Theory of the Firm in Perfect Competition

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Theory of the Firm in Perfect Competition

• Two Critical Decisions Long Run vs Short Run
  Widget Production

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The Firms Problem

• Maximize profit p
• Given available technology Q(K,L)
• Given prices of inputs w and r
• Given price of final good Q

3
Two Critical Decisions

• How to produce?
• List technically efficient methods
• Choose the lowest cost method L,K
• TC(Q)wLrK
• How much to produce?
• Profit Total Revenue-Total Costs
• Total RevenuePQ
• Total CostsTC(Q)

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Total Revenue-Total Cost
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Profit
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Profit Maximization Rule
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Long Run vs Short Run

• In LONG RUN, both K and L are variable. In
  SHORT RUN, K is fixed. Only L is variable.

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Short Run Production

• Widget manufacturing
• Variable Input -- Labor (Staples)
• Fixed Inputs -- Table, Stapler
• Production Table
• Total Product -- total number of widgets
• Average Product -- total number of widgets
  divided by total number of workers
• Marginal Product -- change in number of widgets
  following addition of worker

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Law of Diminishing Marginal Returns

• Increasing the number of units of labor
  eventually reduces the marginal product with the
  number of staplers held constant

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Short Run Costs

• Fixed vs variable costs
• ATCTotal Cost/Output
• AVCTotal Variable Cost/Output
• AFCTotal Fixed Cost/Output
• MC DTC/DQ
• Change in Total Cost associated with last unit
  produced

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Long Run Production

• What combinations of labor and staplers might be
  technically efficient?
• What would happen to output if doubled both the
  number of workers and the number of staplers?

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Technically Efficient Technologies Q20
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Cost Minimizing Technology? w5 and r10
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Long Run Production
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Long Run Total Costs
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Returns to Scale

• Increasing Returns to Scale
• As inputs double, output more than doubles
• Average total costs are decreasing
• Constant Returns to Scale
• As inputs double, output doubles
• Average total costs are constant
• Decreasing Returns to Scale
• As inputs double, output less than doubles
• Average total costs are increasing

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Graphical Approach

• Production Function Qf(K,L)
• Isoquants -- graph technically efficient
  combinations of K and L to produce fixed Q
• Isocost line -- combinations of K and L available
  at cost C.

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Isoquants