Bridging Economics Chapter 3 Subject Guide

Chapter 3: Production and the behaviour of the firm
Chapter 3: Production and the behaviour

of the firm
Learning outcomes
At the end of this chapter, you should be able to:
define the concepts of productive efficiency, isoquants and iso-cost,
marginal and average product, constant returns to scale, transaction
costs, diminishing marginal return fixed and variable costs, the
relationship between marginal and average costs
use these definitions to give examples of increasing returns to scale, the
interrelation between marginal cost and returns to scale, homogeneous
production function, and profit maximisation with respect to output
and the firms supply curve
construct cost-functions and derive their relation to the production
function
use diagrams to analyse problems involving short-run and long-run
average cost schedule.
Reading
BFD Chapters 6 and 7.
LC Chapter 6.
Production functions
Reading
LC Chapter 6 p.117.
Production is a process whereby the combined activity of various economic

goods creates another economic good. To simplify our explanations, we
will divide all goods used in the production of other goods into two
categories: Labour (L) and Capital (C). Capital denotes all non-labour
inputs, such as machinery and other physical assets..
In the real world, the L and C inputs are typically aggregates of various kinds
of labour, and various kinds of capital, but again we will simplify and assume
that there is only one kind of labour input and only one kind of capital input.
The process of production simply relates a set of quantities of inputs K
and L (factors of production) to a quantity of output, X. This can be
expressed as a function, X = f(K,L). The function gives the level of output
X for any combined level of capital and labour inputs.
From an analytical point of view, the production function is very much
the same as the utility function (see Chapter 2). In both cases, we use
economic goods to produce another economic good. The difference is that
in the case of the production function we produce tangible economic
goods, while in the case of utility (which is an abstract notion) we
produced a non-tangible economic good.
Since we assume that factors of production are scarce, and that the
output produced is desirable, we are interested in finding the optimal
combination of inputs that will produce the optimal amount of output a
state that we call productive efficiency.
Previously we have
used the letter C to
refer to Capital; from
here on we will use the
letter K, which is the
normal convention in
economics.
Contrast this with

utility functions,
where our goal was to
choose consumption
in such a way as
to maximise utility.
This corresponds to
allocative efficiency.
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02 Introduction to economics
In order to find the state of productive efficiency, we first have to look

at the circumstances of production.
Suppose that a certain commodity X is produced by using labour and
capital. How does this production process work?
In Figure 3.1 we set the horizontal axis to denote the quantity of
labour (L) used (measured in work-hours) while the vertical axis denotes
quantities of capital (K) used (measured in machine hours).

Figure 3.1: Combinations of production inputs.
At A, the combination of L0 units of labour (measured in hours) and K0

units of capital (measured in hours) can produce X0 units of X, so X0 =
f(K0, L0). At any point in quadrant III, the combination of labour and
capital will yield less units of X than X0. All points in quadrant I suggest
combinations of inputs which yield X X0. There are points in quadrants
IV and II where the loss of output as a result of a fall in the level of one
input can be offset by an increase in the use of the other input (compare
this to our analysis of utility in Chapter 2).
Choose a point in the four quadrants at random. What can you say about output in the
quadrant you have pinned?
Put differently, we can increase the level of output if we increase one
or both inputs, just as we could increase utility if we increased our
consumption of one or more goods. However, as with utility analysis, this
implies two things about our production function: First, that technology
is continuous, and second, that the two inputs can be divided and
substituted at all levels. This means that when we move from a point
such as B in quadrant III to a point like C in quadrant I, output increases
continuously as we continuously increase both inputs. Hence, as at B X
X0 and at C X X0, there is a point like D where X = X0. This means that
all the other points of equal output (called isoquants) are located in
quadrants IV and II. Like indifference curves (see Chapter 2), they will
be located on a downward sloping line.
The assumptions of divisibility and substitutability are not as
straightforward as in the case of utility analysis. Divisibility simply means
that we can measure inputs in terms of their time contribution. If there
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is divisibility, we can talk of any fraction of a unit that can affect output.
While some may have difficulties with this, we shall not consider it as a
serious problem. Substitutability is a much more difficult problem.
Consider linear production processes, and assume that we have three
different such production processes, or technologies: T1, T2 and T3. Each
technology requires different combinations of inputs in the production
process, as indicated by the slope of the rays through the origin.
Furthermore, assume that we cannot increase output by merely increasing
one of the inputs. We must use both and maintain the same proportions
between them. (This is called a Leontief-style production function.) So,
in the case of A in process 1, you need L10 units of labour and K10 units of
capital to produce 1 unit of X (Figure 3.2).

!
Figure 3.2: Production isoquants.
The isoquant is L-shaped because increasing only labour or capital

(points B or C) will not increase output. Many people think this is how
production technologies really look. But in such a case there is clearly
no substitutability between the means of production. If you want to
produce 2 units of X using process 1, you will need to move to a point like
D, where both labour and capital have been increased to L11.units of labour
and K11 units of capital. The fixed proportion between the two means of
production is captured by the ratio of capital to labour (K/L) which is
depicted by the slope of the ray from the origin. At both A and D.
However, if we take substitutability to mean that we can choose

combinations of technology, then we may be able to move closer to the
notion of substitutability. If points A and E represent the combination
of capital and labour required for the production of one unit of X under
technologies 1 and 2 respectively, point F represents the inputs required
to produce one unit of X by a combination of the two technologies. The
greater the share of technology 1 has in the production, the nearer F
will be to A. The greater the share of technology 2 in the production, the
nearer F will get to E.
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If, in addition, we have technology 3 to consider, F ' depicts the level of

inputs required for the production of one unit of X with the combination
of technologies 2 and 3. As before, the more of technology 2 we use,
the nearer F ' will be to E. The more of technology 3 we use, the nearer
F F ' will be to G. If indeed we can mix technologies, we can see that the
levels of inputs required for the production of one unit of output are
arranged along the heavy curve in figure n, which may remind you of
the indifference curve. This means that if we have a very large number
of technologies available, the move from one technology to another can
constitute the notion of input substitutability.
Therefore, we would claim that while smooth functions may not directly
capture the nature of the production process, they nevertheless constitute
a good abstraction of it. We will obviously be looking for a function that
will be able to generate similar properties as the mixture of processes (i.e.
smooth isoquants which are convex).
Such a production function is given by X = f(K,L), where f is a realnumber, continuous and twice differentiable function.
Properties of the production function.
Figure 3.3: Properties of the production function.
a. It is increasing in L and K (): As we increase the amount of one or

both inputs used, output increases.
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Figure 3.4: Marginal product.
b. The marginal product (MP) of Capital and Labour: Defines the increase
in output for a one-unit increase of a particular input, keeping the
other one constant:
at L0 for a given level of the other input (K)
We typically assume that the marginal product is increasing for low levels
of an input, but decreasing for high levels. This is referred to as increasing
and diminishing returns to a factor, respectively. This assumption yields
a graph as in Figure 3.4, which depicts the level of output attainable
for every level of one input (here, Labour), keeping the level of the other
input (here, Capital) constant
c. Isoquants: Combinations of K and L which yield the same level of
output are arranged on a curve going through regions IV and II in
Figure 3.3 above. This curve is called the isoquant, and is defined
for every level of output.
d. The slope of the isoquant is defined as dK/dL when X is
unchanged. If we change L by dL, output will change by dL MPL[HS1],
given property (b) above. In the same way, if we change K by dK,
output will change by dK MPK. Along the isoquant, the change in
output as a result of a change in K has to equal the change in output as
a result of a change in L. Hence:
dL MPL = dK MPK
which implies
We thus have to change the amount of K we use by this much to

substitute a unit of L for output to remain unchanged.
e. Diminishing marginal product: because of the diminishing MP.
In terms of Figure 3.5, this means that the slope of the isoquant is
getting flatter as L increases (and steeper as K increases).
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Figure 3.5: The slope of the isoquant.
Returns to scale
Let X denote output. K and L denote the two factors of production, capital
and labour respectively, and f represents the production function:
X = f(L,K).
Returns to scale is a measure of how effective an increase in the scale
of operation would be.
Increasing returns to scale means that the proportionate increase
in output is greater than the proportionate expansion of operations.
Constant returns to scale means the increase in output is
proportionately the same as the increase in operations.
Decreasing returns to scale means that the proportionate increase
in output is less than the proportionate expansion of operation.
In the context of production functions, the scale of operation is
captured by the amount of inputs used. When we talk about changes in
scale we normally mean a change across all inputs. However, you will see
later on that the composition of inputs depends on their relative price, so
the scale of operation would normally relate to the price of the output.
Therefore, a change in scale does not alter the composition of inputs, it
only affects the level of their use. An increase in the scale of production
means that we have increased all inputs by a certain proportion. The
return of this change is measured by the proportionate increase in
output.
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Figure 3.6: Increasing production and returns to scale.
In Figure 3.6, increases in scale are depicted by a movement along a ray

from the origin. The slope of such rays, in this diagram, represents a given
capital-to-labour ratio (K/L) (also known as the inputs composition).
As we move along such a ray, the levels of inputs is increased by the
same proportion (otherwise the inputs composition will change and we
will be doing more than merely expanding our operation) and output
(represented by the relevant isoquants) will rise too.
We began at point A in the above diagram. We may now wish to increase
the scale of our operation by a certain proportion, say ( > 1). We
therefore increase both Labour and Capital by such that KB = KA and LB
= LA. Clearly the input composition will remain constant, thus:
At point B, output too has increased. Let us suppose that XB = XA, which
means that output increased by . Whether or not there are increasing,
constant or decreasing returns to scale depends now on whether is
greater, equal, or less than .
A simple way to look at this issue is by examining functions which have a
special property: homogeneity. This can be defined as follows:
Definition 6
f (X1, , Xn) will be called homogenous of degree t if for all X1, , Xn in its domain
and for all , f (X1, , Xn) = tf (X1, , Xn).
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A homogenous production function means that if we increase all

inputs by a certain proportion, the increase in output can be described
as a function of the increase in inputs. That is to say, can be written as
a function of , (), for instance in the function where, if we multiply
all inputs by , output will rise by = t. We can translate this into a
production function, since represents the proportional increase in
output:
f (L, K) = t f (L, K) = t x
If t = 1, it means that an increase in all inputs by a certain proportion
will increase output by the same proportion ( = t = ). This is the
property of constant returns to scale; it means that as we increase
the scale of our operation by increasing all inputs, output will rise by
exactly the same proportion as the increase in inputs.
If t > 1, it means that an increase in all inputs by a certain proportion
will increase output by a greater proportion ( = t > ). This is the
property of increasing returns to scale.
Finally, if t < 1, then output will increase by a lesser proportion than
the increase in inputs ( = t < ). This is the property of decreasing
returns to scale.
Generally, we assume that all types of returns to scale are present in the
process of production. We believe that increasing returns to scale are
likely at the first stages of production, at low levels of production, and
decreasing returns to scale will appear as output grows. This will often
be due to human factors, such as organisation (i.e. hierarchy) as well as
control as some of the reasons why any operation is bound to encounter
decreasing returns at some stage.
Note: returns to scale refers to a change in all inputs.
If we had increasing returns to scale throughout the production process, what do you
think the optimal number of firms producing a good would be? Why?
Figure 3.7 depicts the production function where the returns to scale
increases at the beginning and decreases towards the end. To make it
simple, suppose that V is a composite input, comprised of both labour and
capital in a certain. proportion. We thus get the relationship between the
level of (composite) input. and the level of output as shown.
Figure 3.7: A typical production function, derived from isoquants.

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Notice (in the right-hand diagram) that at first, fixed increments in output.
require ever-decreasing increases in inputs (which means increasing
returns to scale). Later, one can see that fixed increases in output require
ever-increasing increases in inputs (in other words decreasing returns to
scale).
The corresponding points in the left-hand diagram depict the firms growth
of output when all inputs are increased by the same proportion, along the
ray through the origin. When production functions have the property of
homogeneity, this ray will also become the firms expansion path. This
path depicts all the optimal combinations of inputs with which one can
produce a chosen level of output for given factor prices. As both inputs
change here, this is called the long-run expansion path. We will
discuss the difference between long run and short run in a little while.
Returns to factor (marginal product)

By definition, if there is more than one factor of production, the
contribution of a single factor must be analysed when the other inputs are
held constant. Marginal product tells us how a change in a single input
affects output. If X = f (L, K), then the marginal product of labour is the
change in X (dX) that results from a change in L (dL) when K is constant.
MPL is thus defined by (dX/dL).
Can a function exhibit increasing returns to scale and diminishing marginal product at the
same time? Explain your answer.
Average product
We define the average product as the output per unit of input: AP = X/L.
Short-run

M
!

Figure 3.8: Short-run production functions.
In the short run we assume that not all inputs are variable, unlike the
case considered above, when we looked at the long-run expansion path.
In this case, where there are only two inputs, it means, for instance, that
the quantity of capital (K) is given and we can only change output by
changing the other input, labour. Figure 3.8 depicts the production
function when capital is fixed at a level K0.
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At low levels of production, it is reasonable to suppose that any increase

in the variable input will add to output in increasing increments (i.e.
increasing marginal product). At a certain point the amount of the
variable input, relative to the fixed input, will increase so much that its
contribution to output will have to fall.
Thus, at first, the production function exhibits increasing MPL, and then
diminishing MPL. We can now clearly see that MPL = dX/dL will give us the
slope of the production function (on the right-hand side) for the short-run
case, where the amount of capital is fixed (Question: Why?). Up to point
M, the slope increases, then, it diminishes.
In the left-hand diagram, we can see the corresponding points of
production. These form what one may consider the short-run
expansion path. Along this expansion path the level of capital is fixed
and the only way to increase output is through increases in labour inputs.
Average and marginal product
M

Figure 3.9: Average and marginal product.
In the right-hand graph of Figure 3.8, the slope of the ray from the origin
to any of the three points A, B, C is of the form X/L. This is precisely the
average product of an input, the AP. We can see how it increases between
A and B and diminishes afterwards. At point B, where the slope (the AP), is
at its highest, the slope of the ray equals the gradient of f, and thus equals
MPL. Figure 3.9 depicts these relationships.
The behaviour of the firm

Firms have to make two decisions: how much to produce and which
technology to use (that is, what the input composition will be). The
choice of technology is, in principle, very similar to the way individuals
choose their consumption basket. The production function, which
determines the amount of output produced for given inputs, is similar to
the utility function faced by the consumer.
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We generally assume that firms wish to maximise profit. (Whether this

is really the case and what the consequences might be if it was not, is an
interesting subject which we will not consider here.)
Consider the profit function:
= pX X c(X)
where pX X is the revenue from selling X units of a good, while c(X)
represents the cost of producing them. We shall assume at this stage that
prices (of product as well as inputs) are given (that is, determined by
exogenous factors).
This formulation of the profit function clearly shows how the choice of
quantity and technology affects the profit generated. The quantity chosen will
affect both the revenue and the cost, while the choice of technology will affect
only the cost. We will now separate the effects of the choice of technology and
of quantity in order to understand their impact on the profit function.
One way of separating the effects is to fix a total cost of production, c0, and
then to find the highest level of output which is feasible. This is depicted
in Figure 3.10.
Why would this maximise profit? (Consider the form of the revenue function.)

"
#

Figure 3.10: Profit maximisation: maximising output for given cost.
For a given level of cost c0, the firm can choose all combinations of labour
(L) and capital (K) that are within its budget constraint. The rate at
which the firm can substitute capital for labour is given by the market
exchange rate, which is the relative prices of capital and labour,
here defined as w0/r0 units of capital per labour.
The highest level of output which is now feasible is given by the highest
isoquant. The choice of input combinations is therefore determined at
the point where the isoquant (derived from the production function) is
tangential to the isocost (the firms budget constraint). At that point,
the slope of the isocost, which is the market rate of exchange between
capital and labour, is the same as the slope of the isoquant. The latter is
really the technological rate of substitution between capital and labour.
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This solution implies that at the optimal point, the firm will gain no extra
profit by exchanging labour and capital at the margin. If the firm gives
up some labour, but wants to keep the level of output constant, then the
amount of extra capital needed will cost exactly the amount saved by
reducing labour, leaving the total cost of production unchanged. Point B in
Figure 3.10 is clearly not optimal. If the firm gave up one unit of labour
it would need units of capital to remain at the same level of output. But
in the market place, it can get ( + ) units of capital per unit of labour.
This means that the firm can improve its performance through market
operations, changing the technology it uses.
&
"

Figure 3.11: Long-run expansion paths.
For any given relative factor prices we can get the set of all points where
the firm is producing optimally. These points, captured in Figure 3.11,
are what we call the firms expansion path. It is a long-run expansion
path as all means of production vary in the process of expansion.
In the case where the production function is homogeneous, the expansion
path will be a straight line.
So far, however, we have only talked about the choice of technology (input
composition) which constitutes optimal choice. We have not yet dealt with
the question of how much X to produce. The answer to this depends on
the relationship between output (X) and the isocost lines. This relationship
is explored in the next section.
The cost functions

1. The general form of the cost function in our two inputs model is:
C(K,L) = wL + rK
where w and r are the market prices of labour and capital respectively.
We shall assume that these prices are fixed.
2. Long-run cost function: We assume all inputs to be variable in the long
run. When we discussed production functions, we assumed that low
levels of production exhibited increasing returns to scale. An increase
in output will require decreasing increases in inputs, and hence a
decreasing increase in cost. In Figure 3.12 this is the case between
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the origin and point A. We assumed, when discussing production

functions, that at first, it is most likely that the process of production
will be characterised by increasing returns to scale, hence, an increase
of a unit of output will require a decreasing increase in inputs, thus, a
decreasing increase in cost. For the production function below, this is
the case between the origin and point A.
"

Figure 3.12: Production functions and the total cost curve.
For higher level of outputs (beyond point A), we assume the process
exhibits decreasing returns to scale. Every further increase in output
will require ever-increasing increases in inputs. This means that, for
fixed prices, the total cost of production will increase faster and faster.
See Figure 3.12 for the derivation of the total cost curve from the
production function.
3. Marginal costs: the change in total cost C that results from a change
in output X.
MC is therefore dC/dX. We can clearly see that this is the gradient
of the cost function in the above diagram. Notice that Marginal
Cost and Returns to Scale are inversely related. When there are
increasing returns to scale, there will be diminishing marginal cost.
The production of every extra unit of output will require decreasing
increases in inputs and thus, decreasing cost per extra unit.
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4. Average costs: The cost per unit of output.

Again, as AC = C/X, we can see that average cost is the slope of the ray
from the origin to a point on the cost curve in the above diagram.1
Note from the figure

that MC is equal to
AC only at the point
where average cost is
at a minimum. Thus, the
marginal cost curve will
cut the average cost
curve at the point where
AC is at a minimum.
5. Short run: In the short run, one of the means of production is fixed (the
capital used to set up the production facility, for example) and its costs
are independent of the quantity produced, because we cannot change
the quantity of it that is used. The cost function, therefore, is divided
into two elements:
Fixed Costs (FC), and Variable Costs (VC), which remain a function of
output: VC(X). Hence, we define the Short Run Total Cost as:
SRC = FC + VC(X)
To see how the SRC function behaves, we only have to recall the shortrun production function. The short-run production function has the same
shape as the long-run production function, though for different reasons.
Translating it into a cost function repeats the argument we had for the
long-run. Assume that the amount of capital used is fixed, and that we
can only vary the amount of labour used in the production process.
Whenever marginal product is rising, the cost of an extra unit (the
marginal cost) will be decreasing. This is so because increased
productivity means that one would need less labour than one needed
before for an extra unit of output.
Therefore, the VC(X) part of the SRC behaves in exactly the same
way as the LRC, and has the same general shape. The only difference,
therefore, will be the position of the SRC. Figure 3.13 depicts the
relationship between the long- and the short-run cost functions:

*
&

&
'

1
1

!

!
"

*
Figure 3.13: Long- and short-run production and cost functions.
Given input prices w0 and r0, our long-run level of output X would have
been produced using a K/L ratio (representing a particular choice of
technology) according to the long-run expansion path, which connects
all points where the slope of the isocost lines is equal to the slope of
the isoquants (points such as A or B). If, say, K is fixed at K0 in the
short run, the short-run expansion path is given by the horizontal line
at K0. Clearly, only at point A (and, associated with it, an output level
X0) would the firm be able to use the same combination of K and L in
both the long run and the short run (so for this output level, the level
at which capital is fixed in the short run is exactly the level that would
have been chosen without such a constraint, i.e. in the long run).
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At other levels of output, say a lower level such as X1, the combinations
of K and L used would be different in the long and short run, due to
the fixed amount of capital available. Given the shape of isoquants,
this means that the cost of producing X1 in the short run (at C) must be
higher than the cost of producing the same amount in the long run (at
B): C is on a higher isocost line than B.
Show that this holds true for output levels above X0 as well.
We can see the intuition behind this by noting that firms try to
maximise profits given a number of constraints, such as their available
technologies, input prices and the price they can charge for the output
they produce. If we now introduce an extra constraint (for example the
constraint that capital is fixed in the short run), it is clear that we are
not making the firms job any easier. That is, we cannot be lowering
its cost of production. At best (for an output level X0), the cost stays the
same; for other output levels, it will increase.
6. The relationship between long-run and short-run average cost (LRAC
and SRAC):

&

&

Figure 3.14: The derivation of SRAC and LRAC.
The top part of Figure 3.14 again shows the Long-Run and Short-Run
Total Cost functions. As before, we can find the average costs for each
level of output by calculating the slope C/X of a ray from the origin. Given
the shape and position of the SRC and LRC discussed before, we can see
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that for any given level of output, the slope of the ray that reaches the SRC
must be at least as great as that of a ray reaching the LRC. Therefore, the
SRAC will be greater than or equal to the LRAC. Equality is achieved only
when the long run and the short run use the same input combinations.
Application
Let us analyse the effects of a fall in the wage rate on the long-run cost.

Figure 3.15: A fall in the wage rate.
Suppose we are producing X0 with a total cost of C0 (point A in the above

diagram). The slope of the isocost line is w/r. Now, as the wage rate
falls, the intercept of the isocost line (associated with the same total cost
as before, C0) shifts to the right along the L-axis. Point B depicts the new
optimal level of production at the current level of cost if all means of
production are variable. We see that for the same level of cost we can now
produce more of X.
In order to see what happens to the total costs at any level of output,
we must consider what the cost would be of producing optimally the
previous quantity of X (X0). The broken line at point C, on the same
isoquant as before, gives us this information. Clearly, this broken line,
which has the same slope as our new isocost line, reflects a lower cost than
that going through point A.
Hence, for any level of output, total cost will fall and so will the average
cost. As the marginal product of any of the inputs has not changed, it will
also cost less to increase output by a single unit of output at any level of
production.
Producer behaviour with respect to output

So far we have mainly looked at the question of how a producer will choose
the combination of labour and capital which will bring about maximum
profit for any amount of X he might intend to produce. In other words, we
have minimised the cost of producing some output X. Naturally, there is also
the question of how much to produce in the first place. To analyse this, we
simply have to rewrite the profit function and take a closer look at the role
of X (the level of output) in determining the maximum profit.
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The producers problem will now be written as:

max (X) = R(X) C(X)
Our analysis of how to minimise the cost of production for any level of X
told us all we need to know about the cost function C(X). However, we do
not know much about the revenue function R(X).
The revenue each firm earns is simply the price of its output multiplied by
the quantity sold. Its general form is:
R(X) = pX(X)X
where pX(X) is the inverse demand function which the producer confronts.
In a perfectly competitive market where his choice of output does not
influence the price R becomes simply:
R = pXX
What is max per unit of X produced on production of 500 units when total R = 6,250
and total C = 3,975?
In general, a change in R can be broken down to dR = dPX +dXP, where
dPX is the loss of revenue on previous sales (if the price of X decreased)
and dXP is the gain on new sales at the current price. By now, this should
sound very familiar. If not, read again the section on the price elasticity of
demand.
We now want to know how revenue changes when we produce one more
unit of X. We call this change in revenue the marginal revenue and we
denote it by MR = dR/dX.
In the case of perfect competition, where the firms behaviour does not
influence the price, the sale of one more unit will increase revenue by the
price we get for that unit. In other words, the competitive firms revenue
will change according to the change in sales. The price will not be affected
by these changes. Hence:
dRPC = pX dX
If we divide this by dX, we get the marginal revenue:
Hence, the marginal revenue in the case of perfect competition is simply

the price of the output in the market.
For more general revenue functions, we can find the marginal revenue by
similar means. All we have to do is to take the derivative of the revenue
function, R(X) = pX(X)X, with respect to X. We find that:
where dP/dX is the derivative of the demand function. It shows how the
price will change if output is changed. As dP/dX <0, it is clear that MR(X)
< PX(X); that is, the MR(X) curve will normally lie below the demand
schedule.
Are there any situations in which this would not be true?
109
Now, if we multiply and divide dP/dX X by P/P, we can write:
where is the price elasticity of demand.

In a perfectly competitive market, the price elasticity of demand which the
individual producer confronts goes to infinity. Therefore:
Now that we have studied the revenue function, we can add it to the cost
function which we studied before. Recall that (X) = R(X) C(X). For a
firm in a perfectly competitive market, we can thus derive the following
profit function:

Figure 3.16: Cost, revenue and the profit function for a perfectly competitive
market.
The R function of a competitive industry has a constant slope, PX, which

is the firms MR (= dR/dX). The greatest distance between it and the cost
function is always where the gradient of C(X) (i.e. MC(X)) equals the
gradient of R (MR). However, there are two points where the distance is
the furthest. In the one case we will be minimising profit; in the other, we
will be maximising it. Therefore, although MR(X) = MC(X) is a necessary
condition for profit maximisation, it is not a sufficient one.
110
Instead of exploring the mathematics of second order conditions (which

would let us choose the output level which actually maximises profits),
let us take another look at the profit function. Clearly, what distinguishes
the profit maximisation point from the other optimal solution (albeit to a
different problem) is that profits are positive.
We can rewrite the profit function in the following way:
Clearly, for > 0, we need that PX > AC(X).

We can summarise our analysis so far in two principles which will guide
the behaviour of the firm:
1. The decision over how much to produce.
The answer is to produce such as quantity of X that:
MC(X) = MRc = PX
2. The decision over whether to produce at all.
The answer here is to produce as long as:
PX AC(X)
Hence, provided that condition (2) is satisfied (i.e. provided the firm is
willing to stay in the market), the supply of the firm will be guided by the
part of the MC(X) function which is above the AC(X) function. We shall
call this part the supply curve of the firm.
Note: You should pay attention here to the difference between the short
and the long run and the roles of both average cost and average variable
cost.
To complete the analysis make sure that you can use Figure 3.17 alone to explain the
two principles which constitute the firms behaviour.
Figure 3.17: The firms supply curve.
111
A numerical example
Production functions
Consider the production circumstances of a good X which requires only
one input (labour) for production. The technology available has the
following results:
L
TP = X
AP = X/L
MP = dX/dL
24
12
15
42
14
18
60
15
18
75
15
15
87
14.5
12
96
13.7
101
12.6
101
11.2
10
95
9.5
Figure 3.18 depicts how total product (TP), average and marginal
product (AP and MP) change with the change in input (L). You can also
see how they relate to each other.

Figure 3.18: TP, AP and MP: a numerical example.
Notice that as long as the marginal product is greater than the average
product, the latter is rising. This is because the marginal product describes
the contribution of the last unit of input. As long as this contribution
112
is greater than the average, the average will have to rise. In brief, what
you see is that the AP is at its highest when it is the same as the marginal
product. If the marginal product is diminishing, every extra unit of output
will require more and more inputs. Thus, the product per input will have
to fall. The reason why it does not fall immediately when marginal product
begins to fall is that the increases in output at the beginning were so great
that it takes a much sharper decline in productivity to change the direction
of the average product.
Cost functions
Suppose now that the production of X requires a licence which costs
1,130.
A labour unit costs 900 (for the duration of the production process). We
can therefore distinguish between fixed costs (FC) which are unaffected
by the level of output produced, and variable costs (VC), which reflect the
level of production. Together, these give the total cost (TC) of producing a
given level of output X:
TC = FC + VC
The average cost (AC) is simply TC/X. Naturally, average cost is the sum
of the AFC (= FC/X) and AVC (= VC/X). The marginal cost (MC) is the
change in cost per extra unit of output. Evidently, this change will depend
on the productivity of labour. The more productive labour is, the less
labour units will be required for the production of one unit of output.
For instance, one unit of labour may produce 9 units of X. Hence, one X
would require 1/9 units of labour. Note from the previous table that 9 is
the marginal product of the first labour unit. Hence, the amount of labour
required for the production of one unit is always 1/MP. As we pay W =
900 per labour unit, the cost of one unit of output will be [900 1/9] =
100. In general, therefore, we can write:
Given this information, we can calculate the cost functions for the firm:
L
TP = X
FC
VC
TC
AFC
AVC
AC
MC
1130
900
2030
125.6
100.0
225.6
100
24
1130
1800
2930
47.1
75.0
122.1
60
42
1130
2700
3830
26.9
64.3
91.2
50
60
1130
3600
4730
18.8
60.0
78.8
50
75
1130
4500
5630
15.1
60.0
75.1
60
87
1130
5400
6530
13.0
62.1
75.1
75
96
1130
6300
7430
11.8
65.6
77.4
100
101
1130
7200
8330
11.2
71.3
82.5
180
The general generation of the U shaped AC function is depicted in the

lower graph of Figure 3.19. Clearly, AC = AFC + AVC. Since FC is
unchanged as output increases, FC/X will be declining as X increases. Due
to diminishing Marginal Product, every extra unit of output will require
ever-increasing cost. Hence, VC/X is rising with output. For very low levels
of X, FC/X is a large number while VC/X is small. The shape of the AC will
thus be dominated by AFC. For large X, FC/X is almost zero. The shape of
AC will thus be dominated by AVC.
113

Figure 3.19: Cost functions: a numerical example.
Profit maximisation
Suppose now that the firm can sell a unit of X for 100. We shall also assume
that whatever the firm does, it will not affect the market price as the firm is
too small. Hence, the revenue of the firm is PXX and the marginal revenue
(the revenue of the last unit sold) will be the price PX. The following table
describes the situation of the firm under various levels of production.
TP
TVC
TC
MR
MC
AVC
AC
100
1130
130
100
900
900
2030
1130
100
100
100.0
225.6
24
100
2400
1800
2930
530
100
60
40
75.0
122.1
42
100
4200
2700
3830
370
100
50
50
64.3
91.2
60
100
6000
3600
4730
1270
100
50
50
60.0
78.8
75
100
7500
4500
5630
1870
100
60
40
60.0
75.1
87
100
8700
5400
6530
2170
100
75
25
62.1
75.1
96
100
9600
6300
7430
2170
100
100
65.6
77.4
101
100
10100
7200
8330
1770
100
180
80
71.3
82.5
Notice that profit is maximised (M = 0 and > 0) when MR = MC and

when P = MR > AC.
The firm as an organisation: a note

In everything we have said so far, we treated the firm as an abstract object,
a profit maximising agent. But as we all know, firms are nothing like this.
They are large-scale organisations involving a great number of people with
different skills, wants and background. Can we really say that the firm is
simply a profit maximising agent?
114
Since our purpose in using economics is to describe the world around us,
we have to be aware that the firm is a much more complicated structure
than the abstract notion of a profit maximiser might suggest. This does not
necessarily mean that our representation of those firms as simple profit
maximisers is not true: it might be a fairly good description of how firms
actually behave. Nonetheless, it is useful for us to spend some time looking
at how the organisation of a firm might influence (and be influenced by)
its economic environment.
There are two separate issues which we have to consider when we
examine the organisation of the firm. First, given the current structure of
corporations, where ownership is in the hands of shareholders who are not
the managers, it is not obvious that the managers would necessarily have
the interest of the shareholders close to their hearts.
There is little doubt that the shareholders would want the managers to
maximise profit. Most shareholders are not involved in the firm, and
they have no other consideration apart from profit maximisation. The
managers, on the other hand, are working in the corporation and must
consider the interests of other groups with whom they are in daily contact.
They are salaried, and so their earnings may be slightly less sensitive to
changes in the performance of the corporation than the income of the
shareholders would be (shareholders receive their income in the form of
dividends or of capital gains from selling shares).
Consequently, the shareholders, who have the power to appoint or sack
the managers, will face what is called the principal-agent problem. The
shareholders are the principals who want their agents (the managers) to
maximise profit. The managers have a great informational advantage over
the shareholders, who are less familiar with the issues associated with
running the corporation and are therefore susceptible to all kind of excuses
and stories which the managers can put forward to justify their actions
(and the subsequent reduced profit). The question for the shareholders,
therefore, is how to write a contract that would give the managers the
incentive to maximise profits. One of the most common incentives is some
form of performance-related pay, but whether this actually provides a
sufficient incentive for the managers is a different story.
The second and far more important issue is how the firm (or corporation)
evolved and how it might change. Put differently, why do we have
corporations in the first place?
These are very difficult and important questions to which all economists
must pay attention. Unfortunately, economic theory has not produced any
theories that would do justice to the importance of the question. If we
understood why corporations exist, we would be able to understand how
they operate, what will make them succeed and what will change them.
In this context, I would like to draw your attention to two approaches
to the problem. First we have the real evolutionary approach. This
approach examines how and why corporations have been formed over
the years. For instance, when comparing the evolution of Russian and
Indian village communities, some authors have found that while the
sense of kinship among Indian village communities has decreased, that
among Russian communities remains very strong. A possible explanation
for this phenomenon is that while Indian village communities are located
in relatively populated areas, the Russian villages were located in a vast,
much emptier area. This allowed dissenting groups of people to move
away from existing village communities and set up new ones.
115
The consequences of this difference for the evolution of the institution of

private property were immense. In India, the outcome was the emergence
of private ownership of land, while in Russia, the arable land had been
periodically redistributed and, as one scholar puts it, the village artificer, even
should he carry his tool to a distance, works for the profit of his co-villager
(Maine, H. (1987) The Early History of Institution, London, John Murray, p.81
though admittedly this was a long time ago). Along similar lines, though in
a much more complex setting, one can examine how corporations have been
formed. For instance, one must inquire why it is that the English bankruptcy
laws are so different from the American ones, and what consequences this
might have on the organisation of productive activities.
The second approach is basically trying to explain the corporation from an
analytical point of view. Recall that in Chapter 1 we discussed specialisation
and trade. We saw there that once people specialise, there will be a gap
between how much it costs them to produce a good and how much others are
willing to pay for it. Suppose that you specialise in potato production and you
come to the market once a week with your sack of potatoes. Suppose too that
you would like to find in the market, in return for your potatoes, a nourishing
breakfast. There is a very large gap between what you are willing to pay for
that breakfast and what it really cost to produce. However, if you wanted to
research the breakfast market thoroughly, you would need to invest a great
deal of time. You would need to visit all other producers in the community
and ask them about the properties of the goods which they produce. You will
need to study nutrition to create the bundle of goods which will constitute
your breakfast. During all the time you are researching into the question, you
are not selling potatoes and, if you have to go to the library in the village, you
will even be producing fewer potatoes. So matching your desires with what is
brought to the market will cost you a great deal.
If, instead, someone took on the role of entrepreneur, they would do
the work for you, finding out what you want and roaming the village to
discover whether the combination of goods can be produced, leaving you
to carry on producing potatoes. Alternatively, they may persuade someone
to produce the goods you want, so that next time you go to the market,
they will be there. Given the difference between what you were willing
to pay and what it costs others to produce, the entrepreneur can make a
profit. This is a case where the middle man is most important. Without
the entrepreneur, it would cost you much more to exchange potatoes for
breakfast. The entrepreneur could operate because they were cutting your
transaction cost. As long as this is possible, there will be room for an
organisation like the firm which will do this work for you.
There is an additional problem, however. If the job of the entrepreneur is
simply to sign contracts with various agents to provide a good at a lower
rate than that which the consumer is willing to pay, the source of efficiency
for the organisation is simply the contracts. So again we have the issue of
designing contracts that will create the incentive for the people connected
with the corporation to do their best. However, as contracts do not cover
all eventualities (they are incomplete), there will be instances where
the contract does not specify who is entitled to what, and the question of
ownership emerges.
We have thus come full circle: from explaining private ownership as a
social institution which developed from the crumbling tribal sense of
community, to finding that this institution holds the key to the life of the
corporation. Unfortunately, these areas of research have not yet come
together, but as you can see, there is still a lot to be done to develop the
language with which we discuss economic and social organisation.
116
Self-assessment
Check your knowledge
Check back through the text if you are not sure about any of these.
Define the concepts of productive efficiency, isoquants and iso-cost,
marginal and average product, constant returns to scale, transaction
costs, diminishing marginal return fixed and variable costs, the
relationship between marginal and average costs.
Use these definitions to give examples of increasing returns to scale, the
interrelation between marginal cost and returns to scale, homogeneous
production function, and profit maximisation with respect to output
and the firms supply curve.
Construct cost-functions and derive their relation to the production
function.
Use diagrams to analyse problems involving short-run and long-run
average cost schedule.
Give an example of:
increasing returns to scale
the inverse relationship between marginal cost and returns to scale
a homogeneous production function.
Test your understanding

In this section, you will find a set of problems of the kind you will meet in
the exam. The answers follow on page 118.
Question 1
Short-run average cost always lies above long-run average cost
except at one point. However, while it is clear that with a fixed
amount of one input the firm cannot expand along its long-run
expansion path, it can always use less of it and follow its longrun expansion path. Therefore, short-run average cost should be
exactly the same as long-run average cost up to a certain point.
a. Derive the long-run average cost schedule.

b. What is the difference between the short and the long runs?
c. Derive the short-run average cost schedule.
d. Comment on the above statement.
Question 2
a. Under which conditions will the long-run average cost and marginal
cost be the same?
b. Will the short-run average cost be the same as the long-run average
cost?
c. Will the short-run marginal cost be the same as the short-run average
cost?
Question 3
a. Explain, using diagrams, why the short-run cost function is tangent to
the long-run cost function at one point only.
b. Assuming upward sloping expansion paths, what will happen to the
level of output at which such tangency occurs, the higher is the level of
fixed capital? Does this mean that the level of capital which generates
117
the coincidence of the short-run and the long-run minimum average

costs is an optimal level of fixed capital?
c. Will the long- and the short-run average cost of a production process
which exhibits only increasing returns to scale (at the relevant section
of output) have similar U-shapes? Explain.
Answers
Question 1
a. Deriving long-run average cost. The key issues here are:
associating the shape of the long-run cost function with the relevant
properties of the production function; recognising that average costs
can be depicted by the ray from the origin; deriving the average cost
from the change in the slope of that ray from the origin. All of these are
in the domain of testing ones familiarity with various models.
b. Here, as in part (a), we need a simple exposition of material which is
covered in great detail in the present chapter. First, students should
demonstrate that they recognise the role of fixed costs in the distinction
between the long and the short run. An explanation of the short-run
cost curve and its position relative to the long-run curve is essential.
c. The derivation process should be explained carefully, where we
compare the ray from the origin (the average cost) which is associated
with the long-run cost curve with that ray which is associated with the
short-run curve.
d. Here, the more analytical part of the question begins. The statement
suggests that as we can always produce less with those means of
production which we have, there is no reason why producing less
than the level of output for which both short- and long-run cost
coincide, should cost more than it would if we could vary all means of
production.
The choice of framework here is crucial and, as you see below, it is the
firms optimal choice in the production factors plane:
Figure 3.20
118
Translating the question into the language of the model: It is

proposed in the statement that there is no reason why the firm should
not produce at point C (with the long-run optimal mix of inputs) as it can
always reduce the amount of capital it uses. Obviously, while it is true that
the firm can use less capital, it will still have to pay for the idle means of
production. If at B the short-run total costs are:
CB1 = r0K0 + w0LB1
at C they will be:
CC1 = r0K0 + w0LC1
As LC1 > LB1, the actual costs at C are higher than at B and the configuration
around point C is not really feasible. It is not necessary to construct the
argument in this formal way but as you can see it is clearer and shorter.
Question 2
This is a question about (i) a constant return to scale production function;
(ii) the relationship between the properties of production functions and
those of the cost functions; and (iii) the difference between the short and
the long runs.
a. The main points here are these:
an understanding of the properties of the CRS production function
and its significance for the derivation of the corresponding long-run
cost function with its constant slope and 0-origin
the derivation of the long-run average and marginal cost functions
as depicted in Figure 3.21.

Figure 3.21
You are expected to demonstrate that you understand the geometrical

representation of both the average and marginal cost in the left-hand
diagram.
b. and c. An understanding is required here that returns to scale is a longrun property of production and that it does not affect the short-run
principle of diminishing returns to factor.
119
Figure 3.22
The answers to (b) and (c) are self-evident from Figure 3.22.
Question 3
a. The issue here is a recurring one: why should the short-run cost lie
everywhere above the long-run cost except at one point only? I am
sure that many of you will produce here the familiar picture shown in
Figure 3.23.

Figure 3.23
But this merely constitutes a restatement of what needs to be

explained. We need an explanation for this graph, pointing out
that there is only one combination of inputs which is optimal in the
long run for each level of output. In the short run, one of the means
of production is fixed. Hence, there will be only one level of output
which will be produced using the same input mix in both the long and
the short run. At any other level of output, as the short run adds a
constraint, the cost of production will have to be higher.
The above diagram is fully acceptable if accompanied by a graphic
explanation in the L,K space, where students are expected to produce
the long-run and the short-run expansion paths (Figure 3.24).
120


&
&

#
#
*
'
'
'
&
&
&
Figure 3.24
b. We normally assume that the long-run expansion path is upward

sloping. The short-run expansion path is horizontal. It is easy to see
that there is only one level of output for which the choice of inputs
will be on both the long-run and the short-run expansion path
(point C above). In addition, we expect students to show why at any
other point, the short-run costs are higher than the long-run costs.
Comparing the long-run cost of producing, say, X0 (A) with that of the
short-run cost for producing the same level of output (B) will yield:
CA0 = r0 K0 + w0 LA0 < CB0 = r0K0 + w0 LB0
Hence, the short-run cost lies everywhere above long-run cost with the
exception of point C which is common to both expansion paths.
There are two elements to this section:
To show that the tangency between the long-run and the short-run
average cost curves occurs at higher levels of output the higher is
the level of fixed capital.
"
"
Figure 3.25
121
As in Figure 3.25, this should be fairly obvious (a move from A to B).

The second element is a much more important component in
this sub-question. It is the question whether the level of K which
produces a tangency between the long-run and the short-run
average cost curves at their minimum can be considered as an
optimal level of fixed capital.
Here, you are expected to demonstrate that you understand the
relationship between section (a) and the average cost curve. Ideally,
you are expected to produce diagrams as shown in Figure 3.26,
where you explain how the short-run average cost relates to the
long-run average cost.

Figure 3.26
In addition, we would like you to demonstrate that you understand

that at the minimum of long-run average cost, the short-run average
cost is at its minimum too.
The main part of the answer is the explanation of the significance of
producing at the minimum average cost. We expect you to say that
only if the objective of the firm is to fully utilise its resources will the
minimum average cost be an optimal solution. As such, it can be said
that the level of capital which facilitates production at this level of cost
in the short run can be considered as optimal. However, as this is not
really the objective function of the firm, producing a level of output
where the short-run average cost is tangent to the long-run average
122
cost at the minimum of both functions, doesnt have anything to do

with the concept of optimality.
c. This section is the more demanding part of the question, where we
expect students to produce the cost functions for the long run as well
as the short run in the case of increasing returns to scale. Figure 3.27
shows what should emerge.
Figure 3.27
While the long-run average cost will be falling, the short-run average
cost should have its normal U-shape as increasing returns to scale is a
long-run property of the cost function.
123

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Chapter 3: Production and the behaviour of the firm

Chapter 3: Production and the behaviour

Production is a process whereby the combined activity of various economic

Contrast this with

In order to find the state of productive efficiency, we first have to look

Figure 3.1: Combinations of production inputs.

At A, the combination of L0 units of labour (measured in hours) and K0

Chapter 3: Production and the behaviour of the firm

Figure 3.2: Production isoquants.

The isoquant is L-shaped because increasing only labour or capital

However, if we take substitutability to mean that we can choose

If, in addition, we have technology 3 to consider, F ' depicts the level of

Properties of the production function.

Figure 3.3: Properties of the production function.

a. It is increasing in L and K (): As we increase the amount of one or

Chapter 3: Production and the behaviour of the firm

Figure 3.4: Marginal product.

We thus have to change the amount of K we use by this much to

Figure 3.5: The slope of the isoquant.

Chapter 3: Production and the behaviour of the firm

Figure 3.6: Increasing production and returns to scale.

In Figure 3.6, increases in scale are depicted by a movement along a ray

A homogenous production function means that if we increase all

Figure 3.7: A typical production function, derived from isoquants.

Chapter 3: Production and the behaviour of the firm

Returns to factor (marginal product)

Figure 3.8: Short-run production functions.

At low levels of production, it is reasonable to suppose that any increase

Figure 3.9: Average and marginal product.

The behaviour of the firm

Chapter 3: Production and the behaviour of the firm

We generally assume that firms wish to maximise profit. (Whether this

Figure 3.10: Profit maximisation: maximising output for given cost.

Figure 3.11: Long-run expansion paths.

The cost functions

Chapter 3: Production and the behaviour of the firm

the origin and point A. We assumed, when discussing production

Figure 3.12: Production functions and the total cost curve.

4. Average costs: The cost per unit of output.

Note from the figure

Figure 3.13: Long- and short-run production and cost functions.

Chapter 3: Production and the behaviour of the firm

Figure 3.14: The derivation of SRAC and LRAC.

Figure 3.15: A fall in the wage rate.

Suppose we are producing X0 with a total cost of C0 (point A in the above

Producer behaviour with respect to output

Chapter 3: Production and the behaviour of the firm

The producers problem will now be written as:

Hence, the marginal revenue in the case of perfect competition is simply

Now, if we multiply and divide dP/dX X by P/P, we can write:

where is the price elasticity of demand.

The R function of a competitive industry has a constant slope, PX, which

Chapter 3: Production and the behaviour of the firm

Instead of exploring the mathematics of second order conditions (which

Clearly, for > 0, we need that PX > AC(X).

Figure 3.17: The firms supply curve.

Figure 3.18: TP, AP and MP: a numerical example.

Chapter 3: Production and the behaviour of the firm

The general generation of the U shaped AC function is depicted in the

Figure 3.19: Cost functions: a numerical example.

Notice that profit is maximised (M = 0 and > 0) when MR = MC and

The firm as an organisation: a note

Chapter 3: Production and the behaviour of the firm

The consequences of this difference for the evolution of the institution of