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- 1. Business Firm An entity that employs factors of production (resources) to produce goods and services to be sold to consumers, other firms, or the government.
- 2. Managerial Coordination and Business Firms The process in which managers direct employees to perform certain tasks.
- 3. Why Do Business Firms Arise in the First Place? Firms are formed when benefits can be obtained from individuals working as a team.
- 4. Problem of and Solutions for “Team” Work Problem: Shirking - The behavior of a worker who is putting forth less than the agreed to effort. Solution: Monitor – Person (manager) in a business firm who coordinates team production and reduces shirking. Problem: Monitor shirking Solution: Make the monitor a Residual Claimants Persons who share in the profits of a business firm.
- 5. Markets: Inside and Outside the Firm Economics is largely about trades or exchanges; it is about market transactions. In supply-and-demand analysis, the exchanges are between buyers of goods and services and sellers of goods and services. In the theory of the firm, the exchanges take place at two levels: (1) at the level of individuals coming together to form a team and (2) at the level of workers “choosing” a monitor.
- 6. Firm’s Objective: Maximizing Profit The difference between total revenue and total cost. Profit = Total revenue - Total cost
- 7. Explicit and Implicit Cost Explicit Cost - A cost incurred when an actual (monetary) payment is made. Implicit Cost - A cost that represents the value of resources used in production for which no actual (monetary) payment is made.
- 8. Accounting, Economic and Normal Profit I Accounting Profit - The difference between total revenue and explicit costs. Economic Profit - The difference between total revenue and total cost, including both explicit and implicit costs. Normal Profit - Zero economic profit. A firm that earns normal profit is earning revenue equal to its total costs (explicit plus implicit costs). This is the level of profit necessary to keep resources employed in that particular firm.
- 9. Accounting, Economic and Normal Profit II
- 10. Production and Cost: Fixed and Variable Inputs Fixed Input - An input whose quantity cannot be changed as output changes. Variable Input - An input whose quantity can be changed as output changes.
- 11. Production and Cost: Short and Long Run Short Run - A period of time in which some inputs in the production process are fixed. Long Run - A period of time in which all inputs in the production process can be varied (no inputs are fixed).
- 12. Marginal Physical Product (MPP) Marginal Physical Product (MPP) - The change in output that results from changing the variable input by one unit, holding all other inputs fixed
- 13. Production in the Short Run and the Law of Diminishing Marginal Returns In the short run, as additional units of a variable input are added to a fixed input, the marginal physical product of the variable input may increase at first. Eventually, the marginal physical product of the variable input decreases. The point at which marginal physical product decreases is the point at which diminishing marginal returns have set in.
- 14. Law of Diminishing Marginal Returns Law of Diminishing Marginal Returns As ever-larger amounts of a variable input are combined with fixed inputs, eventually, the marginal physical product of the variable input will decline.
- 15. Production in the Short Run and the Law of Diminishing Marginal Productivity
- 16. Fixed, Variable, Total and Marginal Cost Fixed Costs (FC) - Costs that do not vary with output; the costs associated with fixed inputs. Variable Cost (VC) - Costs that vary with output; the costs associated with variable inputs. Total Cost (TC) - The sum of fixed costs and variable costs. TC = TFC + TVC Marginal Cost (MC) - The change in total cost that results from a change in output: MC = ΔTC/Δ Q.
- 17. Marginal Physical Product and Marginal Cost I
- 18. Marginal Physical Product and Marginal Cost II The marginal physical product of labor curve is derived by plotting the data from columns 2 and 4 in the exhibit. The marginal cost curve is derived by plotting the data from columns 3 and 8 in the exhibit. See next slide.
- 19. Notice that as the MPP curve rises, the MC curve falls; and as the MPP curve falls, the MC curve rises.
- 20. Average Productivity Q = Output L = Number of units of labor
- 21. Average Fixed, Variable and Total Cost Average Fixed Cost (AFC) - Total fixed cost divided by quantity of output: AFC = TFC / Q. Average Variable Cost (AVC) - Total variable cost divided by quantity of output: AVC = TVC / Q. Average Total Cost (ATC), or Unit Cost Total cost divided by quantity of output: ATC = TC / Q.
- 22. Total, Average & Marginal Costs I
- 23. Total, Average & Marginal Costs II
- 24. Average-Marginal Rule When the marginal magnitude is above the average magnitude, the average magnitude rises; when the marginal magnitude is below the average magnitude, the average magnitude falls.
- 25. Average and Marginal Cost Curves
- 26. Tying Production to Costs What happens in terms of production (MPP rising or falling) affects MC, which in turn eventually affects AVC and ATC.
- 27. Production and Costs in the Long Run In the short run, there are fixed costs and variable costs; therefore, total cost is the sum of the two. A period of time in which all inputs in the production process can be varied (no inputs are fixed). In the long run, there are no fixed costs, so variable costs are total costs.
- 28. Long-Run Average Total Cost (LRATC) Curve A curve that shows the lowest (unit) cost at which the firm can produce any given level of output.
- 29. Long-Run Average Total Cost Curve (LRATC ) There are three short-run average total cost curves for three different plant sizes. If these are the only plant sizes, the longrun average total cost curve is the heavily shaded, blue scalloped curve.
- 30. Long-Run Average Total Cost Curve (LRATC ) The long-run average total cost curve is the heavily shaded, blue smooth curve. The LRATC curve is not scalloped because it is assumed that there are so many plant sizes that the LRATC curve touches each SRATC curve at only one point.
- 31. Economies of Scale I Economies of Scale exist when inputs are increased by some percentage and output increases by a greater percentage, causing unit costs to fall. Constant Returns to Scale exist when inputs are increased by some percentage and output increases by an equal percentage, causing unit costs to remain constant. Diseconomies of Scale exist when inputs are increased by some percentage and output increases by a smaller percentage, causing unit costs to rise.
- 32. Why Economies of Scale? Up to a certain point, long-run unit costs of production fall as a firm grows. There are two main reasons for this: Growing firms offer greater opportunities for employees to specialize. Growing firms can take advantage of highly efficient mass production techniques and equipment that ordinarily require large setup costs and thus are economical only if they can be spread over a large number of units. 2/3 rule
- 33. Why Diseconomies of Scale? In very large firms, managers often find it difficult to coordinate work activities, communicate their directives to the right persons in satisfactory time, and monitor personnel effectively.
- 34. Economies of Scale II The lowest output level at which average total costs are minimized.
- 35. Shifts in Cost Curves A firm’s cost curves will shift if there is a change in: Taxes Input prices Technology.
- 36. Isoquants An isoquant is a graph that shows all the combinations of capital and labour that can be used to produce a given amount of output. 36
- 37. Properties of Isoquant Maps There are an infinite number of combinations of labour and capital that can produce each level of output. Every point lies on some isoquant. The slope of an isoquant is equal to: MPlabour / MPcapital = - MPL / MPK = ΔK / ΔL The slope of the isoquant is called the marginal rate of technical substitution which can be defined as the rate at which a firm can substitute capital for labour and hold output constant. 37 -
- 38. Isoquants Showing All Combinations of Capital and Labour That Can Be Used to Produce 50, 100, and 150 Units of Output 38
- 39. The Slope of an Isoquant Is Equal to the Ratio of MPL to MPK 39
- 40. Isocosts An isocost is a graph that shows all the combinations of capital and labour available for a given cost. 40
- 41. Isocost Lines Showing the Combinations of Capital and Labour Available for $5, $6, & $7 41
- 42. Isocost Line Showing All Combinations of Capital and Labour Available for $25 The slope of an isocost line is equal to - PL / PK. The simple way to draw an isocost is to calculate the endpoints on the line and connect them. 42
- 43. The Cost Minimizing Equilibrium Condition Slope of isoquant = - MPL / MPK Slope of isocost = - PL / PK For cost minimization we set these equal and rearrange to obtain: MPL / PL = MPK / PK 43
- 44. Finding the Least-Cost Combination of Capital and Labour to Produce 50 Units of Output Profit-maximizing firms will minimize costs by producing their chosen level of output with the technology represented by the point at which the isoquant is tangent to an isocost line. Point A on this diagram 44
- 45. Minimizing Cost of Production for qx = 50, qx = 100, and qx = 150 Plotting a series of cost- minimizing combinations of inputs - shown here as A, B and C enables us to derive a cost curve. 45
- 46. A Cost Curve Showing the Minimum Cost of Producing Each Level of Output 46
- 47. Review Terms & Concepts isocost line isoquant marginal rate of technical substitution 47
- 48. The Cobb-Douglas Production Function Y = AK L α (1-α)
- 49. History Developed by Paul Douglas and C. W. Cobb in the 1930’s The Cobb-Douglas Production Function
- 50. History Developed by Paul Douglas and C. W. Cobb in the 1930’s Douglas went on to be professor at Chicago and U.S. Senator Cobb - ?? The Cobb-Douglas Production Function
- 51. The General Problem An increase in a nation’s capital stock or labor force means more output. Is there a mathematical formula that relates capital, labor and output? The Cobb-Douglas Production Function
- 52. The General Form α 1−α t t Yt = At K L The Cobb-Douglas Production Function
- 53. Increasing Capital Yo = AK L α o 1−α o Y = A(2 K o ) L α The Cobb-Douglas Production Function 1−α o
- 54. Increasing Capital Yo = AK L α o 1−α o Y = A(2 K o ) L α α α o 1−α o 2 AK L The Cobb-Douglas Production Function 1−α o = = 2 Yo α
- 55. Increasing Capital Yo = AK L α o 1−α o Y = A(2 K o ) L α α α o 1−α o 2 AK L = = 2 Yo Diminishing returns to proportion The Cobb-Douglas Production Function 1−α o α
- 56. Increasing Labor Yo = AK L α o α 1−α o Y = AK o (2 Lo ) The Cobb-Douglas Production Function 1−α
- 57. Increasing Labor Yo = AK L α o α 1−α o Y = AK o (2 Lo ) 1−α 2 The Cobb-Douglas Production Function α o 1−α o AK L 1−α = = 2 Yo 1−α
- 58. Increasing Labor Yo = AK L α o 1−α o α Y = AK o (2 Lo ) 1−α 2 α o 1−α o AK L 1−α = 2 Yo Diminishing returns to proportion The Cobb-Douglas Production Function = 1−α
- 59. Increasing Both Yo = AK L α o 1−α o Y = A(2 K o ) (2 Lo ) α The Cobb-Douglas Production Function 1−α
- 60. Increasing Both Yo = AK L α o 1−α o Y = A(2 K o ) (2 Lo ) α α o 1−α o 2 AK L The Cobb-Douglas Production Function 1−α = 2 Yo =
- 61. Increasing Both Yo = AK L α o 1−α o Y = A(2 K o ) (2 Lo ) α α o 1−α o 2 AK L 1−α = 2 Yo Constant returns to scale The Cobb-Douglas Production Function =
- 62. Substitution Yo = AK L α o 1−α o Y = A(2 K o ) ( xLo ) α Capital and Labor Can be Substituted The Cobb-Douglas Production Function 1−α = Yo
- 63. An Illustration Yt = At K L 1/ 2 t The Cobb-Douglas Production Function 1/ 2 t
- 64. An Illustration Y = AK L 1/ 2 The Cobb-Douglas Production Function 1/ 2
- 65. An Illustration Y = A KL The Cobb-Douglas Production Function
- 66. An Illustration A =3 L =10 Y = A KL K =10 The Cobb-Douglas Production Function
- 67. An Illustration Y = 3 (10)(10) = 3 100 = 30 The Cobb-Douglas Production Function
- 68. Doubling Capital Y = 3 (20)(10) = 3 200 = 30 2 ≅ 42 The Cobb-Douglas Production Function
- 69. Constant Returns to Scale Y = 3 (20)(20) = 3 400 = 60 The Cobb-Douglas Production Function
- 70. Substitution Y = 3 (20)( x) = 30 x=5 The Cobb-Douglas Production Function
- 71. Estimation Yt = At K L α t 1−α t log(Yt ) = log( At ) + α log( K t ) + (1 − α ) log( Lt ) The Cobb-Douglas Production Function
- 72. Estimation log(Yt ) = C + t + β1 log( K t ) + β 2 log( Lt ) + ε t The Cobb-Douglas Production Function
- 73. Estimation log(Yt ) = α + β1 log( K t ) + β 2 log( Lt ) + ε t Statistical issues abound! The Cobb-Douglas Production Function
- 74. Factor Payments α = % of Income going to owners of capital 1-α = % of Income going to workers The Cobb-Douglas Production Function
- 75. How well does it work? Yt = At K L α t β t You can’t beat something with nothing The Cobb-Douglas Production Function
- 76. Leontief Production Function K L The Cobb-Douglas Production Function
- 77. Leontief Production Function K = aY L = bY K L The Cobb-Douglas Production Function
- 78. Leontief Production Function K = aY L = bY K L The Cobb-Douglas Production Function
- 79. Leontief Production Function K K = aY L = bY σ=0 L The Cobb-Douglas Production Function
- 80. Leontief Production Function K = aY L = bY K Doesn’t work. We can and do substitute labor for capital all the time The Cobb-Douglas Production Function L
- 81. Other Factors? Yt = At K L LND α t The Cobb-Douglas Production Function β t 1−α − β t
- 82. And in Conclusion… α 1−α t t Yt = At K L The Cobb-Douglas Production Function

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