Microeconomics 1

Lecture Note 9

Juyoung Cheong

Kyung Hee University

Theory of the Firm

I Firm: Entity that converts inputs into outputs and sells its
output to the market

I Input: Land, Labor, Capital

I Capital: durable goods used in the production of other goods
Theory of the Firm

1. Unlike utility, output is cardinal — 10 units of output is indeed

5 times more than 2 units of output

2. Unlike the consumer, a firm does not have a budget constraint

I We assume that the firm has access to a perfect capital market
— as long as the production is profitable, it can be financed
Production Function

I The production function describes how inputs are turned into

outputs:
I Q = F (L, K )
I Q: Total Product, L: Labor, K : Capital

I Firms produce maximum quantity that can be produced given

L and K
I efficient production: cannot produce more with given input
Short-Run and Long-Run

Short Run Period of time in which the quantity of at least one

input is fixed
(As a convention, we usually call the fixed input
“capital” and the variable input “Labor”)
Long Run Period of time in which the quantities of all inputs are
variable

I Important: Short-run and Long-run are defined by the

variability of inputs, not length of time!
Short-Run Production

I Short-Run

I Assume capital is fixed

I Q = F (L, K )

I If a firm wants to increase production, it has only one option⇒

increase labor
Properties of Short-Run Production Function

I Total Product (TP)

I Total amount of output that factors of production create
I Total product increases with increases in variable factor (up to
a point)
I Marginal Product (MP)
I The change in output that occurs when one additional unit of
an input is added, holding other inputs fixed.
I MPL = ∆Q∆L = ∂L
∂Q

I Average Product (AP)

I Ratio of output to number of workers used to produce that
output
I APL = QL
I Increasing if MP is greater, decreasing if MP is less.
Law of Diminishing Marginal Product (Returns)

I Diminishing marginal product (returns): As ever larger

amounts of an input are added to fixed inputs, eventually the
MP of the variable input will decline.

I As more and more workers are hired at a firm, each additional

worker contributes less and less to production because the firm
has a limited amount of equipment.

I Not necessary to decline right away

I Only holds if holding other factors constant

I Why? If capital is fixed,

I not enough machines for everyone
I getting in each others way
Law of Diminishing Marginal Product (Returns)

I Diminishing marginal product (returns)

I In mathematical terms, it means that MPL (L, K ) is decreasing

in L (given K ) and MPK (L, K ) is decreasing in K (given L)

I Or, the second derivatives FLL (partially differentiate F w.r.t. L

twice) and FKK (partially differentiate F w.r.t. K twice) are
both negative
Marginal Product and Average Product

I MP curve crosses at height of AP curve.

MP, AP: Mathematical Example

I Suppose Q = F (L, K ) = 40KL − K 2 L2

I What are the marginal product of labor and the average

product of labor when K =10?

I Is it observing diminishing marginal products?

MP, AP: Mathematical Example

∂Q
I MPL = ∂L = 40K − 2K 2 L

I If K = 10, MPL = 400 − 200L

I As L increases, MPL always decreases ⇒ diminishing marginal

returns!

Q 40KL−K 2 L2
I APL = L = L = 40K − K 2 L

I If K = 10, APL = 400 − 100L

Long-Run Production Function

I Firms can produce a given level of output (Q) using a variety

of combinations of inputs

I Q = F (L, K )
I Both L and K can vary to produce a certain level of Q = Q̄.
Contour Lines of the Production Function

I Just like the utility function, the production function is a

two-variable function

I So just as we work with indifference curves for consumers, we

would like to work with the contour lines of the production
function

I Contour lines of the production function are called isoquants

I Each isoquant plots the combination of L and K which yields
the same output level
Isoquants

Q3
Q2
Q1
L
Drawing Isoquants

I Suppose the production function is

1 1
F (L, K ) = L 2 K 2

I Then an isoquant is the collection of all points (L, K ) such that

1 1
F (L, K ) = L 2 K 2 = constant
√
I For instance, if we choose the constant to be 2 3, then we
would like to find the points (L, K ) such that
1 1 √
L2 K 2 = 2 3
LK = 12
12
K=
L
Drawing Isoquants

1 1
F (L, K ) = L 2 K 2
10

L
5 10
Drawing Isoquants

K
12

4
3
2
√
1 Q=2 3
L
1 2 3 4 6 12
Drawing Isoquants

2
√
1 √ Q=2 3
Q=2 2 L
1 2 4 8
Drawing Isoquants

K
12.5

2 Q=5
√
√ Q=2 3
Q=2 2 L
2 5 12.5
Properties of Isoquants

1. Further an isoquant is from the origin, the greater the level of

output.

2. Isoquants do NOT cross.

3. Isoquants must slope downward.

I If upward, firms could get the same output with less inputs
⇒Not efficient!
Slope of an Isoquant
I When we want to find the slope of an isoquant, we are asking
the question:

If I change L by a bit, how much does K have to change in

order to remain on the curve?

I On the isoquant, we have

Q = F (L, K ) = constant

it means
∂Q ∂Q
dL + dK = dQ = 0
|∂L{z } |∂K{z }
change in change in
Q due to Q due to
change in L change in
K
Slope of an Isoquant

∂Q ∂Q
dL + dK = 0
|∂L{z } |∂K{z }
change in change in y
Q due to due to
change in L change in
K
∂Q ∂Q
dK = − dL
∂K ∂L

∂Q
dK ∂L
= − ∂Q
dL ∂K
Slope of an Isoquant

∂Q
dK ∂L
= − ∂Q
dL ∂K
If the change in L is very small,

I ∂Q is the Marginal Product of Labor (MPL ), obtained by

∂L
differentiating the production function with respect to L
(holding K as a constant), also denoted as FL (L, K )

I ∂Q is the Marginal Product of Capital (MPK ), obtained by

∂K
differentiating the production function with respect to K
(holding L as a constant), also denoted as FK (L, K )

I dK is the slope of the isoquant, which is known as the

dL
Marginal Rate of Technical Substitution (between L and K )
Marginal Rate of Technical Substitution

I The Marginal Rate of Technical Substitution (MRTS), which is

the slope of the isoquant (at a certain point (L, K )) is given by

MPL (L, K )
MRTS(L, K ) = −
MPK (L, K )
I Or,
∂F (L,K )
MRTS(L, K ) = − ∂F ∂L
(L,K )
∂K

I Intuitively, MRTS shows ability of a firm to replace one input

(capital) with another (labor) while holding output constant.
Diminishing Marginal Rate of Technical Substitution

I Just as in consumer theory, we assume Diminishing Marginal

Rate of Technical Substitution

I That is, along an isoquant, as the amount of L increases, the

absolute value of MRTS decreases

I Intuitively, holding output constant, it is harder to substitute

capital with labor as the capital/labor ratio falls
(or, it is harder to substitute labor with capital as the
capital/labor ratio increases)

I Again this is an “average is better than extreme” type of

assumption
“Non-standard” Isoquants

1. Perfect Substitutes
I One factor could easily replace another.
I e.g. Q = 2K + L

L
Q1 Q2 Q3 Q4
“Non-standard” Isoquants

2. Factors cannot be substituted at all

I Factors must be used in fixed proportions
I e.g. Q = min{K , L}

Q3
Q2
Q1
L
Returns to Scale

I Scale increase: Proportional increase in inputs

I e.g building a second plant

I NOT holding one fixed, or moving along on isoquant as before

I All inputs increases proportionally
I necessarily a Long-Run analysis
Constant Returns to Scale (CRS)

I Proportional increase in all input levels leads to output growth

in the same proportion

I e.g. double all inputs ⇒double output

I F (2L, 2K ) = 2F (L, K ) = 2Q
Increasing Returns to Scale (IRS)

I Proportional increase in all input levels leads to greater than

proportionate output growth

I Also it is called “Economies of Scale”.

I F (2L, 2K ) > 2F (L, K ) = 2Q

I e.g. double all inputs ⇒tripled output

I F (2L, 2K ) = 3F (L, K ) = 3Q > 2Q

I Reasons:
I Greater specialization:
I assembly line vs. one person does all
I Learning by doing:
I correct mistakes made originally
Decreasing Returns to Scale (DRS)

I Proportional increase in all input levels leads to less than

proportionate output growth
I Also it is called “Diseconomies of Scale”.
I F (2L, 2K ) < 2F (L, K ) = 2Q
I e.g. double all inputs ⇒one and half more output
I F (2L, 2K ) = 1.5F (L, K ) = 1.5Q < 2Q

I Reasons:
I Organizational difficulties
I Less efficient resources used
Examples

1. Cobb-Douglas Prodcution Function

I Q1 = ALα K β , where A: Technology

I If doubled input,
I Q2 = A(2L)α (2K )β = 2α+β ALα K β = 2α+β Q1

I If α + β = 1,Q2 = 2Q1 . ∴CRS.

I If α + β < 1,Q2 < 2Q1 . ∴DRS.
I If α + β > 1, Q2 > 2Q1 . ∴ IRS.
Examples

2.Perfect Substitute Production Function

I Q1 = L + K

I If doubled input,
I Q2 = 2L + 2K = 2(L + K ) = 2Q1

I CRS
Examples

3. Production Function
I Q1 = LK

I If doubled input,
I Q2 = 2L2K = 4(LK ) = 4Q1

I IRS
Returns to Scale on Isoquants

Capital

As we travel along any ray

from the origin, the in-
crement of the isoquant
heights tells us about the
returns to scale

Q1
Q2
Q3
Labor
0
Firm’s Decision Problem

I There are two approaches to look at a firm’s production

decision

1. Consider the profit-maximization problem all in one go

2. Break the production decision into two steps:

First find the minimal cost of producing different levels of
output
Next, using the production cost information, find the optimal
level of output