Microeconomic Analysis

ECON 520 - SS 11-12

KFUPM - Fall-22
Dr. Muhammad Imran Chaudhry, CFA
 Overview-Producer Theory
• In this module we learn about:
– The microeconomic foundations of supply curve in the canonical
supply & demand model.
– Derivation of supply curves as the solution to producer’s profit
maximization problem.
– Applications of producer theory in different contexts, e.g. short-run
and long-run profit maximization, cost behavior and firm entry/exit
decisions.
– All important results are explained at three levels i.e. intuitively,
graphically and mathematically.
• Two building blocks of producer theory are:
– Factors of Production: Inputs i.e. land, labor, capital and raw material.
– Technology: How firms can (feasibly) produce output given inputs.
 Overview-Producer Theory
• Modelling producers’ decisions in perfectly competitive market:
– No producer is large enough to influence market prices. Firms are price-
takers i.e., each firm can sell as much as it wants at the market price.
– Each firm produces (roughly) identical goods e.g., eggs, wheat, pencils.
– There is free entry and exit i.e., entering/exiting the market is easy.
• Primary objective of producers/firms is to maximize net profits:
– We need to understand how producers/firms in a perfectly competitive
market decide what quantity to produce.
• Application of the principle of optimization and thinking at the margin!
• A firm’s choice/decision problem consists of three components.
– Production Technology: How inputs are combined to make output e.g.,
some combination of seed, land, chemicals, machinery, labor and fuel to
grow potatoes. Guns, labor and equipment for a security company.
 Overview-Producer Theory
– Production Costs: How much it costs to produce unit of output i.e., cost
of doing business, and how costs behave as production levels are varied.
– Revenues: Price at which a unit of output can be sold in the market.
– In particular, for perfectly competitive firms, there is a close relationship
between nature of production technologies and behavior of production
costs.
• Modelling each of these components will yield a set of decision
rules that govern optimal production levels of profit-maximizing
firms in different contexts (e.g., short-run and long-run)
– The same structure is subsequently utilized to derive optimal production
choices of firms under other market structures i.e., monopoly, oligopoly
and monopolistic competition.
– Studying these components also provides a blueprint of how economists
think about a problem!
 Production Technology: Inputs to Outputs
• Firms are entities that produce and sell goods or services in an
economy, and essentially combine inputs e.g., labor and capital
to create outputs (e.g., cheese and cars).
• The components of the production process are:
– Factors of Production: Set of inputs available to a firm i.e., capital, labor,
raw materials and organizational (knowledge) resources etc.
– Technology: How firms produce output from a set of inputs.
• Firms face technological constraints i.e., number of feasible approaches to
produce maximum amount of output from a given set of inputs.
• Relationship between the quantity of inputs used and quantity
of outputs produced is represented by a production function.
– Production function signifies an engineering relationship that describes
the optimal amount of input required to produce a given output.
 Short-Run Production Function
• Economists propose a clear distinction between short-run and
long-run production decisions in theory of the firm:
– Short-run is the period of time when only some of a firms’ inputs can
be varied i.e., at least one factor of production is fixed in the short-run
e.g., takes 1-2 years to change size of factory or develop an oil well.
– Long-run is the period of time wherein firms can change any input i.e.,
all factors of production can be varied in the long-run.
• For simplicity, we assume firms can employ only two factors of
production:
– Physical capital is a fixed factor of production — an input that cannot
change in the short run.
– Labor is a variable factor of production — an input that can change in
the short run.
 Short-Run Production Function
• At a given level of capital, if we graph the relationship between
output (Y-axis) and labor (x-axis).
– Marginal product is the change in total output associated with one more
unit of labor i.e., extra amount of output produced by an additional unit
of variable input.
– Mathematically, the marginal product of labor at any given level of labor
is equal to the derivative of the production function at that point.
– The marginal product of inputs increase with the first few units of input
due to specialization.
• Workers develop specific skills that increases total productivity e.g. one digs
the hole and other moves away the excess mud.
– Due to the fixed level of one input in the short run, extra output from an
additional unit of input generally increases at a decreasing rate.
• Intuition: Keep on hiring more workers but only have one available machine
e.g. one shovel and many workers trying to dig a hole.
 Short-Run Production Function
• Law of Diminishing Returns: After a certain point, the marginal
product begins to decrease i.e., successive increases in inputs
produce less and less additional units of output.
– Graphically, production function become flatter.
 Profit Maximization-Short Run
• Objective of firm is to maximize profits i.e. Revenues – Costs. Key to
profit maximization is efficient production.
• In our analysis of the profit maximization problem we assume:
– Competitive markets for all factors of production and output
market.
– All factors of production valued at their market price.
• In the short-run, firms are obligated to employ some factors of
production even if it decides to produce zero output.
• Mathematical Formulation: p.f(K,L) – wL- rK
– Capital (K )is fixed in the short run, so firms need to determine optimal
amount of Labor (L) to hire.
– Where p is price of output, f()is the production function, w is the wage
rate and r is the rental rate of capital.
 Profit Maximization-Short Run
• Mathematical analysis: Taking first order condition we
get the optimality conditions:
– p.(MPL)= w i.e., value of marginal product of labor equals wage
rate. If value of marginal product exceeds wages, then profit can
be increased by hiring additional labor, and if value of marginal
product less than wage then profit can be increased by laying off
workers.
• Graphical Analysis:
– Derive iso-profit lines: solve for output (q) in the profit equation
and express it as a function of labor (L) i.e. all combinations of
inputs and outputs that give a constant level of profit. Higher
levels of profits are represented with higher iso-profit lines.
– Optimality condition: Point where iso-profit lines are tangent to
the production function.
 Profit Maximization-Long Run
• In the long-run all factors of production are variable.
– Firms free to choose level of all inputs in the long-run and will choose
levels of all inputs optimally.
• Mathematical Formulation: p.f(K,L) – wL- rK
– Firms determine optimal amount of both labor and capital. Optimality
conditions: (1) p.(MPL)= w and (2) p.(MPK)= r
– If firms choose the optimal level of each factor, then value of marginal
product of each factor of production should equal its price.
• If a firm is maximizing profits, then it must be minimizing costs.
Otherwise, the firm can produce output in a cheaper way and
increase profits!
– Duality Concept: Minimizing cost of producing a given level of output
first and then choose the profit maximizing level of output.