MICROECONOMICS - CHAPTER 6

THE THEORY OF
FIRM BEHAVIOR
Ph.D Hoang Van Hai
Danang, December 2024
 AGENDA

I. THE THEORY OF PRODUCTION

II. THE THEORY OF COST
III. THE THEORY OF PROFIT
I. THE THEORY OF PRODUCTION

1. Definitions
2. Production Function
3. Production Function With One Input Variable
4. Production in the Long Run
I. THE THEORY OF PRODUCTION
1. Definitions
a. Production
• Production is the process of utilizing various types of goods and services,
referred to as inputs or factors of production, to create new goods
and services, known as outputs (or products).

b. Technology
• Technology is understood as the methods or techniques that combine
input factors to create output products.
I. THE THEORY OF PRODUCTION
1. Definitions
c. Firm
• A firm is an economic organization that hires or purchases input factors
of production to create goods and services for sale to consumers in order
to generate profits.

d. Long-run and Short-run

• Short-run is a period of time in which at least one input is fixed.
Conversely, long-run is a period of time in which a firm can change all
input factors used in the production process
I. THE THEORY OF PRODUCTION
2. Production function
• A production function shows the relationship between the quantity of
inputs used to produce a good and the quantity of output of that
good.
• The production function is generally expressed as

Q = f(x1, x2, ..., xn)

 Q represents the output quantity

 x1, x2, ..., xn are the factors of production
I. THE THEORY OF PRODUCTION
2. Production function

• If we hold other production factors fixed and only consider two factors,
labor (L) and capital (K), then the production function can be written as

Q or TP = f(K, L)
I. THE THEORY OF PRODUCTION

2. Production function
• The Cobb-Douglas production function

 Q or TP: Output or Total Production

 A: Technology (constant)
 K: Capital
Q or TP = A.K .L α β

 α: Output elasticity of capital

 L: labor
 β: Output elasticity of labor
I. THE THEORY OF PRODUCTION

2. Production function

• Returns to scale is a concept that describes how changes in output

relate to changes in the quantities of all inputs used in production,
when those inputs are increased or decreased by the same proportion.
• Three cases of returns to scale:
 Economies of scale
 Diseconomies of scale
 Constant Returns to Scale
I. THE THEORY OF PRODUCTION

2. Production function
• Economies of Scale: 1% increase in inputs or → more than 1% increase in outputs

f (hK, hL) > hf (K, L)

• Diseconomies of Scale: 1% increase in inputs → less than 1% increase in

outputs
f (hK, hL) < hf (K, L)

• The Constant Returns to Scale: 1% increase in inputs → 1% increase in

outputs
f (hK, hL) = hf (K, L)
I. THE THEORY OF PRODUCTION

2. Production function
• Regarding the Cobb-Douglas production function, the sum of the
coefficients α and β can indicate the Returns to Scale.

Q or TP = A.Kα.Lβ

 If α + β = 1, the production function reflects Constant Returns to

Scale.
 If α + β < 1, the production function exhibits Diseconomies of
Scale.
I. THE THEORY OF PRODUCTION

3. Production Function With One Input Variable

• When studying the short-run production function, we assume that only the
quantity of labor (L) input used in production can vary, while the amount of
capital (K) input remains unchanged.
• Therefore, the production function is a single-variable function of L and is
represented as:

Q or TP = f(L)
I. THE THEORY OF PRODUCTION
3. Production Function With One Input Variable
a. Average labor productivity (APL)
• Average Labor Productivity (ALP) or Average Product of Labor (APL) is the
quantity of output measured per unit of labor input.
• Average labor productivity is determined by dividing the output quantity by the
number of labor units used to produce that output.

APL =

The same could be said about APK=

I. THE THEORY OF PRODUCTION
3. Production Function With One Input Variable
b. Marginal Product (MP)
• The marginal product (MP) refers to the additional output when adding one
additional unit of input with all other inputs constant.

MP =

• Marginal Product of Labor (MPL ) is the increase in the amount of output from
an additional unit of labor.

MP L =
I. THE THEORY OF PRODUCTION
3. Production Function With One Input Variable
c. Diminishing marginal product

• The marginal product of any variable input will initially increase and
eventually diminish at a certain point, as we continue to add additional
units of that input into the production process (while holding the other
input constant).

What is the Relationship between MPL and APL?

I. THE THEORY OF PRODUCTION
3. Production Function With One Input Variable
c. Diminishing marginal product

• When MPL is increasing, Q is increasing gradually.

• When MPL is decreasing, Q is still increasing, but slowly.

• When MPL is zero, Q is at its maximum.

• When MPL is < 0, Q is decreasing

I. THE THEORY OF PRODUCTION
3. Production Function With One Input Variable
c. Diminishing marginal product

• Diminishing marginal productivity describes the relationship between average

product of labor (APL) and marginal product of labor (MPL):
 As the quantity of labor used increases, APL initially increases and reaches a
maximum at APLmax before gradually decreasing.
 Similarly, MPL increases and reaches a maximum at MPLmax before decreasing
through the point of APLmax and eventually becoming zero (MPL = 0).
I. THE THEORY OF PRODUCTION
3. Production Function With One Input Variable
c. Diminishing marginal product

• When MPL is greater than APL, APL is increasing.

• When MPL is less than APL, APL is decreasing.

• When MPL is zero, TP or Q is at its maximum.

• The MPL curve crosses the APL curve at the APL

curve’s maximum.
I. THE THEORY OF PRODUCTION
3. Production Function With One Input Variable
c. Diminishing marginal product

• Diminishing marginal productivity allows for an optimal allocation of inputs

• It reveals the relationship between marginal product (MP) and marginal cost (MC).

 MP ↑ => MC ↓
MC =  MPmax ↓ => MCmin
 MP ↓ => MC ↑
I. THE THEORY OF PRODUCTION
3. Production Function With One Input Variable
c. Diminishing marginal product

• Using the Cobb-Douglas production function to demonstrate...

Q f(K,L) = A.Kα.Lβ , (0 < α , β <1)

When L = const
 MPK = Q’K= α A.Kα-1.Lβ
 (MPK)’= (α A.Kα-1.Lβ)’ = α(α-1) A.Kα-2.Lβ
α <1 => (α-1) <0 => (MPK)’<0 => MP ↓

• Similarly, when K = const, MP ↓

I. THE THEORY OF PRODUCTION
4. Production in the Long Run
a. Isoquant Curve

•All combinations of labor and capital that produce the same level of output
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
a. Isoquant Curve

•Properties of isoquants
 Isoquants are downward sloping
 Isoquants that are closer to the right-hand side represent higher
levels of output.
 Isoquants do not intersect or cross each other.
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
a. Isoquant Curve

Slope of the isoquant

= Marginal rate of technical substitution (MRTS): rate at which

labor can be substituted for capital, so that output remains constant.
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
a. Isoquant Curve

The marginal rate of technical substitution (MRTS) decreases as the input L increases.
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
a. Isoquant Curve
• Special Cases Of Isoquant Curves

Perfect Substitutes
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
a. Isoquant Curve
• Special Cases Of Isoquant Curves

Perfect Complements
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
b. Isocost Line
•An Isocost line shows the different combinations of factors of
production that can be employed with a given total cost.

.A C
.
B
.
D
• Slope of the isocost: .
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
b. Isocost Line
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
b. Isocost Line
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
c. Production optimization
I. THE THEORY OF PRODUCTION
4. Production in the Long Run
c. Production optimization
• At point C, the slope of the Isoquant curve equals the slope of the Isocost line:
II. THE THEORY OF COST

1. Definitions
2. Costs in the Short Run and Long Run
3. Total cost; Average cost; Economic cost
II. THE THEORY OF COST
1. Definitons
a. Resource Costs
• Resource cost is the cost of resources typically measured in terms
of the goods used to produce a product.

b. Accounting Costs & Economic Costs

• Accounting cost (also known as financial cost) is the actual cost incurred in
monetary terms (explicit cost) to produce a product, excluding the opportunity costs
of the inputs used in the production process.
• Economic cost is the total monetary cost of producing a product, including both
accounting costs and opportunity costs.
• Economic cost = Accounting cost + Opportunity cost
II. THE THEORY OF COST
2. Costs in the Short Run
a. Total Fixed Cost (TFC)

• Fixed cost is the cost that does not

change when the quantity changes
(i.e., it is independent of the
quantity produced and still incurs
even when there is no production).
• Q ↑, ↓, = 0 => FC = const
• FC = TC - VC
II. THE THEORY OF COST
2. Costs in the Short Run
b. Total Variable Cost (TVC)

• Total Variable Cost is the cost that

depends on the quantity produced,
meaning that as output increases,
total variable costs increase, and vice
versa.
• Q ↑, ↓, = 0 => VC ↑, ↓
• VC = TC – FC
• Note:
 Q = 0 => VC = 0
 Variable cost (VC) always differs
from total cost (TC) by a fixed
amount, which is the fixed cost (FC).
II. THE THEORY OF COST
2. Costs in the Short Run
c. Total Cost (TC)

• Total cost is the sum of all resources

measured in market value used to
produce a product. Total cost includes
both variable costs and fixed costs..
• TC = FC + VC
 TCq=0 = FC
II. THE THEORY OF COST
2. Costs in the Short Run
d. Average Costs in the Short Run

• Average Fixed Cost (AFC) is the fixed cost per unit of output.
 AFC = FC / Q => FC = AFC x Q
 AFC = ATC - AVC
• Average Variable Cost (AVC) is the variable cost per unit of output
 AVC = VC / Q => VC = AVC * Q
 AVC = ATC – AFC
• Average Total Cost (ATC) is the total cost of production per unit of output.
 ATC = TC / Q => TC = ATC * Q
 ATC = AVC + AFC
II. THE THEORY OF COST
2. Costs in the Short Run
e. Marginal Cost (MC)
• Marginal cost is the additional cost incurred when producing an additional unit of
output.
• Note
 The marginal cost (MC) curve has a U-shape and always passes through the
minimum points of average total cost (ATC) and average variable cost (AVC).
 The upward slope of MC is due to the law of diminishing marginal productivity.

MC = = = W =W
II. THE THEORY OF COST
2. Costs in the Short Run
e. Marginal Cost (MC)

• MC decreases when marginal product

of labor (MPL) increases with a
decrease in the labor input (L).
• MC increases when PL decreases with
an increase in the labor input (L).
• Mcmin when MPLmax, which occurs at
the optimal level of labor input (L*).
• MC = TC' and MC = VC'
II. THE THEORY OF COST
2. Costs in the Short Run
e. Marginal Cost (MC)
• The Average Total Cost (ATC) curve has a U-shaped pattern and crosses the
Marginal Cost (MC) curve at ATCmin.
• Since MC curve crosses ATCmin  (ATC)’= 0  )’ = 0  (
 MC = ATC  (ATC)’= 0, ATCmin => MC crosses ATC at ATCmin
 MC > ATC  (ATC)’> 0, Q ↑, ATC ↑ => When MC > ATC, ATC increases gradually.
 MC < ATC  (ATC)’< 0, Q ↑, AVC ↓ => When MC<ATC, ATC decreases gradually.
II. THE THEORY OF COST
2. Costs in the Short Run
e. Marginal Cost (MC)
• FC (Fixed Cost) is a horizontal line.
• VC (Variable Cost) and TC (Total Cost) slope upward and are evenly separated by
an amount equal to FC.
• AFC (Average Fixed Cost) always slopes downward to the right.
• AVC (Average Variable Cost) and ATC (Average Total Cost) have a U-shaped
pattern.
• MC (Marginal Cost) also has a U-shaped pattern and passes through the two
minimum points of AVC and ATC.
II. THE THEORY OF COST
2. Costs in the Short Run
e. Marginal Cost (MC)
• FC (Fixed Cost) is a horizontal line.
• VC (Variable Cost) and TC (Total Cost) slope upward and are evenly separated by
an amount equal to FC.
• AFC (Average Fixed Cost) always slopes downward to the right.
• AVC (Average Variable Cost) and ATC (Average Total Cost) have a U-shaped
pattern.
• MC (Marginal Cost) also has a U-shaped pattern and passes through the two
minimum points of AVC and ATC.
II. THE THEORY OF COST
2. Costs in the Short Run
e. Marginal Cost (MC)
• MC (Marginal Cost) also has a U-shaped pattern
• The relationship between MC and MP
 MC = ΔVC/ Δ Q
 ΔVC = W. ΔL
 MC = W/(ΔQ/ΔL) = W/MP
 MP ↑ => MC↓
 MPMAX => MCMIN
 MP ↓ => MC ↑
 MC has a U-shaped pattern
II. THE THEORY OF COST
2. Costs in the Short Run

• Fixed costs (FC) are one of the factors that determine whether a
company should continue or shut down its production. When the losses
exceed the fixed costs, the company will shut down production.
• Average Total Cost (ATC) helps determine the profit per unit of output
and determines the breakeven point (P, Q) for the business.
• Marginal Cost (MC) and ATC are the primary basis for a company to
determine the optimal production quantity (Q*).
• Average Variable Cost (AVC) helps determine the shutdown price.
II. THE THEORY OF COST
3. Costs in the Long Run

• LTC (Long-Run Total Cost)

refers to the total cost when all
input factors change.
II. THE THEORY OF COST
3. Costs in the Long Run

• Long-Run Average Cost (LAC)

is the total long-run cost per
unit of output.
II. THE THEORY OF COST
3. Costs in the Long Run
Increasing Returns to Scale Decreasing Returns to Scale

Constant Returns to Scale General

II. THE THEORY OF COST
3. Costs in the Long Run
II. THE THEORY OF COST
3. Costs in the Long Run

• Long-Run Marginal Cost (LRMC) is the change in the total

long-run cost when there is a change in one unit of output.

• LMC crosses LATC at LATCmin

II. THE THEORY OF COST
3. Costs in the Long Run
Increasing Returns to Scale Decreasing Returns to Scale

Constant Returns to Scale General

III. THE THEORY OF PROFIT
1. Profit
• Definition: Profit is a quantity that
reflects the difference between the
revenue obtained and the costs incurred
to achieve that revenue.

• Function: = TR - TC = Q * (P - ATC)
III. THE THEORY OF PROFIT
2. Average Revenue and Marginal Revenue
• Average revenue (AR) is the total revenue divided
by the number of units of products sold.

• Marginal revenue (MR) is the additional revenue

obtained from selling one additional unit of a product.
III. THE THEORY OF PROFIT
3. Condition For Profit Maximization Of A Firm

• Profit = Total Revenue – Total Cost

• π = TR - TC
• πmax when
 π’ = 0 => (TR - TC)’ = 0 => MR =MC

 If MR > MC then increasing Q will increase π
 If MR < MC then decreasing Q will increase π
 If MR = MC then Q is optimal (Q*) and πmax
III. THE THEORY OF PROFIT
3. Condition For Profit Maximization Of A Firm

• Summary: Every business will increase its output as long as

the marginal revenue exceeds the marginal cost (MR > MC)

optimal quantity of output, or Q*, to maximize profit ( 𝜋 Max).

until MR equals MC. At this point, the business determines the

 If MR > MC: Increasing Q will increase profit (𝜋).

 If MR < MC: Decreasing Q will increase profit (𝜋).
 If MR = MC: Q is the optimal quantity (Q*) for maximizing profit (𝜋
Max).
III. THE THEORY OF PROFIT
4. Factors That Influence Profit
a. Accounting Profit vs Economic Profit

• Accounting profit (Accounting 𝜋) = Total Revenue (TR) - Total

Accounting Cost (TAC)
• Economic profit (Economic 𝜋 ) = TR - Total Economic Cost (TEC)
= TR - Total Accounting Cost (TAC) - Opportunity Cost (O.C)
• Accounting 𝜋 - Economic 𝜋 = O.C
 Since TEC > TAC by an amount of O.C => economic 𝜋 <
accounting 𝜋, by the amount of O.C.
III. THE THEORY OF PROFIT
4. Factors That Influence Profit
b. Average Unit and Supernormal profit

• Since 𝜋 = TR - TC = Q (P - ATC) => Average 𝜋 = 𝜋 /Q = (P - ATC)

• Supernormal 𝜋 = Exceeding 𝜋 * Average 𝜋
THANK
YOU!
Ph.D Hoang Van Hai
Danang, 19 TH December 2023