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Week 5 lecture
Firm behaviour

ECN113
Dr. Eileen Tipoe
Outline
1. Production functions and returns to scale
Determining returns to scale (increasing, decreasing, or constant)

2. Price-taking firms
Finding short-run and long-run equilibria mathematically

3. Cost minimisation
Choosing the cheapest way to produce the optimal quantity
If you have any questions during the lecture…
Submit your questions here: https://forms.office.com/r/x3Vyb3imcf
Production function: Returns to scale
Production functions !(#, %) describe the amount of output that
can be produced by any given amount or combination of input(s).
 Production functions: Returns to scale
Intuitive definitions:
• Economies of scale/increasing returns = We double all the inputs and output
more than doubles.
• Diseconomies of scale/decreasing returns = We double all the inputs and
output increases by less than double.
• Constant returns to scale = We double all the inputs and output doubles.
Output, ! Output, ! Output, !
Increasing returns: Convex Decreasing returns: Concave Constant returns: Linear
production function production function production function

Input, " Input, " Input, "

Production function: Returns to scale
Determining returns to scale from a firm’s production function: !(#, %)
1. Multiply all variables by a factor (!): " !#, !%
2. Try to rewrite the function as: " !#, !% = !# "(#, %) If n > 1: Economies of scale/
$
Increasing returns
E.g. " #, % = 2# %
If n = 1: Constant returns to scale
Multiply all variables by the factor !
If n < 1: Diseconomies of scale/
" !#, !% = 2(!#) (!%) $
Decreasing returns
Simplify the expression; try to separate ! from the other terms
= 2!$# $!% Multiply out the brackets

= !%2# $% Combine the & terms

= !%"(#, %)
n = 3: Increasing returns to scale
Production function: Returns to scale
Does the function ! #, % = #!/# + %!/# have increasing, decreasing, or
constant returns to scale?
Production function: Returns to scale
Does the function ! #, % = #!/# + %!/# have increasing, decreasing, or
constant returns to scale?

" #, % = # '/$ + %'/$

" !#, !% = (!#)'/$ + (!%)'/$ Multiply all variables by the factor !

" !#, !% = !'/$# '/$ + !'/$%'/$ Multiply out the brackets

" !#, !% = !'/$(# '/$ + %'/$) Factorize the ! terms

= !'/$"(#, %)
n = 1/2: Decreasing returns to scale
2. Short-run and long-run equilibria
Perfect competition: Recap
All buyers and sellers are price-takers
• Homogeneous good/service
• Large number of buyers/sellers
• Buyers and sellers all act independently of one another
• Price information easily available to buyers and sellers
Other conditions (complete contracts, no transaction costs, no external effects)

In the short run, firms produce where

+ = ,-
In the long run, firms produce where
+ = ,- = .- (min /0)
 How to solve for short-run equilibrium
Information given: Example
• Market demand curve • Market demand: " = 120 − 3)
• Current number of firms in the market • 20 firms in the market
• Cost function of each firm (identical) • Each firm’s cost function: * = +! + + + 1
Short-run
1. Set P = MC to find the firms’ supply curve. 1. MC = 2+ + 1 so ) = 2+ + 1 or + = !"() − 1)
2. Multiply by number of firms to get market 2. Market supply (") = 20+ = 10() − 1)
supply curve. sfsdsdfsdfsf
3. Set supply = demand to find market 3. 10() − 1) = 120 − 3)
quantity and price. 13) = 130 so ) = 10 and " = 120 − 30 = 90.
4. Divide market quantity by number of firms 4. Market quantity/# of firms = 90/20 = 4.5, so
to find the quantity produced by each firm. each firm produces 4.5 units.
Market equilibrium: Short-run vs Long-run
Let’s illustrate our example using the firm and market diagrams.
Short-run equilibrium (B): 20 firms, each produce 4.5 units and sell them at a price of 10.

) = 2, + 1 Supply (MC) in short-

Marginal cost curve Original supply (MC) #
run equilibrium ) = #% 1+1

Original demand

B B
10

Zero economic
profit (AC curve)
/0 = , + 1 + $# Demand curve

4.5 90
Market equilibrium: Worked example (part 1)
The market demand curve is 1 = 120/5 (1 = market supply) and there are 40 price-taking
firms in the market, each with cost function 0 6 = 1 + 26%/$ (6 = individual supply).
What is the short-run equilibrium quantity produced by each firm?
What is the market price?
Market equilibrium: Worked example (part 1)
The market demand curve is 1 = 120/5 (1 = market supply) and there are 40 price-taking
firms in the market, each with cost function 0 6 = 1 + 26%/$ (6 = individual supply).
What is the short-run equilibrium quantity produced by each firm?
What is the market price?

1. Set P = MC to find the firms’ supply curve. 70 = 23

24 = 36 '/$ so 5 = 36'/$
Supply function: rearrange for ! 6 = ('%5)$= '55$
$
2. Multiply by number of firms to get market Market supply: 1 = 406 = !" #
5
supply curve.
'$6 86 $ 5 %
3. Set supply = demand to find market 7 = 5 5 120( 86 ) = 5
'$6
quantity and price. 5 = 3, so 1 = = 40
%
4. Divide market quantity by number of firms Total quantity (40) divided by 40 firms
to find the quantity produced by each firm. = 1 unit per firm
 How to solve for long-run equilibrium
Information given: Example
• Market demand curve • Market demand: " = 120 − 3)
• Current number of firms in the market • 20 firms in the market
• Cost function of each firm (identical) • Each firm’s cost function: * = +! + + + 1
Long-run
1. Set MC = AC (or minimise AC) to find the 1. Set MC = AC: 2+ + 1 = + + 1 + &! hello hello
quantity each firm supplies. heso + = &! and + = 1.
2. Substitute into firm supply curve to find 2. 5 = 26 + 1 so 5 = 2(1) + 1 = 3. hello
the market price. hello
3. Substitute market price into demand 3. 1 = 120 − 3(3) = 111.
curve to find market quantity.
4. Divide market quantity by firm quantity 4. 111 units produced; each firm produces
to find the number of firms. 1 unit, so 111 firms in long-run equilibrium.
Market equilibrium: Short-run vs Long-run
Let’s illustrate our example using the firm and market diagrams.
Short-run equilibrium (B): 20 firms, each produce 4.5 units and sell them at a price of 10.
Long-run equilibrium (D): 111 firms, each produce 1 unit and sell it at a price of 3.
) = 2, + 1 Supply (MC) in short-
Marginal cost curve Original supply (MC) #
run equilibrium ) = #% 1+1

Original demand
Supply (MC) in long-run
B equilibrium
B '
10 ) = ### 1+1
D D
3
Zero economic
profit (AC curve)
/0 = , + 1 + $# Demand curve

1 4.5 90 111
Market equilibrium: Worked example (part 2)
The market demand curve is 1 = 120/5 (1 = market supply) and there are 40 price-taking
firms in the market, each with cost function 0 6 = 1 + 26%/$ (6 = individual supply).
What is the long-run equilibrium quantity produced by each firm?
Market equilibrium: Worked example (part 2)
The market demand curve is 1 = 120/5 (1 = market supply) and there are 40 price-taking
firms in the market, each with cost function 0 6 = 1 + 26%/$ (6 = individual supply).
What is the long-run equilibrium quantity produced by each firm?

Method 1: minimise /0 Method 2: set 70 = /0

/0 = 3(4)
4 = 26 '/$ + 6 ;' 36'/$ = 26'/$ + 6;'
2<3
= 6;'/$ − 6;$ =0 6'/$ = 6;'
24
'
= ' 6 = 4'
4 4$

6=1 6=1
(The market is in long-run equilibrium.)
3. Cost minimization
 Cost minimization Once the firm has chosen how much to produce,
what is the cheapest way to produce it?

Choose the combinations of inputs (# and %) to minimise the cost (;) of producing a
given amount of output (<).
Isoquant shows all combinations of " and # that
Capital (") produce a particular value of output ($).
Points B and C are feasible
(produce the required output) Isoquant: 5 4, 2 = 7 !"#
Slope = !!"$ %&/%#
(= %&/%$ = −%$ )
B %#
but inefficient (cost more than
point A).
A

Point D costs less than point A C

D
but is infeasible (lies below Isocost: 0 = 12 + 34 Slope = !()
the isoquant so cannot Isocost shows all combinations of
produce the required output). Labour (#) " and # that cost the same.

At the optimal point (A), the isoquant is

tangent to the lowest possible isocost:
Example: Continuous, non-linear production function
General principle: Solve a pair of simultaneous equations by substitution
"#$ &
=
"#% '
8(4, 2) = Output

Need to produce an output of 50. Cost of inputs: = = £10, > = £5

Production function: "(#, %) = #%
Equation 1: %
&
= '"
( 1. Rearrange Equation 1: # = 2%
Equation 2: #% = 50 2. Substitute # = 2% into Equation 2: 2%$ = 50
3. Solve for %: %$ = 25 so % = 5
4. Substitute % = 5 into the expression from 1. to find #: # = 2 5 = 10
5. Cost of this choice of inputs = wL + r# = 10 5 + 5 10 = £100
Cost minimization: Example
Suppose the firm’s profit-maximizing quantity is 300 units. Their production function is
f K, L = 5# $/=% , the per-unit cost of labour is £10, and the cost of capital is £12. What
is the cheapest way of producing 300 units? What is the total cost?
Cost minimization: Example
Suppose the firm’s profit-maximizing quantity is 300 units. Their production function is
f K, L = 5# $/=% , the per-unit cost of labour is £10, and the cost of capital is £12. What
is the cheapest way of producing 300 units? What is the total cost?
B7?
1) At the optimal point: B7> =C
D
2) Firm must produce 300: 5" "/$# = 300 Substitute % = 3# into equation 2):
Start by simplifying equation 1): 5# $/=(3#) = 300
15# A/= = 300

'6 =>$/(
# = (%66
'= ) =/A = 8.5

'$ = $>*+/( ?
% = 3 8.5 = 25.5
=
@ = =>
$? Total cost = 10 25.5 + 12 8.5
10% = 30# % = 3# = 357
Problem-solving methods we covered so far…

Determining returns to scale from a Perfect competition

firm’s production function Short run: * = +,
! '#, '% = '( !(#, %) Long run: * = +, = -,

(Week 3 material)
Unconstrained profit maximisation Constrained cost minimisation
!"# %
FOC = 0; SOC(s) < 0 !"$
= &
and ! #, % = )
Find optimal quantity to produce Find cheapest way to produce
optimal quantity (or any quantity)
Summary
Learning objectives: Key concepts
• Determine whether a function has increasing, • Returns to scale (increasing,
decreasing, or constant returns to scale decreasing, constant)
• Solve for short-run and long-run equilibrium • First-order condition, Second-order
outcomes. condition
• Understand how firms minimise costs of production • Marginal product of capital; Marginal
under constraints product of labour
• Solve cost-minimisation problems • Isocost
• Isoquant
• Short-run/Long-run equilibrium
Self-study material…
• More about cost minimisation (perfect substitutes, perfect complements); practice questions

In the next session… If your math is a bit rusty, try the

Week 4 optional worksheets for
• More about consumers – mathematical problem-solving extra practice.