Theory of The Firm (Microeconomics)

Outline:
1. Production
Function
2. Production with 1 - input case
Deriving a Production Function
Total Product (TP)
Average Product (AP)
Marginal Product (MP)
Law of Diminishing MP
Relationships between TP, AP, and MP
Regions of production
Optimal Employment of an input
3.
Production with 2 - input case
Isoquant
MRTS
RTS
Isocost
Optimal Input Employment
Technological change
Few Working Definitions:

1. Variable
inputs
2. Fixed inputs
3. Short run
4. Long run
What is a production function?
P.F. show a technical relationship between inputs and

outputs
P.F. shows the maximum output that can be produced
from various combinations of inputs using a given
technology in a given time period.
Mathematically,
q = f (K,L,M..)
(1)
= output
K = capital (machine)
L = Labour
M = Raw materials
To Simplify:
q = f (K,L)
(2)
where,
q
Assume:
q = f (LK)
(3)
SR situation, where K is assumed to be
fixed fixed input.
q
TP
L*
(LK)
if q = output (Total Product)

Average Product (AP)
q
APL
L
Marginal Product (MP)
The additional output that can be produced by
one more unit of a particular input while holding
all other inputs constant.
MPL
TP
L
Q
=
L
Lim L 0
MPL
on the TP
=dQ
dL
= Slope of a point
curve
TABLE 6.1 Production with One Variable Input

Average
Product (q/L)
Marginal
Product (q/L)
Amount
of Labor (L)
0
Amount
of Capital (K)
10
Total
Output (q)
0
10
10
10
10
10
30
15
20
10
60
20
30
10
80
20
20
10
95
19
15
10
108
18
13
10
112
16
10
112
14
10
108
12
10
10
100
10
Figure 6.2 Production with One Variable Input
Example:
Given the general Cobb Douglas Production
function as:
q = KL
1. APL
2. MPL
q
L
K L
= L
dq
dL
d(KL)
=
dL
= KL
KL
= L
= KL
= APL
Law of Diminishing Marginal Productivity

as one of the inputs (variable) is increased while the
other remain fixed, a point will be reached where MP of
one variable input will eventually diminishes.
TOTAL PRODUCT, MARGINAL PRODUCT, AND AVERAGE PRODUCT OF LABOR

WITH FIXED CAPITAL
MPL = Q
APL = Q
Capital,
Labor, L
Output, Q
18
13
36
18
12
56
20*
14
75
19
15*
90
15
15*
98
14
104
13
108
12
10
110*
11
11
110*
0*
10
12
108
-2
Relationships between TP, AP and MP:
*D
Max TP = Q
q
C
TP
(inflection point)
L1
I
MP
AP
L2
II
L*
LK
III
Max TP
A
MP = AP at maximum AP
AP=
L1
L2
C
L*
Q
L
LK
MP=
Q
L
Stage I
from origin to point AP maximum.
MPL > APL and APL is rising

Irrational region of production
Stage II
begins from a point where MPL
intersects APL (ie. MPL = APL) until
MPL = 0
MPL < APL and APL is decreasing
Rational region of production
Stage III begins from a point of maximum TP

or MP = 0
MP < 0
Irrational region of production
Why at point B, MP = AP ?
dq
Slope of point B = MPL ( or
)
dL
Slope of a straight line (ray) from the origin
to point B is : BL
2
OL2
BL2 = output at B
OL2 = labor input
BL2
OL2
q
L=
= APL
at point B, MPL = APL ( tangency between a

ray from origin to TP at B)
Proof:
Suppose : q = f (LK)
MPL = dq/dL
APL = q/L
At point B, APL is maximum APL = MPL
d (q
L
APL max
dL
= 0
using quotient rule:

dq
q
L.
- q (1)
d( )
dL
L
=
dL
L2
dq _ q
= 0
L
dL
2
set
= 0
Cross multiplication:
dq
dL
q
L
= 0
or MPL - APL = 0
or MPL = APL at max APL
Q.E.D
Assume :
Profit
Firm operates in a perfectly competitive

industry
P is fixed
Input price r and w are fixed
Firm is maximizing its profit
q = f (LK)
= Total Revenue Total cost
TR = P x q = P. f (LK)
(SR) TC = rK + wL
= TR TC
= P. f (LK) rK - wL
To max. :
d
dL
set
P. f L w = 0
P. f L = w
dq
but f L =
= MPL
dL
P. MPL = w
But
P. MPL
= Value Marginal Product of Labor

(VMPL)
Optimal input employment occurs when:
VMPL = w
$
w1
w2
L1*
L 2*
VMPL
L
VMPL curve is a SR input demand curve in a perfectly

competitive firm
Total and Marginal Product, Total Revenue

And Marginal Revenue Product Functions
For Labor for the Production Function
Q = 100K.5L.5, K = 4, and P = $ 2
L
TPL = Q
MPL = Q/L
TR = PXQ
MRPL =
P = MRXMPL
(VMPL)
$ 0
200
200
400
$ 400
283
83
566
166
346
63
692
126
400
54
800
108
447
47
894
94
490
43
980
86
529
39
1,058
78
565
36
1,130
72
$/ L
(w)
W = 108
W = 78
MRPL
The Optimal Quantity of Labor to be Hired
Re : Optimal input employment

VMPL = P. MPL = w
but P and w are fixed (by assumption)
What happens to input employment when MPL changes?
VMPL changes
shifting of VMPL curve
more labor will be employed when MPL or VMPL
shif to the right at a particular wage rate
$
VMPL
VMPL
L*
L**
The firms production function

For
a particular good (q)

Shows the maximum amount of the good that can
be produced
Using alternative combinations of capital (k) and
labor (l)
q = f(k,l)
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copied, scanned, or duplicated, in whole or in part, except
23
Marginal physical product

The
additional output that can be produced

By employing one more unit of that input
Holding other inputs constant
q
marginal physical product of capital MPk
fk
k
q
marginal physical product of labor MPl
fl
l
24
Marginal physical product

Depends
on how much of that input is used
Diminishing marginal productivity
MPk f
2 f kk f11 0
k
k
2
MPl f
2 f ll f 22 0
l
l
2

25
Changes in the marginal productivity of labor

Also
depend on changes in other inputs such as

capital
We need to consider flk which is often > 0
MPl
f lk
k

26
Labor productivity
Often
means average productivity
Average product of labor
output
q f (k , l )
APl

labor input l
l
APl also depends on the amount of capital
employed

27
Suppose the production function for flyswatters can be

represented by
q = f(k,l) = 600k 2l2 - k 3l3
To construct MPl and APl, we must assume a value for k
Let k = 10
The production function becomes
q = 60,000l2 - 1000l3
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28
The marginal productivity function is

MPl = q/l = 120,000l - 3000l2
Which
diminishes as l increases
This implies that q has a maximum value:
120,000l - 3000l2 = 0
40l = l2
l = 40
Labor input beyond l = 40 reduces output
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29
To find average productivity, we hold k=10 and

solve
APl = q/l = 60,000l - 1000l2
APl reaches its maximum where
APl/l = 60,000 - 2000l = 0
l = 30
When l = 30, APl = MPl = 900,000
When
APl is at its maximum, APl and MPl are equal
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
30
Assume :
q = f (K,L)
Graphically :
q
Production
surface
q0
K
*
0
*q
q0
If draw in K L plane, we get:

K
A
B
Isoquant
map
C D
q0 = 20 units
q = 10 units
L
Process
#K
#L
Output level
20
20
20
20
20
we obtain isoquants
Isoquant locus that shows various combinations of

inputs K dan L that produce the same amount
of output.
K
K1
q0
K0
L
L0
L1
Slope of an isoquant is the Marginal Rate of Technical

Substitution (MRTS)
K
MRTSLK = L
dK
=
dL -
Characteristics of Isoquant:
1. Isoquants
cannot cross
2. They are dense
3. Isoquants are assumed to be convex to the
origin
4. The output level increases as one moves in
the northeasterly direction on the isoquant
map.
Marginal rate of technical substitution

(MRTS)
Shows
the rate at which labor can be substituted

for capital
Holding output constant along an isoquant
dk
RTS (l for k )
dl

35
q q0
Marginal Rate of Technical Substitution (MRTS):

MRTS the rate at which one input can be substituted
with another input while holding output constant.
MRTS and Marginal Productivities:

Re : q = f (K,L)
Take total derivatives:
dq = f dK
+f
dL
But along an isoquant, dq = 0
0 = f
K
Re arranging:
(2)
d L
dK +f
dK
f
L
dL
(1)
But slope of isoquant or MRTS = -
dL
Re arranging (2) :
- dK
dL
but
f / L
f / K
f/L = MPL
f/K = MPK
dK
dL
f / L
=MPL
f / K
MPK
MRTSLK = MPLMPK
dK
MRTS will be positive (or zero)

Because
MPl and MPk will both be nonnegative
Not possible to derive a diminishing MRTS

From
the assumption of diminishing marginal

productivity alone
To show that isoquants are convex

Show
that d(MRTS)/dl < 0

38
Since MRTS = fl/fk

And
dk/dl = -fl/fk along an isoquant and Youngs

theorem (fkl = flk)
dRTS d ( f l / f k )
dl
dl
[ f k ( f ll f lk dk / dl ) - f l ( f kl f kk dk / dl )]
( fk )2
( f k2 f ll - 2 f k f l f kl f l 2 f kk )
( f k )3
39
Denominator is positive
Because
we have assumed fk > 0
The ratio will be negative if fkl is positive

Because
fll and fkk are both assumed to be
negative
Intuitively, it seems reasonable that fkl = flk

should be positive
If
workers have more capital, they will be more

productive

40
But some production functions have fkl < 0

over some input ranges
Assuming
diminishing MRTS means that MPl and

MPk diminish quickly enough to compensate for
any possible negative cross-productivity effects

41
Production function:
q = f(k,l) = 600k 2l 2 - k 3l 3
Marginal productivity functions:
MPl = fl = 1200k 2l - 3k 3l 2
MPk = fk = 1200kl 2 - 3k 2l 3
Will
be positive for values of k and l for which kl < 400
42
Because
fll = 1200k 2 - 6k 3l and fkk = 1200l 2 - 6kl 3
Diminishing
marginal productivities for sufficiently large

values of k and l
fll and fkk < 0 if kl > 200
Cross differentiation of either of the marginal

productivity functions yields
fkl = flk = 2400kl - 9k 2l 2

Which
is positive only for kl < 266
43
Example:
Suppose : q = KL
----------------(1)
MRTSLK = MPL/MPK
From (1) :
MPL =
MPK =
q = K L-1 =
L
q
= K-1L =
MRTSLK =KMPL/MPK
KL
L
q/L
q/K
K L
= K (/)(K/L)
Diminishing MRTS
q/L
MRTS gets smaller as we move down along an isoquant
q/K
ie. the slope of an isoquant is getting smaller (diminishing)!
Marginal Rate of Technical Substitution
Capital
Per
5
Month
A
K=2
4
L=1
3
K=1
C
K=/
L=1
L=1
Q3 = 90
K=/
Q2 = 75
L=1
Q1 = 55
1
Labor per Month
Q: How does output respond when all inputs

change by the same proportion?
RTS
Suppose : Q = f(K,L)
When all inputs are double 3 possibilities:

Output doubles, or
ii. Output increases less than double, or
iii. Output increases by more than two times!
Q = f(K,L)
i.
If
f(2K,2L) = 2f(K,L) = 2Q
Doubling of K and L will cause output to double

CONSTANT RTS
If
f(2K,2L) < 2f(K,L) = 2Q

Doubling of K and L will cause output to be less than
double
DECREASING RTS
If
f(2K,2L) > 2f(K,L) = 2Q

A doubling of K and L causes output to more than
double
INCREASING RTS
Production function is given by q = f(k,l)

And
all inputs are multiplied by the same

positive constant (t >1)
Then we classify the returns to scale of the
production function by
Effect on Output
Returns to Scale
f(tk,tl) = tf(k,l) = tq
f(tk,tl) < tf(k,l) = tq
f(tk,tl) > tf(k,l) = tq
Constant
Decreasing
Increasing

48
Formal Definition of RTS

RTS can be defined by considering multiplying all
input by any constant m.
Then let f(mK,mL) = mt f(K,L) = mtQ
if t = 1 CRTS
homogeneus
t < 1 DRTS
t > 1 IRTS
- linearly
Example:
Suppose : Q = AKL
To check for RTS:
Q = A(mK) (mL)
= AmKmL
= m+ (AKL)
= m+Q
Thus,
when +
=1
CRTS
<1
DRTS
>1
IRTS
if Q = AK 4L 5
+ = 4 + 5 = 0.9 <1
Decreasing RTS!
Example:
let Q = 3L + 10K + 500
(i) Suppose L = K = 1
Q = 3(1) + 10(1) + 500 = 513
(ii) Lets double all inputs ie
L= K = 2
Q = 3(2) + 10(2) + 500 = 526
Whe all inputs are doubled, increase in output is

less than double!
The above production function exhibits DRTS!
INCREASING RETURNS TO SCALE

Output
more than doubles when all inputs

are doubled (input increase 10%, output
increases more than 10%).
Larger output associated with lower cost.
Arise because the larger scale of operation
allows managers and workers to specialize
their tasks and use of more sophisticated
equipments and factories.
One firm is more efficient than many.
The isoquants get closer together.
Capital
(machine
hours)
The isoquants
move closer
together
4
30
20
2
10
5
10
Labor (hours)
CONSTANT RETURNS TO SCALE

Output
doubles when all inputs are doubled (input

increase 10%, output increases 10%).
Size
of firms operation does not affect productivity.
May
have a large number of producers.
Isoquants
are equally spaced.
Constant returns-to-scale production

functions
Are
homogeneous of degree one in inputs
f(tk,tl) = t1f(k,l) = tq
The marginal productivity functions

Are
homogeneous of degree zero

If a function is homogeneous of degree k, its
derivatives are homogeneous of degree k-1

55
Marginal productivity of any input

Depends
on the ratio of capital and labor

Not on the absolute levels of these inputs
The RTS between k and l

Depends
only on the ratio of k to l

Not the scale of operation
Homothetic production function
All of the isoquants are radial expansions of one

another

56
Isoquant Map for a Constant Returns-to-Scale Production Function:
k per period
q=3
q=2
q=1
l per period
Because
a constant returns-to-scale production function is homothetic, the RTS depends

only on the ratio of k to l, not on the scale of production. Consequently, along any ray
through the origin (a ray of constant k/l), the RTS will be the same on all isoquants. An
additional feature is that the isoquant labels increase proportionately with the inputs.
57
for use as permitted in a license distributed with a certain

product or service or otherwise on a password-protected
website for classroom use.
Constant returns to scale

Capital
(machine
hours)
A
6
30
4
2
2
0
2
Constant
Returns:
Isoquants are
equally spaced
10
5
10
5
15
5
Labor (hours)
Decreasing returns to scale

output
less than doubles when all inputs are doubled.
Decreasing
Reduction
efficiency with large size.
of entrepreneurial abilities.
Communication
between workers and managers can

become difficult to monitor.
Isoquants
become farther apart.
Decreasing returns to scale

Capital
(machine
hours)
Decreasing Returns:
Isoquants get further
apart
15
2
10
5
10
12
Labor (hours)
Re: Along one isoquant, MRTS will decrease as capital

labor ratio (K/L) decreases.
Elasticity of substitution = =
% in K/L
% in MRTS
measures how easy it is to substitute

capital for labor. (describer the shape of an
isoquant)
Along an isoquant, MRTS and K/L move in the

same direction
the value of is always positive.
ie 0 < <
= the value of determines the shape of
isoquant!
1.
Infinite Production Functions (Perfect Substitutes)

K
(=)
Q1
Q2
isoquant
Q0
MRTS is constant for all possible K, L input combinations

= !
Q= f(K,L) = aK +bL
The production Functions exhibits CRTS!

f(2K,2L) = a(2K) +b(2L)
= 2 (aK +bL)
= 2 f(K,L)
= 2Q
* Slope of each isoquant : -b/a
Isoquants When Inputs Are Perfect Substitutes
Capital
Per
Month
C
Q1
Q2
Q3
Labor per Month
2.
Fixed- Proportions Production Function

K
Leontief
Perfect
Complements
(=0)
K2
K1
K0
Q2
Q1
Q0
L0 L1 L2
=0
Capital and labor must be used in fixed proportions

if neither is to be redundant
Mathematically,
Q= f(K,L) = min (aK, bL)
This function also exhibits CRTS

f(2K,2L) = min {a (2K), b(2k)}
= 2 min (aK,bL)
= 2Q
Proportions Production Function

Capital
Per
Month
Q3
Q2
K1
L1
Q1
Labor per Month
3.
Cobb Douglas Production Function

K
Q3
Q1
Q2
(0<<)
Limited substitutability between K dan L
If 0 < < isoquant will be convex and will

exhibit a diminishing MRTS
Q = f(K,L) = AK L
This function is homogenous of degree +

if + = 1 CRTS!
Technical change can be demonstrated by producing the same

level of output but with less input.
or
same level of input will produce more output
The isoquant shifts in
K
K1
K0
q0
q0
0
L1
L0
The effect of Technological Improvement
The need to distinguish between technical progress

and input substitution
With technical progress, firm can continue to
employ K0 but use less labor L1 to produce q0
APL from q0/L0 to q0/L1
Without technical progress, firm can produce same
output (q0) by employing more capital at K1 and less
labor at L1 substitution of capital for labor.
Input Substitution when an Input Price Changes

Capital
Per
Year
K2
K1
A
Q1
C2
L2
L1
C1
Labor per year
1. HICKS NEUTRAL TECHNOLOGICAL CHANGE

K
K1
a
K1
a'
A
b'
Q1 = 1000 unit
b
(w/r)
Q1 = 1000
unit
(w/r)
With Hicks Neutral technological change, the marginal rate

of technical substitution between labor and capital will not
change.
ie. MRTSLK does not change!
MRTSLK (A) = MRTSLK (A)
At A:
MRTSLK = MPL/MPK = -dK/dL = - w/r
a
=-
At A:
MRTSLK = MPL/MPK = -dK/dL = - (w/r)
a'
= -b'
but a = a and b = b
(w/r) = (w/r)
MPL
MPK
MPL
=
MP
K
2. CAPITAL AUGMENTING TECHNICAL CHANGE:

or
LABOR SAVING TECHNICAL CHANGE:
K
a
K1
b
K1
a'
Q1 = 1000
A
Q1 = 1000
b'
L1
(w/r)
(w/r)
L1
MRTSLK (A) > MRTSLK (A)
K1
MRTSLK = a/b
b
K1
a'
Q1 = 1000
Q1 = 1000
b'
(w/r)
L1
a = a
b < b
(w/r)
L1
With technological change, MRTSLK becomes smaller
MPL (A)
MPK (A)
>
MPL (A)
MPK (A)
K
(w/r) > (w/r)
K1
A
A
KA
K A
Q1 = 1000
Q1 = 1000
(w/r)
LA1 LA
Note:
(w/r)
L1
MPL
MPK
(A)
>
MPL
(A)
MPK
= need to increase this component by:
MPL thong usage of less L
MPK by using more K
With technological change,

MRTSLK (A) < MRTSLK (A)
MRTSLK falls!
MPL
MPK
MPL
(A) <
MPL
(A)
MPK
(A) is falling faster than MPK (A)
with input prices w/r unchanged, the reduction

in labor usage is bigger than capital usage.
3.
LABOR AUGMENTING TECHNICAL CHANGE:

or
CAPITAL SAVING TECHNICAL CHANGE:
(w/r)
(w/r)
w/r
KA
K A
= Initial prices
(w/r) = New prices
(w/r) > (w/r)
Q1 = 1000
A
Q1 = 1000
L A L A
MRTSLK (A) < MRTSLK (A)
MPL
MPK
(A)
<
MPL
MPK
(A)
With technological change,

MRTSLK increases!
MPL
(A) >
MPK
MPL
MPL
(A)
MPK
(A) increases more than MPK (A)
With no change in input prices w/r ,the reduction in labor

usage is bigger than the capital use.
For Equilibrium:
MPL
(A)
must
be reduced by:
MPK
i) MPL through increase usage of L or,
ii) MPK by reducing k.

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Outline:

Deriving a Production Function

Total Product (TP)

Average Product (AP)

Marginal Product (MP)

Relationships between TP, AP, and MP

Optimal Employment of an input

Production with 2 - input case

Few Working Definitions:

What is a production function?

P.F. show a technical relationship between inputs and

if q = output (Total Product)

TABLE 6.1 Production with One Variable Input

Figure 6.2 Production with One Variable Input

Law of Diminishing Marginal Productivity

TOTAL PRODUCT, MARGINAL PRODUCT, AND AVERAGE PRODUCT OF LABOR

Relationships between TP, AP and MP:

from origin to point AP maximum.

MPL > APL and APL is rising

Stage III begins from a point of maximum TP

at point B, MPL = APL ( tangency between a

using quotient rule:

Firm operates in a perfectly competitive

= Value Marginal Product of Labor

VMPL curve is a SR input demand curve in a perfectly

Total and Marginal Product, Total Revenue

The Optimal Quantity of Labor to be Hired

Re : Optimal input employment

The firms production function

a particular good (q)

2012 Cengage Learning. All Rights Reserved. May not be

Marginal physical product

additional output that can be produced

Marginal physical product

on how much of that input is used

Diminishing marginal productivity

2012 Cengage Learning. All Rights Reserved. May not be

Changes in the marginal productivity of labor

depend on changes in other inputs such as

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means average productivity

Average product of labor

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Suppose the production function for flyswatters can be

The marginal productivity function is

To find average productivity, we hold k=10 and

APl is at its maximum, APl and MPl are equal

If draw in K L plane, we get:

Isoquant locus that shows various combinations of

Slope of an isoquant is the Marginal Rate of Technical

Marginal rate of technical substitution

the rate at which labor can be substituted

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Marginal Rate of Technical Substitution (MRTS):

MRTS and Marginal Productivities:

But along an isoquant, dq = 0

But slope of isoquant or MRTS = -

MRTS will be positive (or zero)

MPl and MPk will both be nonnegative

Not possible to derive a diminishing MRTS

the assumption of diminishing marginal

To show that isoquants are convex

that d(MRTS)/dl < 0