Chapter 19

Technology
Production theory: the output is observable
 Inputs called: factors of production (labor land, raw materials)
 Capital goods: machines, tractors, buildings
 Financial capital: money

Output measured in amount of good produced and input measured in amount of labour hours.
Production set: all the technological choices that a firm can have in order to produce less tan the
maximum.

A production function describes the maximum posible output for a certain input.
 Profit maximization = firm always produce the maximum available from the inputs. If not firm will
be including money for not extra revenues.

Technology with two inputs: isoquants.

 All combinations of input 1 and 2 to generate a same amount of output.
 Isoquants are similar to indiff curves
 Difference: they are labeled with the amount of output they produce not utility as indiff curves and
also is fixed by the technology and not as an arbitrary nature as the utility.

Perfect Substitutes/ perfect complements / cobb douglas ( one of the best examples of well-behaved
isoquants)

Whatever level of output a producer chooses to produce, it will want to do this at the lowest cost.

Monocinity: The assumption that if any input increases, output will also increase (or at least will not
decrease)

Convexity: if we have that two ways of producing y output (x1,x2) and (z1,z2), then we know that their
(weighted) average will also produce at least this level.

 In indiff curves : the assumption that averages were (at least weakly) preferred to extremes.
 The 2 ways of producing y are called “production techniques”
 If the production activities are independent the weighted averdage production are also feaseable. (
production processes done interfeer with each other) pag 355.

Marginal product: extra output we get form having one more unit of factor 1 or 2.

 IS A RATE. The extra amount of output per unit of extra input

 Just like the concept of marginal utility. Expect for the ORDINAL NATURE of utility.

Law of diminishing marginal product: not really a law just a common feature of most kinds of
production processes.

 The marginal product of a factor will diminish as we get more and more of that factor
(expample more and more workers working on the same land will get less and more less
products of it)
 Monotonicity implies that MP is always NON-NEGATIVE.
Technical rate of substitution: slope of the isoquant. How much extra of factor 2 we need if we
want to give up a little bit of factor 1. Measures the trade-off between 2 inputs in production in
order to keep the putput constant.

Diminishining techincal rate of substitution: as we increase in the amount of factor 1 (moving

right in the x axis) the TRS will decrease and it will increase if we move in direction increasing x2
(y) .

Diminishing TRS is related to diminishinf MP but different.

 MP: how the marginal product changes as we increase the amount of x1, holding the
other fixed.
 TRS: how the ratio of marginal product changes as we increase the amount of one factor
and decrease the other as to stay in the same isoquant.

Long run and short run:

 Short: one factor of production is fixed (farmer stuck with the same amout of land to
produce)
 Long: all the factors of production can vary (farmer purchase more land)

Returns to scale: increase the number of all inputs to the production function, could be said that
we will scale the inputs up by some constant factor.

Returns to scale shows you what happens when you increase all inputs while diminishing MP
shows what happens if you only increase the amount of one input. (keep the other fixed)

 Constant: n times the input will give you n times the output.
 Increasing: n times the input will give you more than n times the output.
 Decreasing: n times the input will give you less than n times the output.

If all af the merginal products are diminishing here could be an increasing return to scale? YES.

 Marginal product diminishes because the other input levels are fixed, so the increasing input’s units
each have less and less of other inputs with which to work.
 When all input levels are increased proportionately, there need be no diminution of productivity,
since each input will always have the same amount of other inputs with which to work. Input
productivities need not fall and so returns-to- scale can be constant or increasing.

Chapter 20

Profit maximization
Profit: revenue – cost

Note: if an infividual works on his own firm, his labour in an input a should be counted as a cost and his
wage is simply the market price of labour.

 Value of all inputs and outputs at their opportunity cost (cost of the market)
 To employ a factor should be market price
 Sell the product at the market price (not more, not less)
Firms taking the prices of products as fixed is a reflection of a compeititve market. All agents are “price
takers” not single agent is big enough as to influence the price.

Long run: firm is free to decide to use zero inputs and produce zero outputs and go out of the business.

 Also: he firm is able to vary all factor demands in its effort to profit maximise.

Short run: obligated to employ some factors and produce zero output. Thats why is perfectly possible that
a firm could make negative profits in the short run. (fixed factors should be paid even if the firm decides to
produce zero like machines and building cost)

In the condition of optimization, the value of the marginal product of a factor should equal to its price:
because the marginal product is the change in revenue due to the changed output caused by small change in
quantity of factor 1.

 Increase x1 = increase revenue

This extra factor has a cost. If the extra cost is smaller than the revenue ITS WORTH IT and increasing
profit.

 If the cost exceds the extra revenue its NOT WORTH IT. The profits will be increased by reducing
the demand of this factor.
 We can set π equal to a constant and think of the relationship between the quantities y (revenues) and x1
(cost) hat mantains a certain level of profits.
 Equation its a line with slope w1/p called isoprofit lines.

Isoproft lines: all combinations if an input goods and the output good that give a constant level of out profit pi. We
have the other parallel lines as pi varies.

 Profit maximisation implies reaching the highest attainable isoprofit line: a higher line represents
higher profits
 FIND THE POINT IN THE PRODUCTION FUNCTION THAT HAS THE HIGHEST ASSOCIATED
ISOPROFT LINE. When they are tangent.
 The slope of the production function equal to isoprofit line.
 Slope of the pro = marginal product
 Slope of isoprofit: w1/p

The short-run profit-maximizing plan, the slopes of the short-run production function and the maximal iso-profit line are
equal.

 Slope= w1/p. Higher is the price of the input (w1) stepper will be the line. The o.p moves to the left. This means
that by increasing the price of factor 1 the demand will decrease.
 Lower price of factor 1 (w1)= increase demand
 Higer price of factor = decrease demand
 Higer price of output (product) = increase in the demand of factor 1
 Lower price output = decrease

Reduction in the output price must decrease the supply of output.

Long run profit maximization

If x2 changes there will be no change in the slope (w1/p) = the optimal choice of factor 1 will not change. All the changes
are made in the profts that the firm make.

 At the optimal point the firm could not make any increase in profits by changing factors.
 As long as revenue from an extra unit of a factor exceeds the cost of paying for that factor, output should
expand
• When the cost of employing an extra unit is greater than the revenue benefit, then output should be reduced

Factor demand curves

Mesures the relationship between the price of a factor and the proft maximizing choice of that factor. Inverse demand curve:
what the price of a factor must be for some inouts to be demanded.

Profit maximization and returns to scale

A firm has a long run profit maximizing output and have constant returns to scale and making positive profits. If the input is
doubled the output also. the profits will aso double. This will contradict the rule that at the previous point the firm was not
profit maximizing. So the long run profit should diminish (to 0).

A firm can not have profit max and return to scale long run. In a competitive market equilibrium. Is possible in a non
cometitive.

 Economic profits are NOT the same as accounting profits

 Economic profit: take into account xplicit and implicit costs.
 Accounting cost: only explicit

Accounting: It is a company's total revenue reduced by the explicit costs of producing goods or services.
 These explicit costs involve direct monetary movement and include expenses such as the cost of raw
materials, employee wages, transportation, rent and interest on capital.
Economic: also revenues – cost but also implicit cost. (also the things that you are using that are of your own
that could be selled to somebody else)
 Examples of implicit costs include company-owned buildings, equipment and self-employment
resources.

economic profit are generally lower than accounting.

For a firm that has constant return to scale and perfect competition at all levels of output the profit will be zero in
equilibrium.

1. The firm will get so big that inefficient

2. The firm so big that has a monopoly no reason to take the price as given
3. If one firm can access to more input also another so there will be more competition and the price of output
will decrease, lowering the profits.

Chapter 21

COST MINIMIZATION (non com market)

 In order to have profit maximization there must be minimization cost. a firm can be a profit maximiser only if
it is a cost minimiser. (see slide 15)

Break the profit-maximization problem into two pieces: minimize cost of producing and how to choose the most
profitable level of output.

 minimum cost of producing any level of output (for the given factor prices). Constraint how low to put min
cost is given by the input and level of output.

Cost function: the minimum cost necessary to achieve the desired level of output

Isocost line: all combinations of inputs that have same cost ( c ). As c varies.
 All parallel to each other because changes the cost but not the amount of inputs used.
 Then to find the lowest cost of producing output y need to find the lowest isocost curve that is compatible
with the isoquant for the output level y
Optimal point: graph with x1 , x2. If the isoquant is a nice smooth curve (well behaved technology
and positive solution) then is the tangency between isocost and isoquant.
 The slope of the isoquant = the slope of the isocost
 The techinnical rate of substitution must equal to the price ratio.
 lowest cost of producing output y need to find the lowest isocost curve that is compatible with the isoquant for
the output level y

The cost minimising firm can maintain output by trading factors at the rate at which the market allows them to
be traded.

(if we dont utilize one of the two factors them this tangency condition does not exist)

 in the utility problem we were maximising the quantity labelling the curved (indifference) line, subject to the
constraint of a fixed budget
 in the firm’s problem we minimise cost (the quantityonthe straight line) subject to achieving a given level of
output (the quantity on the curved line)
 [Minimisation & maximisation give similar conditions of optimality]

Conditional factor demand: measure the relationship between prices, output and the optimal factor choice of the firm. (optimal points). How
much of each factor would the firm use if it wanted to produce a certain output in the cheapest way.

X1 * = x1 ( w1 , w2 , y) X2 * = x2 (w1, w2 , y)

Distinct from profit maximising factor demands, but will equal profit maximising demands if y happens to be the
profit maximising output .

Conditional factor demand functions: gives the cost minimizing choices for a level of output
Profit maximizing factor demand: gives the profit maximizing choices for a given price of output.

Examples of cost functions

Perfect complements: the factors are perfect complements. If we want to produce y of output we need y units of x1 and y units x2.
Perfect susbstitutes: the firm will use the cheaper.
Cobb-douglas: the cost will increase or decrease as a and be changes.

Long run and short run costs

Short run cost function: the minimum cost to produce a certain output only adjusting the variables factors.
Long run cost function: the minimum cost of producing a certain output adjusting all the factors of prodution.

Fixed cost: do not vary with the output, be paid in the short run even if the output is 0
Variable cost: vary with the output , if the out put is 0 then 0.
In a long run all cost are variable.

Average cost: are the cost for each product ( production cost / number of output)

Cost function and return to scale:

Constant returns to scale: average costs do not vary with output
Increasing return to scale: doubling output requires less than doubling inputs so the average cost will decrease with
the output increasing.
Decreasing returns to scale: doubling output requires more than a doubling of inputs, and hence average costs increase with output
increases.

CHAPTER 22

COST CURVES
Cost curves: to draw the cost function.
Cost: sum of fixed + variable costs
Fixed cost: do not vary with output, they are payments that need to be done and paid regardless of the output.
Variable cost: vary with the output.

Average cost: cost per product

Average variable cost function: variable cost per unit of output. Will increase because as more output is made because as more output is
prodiced workers will work less efficiently and increase variable cost. (for diminishing marginal product) people will start getting in each others
ways so to make the same output it will cost more work.
Average fixed cost production: fixed cost per output

If the average variable cost curve equals the marginal product then the average cost is constant with the output.

Marginal cost (additional cost of producing one more unit)

Interest is the marginal cost curve.
 Marginal cost curve: the extra cost to produce a an extra unit
measures the change in costs for a given change in output. (at any increases of output how cost will change)
 In a competitive market the marginal revenue = market price

Rate of change: change of cost with output

 in the first product produces the marginal cost = average variable cost.

If the marginal cost is higher the variable cost curve then the average cost curve is increasing. And viceversa.

1. Average variable cost may inicially slope down. It will eventually rise, as long they are fixed factors
2. Average cost curve will inicially fall due to the fixe cost and increase due to the variable cost
3. Marginal cost = variable cost equal at the first unit of input
4. The marginal curve passes through the min point of both the average var cost and av cost curve.

Average (variable) costs will be neither rising nor falling when marginal cost equals average (variable) costs. Thus the
marginal cost curve will intersect average total costs and average variable costs at their minimum points.

Marginal costs and average variable costs are the same for the initial little bit of output.

At the minimum of the average total cost is reached whe it equals to the marginal product.

Long - short run cost

Long: There are not fixed factors meaning that is always possible to produce zero units of output at zero cost, meaning
that is always possible to get out of business.

In the short run the firm will choose an optimal point of production were cost are minimized.

Tangent of short and long run total average cost: this two lines will touch because the long run firms average cost
has to be the same or less than the short cost. (duo to the fact that the firm can improve) they can be the same because
they could also still choosing the same of the short run.
 As the long run changes output this will be different short run’s cost curve. The long run average cost in an
envelope of all the possible average short runs cost curves (so for diff choices of output).

Short and long curves marginal cost: when the short and long run cost are tangent the average total cost is the same
and also the marginal cost.
 The long run marginal cost line is flatter than the short run. (see slide)

Chapter 23 FIRM SUPPLY

A firm have:
1. Technological constraints summarized by the production function (single output can be obtained by single
combinations of inputs)
2. Economic constraints summarized by the const function (cost of inputs that creates certain output)
3. Market constaint (a firm can only produce what people are willing to buy) and the competition between
firms.

When the market it purely competitive the price of the product do not depend on the firm and its indepdendet from the
level of output. All the firms are price takers they take the price of their products as the market price.

Competitive behavior: taking the market price as outside of control. If a firms sell more than the market price they
will not sell, if they sell at the market price they will sell an amount and if it sels at lower than merket price they will
get the entire demand.
Market demand curve: the relationship between market price and the demand. (depends on the costumer)
Demand curve facing a firm: relationship between the markket price and the production. (depends in the behaviour of
other firms)
CHAPTER 23 FIRM SUPPLY

In a competitive market the firm is a price taker. If they put higher price dont sell anything and if they out lower they
will have all the demand.

The marginal cost curve on the firms diagram is the same as the market supply curve because P=MC. A firm
will only supply when the marginal cost curve is positive slope.

There are 2 times that mc=mr one is the min and one is the max. Only chose the one that lies on the positive slope of
mc. Thus. Mc=mr is a necessary condition but not a sufficient.

Shutdown condition: the firm will be better producing 0 is this is complied.

ATC=MC to the left a firm will start supplying. If the pint were mc=mr= price is lower than this the firm will
produce 0.

The supply curve is the upward-sloping part of the marginal cost curve that lies above the average cost curve.
The firm will not produce on the points that are below the average cost curve. Production 0 in order to have
less losses.

In a competitive market if all firms are profit maximizing they will have all the same marginal costs.

Long run: averaga cost curves tends to be flatter. Still getting max profit when mc=mr= p
 If the firms shouts down they can generate 0 profits. Even elimintae the fixed costs.
 The lonr run supply is more elastic as is more responsive to price
 The long run price has to be as least big as the average cost.

CHAPTER 24 INDUSTRY SUPPLY

If the market is competitive all the firms are price takers. Then the industry supply is the sum of firm supplies at a
certain price. If there are 2 firms one producing 10 and the other one 20 the ind. Supply = 30.

In a short run there can not be exit and entries of firms because there are fixed factors. Only in long run.

Even if a firm is making negative profit it will still be better for it to stay in business in the short run if the price and
output lies above the average variable curve. It will be better this than to not produce anything.

LONG RUN: Since all the firms have the same technology to produce the same product their marginal cost curve will
be the same. Which meand the graph in industry supply.
o If a firm is making looses at the long run they have no reason to stay in market no they will exist the industry.
Since exiting make their losses reduce to 0. Meaning that the only part relevant of the long run supply curve
is above the average cost curve. Since this means non negative profits.
o If a firm is making profits we will expect another firm to enter.
o When there are no barriers to enter: industry with free entry
o Berrier to entry: lisenses or legal restrictions.
o Each time that a firm enters or exist from a market the amount produced will change and the price also.
o P = c (y) / y is the minimum value of average point and is the lowest price that it could be charged for the
product and still allow them to break even.
o P`: is the lowest that the price could go being it the lowest possible intersection between s and d. With p’ ≥ p
Long run supply curve: once a firm is making a profit another will will neter making them
o As more firms are in the market there are larger levels of output.
o The supply curve will be getting flatter and flatter as more firm enters because the supply lines will be more
sensitive to the change in price. (flatter)
o When a lot of firms are in the industry the supply curve will be a flat line were the price = minimumin
average cost.
o (as supply gets flatter and flatter the price gets more closer to the min average cost) so the industry supply
curve is being the same as the min average cost.
Industry supply curve = a horizontal (elastic) line at the level of marginal costs and (minimised) average costs of each firm.

MC=AV cost = supply curve

If long-run average costs are unchanging with output and always equal to marginal costs (for given
factor prices), then constant returns to scale.

In a competitive industry with free entry profits can not get very far from 0. If at one time theres a lot
of profits then another firm will enter and push if towards 0.

The long run supply curve of a competitive industry with free entry will look like the long run supply
curve of a firm wil constant returns to scale: a flat line. (because adding more firms is just like
replicating the same thing which is constant return to scale)

The meaning of 0 profit: so, in a competitive market profits will be driven to zero by new entrats
becase whenever profits are positive there will be an incentive for another firm to enter and acuqire
some profits. At the point were the profits are 0 there is no incentive to more firms to enter so the
industry stops growing.
o When te profits are 0 all the factors (inputs) of the firms are being paid at their market price. As
if they were utlized elsewhere.
o The firm still making profits only that all the profits that they made is being utilized to pay all
the inputs. Each factor is earning the same that it could learn in another place so there are not
pure profits, so there is not incentive to attracit new factors.
o But there is nothing them to leave the industry, in fact firms with 0 economic profits are mature
industries.
o any amount that is earned in excess after the payment of factors is pure economic profit. But
at this point another firm will try to enter and drive it to 0.
o Profit= the poeple pay more that it cost you to produce. So more firms lower the price.

The market is:

1. Pareto efficient: becasue the consumer value more (or equal) than price and the firm is
winning such that they can keep producing.
2. Allocatevely efficient: optimal distributions of goods and services (invisible hand)
3. Technically efficient: they can produce using the fewest inputs and making the best of them
4. Productive efficient: they are able to produce at the min point of ATC.

PROFITS MADE when the number of the industries is fixed? because some factors of production are
available in a fix supply. Such:
o Nature: Agriculture- only few lands suitable for agriculture / oil
o Law: licenses and permits. (liquor and taxis)
They still not making profits because:

Remember: we should value each factor of production at its market price (opporunity cost)
o If we have + profits of a farmer and he forgot to count the land. The market cost of the land is
the profit. So their profits still be 0.
o What matter is not at which price you bought the input but at which price you could
sell it

So they will never make profits?

The things that will make profits are when there are inputs that are scarce, and the owners fo this
factors will get good money.

L.M: competitve between clubs to have him will increase his salary. So the cost of paying this players
will always take the profits down.
o If barcelona owned L.M nothing will change because is still a cost as if they were hiring him.
They could use him to play for another team.
o No economic profits.
o When the demand is high and the supply is low such as when we talk about scarce inputs
such L.M theres economic rent. Which is the extra amount that a firm will pay to him in order
to play for them. This economic rent could be used in another inouts but is used here.

COFFEE BARS UK:

 o The bars were selling the coffee at 2 and the cost to make it is 50-40 cents. But they are not
making any profits.
o Coffee shops like crowded places to put their stores so they compete for this scarce places,
increasing the rent of it.
o So the owner of the prices will set the price just at the max price they are prepared to pay that
will be when they make 0 profits.
o Even if the company owned the local it still be considered a price because is teh cost of not
renting it to another company.

So a firm culd enter into a market by making a new firm or buy an existinf firm. If you do a new firm you will have to get the
same input. Then you could be making profits. But if there are some factors that are scarce then the competition for those factors
will increase the price of them driving the profits to 0.

Economic rent: market price – cost of production .The extra payment that is made for a factor of production that are in excess
from the minimum payment necessary to have that factor supplied.

o It cost 1 to pump uo oil, but the market sell it at 500. A lot of people want oil. And they are willing to pay more than its
cost of production for it. 499 = economic rent.

CHAPTER 25 MONOPOLY

The entire market is supplied by one firm = monopoly. The firm will not take the price as given, they will chose the
level of output that will maximise their profit. If it chooses a high price it will only sell a small quantity. So the
behaviour of the customer will constraint the monopoly to chose price (the monopoly will put the price and the
consumer will decide how much to buy it).

The higher price that a monopoly could charge is the highest poin that the people are willing to pay. It must be on the
demand curve.

Maximizing profits: price is a function of output. So the firm will put the price of it based on the market demand.
 At the optimal condition the marginal revenue equal to the marginal cost. The extra revenue that the firm gets
for one unit equals to the cost of producing that unit. In the competitive market the marginal revenue should
be bigger than the cost and the firm will tend to increase output, viceversa with decreasing. The only point
that the firm have no incentive to change output is when they are equal.

Marginal revenue: (the change in revenue when we produce one more unit of output) when the monopoly produce
one more unit theres a loss in revenue because the price has to drop in order to sell this extra output.
 In a competitive market if the price is reduce then the firm will sell more but due to the fact that this is
a monopoly the firm has already all the market so the firm will reduce profits.
 The marginal revenue is smaller than the price ( because is profit minus something)
 Marginal curve always smaller than the demand curve
 Marginal curve not longer concided with the supply curve because mc is not equal to p.

For a monopoly profits can be positive in a long run.

Competitive: free entry = profit squezeed to 0

 Not change output because it change nothing in the profit.
Monopoly: not free entry = positive profit / no force push profit to 0.
 They reduce output in order to push profits up.

Elasticity and revenue: intuitive because if demand isn’t responsive to price then when you produce lessyou reduce
cost and increase revenue and profit.
  Monopoly always want an elastic demand so greater than one in order to have revenue. (see the formula 1 –
½. If you increase the price you will increase revenue
 MC(y) must always be non-negative, so MR(y) must be non-negative at optimal choice.
 Price elasticity of demands goes towards infinity. if you increase the product price the revenues will increase.
 If the elasticity is constant (does not change regardless of y) then the markrup (below part of the fraction) is a
constant fraction of the price.
 A monopoly with a constant elasticity demand curve will change the price as a constant markrupt of the
marginal cost. Due that the markrupt is greater than one the markupt curve will be higher than the marginal
cost.

The profit maximizing point is founded when the demand curve crosses with the curve of the price ( MC / 1 – 1/e)

Reducing output reduces costs and increases revenues, increase profit

Increasing output increases cost and decreases revenue, decreasing profit

Markup pricing: (pricing policy for monopoly)

 Markup always greater than 1 bc e > 1.
 If the elasticity is constant (does not change regardless of the output) the markrupt is a constant
franction of the price.

Linear demand: the marginal revenue line will be the same with twice slope.

Inefficiency: so monopoly restricts quantity in order to keep high price to make profit. This profit is taken
away from the consumer surplus. Consumers will be worse off in an industry organized by a monopoly.
 Competitive:
1. pareto efficient because all the trades possible are done. When P=MC
2. minimum cost per unit achieved
 Monopoly:
1. theres a dead weight so all the trades are not made. There is a hole range of output where people
are willing to pay more por a unit of output than it cost making it. (this is the pareto improvement) A
monopoly could become pareto efficient only if they could be able to sell one more unit decreasing
the price for some people.
2. Cost per unit are higher (there are not forces driving cost down such as free entry competitive
market)
 The monopoly IS cost minimizing but at a higher cost per unit.

Why monopolies exist?

1. The market could support only one monopoly not 2.
2. Artificial barriers to enter.
a. A patent is an exclusive right to benefit from their invention given by the goverment for an
speficic time. This is given in order to encourage innovation. If this did not exist no firms will
invest on innovations due to the fact that it will be copied by other firms. The more gains can
the firm acquire the more they are willing to have that patent. The goverment allow then to
have monopolies for years in order to recover the initial investment they made. So the state
does not have to spend on it.

Why does monopoly does not just set P=MC? Ymc is an efficivnet level of output but the firm will not be
able to cover ir cost. So the monopoly will produce less output that the efficient amount.

 Natural monopoly: when large fixed cost and small marginal cost.
 Of we allow natural monopoly to set the prices it will be bad for pareto inefficiency and force the
monopoly to have a competitive price will imply negative profits. This firms are manages by the
govermned or controlled by it. Controlled: The prices can only be fixed at a level that the firm is
just allowed to break even.
 If the minimum efficient scale (mes) is little relative to the demand then is market competition if is
not that small then monopoly.
 Mes: the lowest part of the average cost curve.
 Also cartel: which are group of firms that agree to set a high price to increase profits. Illegal.
 Also merely because they were the first to enter into the market. And they have enough advantage
in order to discorage other firms from entering.