Managerial Economics & Business

Strategy

Chapter 5
The Production
Process and Costs

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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
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 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

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 Production Function Algebraic
Forms
 Linear production function: inputs are perfect
substitutes.
Q  F K , L   aK  bL
 Leontief production function: inputs are used in
fixed proportions.
Q  F K , L   min bK , cL
 Cobb-Douglas production function: inputs have
a degree of substitutability.
Q  F K , L   K a Lb
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 Productivity Measures:
Total Product
 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

5-6
 Productivity Measures: Average
Product of an Input
 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.
• Example: Q = F(K,L) = K.5 L.5
 If the inputs are K = 16 and L = 16, then the average product of
labor is APL = [(16) 0.5(16)0.5]/16 = 1.
– Average Product of Capital: APK = Q/K.
• Measures the output of an “average” unit of capital.
• Example: Q = F(K,L) = K.5 L.5
 If the inputs are K = 16 and L = 16, then the average product of
capital is APK = [(16)0.5(16)0.5]/16 = 1.

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 Productivity Measures: Marginal
Product of an Input
 Marginal Product on an Input: change in total
output attributable to the last unit of an input.
– Marginal Product of Labor: MPL = DQ/DL
• Measures the output produced by the last worker.
• Slope of the short-run production function (with respect
to labor).
– Marginal Product of Capital: MPK = DQ/DK
• 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).

5-8
Increasing, Diminishing and
Negative Marginal Returns
Increasing Diminishing Negative
Q Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
5-9
 Guiding the Production Process
 Producing on the production function
– Aligning incentives to induce maximum worker
effort.
 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
.

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 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.

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 Marginal Rate of Technical
Substitution (MRTS)
 The rate at which two inputs are
substituted while maintaining the same
output level.
MPL
MRTS KL 
MPK

5-12
 Linear Isoquants

 Capital and labor K

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

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

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 Cobb-Douglas Isoquants
 Inputs are not perfectly
substitutable. K
Q3
 Diminishing marginal Increasing
Q2
rate of technical Output
Q1
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
 MRTSKL = MPL/MPK L

5-15
 Isocost
 The combinations of inputs K New Isocost Line
that produce a given level of associated with higher
C1/r costs (C0 < C1).
output at the same cost:
wL + rK = C C0/r
 Rearranging,
C0 C1
K= (1/r)C - (w/r)L C0/w C1/w L
 For given input prices, K
isocosts farther from the New Isocost Line for
a decrease in the
origin are associated with C/r wage (price of labor:
higher costs. w0 > w1).
 Changes in input prices
change the slope of the
isocost line. C/w0 C/w1
L

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 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

5-17
 Cost Minimization

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

5-18
 Optimal Input Substitution
 A firm initially produces Q0
by employing the K
combination of inputs
represented by point A at a
cost of C0.
 Suppose w0 falls to w1.
– The isocost curve rotates A
counterclockwise; which K0
represents the same cost
level prior to the wage
change. B
– To produce the same level of K1
output, Q0, the firm will
produce on a lower isocost
line (C1) at a point B.
Q0
– The slope of the new isocost
line represents the lower
wage relative to the rental C0/w1 L
rate of capital. 0 L0 L1 C0/w0 C1/w1

5-19
 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

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 Total and Variable Costs
C(Q): Minimum total cost of $
producing alternative levels
C(Q) = VC + FC
of output:

C(Q) = VC(Q) + FC VC(Q)

VC(Q): Costs that vary

with output.

FC: Costs that do not FC

vary with output.

0 Q

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 Fixed and Sunk Costs

FC: Costs that do not $

change as output changes. C(Q) = VC + FC

Sunk Cost: A cost that is

VC(Q)
forever lost after it has been
paid.

Decision makers should

ignore sunk costs to
FC
maximize profit or minimize
losses

Q
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 Some Definitions
Average Total Cost
ATC = AVC + AFC $
ATC = C(Q)/Q MC ATC
AVC

Average Variable Cost

AVC = VC(Q)/Q

Average Fixed Cost MR

AFC = FC/Q

Marginal Cost
MC = DC/DQ AFC

Q 5-23
 Fixed Cost
Q0(ATC-AVC)
MC
$ = Q0 AFC ATC
= Q0(FC/ Q0) AVC

= FC
ATC
AFC Fixed Cost
AVC

Q0 Q

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

AVC
Variable Cost Minimum of AVC

Q0 Q

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

= C(Q0)
AVC

ATC

Minimum of ATC
Total Cost

Q0 Q

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 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

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 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

5-28
 Long-Run Average Costs
$

LRAC

Economies Diseconomies
of Scale of Scale
Q* Q

5-29
 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

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 Economies of Scope
 C(Q1, 0) + C(0, Q2) > C(Q1, Q2).
– It is cheaper to produce the two outputs jointly
instead of separately.
 Example:
– It is cheaper for Time-Warner to produce
Internet connections and Instant Messaging
services jointly than separately.

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 Cost Complementarity
 The marginal cost of producing good 1
declines as more of good two is produced:

DMC1(Q1,Q2) /DQ2 < 0.

 Example:
– Cow hides and steaks.

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 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
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 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

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 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.

5-35