2. Types of Firms
• Sole or Individual Proprietorship
• Partnership
• Limited Liability Companies or Corporation
3. Individual Proprietorship
• a single person holds the entire operation as
his personal property, usually managing it on a
day-to-day basis.
4. Partnership
• may have from two to 50 or more members,
as in the case of large law and accounting
firms, brokerage houses, and advertising
agencies. This form of business is owned by
the partners themselves; they may receive
varying shares of the profits depending on
their investment or contribution. Whenever a
member leaves or a new member is added,
the firm must be reconstituted as a new
partnership.
5. Partnership
• The distinguishing features of the partnership
are the personal and unrestricted liability of
each partner for the debts and obligations of
the firm (whether he assented to their being
incurred or not) and the right of each partner
to participate in the management of the firm
and to act as an agent of it in entering into
legal transactions on its behalf.
6. Partnership
• a partner may assign his share or interest in a
partnership to anyone he wishes unless the
partnership agreement forbids this, but the
assignment does not make the assignee a
partner unless all the other partners agree. If
they do not, the assignee is merely entitled to
receive the financial benefits attached to the
share or interest without being able to take
part in the management of the firm, but
neither is he personally liable for the debts of
the firm.
7. Corporation
• the limited-liability company, or corporation,
denotes incorporated groups of persons—that
is, a number of persons considered as a legal
entity (or fictive “person”) with property,
powers, and liabilities separate from those of
its members; the company is legally separate
from the individuals who work for it, whether
they be shareholders or employees or both; it
can enter into legal relations with them, make
contracts with them, and sue and be sued by
them.
8. Corporation
• formed not simply by an agreement entered
into between its first members; it must also be
registered at a public office (SEC) or court
designated by law or otherwise obtain official
acknowledgment of its existence.
• Shares are freely transferable unless the
company's constitution imposes restrictions
on their transfer
11. The Production & Utility Functions
Production Function Utility Function
Output from inputs Preference level
from purchases
Derived from Derived from
technologies preferences
Cardinal(Defn: given Ordinal
amount of inputs
yields a unique and
specific amount of
output)
Marginal Product Marginal Utility
11
12. The Production Function & Technical Efficiency
Q
Production Function
Q = f(L)
D
•
C
• •B
Production Set
•A
L
12
13. The Production Function & Technical Efficiency
Definition: The feasible
but inefficient points below
the production function
make up the firm’s
production set.
13
14. The Production Function & Technical Efficiency
• The variables in the production function are flows (the
amount of the input used per unit of time), not stocks (the
absolute quantity of the input).
• Example: stock of capital is the total factory installation;
flow of capital is the machine hours used per unit of time in
production (including depreciation).
• Capital refers to physical capital (definition: goods that
are themselves produced goods) and not financial capital
(definition: the money required to start or maintain
production).
14
15. ANALYSIS
• Production Function
Q = F(K,L)
• Q is quantity of output produced.
• K is capital input.
• L is labor input.
• F is a functional form relating the inputs to output.
The maximum amount of output that can be
produced with K units of capital and L units of
labor.
• Short-Run vs. Long-Run Decisions
• Fixed vs. Variable Inputs
17. The Marginal Product
Definition: The marginal product of an input is the
change in output that results from a small change
in an input holding the levels of all other inputs
constant.
MPL = Q/L
• (holding constant all other
inputs)
MPK = Q/K
• (holding constant all other
inputs)
17
18. The Marginal Product
Definition: The marginal product of an input is the
change in output that results from a small change
in an input holding the levels of all other inputs
constant.
Marginal Product of Labor: MPL = Q/L
Measures the output produced by the last worker.
Slope of the short-run production function (with respect to labor).
Marginal Product of Capital: MPK = Q/K
Measures the output produced by the last unit of capital.
When capital is allowed to vary in the short run, MPK is the slope of the
production function (with respect to capital).
18
19. Marginal Product
• Marginal Product on an Input: change in total output
attributable to the last unit of an input.
Marginal Product of Labor: MPL = Q/L
• Measures the output produced by the last worker.
• Slope of the short-run production function (with respect to labor).
Marginal Product of Capital: MPK = Q/K
• Measures the output produced by the last unit of capital.
• When capital is allowed to vary in the short run, MPK is the slope
of the production function (with respect to capital).
20. The Average Product & Diminishing Returns
Definition: The average product of an
input is equal to the total output that is to
be produced divided by the quantity of the
input that is used in its production:
APL = Q/L
APK = Q/K
Definition: The law of diminishing marginal
returns states that marginal products (eventually)
decline as the quantity used of a single input
increases.
20
21. Total, Average, and Marginal
• When a total magnitude is rising, the
corresponding marginal magnitude is positive.
• When an average magnitude is falling, the
corresponding marginal magnitude must be
smaller than the average magnitude.
21
22. Total, Average, and Marginal
TPL maximized where MPL
is zero. TPL falls where
MPL is negative; TPL rises
where MPL is positive.
22
23. Decisions
• Producing on the production function
– Aligning incentives to induce maximum worker
effort.
• Employing the right level of inputs (capital or
labor intensive)
– When labor or capital vary in the short run, to
maximize profit a manager will hire
• labor until the value of marginal product of labor
equals the wage: VMPL = w, where VMPL = P x MPL.
• capital until the value of marginal product of capital
equals the rental rate: VMPK = r, where VMPK = P x MPK
.
24. ISOQUANT
• illustrates the combinations of inputs (K, L)
that yield the producer the same level of
output.
• The shape of an isoquant reflects the ease
with which a producer can substitute among
inputs while maintaining the same level of
output.
25. The Production & Utility Functions
Production Function Utility Function
Isoquant(Defn: all Indifference Curve
possible
combinations of
inputs that just
suffice to produce a
given amount of
output)
Marginal Rate of Marginal Rate of
Technical Substitution
Substitution
25
26. Isoquants
Definition: An isoquant traces
out all the combinations of
inputs (labor and capital) that
allow that firm to produce the
same quantity of output
Example: Q = K1/2L1/2
What is the equation of the isoquant for Q =
20?
20 = K1/2L1/2
=> 400 = KL
=> K = 400/L
26
27. Isoquants
K
All combinations of (L,K) along the
isoquant produce 20 units of
output.
Q = 20
Slope=K/L Q = 10
0 L
27
28. Marginal Rate of Technical Substitution
Definition: The marginal rate of technical substitution
measures the amount of an input, L, the firm would require in
exchange for using a little less of another input, K, in order to just
be able to produce the same output as before.
MRTSL,K = -K/L (for a constant level of output)
Marginal products and the MRTS are related:
MPL(L) + MPK(K) = 0
=> MPL/MPK = -K/L = MRTSL,K
28
29. Marginal Rate of Technical Substitution
• If both marginal products are positive,
the slope of the isoquant is negative.
• If we have diminishing marginal
returns, we also have a diminishing
marginal rate of technical substitution
• For many production functions,
marginal products eventually become
negative. Why don't most graphs of
Isoquants include the upwards-sloping
portion?
29
30. Isoquants
Isoquants
K MPK < 0 Example: The Economic and the
Uneconomic Regions of Production
Q = 20
MPL < 0
Q = 10
0 L
30
31. Linear Isoquants
Capital and labor are
perfect substitutes
Q = aK + bL
MRTSKL = b/a
Linear isoquants imply that
inputs are substituted at a
constant rate, independent of
the input levels employed.
32. Leontief Isoquants
Capital and labor are perfect
complements.
Capital and labor are used in
fixed-proportions.
Q = min {bK, cL}
Since capital and labor are
consumed in fixed proportions
there is no input substitution
along isoquants (hence, no
MRTSKL).
33. Cobb-Douglas Isoquants
Inputs are not perfectly
substitutable.
Diminishing marginal rate
of technical substitution.
As less of one input is used in
the production process,
increasingly more of the other
input must be employed to
produce the same output level.
Q = KaLb
MRTSKL = MPL/MPK
34. Isocosts
The combinations of inputs that
produce a given level of output at
the same cost:
wL + rK = C
Rearranging,
K= (1/r)C - (w/r)L
For given input prices, isocosts
farther from the origin are
associated with higher costs.
Changes in input prices change
the slope of the isocost line.
35. Cost Minimization
• Marginal product per peso spent should be
equal for all inputs:
MPL MPK MPL w
w r MPK r
But, this is just
w
MRTS KL
r
37. Returns to scale
• If a 10% increase in all inputs yields more than
a 10% increase in output, the production
function has increasing returns to scale. If it
yields less than a 10% increase in output, the
production function has decreasing returns to
scale. And if it yields exactly a 10% increase in
output, it has constant returns to scale.
38. Returns to scale
• are important for determining how many firms
will populate an industry. When increasing
returns to scale exist, one large firm will produce
more cheaply than two small firms. Small firms
will thus have a tendency to merge to increase
profits, and those that do not merge will
eventually fail. On the other hand, if an industry
has decreasing returns to scale, a merger of two
small firms to create a large firm will cut output,
raise average costs, and lower profits. In such
industries, many small firms should exist rather
than a few large..
39. Types of Cost
• Variable cost (VC)
• Fixed cost (FC)
• Total cost TC = VC + FC
• Average Cost (AC)
• Marginal Cost (MC)
40. • TC = FC + VC
• AFC = FC/Q
• AVC = VC/Q
• ATC = AFC + AVC
41.
42. • The total variable cost curve has the same
shape as the total cost curve—increasing
output increases variable cost.
43. • The marginal cost curve goes through the
minimum point of the average total cost curve
and average variable cost curve.
• Each of these curves is U-shaped.
44. The average fixed cost curve slopes down continuously; it
looks like a child’s slide – it starts out with a steep decline,
then it becomes flatter and flatter.
• It tells us that as output increases, the same fixed cost can
be spread out over a wider range of output.
45. • When output is increased in the shortrun, it can only be done by
increasing the variable input.
• The law of diminishing marginal productivity sets in as more and
more of a variable input is added to a fixed input.
• Marginal and average productivities fall and marginal costs rise.
46. • And when average productivity of the variable
input falls, average variable cost rise.
• The average total cost curve is the vertical
summation of the average fixed cost curve and the
average variable cost curve.
47. • If the firm increased output enormously, the
average variable cost curve and the average total
cost curve would almost meet.
• The firm’s eye is focused on average total cost—
it wants to keep it low.
48. The Relationship Between
Productivity and Costs
• When one is increasing, the other is decreasing.
• When one is at a maximum, the other is at a
minimum.
49. Relationship between MC and AC
• MC > AC implies AC is increasing
• MC < AC implies AC is decreasing
• Marginal cost curves always intersect average
cost curves at the minimum of the average
cost curve.
• The position of the marginal cost relative to
average total cost tells us whether average
total cost is rising or falling.
50. To summarize:
• If MC > ATC, then ATC is rising.
• If MC = ATC, then ATC is at its low point.
• If MC < ATC, then ATC is falling.
51. • Marginal and average total cost reflect a general
relationship that also holds for marginal cost and average
variable cost.
• If MC > AVC, then AVC is rising.
• If MC = AVC, then AVC is at its low point.
• If MC < AVC, then AVC is falling.
52. • As long as average variable cost does not rise by
more than average fixed cost falls, average total
cost will fall when marginal cost is above average
variable cost,
53.
54. But In Reality
• Some economists have tried to construct a theory of the
firm in which the firm decides prices by a markup over
costs. The attraction of this sort of theory is that, when
asked to explain how they determine the prices they
charge, most sellers talk in terms of markups (which they
sometimes call "profit margins"). The problem with markup
theories is that they have difficulty explaining the
percentage size of the markup (when they bother trying to
explain it at all). Grocery stores, for example, mark up
different products by different percentages, and they have
a much smaller average markup than furniture stores have.
55. • Most economists see markup pricing as a rule-
of-thumb way in which businesses conduct
their affairs. Firms usually do not have the
information needed to compute marginal
costs and revenues. Instead they find rules or
guidelines that work, and stick with them as
long as they perform satisfactorily. If a firm
marks up a product by 50% and finds that it
does not make a profit at that price, it tries
another percentage. When it finally finds a
markup that generates a profit, it will stick
with it.
