4_Producer Theory

Question 1

What determines supply?

Answer 1

• Supply is determined by firms’ behavior
  
  • What is a firms’ objective function? – maximize profits?
  • What are the constraints? – Production technology or cost structure

Question 2

T_wo ways to describe a firms’ maximization problem:_

Answer 2

1. Input rule: find the optimal quantity of inputs with a given technology. This will determine the optimal output (example 2 inputs, 1 output)

• Production factors = inputs:
  
  • Labour (people and human capital)
  • Capital (machinery, buildings etc.)
  • Land and other resources like energy, water…
  • Other factors (like information, social networks etc.)
• Inputs can be substituted (?) to different degrees, e.g. agriculture
  
  • Labour – capital (often good substitutes)
  • Land – chemical/biological inputs (often good substitutes)
• If two factors are not substitutable they are complements

2. Output rule: Find the optimal quantity of outputs. Given a production technology this will determine the optimal quantity of inputs.

Question 3

Firm’s cost structure

Answer 3

Question 4

Firm’s maximization problem

Answer 4

Output rule: Find the optimal quantity of outputs. Given a production technology this will determine the optimal quantity of inputs. It should produce output at the level at which marginal revenue equals marginal cost (MR = MC)

Attached image

Maximizing condition

• MR = MC (general)
• P = MC (price taker)

Question 5

What determines supply?

Answer 5

• Supply behavior of a firm is given by the MC curve (P = MC)
• If P < AC negative profits. Hence, no supply (in the long run) below a price of AC_minimum
• In a competitive market (many suppliers, homogenous good, free entry) firms will enter sector as long as P > MC, supply will increase and P will decrease until P = ATC (AC)