The Production Process and

Costs

Managerial Economics & Business

Strategy

Chapter 5
 5-2

Overview

I. Production Analysis
– Total Product, Marginal Product, Average Product
– Isoquants
– Isocosts
– Cost Minimization

II. Cost Analysis

– Total Cost, Variable Cost, Fixed Costs
– Cubic Cost Function
– Cost Relations

III. Multi-Product Cost Functions

 5-3

Production Analysis
 Production Function
– Q = F(K,L)
 Q is quantity of output produced.
 K is capital input.
 L is labor input.
 F is a functional form relating the inputs to output.
– The maximum amount of output that can be produced
with K units of capital and L units of labor.
 Short-Run vs. Long-Run Decisions
 Fixed vs. Variable Inputs
 Short-Run vs. Long-Run Decisions

 As a manager, your job is to use the available

production function efficiently; this means that
you must determine how much of each input to
use to produce output.
 fixed and variable factors of production Fixed
factors are the inputs the manager cannot
adjust in the short run. Variable factors are the
inputs a manager can adjust to alter
production.
4
 Short-Run vs. Long-Run Decisions

 The short-run production function is essentially

only a function of labor, since capital is fixed
rather than variable. If K* is the fixed level of
capital, the short-run production function may
be written as
 Q = F(L)= Q = F(K* ,L)

5
 Fixed Variable Change in Output Marginal Average
input cost input cost labour Given product of product of
(k) given (labour) l 3 4 labour labour
1 given [CH(2)] 5 6
2
2 0 - - - -
2 1 1 76 76 76
2 2 1 248 172 124
2 3 1 492 244 164
2 4 1 784 292 196
2 5 1 1,100 316 220
2 6 1 1,416 316 236
2 7 1 1,708 292 244
2 8 1 1,952 244 244
2 9 1 2,124 172 236
2 10 1 2,200 76 220
6 2 11 1 2,156 -44 196
 5-7

Productivity Measures:
Total Product
 An important component of managerial
decision making is the determination of the
productivity of inputs used in the production
process.
 The three most important measures of
productivity are total product, average product,
and marginal product.
 Total Product (TP):
 Total Product (TP): maximum output produced with
given amounts of inputs.
 Example: Cobb-Douglas Production Function:
Q = F(K,L) = K.5 L.5
– K is fixed at 16 units.
– Short run Cobb-Douglass production function:

Q = (16).5 L.5 = 4 L.5

– Total Product when 100 units of labor are used?

Q = 4 (100).5 = 4(10) = 40 units

8
 Total Product (TP):
 Total Product (TP): maximum output produced with given
amounts of inputs.
 For example, the total product of the production process
described in Table 5–1 when 5 units of labor are employed is
1,100. Since the production function defines the maximum
amount of output that can be produced with a given level of
inputs, this is the amount that would be produced if the 5
units of labor put forth maximal effort. Of course, if workers
did not put forth maximal effort, output would be lower.
Five workers who drink coffee all day cannot produce any
output, at least given this production function.
9
 5-10

Average Product
 Average Product of an Input: measure of
output produced per unit of input.
– Average Product of Labor: APL = Q/L.
 Measures the output of an “average” worker.
– Average Product of Capital: APK = Q/K.
 Measures the output of an “average” unit of capital.

 for example, five workers can produce

1,100 units of output; this amounts to 220
units of output per worker.
 5-11

Marginal Product
 Marginal Product on an Input: change in total output
attributable to the last unit of an input.
– Marginal Product of Labor: MPL = Q/L
 Measures the output produced by the last worker.
 Slope of the short-run production function (with respect to labor).
 For example, in Table 5–1 the second unit of labor increases output by
172 units, so the marginal product of the second unit of labor is 172
– Marginal Product of Capital: MPK = Q/K
 Measures the output produced by the last unit of capital.
 When capital is allowed to vary in the short run, MPK is the slope of the
production function (with respect to capital).
 A Production Function
Diminishing Diminishing Diminishing Diminishing
32 marginal absolute marginal absolute
7
30 returns returns returns returns
28
26 6
24
22 TP 5
20
Increasing

Output per worker

18
Output

4
16 marginal
14 returns
3
12
10
2
8
AP
6
4 1
2
0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Number of workers Number of workers MP
(a) Total product (b) Marginal and average product

12
 Relation between Productivity Measures
in Action
Increasing Decreasing Negative
Total marginal marginal marginal
returns to labor returns to labor returns to labor
product
Average Total product (TP)
product
Marginal
product

Average product (APL)

13 0
Marginal product (MP )
 Increasing, Diminishing and
Negative Marginal Returns

 increasing marginal returns Range of input

usage over which marginal product increases.
 Decreasing (diminishing) marginal returns
Range of input usage over which marginal
product declines.
 Negative marginal returns Range of input
usage over which marginal product is negative.

14
 Number of Total Marginal
product Average
workers output product

0 0 —
4 Increasing
1 4 4 marginal returns
6
2 10 5
7
3 17 5.7
6
4 23 5.8
5 Diminishing
5 28 5.6 marginal returns
3
6 31 5.2
1
7 32 4.6
0
8 32 4.0
2 Diminishing
9 30 3.3 absolute returns
5
10 25 2.5
15
 5-16

The Role of the Manager in the

Production Process
 The manager’s role in guiding the production process
described earlier is twofold:
 1- to ensure that the firm operates on the production
function
 2- to ensure that the firm uses the correct level of inputs.
 Producing on the production function
 The production function describes the maximum possible
output that can be produced with given inputs.
– Aligning incentives to induce maximum worker effort.
 The Role of the Manager in the
Production Process

 Employing the right level of inputs

– When labor or capital vary in the short run, to
maximize profit a manager will hire
 labor until the value of marginal product of labor
equals the wage: VMPL = w, where VMPL = P x
MPL.
 capital until the value of marginal product of
capital equals the rental rate: VMPK = r, where
VMPK = P x MPK .

17
 Algebraic Forms of Production
Functions

18
 Algebraic Forms of Production
Functions

 linear production function A production function

that assumes a perfect linear relationship
between all inputs and total output.
 Leontief production function A production
function that assumes that inputs are used in
fixed proportions.
 Cobb-Douglas production function A
production function that assumes some degree
of substitutability among inputs.
19
 Algebraic Forms of Production
Functions in Action

20
 Demonstration Problem 5–1

 The engineers at Morris Industries obtained the

following estimate of the firm’s production
function:
 Q = F(K, L) = min {3K, 4L}
 How much output is produced when 2 units of
labor and 5 units of capital are employed?

21
 Answer:

 We simply calculate F(5, 2). But F(5, 2)

min{3(5), 4(2)} =min{15, 8}.
 Since the minimum of the numbers “15” and
“8” is 8, we know that 5 units of capital and 2
units of labor produce 8 units of output.

22
 Algebraic Measures of
Productivity

23
 Algebraic Measures of Productivity
in Action

24
 Demonstration Problem 5–2

 A firm produces output that can be sold at a

price of $10. The production function is given
by
 Q = F(K,L) = K1/2 L1/2
 If capital is fixed at 1 unit in the short run, how
much labor should the firm employ to maximize
profits if the wage rate is $2?

25
 Answer:
 We simply set the value marginal product of labor equal to
the wage rate and solve for L. Since the production function
is Cobb-Douglas, we know that MPL=b Ka Lb-1 Here a =1/2,
b= 1/2, and K =1. Hence, MPL = 0.5L1/2-1. Now, since
P=$10, we know that VMPL= P*MPL= 0.5L1/2-1. Setting this
equal to the wage, which is $2, we get 0.5L1/2-1 =2.
 If we square both sides of this equation, we get 25/L =4.
Thus the profit-maximizing quantity of labor is L =25/4
6.25 units.

26
 5-27

Isoquant

 Illustrates the long-run combinations of inputs

(K, L) that yield the producer the same level
of output.
 The shape of an isoquant reflects the ease
with which a producer can substitute among
inputs while maintaining the same level of
output.
 5-28

Marginal Rate of Technical

Substitution (MRTS)
 The rate at which two inputs are substituted
while maintaining the same output level.
MPL
MRTS KL 
MPK
 5-29

Linear Isoquants

K
 Capital and labor Increasing
are perfect Output
substitutes
– Q = aK + bL
– MRTSKL = b/a
– Linear isoquants imply
that inputs are
substituted at a constant
rate, independent of the Q1 Q2 Q3
input levels employed. L
 5-30

Leontief Isoquants
Q3
K
 Capital and labor are Q2
perfect complements. Q1 Increasing
Output
 Capital and labor are used
in fixed-proportions.
 Q = min {bK, cL}
 Since capital and labor are
consumed in fixed
proportions there is no input
substitution along isoquants
L
(hence, no MRTSKL).
 5-31

Cobb-Douglas Isoquants
K
Q3
 Inputs are not perfectly Increasing
substitutable. Q2
Output
Q1
 Diminishing marginal rate
of technical substitution.
– As less of one input is used in
the production process,
increasingly more of the other
input must be employed to
produce the same output level.
 Q = KaLb
L
 MRTSKL = MPL/MPK
 Isoquants and Marginal Rate of
Technical Substitution in Action
Capital Input
ut
ou tp
g
sin
nc rea
I

Su
A
bs
tit
ut
in
g
la
bo
r
B
fo
r ca
p ita
l

0 Labor Input
32
5-
3
 Diminishing Marginal Rate of
Technical Substitution in Action
Capital Input

B
A

0 Labor Input
33
Isocost and Changes in
Isocost Lines
 The Production Function

Isocost Line
Capital Input

0 Labor Input
 The Production Function

Changes in the Isocost Line

Capital Input

More expensive input

bundles
New Isocost Line
associated with
higher costs (C0
Less expensive input < C1).
bundles

0 Labor Input
 The Production Function

Changes in the Isocost Line

Capital Input

New Isocost
Line for a
decrease in the
wage (price of
labor: w1 >
w0).

0 Labor Input

5-
37
 5-38

Cost Minimization

 Marginal product per dollar spent should be

equal for all inputs:
MPL MPK MPL w
  
w r MPK r

 But, this is just

w
MRTS KL 
r
 Cost Minimization and the
Cost-Minimizing Input Rule

5-
39 3
40
 Demonstration Problem 5–3
 Temporary Services uses four word processors and two
typewriters to produce reports.
 The marginal product of a typewriter is 50 pages per day,
and the marginal product of a word processor is 500 pages
per day.
 The rental price of a typewriter is $1 per day, whereas the
rental price of a word processor is $50 per day. Is
Temporary Services utilizing typewriters and word
processors in a cost-minimizing manner?

41
 Answer:
 Let MPT be the marginal product of a typewriter and
MPW be the marginal product of a word processor.
 If we let PW and PT be the rental prices of a word
processor and a typewriter, respectively, cost-
minimization requires that
MPT MPW

PT PW
 Substituting in the appropriate values, we see that
50 MPT MPW 500
  
1 PT PW 50
42
  Thus, the marginal product per dollar spent on typewriters
exceeds the marginal product per dollar spent on word
processors. Word processors are 10 times more productive
than typewriters, but 50 times more expensive. The firm
clearly is not minimizing costs and thus should use fewer
word processors and more typewriters

43
 5-44

Optimal Input Substitution

K
 A firm initially produces Q0
by employing the
combination of inputs
represented by point A at a
cost of C0. A
 Suppose w0 falls to w1. K0
– The isocost curve rotates
counterclockwise; which B
represents the same cost level
prior to the wage change.
K1
– To produce the same level of
output, Q0, the firm will
produce on a lower isocost
Q0
line (C1) at a point B.
– The slope of the new isocost
line represents the lower wage
0 L0 L1C0/w0 C1/w1 C0/w1 L
relative to the rental rate of
capital.
 Optimal Input Substitution in
Action
Capital Input
I
New cost-minimizing
point due to higher wage

F B
Initial point of cost minimization
A

H J
0 GLabor Input
45
 5-46

Cost Analysis

 Types of Costs
– Short-Run
 Fixed costs (FC)
 Sunk costs
 Short-run variable
costs (VC)
 Short-run total costs
(TC)
– Long-Run
 All costs are variable
 No fixed costs
 5-47

Total and Variable Costs

$

C(Q): Minimum total cost C(Q) = VC +

of producing alternative FC
levels of output: VC(
Q)
C(Q) = VC(Q) + FC

VC(Q): Costs that vary with F

output. C

FC: Costs that do not vary 0 Q

with output.0
 5-48

Fixed and Sunk Costs

FC: Costs that do not change $
as output changes. C(Q) = VC +
FC
Sunk Cost: A cost that is VC(
forever lost after it has been Q)
paid.

Decision makers should

ignore sunk costs to F
maximize profit or minimize C
losses
Q
 5-49

Some Definitions
Average Total Cost
ATC = AVC + AFC $
ATC = C(Q)/Q MC ATC
AVC
Average Variable Cost
AVC = VC(Q)/Q
MR
Average Fixed Cost
AFC = FC/Q

Marginal Cost AF
MC = C/Q C
Q
 Average and
Marginal Costs

50 5-
 5-51

Fixed Cost
Q0(ATC-AVC)
MC
$ = Q0 AFC ATC
= Q0(FC/ Q0) AVC

= FC
ATC
AFC Fixed Cost
AVC

Q0 Q
 5-52

Variable Cost
Q0AVC MC
$
ATC
= Q0[VC(Q0)/ Q0]
AVC
= VC(Q0)

AVC
Variable Cost Minimum of AVC
Q0 Q
 5-53

Total Cost
Q0ATC
MC
$
= Q0[C(Q0)/ Q0] ATC

= C(Q0)
AVC

ATC

Total Cost Minimum of ATC

Q0 Q
 5-54

Cubic Cost Function

 C(Q) = f + a Q + b Q2 + cQ3
 Marginal Cost?
– Memorize:
MC(Q) = a + 2bQ + 3cQ2
– Calculus:
dC/dQ = a + 2bQ + 3cQ2
 5-55

An Example
– Total Cost: C(Q) = 10 + Q + Q2
– Variable cost function:
VC(Q) = Q + Q2
– Variable cost of producing 2 units:
VC(2) = 2 + (2)2 = 6
– Fixed costs:
FC = 10
– Marginal cost function:
MC(Q) = 1 + 2Q
– Marginal cost of producing 2 units:
MC(2) = 1 + 2(2) = 5
 The Cost Function
Long-Run Costs
 In the long run, all costs are variable since a
manager is free to adjust levels of all inputs.
 Long-run average cost curve
– A curve that defines the minimum average cost of
producing alternative levels of output allowing for
optimal selection of both fixed and variable factors of
production.

56
 The Cost Function
Long-Run Average
Total Costs in Action
LRAC ($)

0 Output

57 5-
 Economies of Scale

 Economies of scale
– Declining portion of the long-run average cost curve
as output increase.
 Diseconomies of scale
– Rising portion of the long-run average cost curve as
output increases.
 Constant returns to scale
– Portion of the long-run average cost curve that
remains constant as output increases.
58
 5-59

Long-Run Average Costs

$

LRAC

Economies Diseconomies
of Scale of Scale
Q* Q
 The Cost Function
Constant Returns to Scale in
Action
LRAC ($)

0 Output
 5-61

Multi-Product Cost Function

 C(Q1, Q2): Cost of jointly producing two

outputs.
 General function form:

C  Q1 , Q2   f  aQ1Q2  bQ  cQ
1
2 2
2
 Multiple-Output Cost
Function

62 5-
63
 Multiple-Output Cost
Function in Action

5-
64 6
 5-65

Quadratic Multi-Product Cost Function

 C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
 MC1(Q1, Q2) = aQ2 + 2Q1
 MC2(Q1, Q2) = aQ1 + 2Q2
 Cost complementarity: a<0
 Economies of scope: f > aQ1Q2
C(Q1 ,0) + C(0, Q2 ) = f + (Q1 )2 + f + (Q2)2
C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
f > aQ1Q2: Joint production is cheaper
 5-66

A Numerical Example:

 C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 + (Q2 )2

 Cost Complementarity?
Yes, since a = -2 < 0
MC1(Q1, Q2) = -2Q2 + 2Q1
 Economies of Scope?
Yes, since 90 > -2Q1Q2
 5-67

Conclusion

 To maximize profits (minimize costs) managers must

use inputs such that the value of marginal of each input
reflects price the firm must pay to employ the input.
 The optimal mix of inputs is achieved when the MRTSKL
= (w/r).
 Cost functions are the foundation for helping to
determine profit-maximizing behavior in future chapters.