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By David F. Heathfield

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Extra resources for An Introduction to Cost and Production Functions

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Fergusson, The Neoclassical Theory of Production and Distribution (1969), Chapters 1-2. The law of diminishing return was first discussed by two classical economists : Ricardo (1846) and von Thunen (1826). But see also Joan Robinson (1960). 1 Optimisation Having outlined the range of choices open to an entrepreneur (the production function), we shall now investigate the economic side of production, that is the choice of a technology and a level of output from among the many possible. The fundamental decision unit here is the firm, and we will assume that the firm's sole aim is to maximise profit.

If the firm expects that P is to be the long-run market price it will build a factory designed for a capacity of q*. But the existence of positive profits will draw new capital to the industry and more firms will be established. This process will force the price down in the long run . This process will continue until the price has fallen to Pmin' The establishment of any new firm will thereafter lead to a market price below the lowest possible cost , and all firms will then make losses. Ultimately, this will lead to the closing of some firms, and the price will increase to Pmin aga in.

Under perfect competition and constant returns to scale the MC curve is horizontal and hence dMC /dq is O. Thus with perfectly competitive markets for input and output and with constant returns to scale both dMR /dq and dMC/dq equal zero and the second order conditions for a maximum are not satisfied . These points are made more rigorously in the mathematical appendix to this chapter. Whether or not the second effect is big depends on the firm's size relative to the total market. If the firm is the sole seller on the market (monopoly) it is reasonable to assume that the product price is affected by a change in output.

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