Chapter 3 Firms & Efficiency

1. Introduction: This chapter is an introduction to the neoclassical theory of production at the level of the firm. The chapter will discuss the isoquant and cost curves which allows us to study the choice of technique of a profit maximization. Section 2 of this chapter set out a framework for comparing techniques of production. Section 3 considers how a profit-maximizing firm might choose between these techniques.

2. Production techniques and the production function. 2 2. Production techniques and the production function. 2.1 choice of alternative techniques: At point C, Is the firm producing with increasing or decreasing return to scale? Answer: If a firm, by doubling inputs, can double more than output, then it enjoys increasing returns to scale. The firm illustrated is not in this situation; along each ray (that is, with each technique), a doubling of inputs produces a doubling of output. Hence the firm faces constant returns to scale. Constant retunes to scale means that, along the ray representing any technique, the distance from the origin is proportionate to the output produced. Hence, with constant returns to scale, halving inputs halves output. Technique A Technique B A2 Capital Service (K) B2 C2 Technique C A1 20,000 units 100 B1 70 C1 55 10,000 units Labour Services (L) 40 70 110 220 Explain the alternative methods of processing 10,000 units. What is Capital Intensive? The higher the capital/labor ratio What is Labor intensive? The higher the labor/capital ratio Which of A, B and C is the most capital intensive technique?

2.2 Substitutability of factors of production: Diminishing Returns of a factor of Production What is Is-oquant? It connects all the different combinations of inputs used to produce a given output Explain the figure.. Each technique shows constant returns to scale .. Why? If Capital services are held constant, what will happen? Moving from X to B3 > from A1 to X The additional output from each successive increment of labor services is diminishing. This is called Diminishing marginal returns to a factor.. Technique A A3 200 Technique B Capital Service (K) A2 A1 x B3 100 B2 20,000 units 70 B1 50 15,000 units 10,000 units 40 80 100 200 Labor Services (L)

2.3 From isoquants to production functions: The isoquant maps can be regarded as defining the technological options open to a firm. These options can be summarized in the form of a production function, then we shall have. Two types of production functions: The shape of a firm's isoquants depends on two key aspects of its technology: 1) the substitutability of labour and capital, and 2) the returns to scale. We can summarize both of these aspects of the technical choices facing the firm using the production function just introduced, of the general form: Q = f (L,K) If there is zero substitutability of factors of production, and constant returns to scale, then labour and capital have to be used in fixed and given proportions. Then the production function will be written in following specific form: Q= f (L, K) = min (a L, b K) Q = min (a L, b K) The key assumptions are that, at any moment in time, there is a range of possible best-practice techniques, known to the firm, and that the firm is always using a best-practice technique.

3. Choice of technique and scale by the profit-maximizing firm. 3 3. Choice of technique and scale by the profit-maximizing firm. 3.1From the Production Function to Minimize Costs: What is ISOCOST Line: It is the line that connects all combinations of factors of production that can be purchased for the same total cost, at given factor prices. Figure 3.9 adds an isoquant map to the set of isocost lines. The output expansion path, which connects the minimum cost input combinations for different levels of output, is not necessarily a straight line. Looking at costs along the expansion path we can assess whether there are economies of scale Isocost is analogous to a consumer’s budget line. Bringing iscosts and isoquants lines to produce the required output at costs L,K and producing Output Expansion Path. Economies of scale: Cost per unit of output declines as output rises. Output expansion path Capital serves Z 150 300 450 K2 Y 35,000 units X K1 20,000 units 8,000 units L1 100 L2 200 300 Labor serves Figure 3.9 the firm's output expansion path with a given factor price ratio

Economies of scale characterizes a production process in which an increase in the number of units produced causes a decrease in the average fixed cost of each unit. Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit-costs. Please read Cost analysis illustrated starting from page 67 (Firms Text) to understand the different Economies of scale situations. Try to solve Exercise 3.6 and explain that to yourself.