clearly impact the total cost of production, c.
• Suppose the cost of input 1, i.e. w1 , increases to w1 ’.
• This means input 1 is now more expensive, which makes the firm worse off (it costs more
to use the same amount, x1 , of input 1).
• Suppose the firm has a fixed production budget of c, and so ceteris paribus (other things
equal) an increase in w1 pivots the isocost line inward as shown in Figure 3.6.
• Note that the x2 -intercept is unaffected as this is c/w2 , and we are assuming c and w2
are unaffected (there is a fixed production budget of c, and w2 does not change).
• The new x1 -intercept is c/w1 ’ and represents the amount of input 1 used when x2 = 0.

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Sensitivity of isocost lines to changes in input costs

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Sensitivity of isocost lines to changes in input costs

• Returning to the original w1 , and still assuming a fixed production budget of c.

• A decrease in the cost of input 2, i.e. w2 , now means factor 2 is less expensive which
makes the firm better off (it costs less to use the same amount, x2 , of input 2).
• A decrease in w2 pivots the isocost line outward as shown in Figure 3.7.
• Note that the x1 -intercept is unaffected as this is c/w1 , and we are assuming c and w1
are unaffected (there is a fixed production budget of c, and w1 does not change).
• The new x2 -intercept is c/w2 ’ and represents the amount of input 2 used when x1 = 0.

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Sensitivity of isocost lines to changes in input costs

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Combining isocost lines and the production function

• The producer’s objective is to minimise cost when producing q units of output subject to
the production function.
• This means the producer is trying to produce q units of output at minimum total cost (i.e.
reach the lowest possible isocost line, where lower isocost lines represent lower total
costs of production), while being constrained by the available technology (as represented
by the production function).
• Figure 3.8 combines isocost lines with a production function. Remember that the producer
wishes to be on the lowest possible isocost line (cost minimisation is necessary for profit
maximisation). We see that the optimal solution is the input combination (x1 *, x2 *), i.e.
using x1 * units of input 1 and x2 * units of input 2 will minimise the total cost of production
of producing q when faced with the isoquant shown (which reflects the available
technology, i.e. the combinations of inputs 1 and 2 required to produce q units of output).

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Combining isocost lines and the production function

• Figure 3.8 combines isocost lines with a production function. Remember that the producer
wishes to be on the lowest possible isocost line (cost minimisation is necessary for profit
maximisation).
• We see that the optimal solution is the input combination (x1 *, x2 *), i.e. using x1 * units
of input 1 and x2 * units of input 2 will minimise the total cost of production of producing q
when faced with the isoquant shown (which reflects the available technology, i.e. the
combinations of inputs 1 and 2 required to produce q units of output).

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Combining isocost lines and the production function

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Combining isocost lines and the production function

• At undergraduate level you would consider this exercise for different types of isoquants
(such as for perfect substitutes, fixed proportions and other types of production functions)
while changing w1 and w2 .
• In this course, we will only consider the basic problem for generic isoquants and isocost
lines as depicted in Figure 3.8, just to give you a sense of what constrained optimisation
problems in production can look like.
• You will likely meet these problems both graphically and mathematically in the future.

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 Conclusion

• We have modelled the producer choice problem of cost minimisation subject to a

production function.
• Producers have to pay production costs to make output, where they are constrained by
the technology which is available.
• A production function models how technology converts inputs into outputs. As such,
economists think of producers as cost minimisers.
• An isoquant depicts input combinations which result in the same level of output.
• The exact shape of isoquants depends on the type of technology.
• Combining isocost lines and an isoquant (for producing q units of output) on a single
diagram, the producer faces a constrained optimisation problem - to minimise the cost of
producing q (by being on the lowest possible isocost line) subject to the production
function.

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 Practice

Activity 3.1
• Suppose inputs 1 and 2 are perfect substitutes, although two units of input 1 are required
to produce a unit of output, while only one unit of input 2 is required.
(a) Write down a suitable production function for this technology.
(b) Draw some examples of isoquants for the production function in part (a).

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 Practice

Approaching to Activity 3.1

a) The appropriate production function is:
f(x1, x2) = x1 2 + x2

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 Practice

Approaching to Activity 3.1

b) To construct some isoquants, set f(x1, x2) = x1/2 + x2 = q, for different values of q.
Rearranging, we have: x2 = q − x1 2
hence the isoquants are straight lines with an x2-intercept of q and a slope of −1/2 (so they are
downward-sloping, as expected). If we consider q = 1, 2 and 3, then we plot the lines x2 = 1 − x1/2
(for q = 1), x2 = 2 − x1/2 (for q = 2), and x2 = 3 − x1/2 (for q = 3). These are shown in the figure below

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 Practice

Activity 3.2
Suppose inputs 1 and 2 are used in fixed proportions in a production process. Three units of input 1
are needed with each unit of input 2 to produce one unit of output.
(a) Write down a suitable production function for this technology.
(b) Draw some examples of isoquants for the production function in part (a).

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 Practice

Approaching to Activity 3.2

(a) The appropriate production function is:
f(x1, x2) = min{x1/3, x2}.

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 Practice

Approaching to Activity 3.2

• To construct some isoquants, set f(x1, x2) = min{x1/3, x2} = q, for different values of q.
• For perfect complements, isoquants are L-shaped, here with kinks at coordinates (3q, q).
If we consider q = 1, 2 and 3, then we plot L-shaped isoquants with kinks at (3, 1), (6, 2)
and (9, 3), respectively. These are shown in the figure below:

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