14.01SC | Fall 2011 | Undergraduate

# Principles of Microeconomics

## Unit 3: Producer Theory

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The goods purchased by consumers are produced by firms, another key set of economic players. This unit introduces you to the study of firm, or producer, behavior. You will learn how to analyze firms’ decisions mathematically using a production function and calculate their optimal level of production, costs, and profits. In addition, you will begin to learn how firms interact in a competitive market in the short-run and the long-run.

 This image is a work of the US Federal Government and in the public domain. Source: Library of Congress. Image courtesy of AndreasPraefcke on Wikipedia. This image is a work of the US Federal Government and in the public domain. Source: Wikipedia. Image courtesy of johnthurm on Flickr.

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### Session Overview

 Working with the firm’s cost function enables us to learn how much of each input the firm should optimally use to produce a given level of output. However, the firm still has to decide how much output it should produce. This decision depends on the type of market the firm is operating in. We begin by analyzing the most common type of market: perfect competition. Firms, like auto racers, operate in a competitive environment. This image is a work of the US Federal Government and in the public domain. Source: Wikipedia.

Keywords: Perfect competition; search theory; residual demand; cost measurement; profit maximization.

### Session Activities

Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

• [R&T] Chapter 9, “Competitive Markets for Goods and Services.”
• [Perloff] Chapter 8, “Competitive Firms and Markets.” (optional)

### Check Yourself

#### Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

###### Question 1

What is the definition of perfect competition?

All firms maximize profits and have optimal levels of labor and capital in perfect competition, but this does not define perfect competition; even firms that are monopolists or oligopolists will maximize profits and set the optimal levels of labor and capital. It is necessary for at least one firm to be producing the good of interest in perfect competition, but not sufficient.

###### Question 2

Consider the market for shoes. If one of the following statements is true, we can conclude that it is not perfectly competitive. Which statement, if true, is evidence against perfect competition?

If entry and exit into a market is restricted, then this is a violation of perfect competition. The other three answers define perfect competition, rather than being in violation of it.

###### Question 3

In a competitive market, the marginal revenue for selling an additional good is, by definition, equal to what quantity?

In a competitive market, every firm is a price-taker, and its decisions about how much to produce do not affect the price. Accordingly, if it sells one more unit, the marginal revenue is the prevailing price.

###### Question 4

A firm should shut down if what condition holds?

If price is below average total cost, but greater than average variable cost, then the firm has negative profits. However, it is still optimal to continue operating to avoid forgoing the fixed costs already paid.

###### Question 5

What is true about the individual firm demand curve that each firm faces in a competitive market?

The individual firm demand curve in a perfectly competitive market is perfectly elastic, or horizontal. Since the firm is a price-taker, it can sell as many units of the output good as it wants to at that price.

### Further Study

These optional resources are provided for students that wish to explore this topic more fully.

Peter A. Diamond - Biographical.” Nobelprize.org.

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### Session Overview

 In this lecture, we continue to learn about competition, and its implications for the supply curve for different goods. We can use this to construct the market supply curve from firms’ supply curves. Now we have all the ingredients for fully understanding the basic supply and demand diagrams that launched our study of economics. In this lecture, we will learn about the factors that influence a firm’s shutdown decision. Image courtesy of johnthurm on Flickr.

Keywords: Shutdown decisions; market supply curves; short-run market equilibrium; long-run market equilibrium.

### Session Activities

Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

• [R&T] Chapter 9, “Competitive Markets for Goods and Services.”
• [Perloff] Chapter 8, “Competitive Firms and Markets.” (optional)

### Check Yourself

#### Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

###### Question 1

If you compare the elasticity of short-run supply in the markets for two different goods and one market has more firms than the other, which will have a more elastic supply curve?

The supply curve becomes flatter (more elastic) with more firms in the market, because a given increase in price calls forth more production when there are many firms rather than one.

###### Question 2

In the long run, firms should decide to shut down if what condition holds?

In the long run, all costs are variable, and thus average variable cost and average cost are equivalent. The firm will shut down if price is less than average cost. Average fixed cost is not a relevant concept in the long-run, because all costs are considered to be variable.

###### Question 3

In the long run, what cost measure is minimized?

In the long-run, average cost is minimized and the equilibrium is found where price equals minimum average costs.

###### Question 4

In recent years, the American automobile manufacturing industry has struggled; assume that some companies are earning negative profits (i.e., they are losing money). In the long-run, what changes will we expect to see in this market?

If profits are negative, firms should exit.

###### Question 5

Which of the following is a reason that the long-run supply curve may not be flat and may instead be upward-sloping?

All of these factors will contribute to a failure of the mechanism by which competition leads to cost minimization in the long-run, and thus will generate an upward-sloping supply curve.

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### Session Overview

 As we’ve already learned, consumers gain utility from buying goods—but every good has to come from somewhere! Goods are produced by firms, and analyzing the decisions of firms is also central to our understanding of the economy. In this lecture, we will learn how companies make important operation decisions. When considering firm production decisions, we must consider the two forms of firm input – labor and capital. This image is a work of the US Federal Government and in the public domain. Source: Library of Congress.

Keywords: Production theory; firm production functions; variable inputs; fixed inputs; short run production; long run production; marginal rate of technical substitution; returns to scale.

### Session Activities

Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

• [R&T] Chapter 8, “Production and Cost.”
• [Perloff] Chapter 6, “Firms and Production.” (optional)

### Check Yourself

#### Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

###### Question 1

What is the primary objective of firms?

Costs and revenue are relevant to the firm's decision, but their primary objective is maximizing profit. Utility is maximized by consumers, not firms.

###### Question 2

What is the difference between the short-run and the long-run from the perspective of production theory?

In the short run, it is easy for a firm to adjust how many employees it has, but it cannot immediately build a new factory or install new equipment. In the long-run, both labor and capital can be changed.

###### Question 3

Which of the following is NOT a property of isoquants?

Isoquants can be linear when inputs are perfectly substitutable, and thus it is not the case that they are always non-linear.

###### Question 4

What is the term used to describe a production function in which you can double all inputs and output increases by more than double?

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### Preparation

The problem set is comprised of challenging questions that test your understanding of the material covered in the course. Make sure you have mastered the concepts and problem solving techniques from the following sessions before attempting the problem set:

### Problem Solving Video

In the video below, a teaching assistant demonstrates his approach to the solution for problem 3 from the problem set. The teaching assistant notes common mistakes made by students and provides problem solving techniques for approaching similar questions on the problem set and exams.

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### Session Overview

 Everything has a cost, and that is true for firms as well as consumers. When firms produce goods, they incur costs that vary depending on how much they are producing. In this lecture, we will analyze firms’ cost functions. Building factory infrastructure is a producer cost. Image courtesy of AndreasPraefcke on Wikipedia.

Keywords: Productivity; food production; costs; marginal costs; long run costs; short run costs.

### Session Activities

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

• [R&T] Chapter 8, “Production and Cost.”
• [Perloff] Chapter 7, “Costs.” (optional)

### Check Yourself

#### Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

###### Question 1

In the short run, how is the marginal cost defined?

The wage rate multiplied by the amount of labor used and the capital rental rate multiplied by the number of machines used are total costs for labor and capital, not marginal costs. The capital rental rate multiplied by the number of machines needed to produce one additional unit also fails to define marginal cost, because in the short-run, capital is not variable, so it cannot be increased to produce additional goods.

###### Question 2

An isocost line is defined as combinations of labor and capital that yield the same levels of what quantity?

An isocost line represents combinations of labor and capital that can be obtained for the same total cost.

###### Question 3

The economically efficient point of production for firms is identified by the tangency of what two objects?

An isoquant is tangent to the isocost line. This is the point where the ratio of marginal products of each input is equal to the ratio of prices, defining the optimal point of production for the firm. It is impossible for two isoquants to be tangent to each other, as isoquants do not cross. Whether the isoquant is tangent to the X-axis is not a relevant for firm-decision-making. It is also impossible for an isoquant to be tangent to the budget constraint, as a budget constraint is a construct used to describe the firm's problem, not the consumer's problem.

###### Question 4

For a fast-food business like McDonald's, as the business expands capital becomes less productive, and the business requires more and more labor. What does this imply about the long-run expansion path?

The expansion path is linear if there is no change in the relative productivity of labor and capital as the business expands. It is convex if capital becomes relatively more productive and the business requires less and less labor (e.g., a high-tech, capital-intensive business.) The specific production function is not relevant if you know how the relative productivities of inputs changes over time.

###### Question 5

What is an example of sunk costs for someone opening a law practice?

The cost of a law school education is a sunk cost because irrespective of future decisions, these costs can never be recouped.

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## Course Info

Fall 2011
##### Learning Resource Types
Lecture Videos
Recitation Videos
Problem Sets with Solutions
Exams with Solutions
Exams
Lecture Notes
Exam Materials
Problem Sets