Institute of Economic Theories - University of Miskolc
Microeconomics
Lecture 4-5
Mónika Kis-Orloczki
Assistant lecturer
orloczki.monika@uni-miskolc.hu
1
• production The process by which inputs
are combined, transformed, and turned into
outputs.
• firm An organization that comes into being
when a person or a group of people decides
to produce a good or service to meet a
perceived demand. Most firms exist to make
a profit.
Inputs
(L, K)
Production
Function
Q = f(L, K)
Output
(Q)
2
The Three Decisions That All Firms Must
Make
1. How much output to supply
2. Which production technology to use
3. How much of each input to demand
The bases of decision making:
1. The market price of output
2. The techniques of production that are available
3. The prices of inputs
Output price determines potential revenues. The techniques
available tell me how much of each input I need, and input
prices tell me how much they will cost. Together, the available
3
production techniques and the prices of inputs determine costs.
Determining the Optimal Method of Production
Price of output
Determines
total revenue
Production techniques
Input prices
Determine total cost
and optimal
method of production
Total revenue
-Total cost with optimal method
= Total profit
optimal method of production The production method
that minimizes cost.
4
Time Horizons for Decision Making
The short run is a period of time in which some of the
firm’s factors of production are fixed. Typically capital
is fixed in the short run.
– Fixed factor – An input whose quantity cannot be
changed in the short run.
– Variable factor – An input whose quantity can be
changed over the time period under consideration.
The long run is the length of time over which all of the
firm’s factors of production can be varied, but its
technology is fixed.
The very long run is the length of time over which all the
firm’s factors of production and its technological
5
possibilities can change.
1. The Short-run Production
Process
Production function A numerical or mathematical
expression of a relationship between inputs and
outputs. It shows units of total product as a function of
units of inputs.
Total product of labour: total quantity of output
produced with a given quantity of a variable input.
TP or Q = f (L)
where
TP or Q = total product or quantity of output
L = quantity of labor input
(quantity of capital input is fixed)
6
Marginal product: the additional output produced with an
additional unit of variable input
MP = ΔTP / ΔL = ΔQ / ΔL
Average product: amount of output per unit of variable input.
The productivity of an individual worker
AP = TP / L or Q / L
7
Output, q, Units per day
C
110
90
56
B
A
L
MP
4
11
L, Workers per day
a
AP
,
20
6
b
15
Average product, APL
Marginal product, MPL
4
6
11
c
8
L, Workers per day
TP increases rapidly up
to level of labor input A
then increases at a
slower rate as labor input
increases.
TP curve becomes flatter
and flatter until it reaches
maximum output level at
C.
Curve implies that
marginal product of labor
first increases rapidly
then decreases,
eventually becoming
zero or less.
Between zero and b,
MP curve lies above
AP curve, causing AP
curve to increase.
Below b, MP curve is
below AP curve,
causing AP curve to
decrease.
Therefore, MP curve
must intersect AP
curve at maximum
point of AP curve.
9
Increasing marginal returns: region where MP curve is
positive and increasing
Law of diminishing returns: region where marginal
product curve is positive but decreasing
Negative marginal returns: region where product curve
is negative so that TP is decreasing
Law of Diminishing Returns :
– Occurs because capital input and technologies are
held constant
– Additional output generated by additional units of
variable input (MP)
10
– Production becomes less constrained
Elasticity of production
Q Q Q Q MPL

: 
: 
L L L L APL
The Relationship between Marginal
=
+
+
and Average Product
1111
2. Long-run decisions
In the long run, all inputs are variable.
Relationship between a flow of inputs and the resulting
flow of output where all inputs are variable:
Q = f (L, K)
where
Q = quantity of output
L = quantity of labor input (variable)
K = quantity of capital input (variable)
both inputs are variable
12
Technical versus Economic
Efficiency
Technical efficiency Obtaining the greatest
possible production of goods and services from
available resources. In other words, resources
are not wasted in the production process.
Technical efficiency is not enough for firms to
maximize profits. The firm must choose among
the technically efficient options to produce a
given level of output at the lowest cost
Economic efficiency
13
Profit Maximization and Cost
Minimization
For any level of output, maximizing profits
requires firms to choose their inputs to minimize
total costs.
A firm is not minimizing costs if it is possible to
substitute one factor for another to keep output
constant while reducing total cost:
 The firm should substitute one factor for another
factor as long as the marginal product of one factor
per dollar spent on it is greater than the marginal
product of the other factor per dollar spent on it. 14
• Labor-intensive method: process that uses large
amounts of labor relative to other inputs
• Capital-intensive method: process that uses large
amounts of capital equipment relative to other inputs
• Input substitution: degree to which one input can be
substituted for another
• Can occur in small-scale or large-scale business
• Some processes may not be conducive to substitution
• Issue is whether the same quality output is being
produced with input substitution
• Factors influencing input substitution
• Technology
• Prices of inputs
• Incentives facing a given producer
15
• Isoquant A graph that shows all the
combinations of capital and labor that can be
used to produce a given amount of output.
K
Input
5
3
Labour
Capital
1
2
3
4
5
1
20
40
55
65
75
2
40
60
75
85
90
3
55
75
90
100
105
4
65
85
100
110
115
5
75
90
105
115
120
Q=75
1
2
L
16
Properties of Isoquants
 The farther an isoquant is from the origin, the
greater the level of output.
 Isoquants do not cross.
 Isoquants slope downward
Marginal rate of technical substitution (MRTS)
The slope of an isoquant, or the rate at which
a firm is able to substitute one input for
another while keeping the level of output
constant.
(MP ) / (MP )  -(K / L)  MRTS
L
K
17
Substitution Among Inputs
K
K
MPL
L
MPK
a
16
K = –6
b
10
L = 1
–3
c
1
–2 1
7
5
4
d
e
–1
q = 10
1
0
1
2
3
4
5
6
7
8
9
10
L
18
Substitutability of Inputs
Isoquants When Inputs Are
Perfect Substitutes
Fixed-Proportions
Production Function
19
Holding the
amount of capital
fixed at a
particular level
(say 3), we can
see that each
additional unit of
labor generates
less and less
additional output.
20
Isocost line A graph that shows all the
combinations of capital and labor available
for a given total cost.
Slope of isocost line
K
TC / PK
PL
L
TC / PL
PK
Movements of the isocost line
• Change in the budget constraint
• The price ratio of the two inputs changes
21
Finding The Least-cost Technology with Isoquants
and Isocosts
K
Q
TC
The firm will choose
the combination of
inputs that is least
costly. The least
costly way to
produce any given
level of output is
indicated by the point
of tangency between
an isocost line (TC)
and the isoquant (Q)
corresponding to that
L level of output.
22
Finding The Least-cost Technology
with Isoquants and Isocosts
At the point where a line is just tangent to a curve, the two have
the same slope. At each point of tangency, the following must
be true:
MPL
PL
slopeof isoquant   slopeof isocost  MPK
PK
Thus,
MPL PL

MPK PK
Dividing both sides by PL and multiplying both sides by
MPK, we get
MPL MPK

PL
PK
23
Example
Suppose the marginal product of capital is 40 units of
output and the price of one unit of capital is $10. The
marginal product of labor is 20 units of output and the
price of one unit of labor is $2.
MPK
40
=
pK
MPL
= 4 <
10
20
=
pL
= 10
2
In this case, the firm can reduce the cost of producing its
current level of output by using more labor and less
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capital.
How does output respond to increases in all inputs
together?
Increasing returns to scale – output increases more than in
proportion to inputs as the scale of a firm’s production
increases.
Constant returns to scale – output increases in proportion to
inputs as the scale of a firm’s production increases.
Decreasing returns to scale – output increases less than in
proportion to inputs as the scale of a firm’s production
increases.
Effect on Output Returns to Scale
f(tk,tl) = tf(k,l)
Constant
f(tk,tl) < tf(k,l)
Decreasing
f(tk,tl) > tf(k,l)
Increasing
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3. The Very Long Run: Changes
In Technology
In the very long run, there are changes in the available
techniques and resources for firms. Such changes
shifts the long-run cost curves.
Technological change refers to all changes in the
available techniques of production.
Economists use the notion of productivity to measure
the extent of technological change.
Faced with increases in the price of an input, firms
may either substitute away (LR) or innovate away
(VLR) from the input.
These two options can involve different actions and
can have different implications for productivity.
26
Institute of Economic Theories - University of Miskolc
Microeconomics
Lecture 6
Mónika Kis-Orloczki
Assistant lecturer
orloczki.monika@uni-miskolc.hu
Explicit costs: payment to an individual that is
recorded in an accounting system.
Implicit costs: value of using a resource that is not
explicitly paid out, is often difficult to measure, and
partly not recorded in an accounting system.
Economic depreciation measured as the change in
the market value of capital over a given period.
Normal profit is the return to entrepreneurship. A
rate of return on capital that is just sufficient to keep
owners and investors satisfied. For relatively riskfree firms, it should be nearly the same as the
interest rate on risk-free government bonds. It is
part of a firm’s economic cost because it is the cost
of the entrepreneur not running another firm. It is
the minimum level of profit required to keep the
factors of production in their current use in the
long run.
Total revenue The amount received from the
sale of the product (Q x P).
Total cost (total economic cost) The total of
explicit (out-of-pocket) and implicit costs.
Accounting profit: difference between total
revenue and accountable costs (explicit costs
+accountable implicit costs (for example
depreciation).
Economic profit: difference between total
revenue and total cost, both implicit and explicit.
 = TR - TC
Implicit Costs versus Explicit Costs,
an example
Pizza dough, tomato sauce, and other
ingredients
Wages
Interest payments on loan to buy pizza
ovens
Electricity
Lease payment for store
$20,000
Foregone salary
Foregone interest
$30,000
$3,000
Economic depreciation
Total
$48,000
$10,000
$6,000
$24,000
10,000
$151,000
Costs and revenues of the firm
Total revenue
Economic profit
Total economic costs
Explicit cost
Implicit costs
Accountable Normal
implicit costs profit
Accounting costs
Accounting profit
Short-Run Costs and Output
Decisions
Fixed cost (FC) Any cost that does not depend
on the firm’s level of output. These costs are
incurred even if the firm is producing nothing.
There are no fixed costs in the long run.
Variable cost (VC) A cost that depends on the
level of production chosen.
Total cost (TC) Fixed costs plus variable costs.
Average fixed cost (AFC) Total fixed cost divided by
the number of units of output; a per-unit measure of
fixed costs.
FC
AFC 
Q
Average variable cost (AVC) Total variable cost divided
by the number of units of output.
VC
AVC 
Q
1
AVC 
* PL
AP L
Average total cost (AC) Total cost divided by the
number of units of output.
TC
AC 
Q
AC  AFC  AVC
Marginal cost (MC) The increase in total cost
that results from producing one more unit of
output. Marginal costs reflect changes in
variable costs.
TC VC
MC 

Q
Q
1
MC 
 PL
MPL
Because fixed costs do
not vary with output, the
only part of TC that
changes is the variable
cost.
The marginal cost (MC),
average total cost (AC),
and average variable
cost (AVC) curves are all
U shaped, and the
marginal cost curve
intersects the average
variable cost and
average total cost curves
at their minimum points.
Relation of MP - MC and AP - AVC
MC
A
B
b
AP
AVC
a
MP
L1
L2
L
Q1
Q2
Q
Summary
Total fixed
costs
Costs that do not depend on the
quantity of output produced. These
must be paid even if output is zero.
TFC
Total variable
costs
Costs that vary with the level of
output.
TVC
Total cost
The total economic cost of all the
inputs used by a firm in
production.
Average fixed
costs
Fixed costs per unit of output.
AFC = TFC/Q
Average
variable costs
Variable costs per unit of output.
AVC = TVC/Q
Average total
costs
Total costs per unit of output.
ATC = TC/Q
ATC = AFC + AVC
Marginal costs
The increase in total cost that
results from producing one
additional unit of output.
MC = TC/Q
TC = TFC + TVC
Long-run costs
Since all inputs are variable, all costs are
variable in the long run.
Long-run average cost (LRAC) measures the
long-run cost of producing one unit of output:
Long- Run T otalCost of Production
LRAC 
Output
The Relationship between Short-Run
Average Cost and Long-Run Average
Cost
LRAC shows minimum average cost of
producing any level of output when all inputs
are variable
Return to scale
what happens to LRAC as a firm increases its plant size