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MSc Le Thanh Thuy
CHAPTER V:
THE THEORY OF PRODUCER’S BEHAVIOR
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This topic will give you a better understanding of
what decisions lie behind the supply curve in a
market
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Why the behaviors of different firm are so
STRANGE????

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I. Theory of production
1. Production function
a. Definitions:
 Production function:
– Relationship between
• Quantity of inputs used to make a good
• And the quantity of output of that good
– Gets flatter as production rises
Cobb-Douglas function
Q = f(K,L) = aKαLβ
Returns to scale:
Rate at which output increases as inputs are
increased proportionately
Return to Scale
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 How does firm decide, in long run, best way to
improve output?
Can change scale of production by increasing
all inputs in proportion
If double inputs, output will most likely
increase but by how much?

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 Economies of scale
 Output increases at a higher rate than the
increased rate of inputs
 Increasing specialization
 Constant returns to scale
 Output increases at a same rate as the increased
rate of inputs
Costs in Short Run and in Long Run
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 Diseconomies of scale
 Output increases at a lower rate than the
increased rate of inputs
 Increasing coordination problems
Note:
f(nK,nL) > nf(K,L): Economies of scale
f(nK,nL) < nf(K,L): Diseconomies of scale
f(nK,nL) = nf(K,L): Constant returns to scale
What is the rule for Return to Scale in Cobb-
Douglas production function???
- α+β < 1: Cobb-Douglas function presents
diseconomies of scale
- α+β > 1: Cobb-Douglas function presents
economies of scale
- α+β = 1: Cobb-Douglas function presents constant
returns to scale

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2. Production in short-term
2.1 Definitions
- Short-term refers to a production which has at
least one unchanged input
In Microeconomics we suppose there are 2 inputs
(Capital – K and Labor – L).
 Which of these two input can not be changed in
short-term???
IT DEPENDS
 Assumptions:
 Technology during the production is supposed to be
unchanged
 Each labor provides same kind of service
- Total quantity (Q): refers to the output of
production using inputs of capital (K) and labor (L)
- Average Physical Product (APP) refers to output
per unit of input using in the production

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- Marginal Physical Product (MPP) or Marginal
Product (MP)
is a measurement of productivity. It refers to the
additional output brought by an additional in the input
2.2 Diminishing marginal product
 Marginal product of an input declines as the
quantity of the input increases
 As input use increases with other inputs fixed,
resulting additions to output eventually
decrease
 When labor use is small and capital fixed,
output increases since workers specialize; MP
of labor increases
 When labor use is large, some workers
become less efficient; MP of labor decreases
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 Diminishing marginal product
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2.3 Relationship between MPP and APP:
MPP intersect with APP at the maximum point of APP
II. Theory of Production Cost (Short-run)
 All firms, from Delta Air Lines to your local deli,
incur costs as they make the goods and services
that they sell.
 As we will see in the coming chapters, a firm’s
costs are a key determinant of its production and
pricing decisions.
Establishing what a firm’s costs are, however, is
not as straightforward as it might seem

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What are Costs?
 Costs as opportunity costs
 The cost of something is what you give up to get
it
 Firm’s cost of production
 Include all the opportunity costs
 Making its output of goods and services
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What are Costs?
 Costs as opportunity costs
 Explicit costs
 Input costs that require an outlay of money by
the firm
 Implicit costs
 Input costs that do not require an outlay of
money by the firm
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What are Costs?
 The cost of capital as an opportunity cost
Implicit cost
Interest income not earned
On financial capital
 Owned as saving
 Invested in business
Not shown as cost by an accountant
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What are Costs?
 Economic profit
Total revenue minus total cost
Including both explicit and implicit costs
 Accounting profit
Total revenue minus total explicit cost
Which profit is expected to be larger?
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 Sunk Cost
 Expenditure cannot be recovered should not influence
firm’s future economic decisions
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1. The Various Measures of Cost
 Fixed costs (FC)
 Do not vary with the quantity of output produced
 Variable costs (VC)
 Vary with the quantity of output produced
 Total cost (TC) = FC + VC
 Total-cost curve
 Relationship between quantity produced and total costs
 Gets steeper as the amount produced rises

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A production function and total cost: Caroline’s cookie factory
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Number
of workers
Output
(quantity of cookies
produced per hour)
Marginal
product
of labor
Cost of
factory
Cost of
workers
Total cost of inputs
(cost of factory +
cost of workers)
0
1
2
3
4
5
6
0
50
90
120
140
150
155
$30
30
30
30
30
30
30
$0
10
20
30
40
50
60
$30
40
50
60
70
80
90
50
40
30
20
10
5
Total
Cost
50
40
30
20
10
80
70
60
$90
Quantity
of Output
(cookies
per hour)
100
80
60
40
20
160
140
120
Caroline’s production function and total-cost curve
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(a) Production function
- The production function gets flatter as the number of workers increases,
which reflects diminishing marginal product.
- The total-cost curve gets steeper as the quantity of output increases because
of diminishing marginal product.
(b) Total-cost curve
Number of
Workers Hired
0 1 2 3 4 5 6
Production
function Total-cost curve
Quantity
of Output
(cookies per hour)
0 20 40 60 80 100 120 140 160
2. Average costs
 Average fixed cost (AFC)
 Fixed cost divided by the quantity of output
 Average variable cost (AVC)
 Variable cost divided by the quantity of output
 Average total cost (ATC)
ATC = AFC + AVC
 Total cost divided by the quantity of output
 Average total cost = Total cost / Quantity
ATC = TC / Q

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 Marginal cost (MC)
 Increase in total cost
 Arising from an extra unit of production
 Marginal cost = Change in total cost / Change in quantity
MC = ΔTC / ΔQ = TC’(Q)
The various measures of cost: Conrad’s coffee shop
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Quantity
of coffee
(cups per hour)
Total
Cost
Fixed
Cost
Variable
Cost
Average
Fixed
Cost
Average
Variable
Cost
Average
Total
Cost
Marginal
Cost
0
1
2
3
4
5
6
7
8
9
10
$3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
$3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
$0.00
0.30
0.80
1.50
2.40
3.50
4.80
6.30
8.00
9.90
12.00
-
$3.00
1.50
1.00
0.75
0.60
0.50
0.43
0.38
0.33
0.30
-
$0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
-
$3.30
1.90
1.50
1.35
1.30
1.30
1.33
1.38
1.43
1.50
$0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
3. Cost curve and their shapes
 Rising marginal cost
Because of diminishing marginal product
 AFC – always declines as output rises
 AVC – typically rises as output increases
Diminishing marginal product
 U-shaped average total cost: ATC = AVC + AFC

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 Relationship between MC and ATC
When MC < ATC: average total cost is falling
When MC > ATC: average total cost is rising
The marginal-cost curve crosses the average-
total-cost curve at its minimum
Conrad’s average-cost and marginal-cost curves
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Costs
1.25
1.00
0.75
0.50
0.25
2.00
1.75
1.50
2.25
2.50
2.75
3.00
3.25
$3.50
This figure shows the average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and
marginal cost (MC) for Conrad’s Coffee Shop. All of these curves are obtained by graphing the data in Table
2. These cost curves show three features that are typical of many firms: (1) Marginal cost rises with the
quantity of output. (2) The average-total-cost curve is U-shaped. (3) The marginal-cost curve crosses the
average-total-cost curve at the minimum of average total cost.
Quantity of Output
(cups of coffee per hour)
0 1 2 3 4 5 6 7 8 9 10
AVC
AFC
ATC
MC
Cost curves for a typical firm
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Costs
1.00
0.50
2.00
1.50
2.50
$3.00
Many firms experience increasing marginal product before diminishing marginal product.
As a result, they have cost curves shaped like those in this figure. Notice that marginal cost
and average variable cost fall for a while before starting to rise.
Quantity of Output
0 2 4 6 8 10 12 14
MC
ATC
AVC
AFC

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Questions:
- Comments on the vertical distance between TC and
VC
- Comments on the vertical distance between ATC and
AVC
III. Theory of Profit
 Total revenue
Amount a firm receives for the sale of its
output
 Total cost
Market value of the inputs a firm uses in
production
 Profit
Total revenue minus total cost
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 How to maximize profit
MR = MC
 How to maximize revenue
MR = 0

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Exercise
Firm A faces with demand function as follows:
(D): P = 640 – Q
Marginal cost: MC = 2Q + 8, FC = 500$
Determine P, Q for:
a. Profit maximizing
b. Total revenue maximizing. Calculate the profit in this
case
If products C and D are close substitutes, an
increase in the price of C will:
 Tend to cause the price of D to fall
 Shift the demand curve of C to the left and the demand
curve of D to the right
 Shift the demand curve of D to the right
 Shift the demand curve of both goods to the right
 Shift the demand curve of both goods to the left
Which of the following statements is CORRECT?
 An increase in the price of C will decrease the price of
complementary product D
 A decrease in income will decrease the demand for an
inferior good
 An increase in income will reduce the demand for a
normal good
 A decline in the price of X will increase the price of
substitute product Y

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Which of the following statements is NOT correct:
 If the relative change in price is greater than the relative
change in the quantity demanded associated with it,
demand is inelastic
 In the range of prices in which demand is elastic, total
revenue will diminish as price decreases
 Total revenue will not change if price varies within a
range where the elasticity coefficient is unity
 Demand tends to be elastic at high prices and inelastic at
low prices
Other things being equal, which of the following
might shift the demand curve for gasoline to the
left?
 The discovery of vast new oil reserves in Alberta
 The development of a low-cost electric automobile
 An increase in the price of train and air transportation
 A large decline in the price of automobile
Which of the following would NOT shift the
demand curve for beef?
 A widely publicized study that indicates beef increases
one’s cholesterol
 A reduction in the price of cattle feed
 An effective advertising campaign by pork producers
 A change in the incomes of beef consumers

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Which of the following statements is INCORRECT:
 If demand increases and supply decreases, equilibrium
price will rise
 If supply increases and demand decreases, equilibrium
price will fall
 If demand decreases and supply increases, equilibrium
price will rise
 If supply declines and demand remains constant,
equilibrium price will rise
If the supply and demand curves for a product
both decrease, we can say that equilibrium:
 Quantity must fall and equilibrium price must rise
 Price must fall, but equilibrium quantity may either rise,
fall or remain unchanged
 Quantity must decline, but equilibrium price may either
rise, fall or remained unchanged
 Quantity and equilibrium price must both decline