Introduction to Microeconomics

Theory of the Firm

Quoc Thai Le*

April 20, 2025
* EFA, International University, VNU-HCM
Materials/Readings

▶ Mankiw, N. G. (2024). Principles of Economics, 10th Edition.

Chapter 14. Boston, MA: Cengage.

▶ https://blackboard.hcmiu.edu.vn/

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Firms
What is a firm?
▶ A firm is any business entity that produces and then sells
goods/services
−→ What is the problem that every firm face?
▶ Production is the process by which the transformation of inputs
(such as machines, labour, land, etc.) to outputs (such as
goods, services, etc.) occurs −→ a production function

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A business establishment: what to consider now?

▶ what to aim at?

▶ what to produce/sell?

▶ what costs to incur?

▶ what decisions to make?

mixture of inputs
quantity to produce
price to sell
etc.

▶ what runs to consider?

=⇒ a business model
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What do firms aim at?

▶ Profits = Total revenues − Total costs = T R − T C =

P × Q − TC

▶ All firms are assumed to pursue the overarching goal of profit

maximization!

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Run(s)

▶ The short run is a period of time when only some of a firm’s

inputs can vary (while some are fixed)
=⇒ Which input tend to vary in the short run?
=⇒ Which input tend to not vary in the short run?
=⇒ The only way to change production in the short run is to change
the amount of variable inputs

▶ The long run is a period of time when all of a firm’s inputs

can vary.

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What do firms’ decisions concern?

▶ The goods/services in business

▶ The costs of doing business

▶ The rewards of doing business ←− market-structure-dependent

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Understanding supply: what lies behind a supply curve?

▶ the production function

▶ the cost structure

▶ the profit-maximization
strategy

▶ the organization/dynamics of
the market

=⇒ the choices/decisions made

by producers/firms

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Costs
Total costs

▶ The measurement of a firm’s total costs is subtle.

▶ A firm’s costs of production should include all the opportunity

costs.
▶ Total costs = Explicit costs + Implicit costs
Explicit costs: costs that require an outlay of money =⇒
Examples?
Implicit costs: costs that do not require an outlay of money =⇒
Examples?
=⇒ Economics versus Accounting

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Opportunity costs of doing business

▶ A business needs a certain amount of sufficient

money/investment to start

▶ Firms in capital-intensive industries have to spend a lot of

money on investment in capital assets =⇒ Examples?

=⇒ The opportunity cost of investment is an implicit cost!

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Opportunity costs of doing business

▶ Suppose that a business needs 100,000 € to start, while the

interest rate is 5%.
▶ What if you borrow 100,000 €.
−→ Explicit costs =
−→ Implicit costs =
▶ What if you use 100,000 € of your savings.
−→ Explicit costs =
−→ Implicit costs =
▶ What if you use 40,000 € of your savings, and borrow the
remaining 60,000 €.
−→ Explicit costs =
−→ Implicit costs =
▶ All in all, Total costs =
=⇒ What matters is not only the explicit costs but also the total
costs!
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Profits
 Profits: Economics versus Accounting

▶ Accounting profits = Total revenues − Explicit costs

▶ Economic profits = Total revenues − Total costs
=⇒ What does it imply?
How an Economist How an Accountant
ccountants Views a Firm Views a Firm
include all
en analyzing Economic
tants measure profit
conomic profit
Accounting
unting profit. profit
Implicit
Revenue costs Revenue
Total
costs

Explicit Explicit
costs costs

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Exercises: profits

Rumplestiltskin opens up a lemonade stand for two hours. He

spends 10 € for ingredients and sells 60 € worth of lemonade.
In the same two hours, he could have mowed his neighbour’s
lawn for 40 €. Rumplestiltskin earns an accounting profit of
. . .(1). . . and then an economic profit of . . .(2). . .

A. 50 €; 10 €
B. 90 €; 50 €
C. 10 €; 50 €
D. 50 €; 90 €

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Exercises: profits

▶ The equilibrium rent on office space has just increased by

$500/month.
▶ Compare the effects on both accounting profit and economic
profit if
you rent your office space
you own your office space

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Production
The production function

▶ A production function shows the relationship between the

quantity of inputs used to produce a good/service and the
quantity of output =⇒ What does a production function
capture?

▶ It can be represented by a table, an equation, a graph, etc.

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Marginal products: rational people think at the margin

▶ The marginal products (M P ) of an input in the production

process is the change in the quantity of output arising when
ceteris paribus an additional unit of the input is used.
▶ If ceteris paribus an additional unit of an input is used, the
output changes accordingly by the marginal products.
change in output ∆Q ∂Q
M P of labour (M P L) = = =
| {z } change in L used ∆L ∂L
K is fixed
change in output ∆Q ∂Q
M P of capital (M P K) = = =
| {z } change in K used ∆K ∂K
L is fixed

change in output
▶ slopethe production function = = MP
change in input used

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Marginal products: rational people think at the margin

▶ As ceteris paribus the quantity of an input increases, while the

total/marginal costs increase, the marginal products of the
input decrease ←− diminishing marginal products ⇐=
Why?

▶ Law of diminishing returns: at a certain point of successive

increases in inputs, marginal products begin to decrease

Notes: K is often assumed to be fixed (e.g. in the short run)

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Marginal products: rational people think at the margin

L Total output ∆L ∆Q MPL K costs L costs Total costs Marginal costs

(Q) (K is fixed) (w = 10)

0 0 30

1 50 30

2 90 30

3 120 30

4 140 30

5 150 30

6 155 30
Notes: The Table illustrates both a production function (in the short run when K is fixed) and the
costs of production.

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Examples: Captain Hook on the farm

▶ Captain Hook decides to

leave the Jolly Roger, and
then starts a new life of
being a farmer growing
wheat in Wonderland with
Emma.

▶ While having a fixed amount

of land, he can hire as many
workers as he wants.
▶ What if Captain Hook hire
one extra worker? =⇒ Shall Captain Hook hire
one extra worker?
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From the production function to the total cost curve

▶ The production function and the total cost curve are the two
opposite sides of the same coin
=⇒ What does it imply?

▶ Whereas the production function gets flatter as production

rises, the total cost curve gets steeper as the amount produced
rises ⇐= Why?

Notes: K is often assumed to be fixed (e.g. in the short run)

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 workers increases, reflecting diminishing marginal product. The total-cost curve in panel
(b) shows the relationship between the quantity of output and total cost of production.
Here, the quantity of output produced (on the horizontal axis) is from column (2) in
From the production function to the total cost curve
Table 1, and the total cost (on the vertical axis) is from column (6). The total-cost curve
gets steeper as the quantity of output increases because of diminishing marginal product.

Production function Total-cost curve

Quantity Total
of Output Cost
(cookies $90
per hour)
160 Production 80 Total-cost
function curve
140 70

120 60

100 50

80 40

60 30

40 20

20 10

0 1 2 3 4 5 6 Number of 0 20 40 60 80 100 120 140 160 Quantity

Workers Hired of Output
(cookies per hour)

Notes: K is often assumed to be fixed (e.g. in the short run)

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Examples: Captain Hook on the farm

▶ Captain Hook, as a rational

farmer, wants to maximize
profits.

=⇒ Shall Captain Hook

produce more/less wheat?

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Cost measures
Various cost measures

▶ Fixed costs (F C): costs that do not vary with the quantity of
output produced in the short run
F C are associated with fixed factors of production
F C are incurred even if the firm produces nothing at all
Examples?

▶ Variable costs (V C): costs that do vary with the quantity of

output produced
V C are associated with variable factors of production
Examples?

▶ Total costs = Fixed costs + Variable costs

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Various cost measures

▶ Average total costs (AT C): the costs of a typical unit of

output if total cost is divided evenly over all the units produced
=⇒ costs per unit/unit costs
Total costs TC
=⇒ Average total costs (AT C) = = =
Quantity of output Q
FC + V C FC VC
= + =
Q Q Q
Average fixed costs (AF C) + Average variable costs (AV C)

▶ Marginal costs (M C): the increase in total costs that arises

from producing one additional unit of output
∆T C dT C
=⇒ M C = =
∆Q dQ
d (F C + V C) dF C dV C dV C
= = + =
dQ dQ dQ dQ

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Various cost measures

Output Total costs Fixed costs Variable costs Averages Marginal costs
(Q) (T C) (F C) (V C) (AF C) (AV C) (AT C) (M C)

0 3.00 0.00

1 3.00 0.30

2 3.00 0.80

3 3.00 1.50

4 3.00 2.40

5 3.00 3.50

6 3.00 4.80

7 3.00 6.30

8 3.00 8.00

9 3.00 9.90

10 3.00 12.00
Notes: The Table illustrates various measures of costs.
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 Cost curves
Total Cost
$15 Total-cost curve
on 14
n 13
cal 12
, 11
10
9
8
7
6
5
4
3
2
1

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
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(cups of coffee per hour) 25/38
 Cost curves
Costs
$3.50
3.25
e
d cost 3.00
AVC), 2.75
aleb’s
2.50
e all
a in 2.25
MC
mmon 2.00
ses
1.75
2)
is 1.50 ATC
cost 1.25 AVC
al-
1.00
f
0.75
0.50
0.25 AFC

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
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Features of cost curves

▶ M C (eventually) rises as Q increases −→ M C is

upward-sloping ⇐= What does it reflect?
▶ AT C is U-shaped ⇐= Why?
−→ the efficient scale of a firm = argmin AT C
Q

▶ the relationship between M C and AT C is true for all firms

M C < AT C ⇐⇒ AT C is falling/downward-sloping
M C > AT C ⇐⇒ AT C is rising/upward-sloping
M C ∩ AT C = min AT C ⇐= Why?
Q

=⇒ Firms, depending on the production process, tend to experience

increasing marginal products for a while before diminishing
marginal products set in; and, therefore, falling-and-then-rising
marginal costs.
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Examples: various cost measures

Costs

$3.00

2.50
MC
2.00

1.50
ATC
AVC
1.00

0.50

AFC
0 2 4 6 8 10 12 14

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Examples: various cost measures

Output Total costs Fixed costs Variable costs Averages Marginal costs
(Q) (T C) (F C) (V C) (AF C) (AV C) (AT C) (M C)

0 100

1 70

2 60

3 160

4 77.50

5 56

6 380

7 520
Notes: The Table illustrates various measures of costs.

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Examples: various cost measures

Find (approximately) AF C, AV C, AT C, and M C when Q = 4

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Runs
Costs in the short run versus in the long run

▶ The division of total costs between fixed and variable costs

depends on the time horizon
▶ Many decisions are fixed in the short run but variable in the
long run
▶ In the short run, firms search for the optimal level of labour
given the fixed level of capital investments. In the long run,
however, firms search for the optimal combination of both
labour and capital investments to achieve the lowest AT C for
each output level.
▶ A firm’s long-run cost curves therefore differ from its short-run
cost curves
▶ LAT C has a much flatter U-shape than SAT C
▶ All the short-run curves lie on/above the long-run curve
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Costs in the short run versus in the long run

▶ As the firm moves along the long-run curve, it is adjusting the

size of capital investments (e.g. the factory) to the quantity of
production.

▶ In the long run, AT C at any Q is the costs per unit using the
most efficient mix of inputs for a given level of Q (e.g. the
factory size with the lowest AT C).

=⇒ How long does it take a firm to switch from the short to

the long run?

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Costs in the short run versus in the long run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day

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Costs in the short run versus in the long run

▶ Firm can choose from a set of different factory sizes

S = {s1 ; s2 ; . . . ; sn } (for instance, 3 factory sizes: S, M and
L). Each size has its own SAT C curve.

▶ The firm can change to a different factory size in the long run,
but not in the short run.

▶ Given a level of output to produce, the firm then chooses the

factory size so that it has the lowest costs per unit in the long
run.

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Costs in the short run versus in the long run

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Costs in the short run versus in the long run

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Economies/Diseconomies of scale

▶ LAT C shows how costs vary with the scale/size of a firm’s

operations
economies of scale: LAT C declines as Q increases
constant returns to scale: LAT C does not vary as Q increases
diseconomies of scale: LAT C rises as Q increases

=⇒ What might cause economies/diseconomies of scale?

economies of scale ←− specialization
diseconomies of scale ←− coordination issues

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How does LAT C change as Q changes?

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