Chapter 5: Profits and Costs
Technologies
A technology is a process by which inputs are converted to an output. E.g. a computer,
a projector, electricity, and software are being combined to produce this lecture.
Usually, several technologies will produce the same product -- a blackboard and chalk
can be used instead of a computer and a projector. But which technology is “best”?
xi denotes the amount used of input i; i.e. the level of input i
y denotes the output level. The technology’s production function states the maximum
amount of output possible from an input bundle.
Technologies with Multiple Inputs
What does a technology look like when there is more than one input?
The two input case: Input levels are x1 and x2. Output level is y.
( )
1 1
EXAMPLE: y=f 2 x 3 ∗x 3
1 2
1 1
The maximal output level for the input bundle (x1, x2) = (1, 8) is: y=2∗1 3∗8 3 =4.
1 1
The maximal output level for the input bundle (x1, x2) = (8, 8) is: y=2∗8 3 ∗8 3 =8.
The y output unit isoquant
is the set of all input
bundles that yield at most
the same output level y.
Marginal (Physical) Products
The marginal product of input i is the rate-of-change of the output level as the level of
input i changes, holding all other input levels fixed.
∂y
That is: MPi =
∂x
Law of Diminishing MP
The marginal product of input i is diminishing if it becomes smaller as the level of input
i increases. That is if:
Technical Rate-of-Substitution
Returns-to-Scale
Returns-to-scale describes how the output level changes as all input levels change in
direct proportion (e.g. all input levels doubled, or halved).
There are three types of returns-to-scale: - Constant Returns to Scale
- Diminishing Returns to Scale
- Increasing Returns to Scale
The Long-Run and the Short-Runs
The long-run is the circumstance in which a firm is unrestricted in its choice of all input
levels.
A short-run is a circumstance in which a firm is restricted in some way in its choice of at
least one input level. There are many possible short-runs.
Examples of restrictions that place a firm into a short-run:
- temporarily being unable to install, or remove, machinery
- being required by law to meet affirmative action quotas
- having to meet domestic content regulations
Profit Maximization
A firm uses inputs j = 1…, m to make products i = 1, …n.
Output levels are y1, …, yn.
Input levels are x1, …, xm.
Product prices are p1, …, pn.
Input prices are w1, …, wm.
The competitive Firm: The competitive firm takes all output prices p1, …, pn and all
input prices w1, …, wm as given constants.
Economic Profit: The economic profit generated by the production plan (x1, …, xm, y1,
…, yn) is: π= p1 y 1+ …+ pn y n−w1 x 1−…−w m xm (PROFIT = REVENUE – COST)
Suppose the firm is in a short-run circumstance in which x 2 ≡ ~
x2 . Its short-run
production function is y=f ( x 1 , ~
x2)
The firm’s fixed cost is FC =w2 ~
x 2 and its profit function is π= py−w1 x 1−w2 ~
x2
A $π iso-profit line contains all the production plans that provide a profit level $π. A $π
iso-profit line’s equation is π= py−w1 x 1−w2 ~x2
Cost Minimization
While Profit Maximization is in the short-run, cost minimization is in the long-run.
A firm is a cost-minimizer if it produces any given output level y >= 0 at smallest
possible total cost.
Min. w1x1 + w2x2 subject to f(x1, x2) = y.
Iso-cost lines: A curve that contains all of the input bundles that cost the same amount
is an iso-cost curve. The same as isoquant and line of indifference.
Example:
The slope of all of the
iso-cost lines will be
the same.
When minimizing a cost function, we have to do as follows:
The minimum x1* and x2*
will be the point were the
iso-cost line is tangent to the
cost function.
The levels x1*(w1,w2,y) and
x2*(w1,w2,y) in the least-
costly input bundle are the
firm’s conditional demands
for inputs 1 and 2.
COST MINIMIZATION EXAMPLE
Y = f(x1, x2) = x1^1/3 * x2^2/3
Input prices are w1 and w2.
Average Total Production Costs
c ( w1 , w2 , y )
AC ( w 1 , w 2 , y )=
y
Constant Returns-to-Scale and Average Total Costs
If a firm’s technology exhibits a constant returns-to-scale, when total production cost
increases the average production cost does not change.
If a firm’s technology exhibits decreasing returns-to-scale, then doubling its output
level from y’ to 2y’ requires more than doubling all input levels. Total production cost
more than doubles. Average production cost increases.
If a firm’s technology exhibits increasing returns-to-scale, then doubling its output level
from y’ to 2y’ requires less than doubling all input levels. Total production cost less
than doubles. Average production cost decreases.
Fixed, Variable & Total Cost Functions
F is the total cost to a firm of its short-run fixed inputs. F, the firm’s fixed cost, does not
vary with the firm’s output level.
cv(y) is the total cost to a firm of its variable inputs when producing y output units.
cv(y) is the firm’s variable cost function.
cv(y) depends upon the levels of the fixed inputs.
c(y) is the total cost of all inputs, fixed and variable, when producing y output units.
c(y) is the firm’s total cost function.
c ( y )=F+ c v ( y )
For y > 0, the firm’s average total cost function is the total cost function over y.
F cv ( y )
AC ( y )= + = AFC ( y ) + AVC ( y )
y y
Marginal Cost Function
Marginal cost is the rate-of-change of variable production cost as the output level
∂ cv ( y )
changes. That is: MC ( y ) =
∂y
MC is the slope of both the variable cost and the total cost functions.
