ECN 201: Principles of Microeconomics Nusrat Jahan Lecture-6 Production Theory

There are 4 market types based on how competitive the market structure is:- 1. Perfect Competition Large number of buyers and sellers Free entry and free exit Homogenous product 2. Monopolistic Competition Differentiated product 3. Oligopoly Small number of firms Identical or differentiated products 4. Monopoly Single firm Barriers to entry

Producer Equilibrium The ultimate aim of any producer is to maximize profit. Producer equilibrium is the situation of profit maximization. At equilibrium the firm produces the maximum possible output and receives the maximum profit. The equilibrium output is also the output level at which the firm has minimum cost.

Production Function The relationship between the input required and the amount of output that can be obtained is called the production function. Production Function can be expressed as: Q= f (K,L) Where, Q= Output, K=Capital and L= Labor  Total Product- the maximum output that a given quantity of input can produce.  Marginal Product- the extra product or output added by an extra unit of input.  Average Product- total product divided by quantity of input employed. Law of Diminishing Returns The marginal product of each unit of output will decline as the amount of that input increases holding all other inputs constant.

Slope of the graph give the Marginal Rate of Technical Substitution. Isoquant When there are more than one factors of production the production function that we obtain is called Isoquant. Isoquant is the locus of points which shows the combination of inputs (capital, K and labor, L) which give the producer the same level of output. It reveals the combination of input that gives a given quantity of output. Slope of the graph give the Marginal Rate of Technical Substitution. L Q (output) K

Returns to Scale How total output changes when the inputs change.  Constant returns to scale- A change in all inputs lead to a proportional change in output.  Increasing returns to scale- A change in all inputs lead to a more than proportional change in output  Decreasing returns to scale- A change in all inputs lead to a less than proportional change in output. Short-run Vs Long-run  Short-run is a time period in which the firms can adjust production by changing variable factors of production but cannot change the fixed factors.  Long-run is a sufficiently long time period in which the firms can adjust production by changing the fixed factors of production.

Cost Function There are three types of costs Total Cost-Lowest total dollar expense needed to produce each level of output. Total Cost= wL+rK Total cost is the summation of fixed cost and variable cost. Total Fixed Cost (TFC) -is the cost of the firm’s fixed factors. Total Variable Cost (TVC) -is the cost of the firm’s variable factors. Marginal Cost (MC) -is the increase in total cost that results from a one-unit increase in output. Average Costs: Average Fixed Cost-Total Fixed Cost/ Total Output Average Variable Cost-Total Variable Cost/ Total Output Average Total Cost-Total Cost/ Total Output

Isocost It refers to equal costs. Isocost line shows the locus of points showing the combination of inputs that can be purchased with the available budget. The slope gives the ratio of Wages ‘w’ (Labor) and Rate of interests ‘r’ (Capital); slope= w/r L K

Producer Equilibrium It is the point where isoquant is tangent to isocost line In equilibrium slope of isoquant curve and isocost line are same; MRTS= w/r L MRTS=w/r q K