CHAPTER 5A

THE PRODUCTION PROCESS  Marginal product of capital:

THE PRODUCTION FUNCTION

TABLE 5-1 MEASURES OF PRODUCTIVITY
 Technology summarizes the feasible means of
converting raw inputs into an output
 Mathematical function that defines the maximum
amount of output that can be produced with a
given set of inputs.
𝑄 = (𝐹 𝐾, 𝐿)
• 𝑄 is the level of output.
• 𝐾 is the quantity of capital input.
• 𝐿 is the quantity of labor input.

FIXED AND VARIABLE INPUTS (PERIODS)

Short Run
Firms must commit a particular size of factory, or
office and cannot easily change these decisions
without a long planning period
 As the usage of labor hired increases, the output
 Period of time where some factors of production
also increases (1-8)
(inputs) are fixed and constrain a manager’s
 When usage of labor reached 8, it starts to
decisions.
decrease when the firm hired from (9-10)
 Capital or Machinery (K) – usually the fixed input
 From the (5-10), APL starts to decrease
 From the (4-8), MPL decreases too and it became
Long Run
negative from (9-10) – Negative Marginal Returns
 In this period, the firm has the Planning Horizon
to labor
necessary to change not only the number of
INCREASING, DECREASING, AND NEGATIVE
workers but the amount of capital as well, since it
MARGINAL RETURNS
can move to a different size factory, office, and the
like.
 Period of time over which all factors of production
(inputs) are variable, and can be adjusted by a
manager
 Both Capital (K) and Labor (L) are variable
inputs.

MEASURES OF PRODUCTIVITY
Total product (TP)
 Maximum level of output that can be produced
with a given amount of inputs.
Average product (AP)
 A measure of the output produced per unit of
input.
 Average product of labor: MEASURES OF PRODUCTIVITY IN ACTION
 Consider the following production function when 5
units of labor and 10 units of capital are combined
produce
 Average product of capital:

 Compute the average product of labor.

Marginal product (MP)

 The change in total product (output) attributable  Compute the average product of capital.
to the last unit of an input.
 Marginal product of labor:
  To maximize profits, use input levels at which
THE ROLE OF THE MANAGER IN THE PRODUCTION marginal benefit equals marginal cost
PROCESS  When the cost of each additional unit of labor is w,
Produce Output on The Production Function the manager should continue to employ labor up
 Aligning incentives to induce maximum worker to the point where VMPL = w in the range of
effort diminishing marginal product.
 The firm should provide: (incentive structure/  The firm could use labor where as MB (VMPL) = MC
profit sharing, commission, quota). (w)
 To induce maximum worker effort.
Use the Right Mix of Inputs to Maximize Profits. ALGEBRAIC FORMS OF PRODUCTION FUNCTIONS
 To maximize profits when labor or capital vary in Linear
the short run, the manager will hire:  Assumes a perfect linear relationship between all
 Labor until the value of the marginal product of inputs and total output.
labor equals the wage rate: Q = F K, L = aK + bL,
𝑉𝑀𝑃𝐿 = 𝑤, where 𝑉𝑀𝑃𝐿 = 𝑃 × 𝑀𝑃𝐿 where 𝑎 and 𝑏 are constants
 Capital until the value of the marginal product of  The production function Is linear: a = 4, b = 1
capital equals the rental rate:  How much output is produced when 2 units of capital
𝑉𝑀𝑃𝐾 = 𝑟, where 𝑉𝑀𝑃𝐾 = 𝑃 × 𝑀𝑃𝐾 and 2 units of labor is utilized?
 Value marginal product: Q = F (K, L)
 The value of the output produced by the last Q = 4(2) + 1 (2) = 8 + 2 = 10 units of output
unit of an input. More capital intensive (4K) than labor intensive
 Law of diminishing returns:  Suppose that a firm’s estimated prosuction function
 The marginal product of an additional unit of is: Q = 3K + 6L
output will at some point be lower than the  How much output is produced when 3 units of capital
marginal product of the previous unit. and 7 units of labor are employed
Q = F(3,7) = 3(3) + 6(7) = 51 units
TABLE 5-2 THE VALUE MARGINAL PRODUCT OF More labor intensive (6L) than capital intensive
LABOR Leontief
 Assumes that inputs are used in fixed proportions
 Output is equal to the minimum input
𝑄 = 𝐹 𝐾, 𝐿 = min 𝑎𝐾, 𝑏𝐿 ,
where 𝑎 and 𝑏 are constants.
 Fixed proportions production function
 Implies that all inputs are used in fixed
proportions
 One keyboard for each keyboarder\
 Suppose the production function is:
Q = min {K,2L}.
 How much output is produced when 9 units of
capital and 4 units of labor are employed
Q = min {9,2(4)} = min {9,8} = 8 outputs
Combination of 1 Capital and 2 Labor can
produce 8 outputs
 As the labors of unit hired increases, price of the
 The engineers at Morris Industries obtained the
output remains and MPL increases up to the 6 th unit
following estimate of the firm’s production
of labor
function: Q = F (K, L) = min {3K, 4L}
 MPL diminishes up to the 10th unit of labor and
 How much output is produced when 2 units of
become negative on the 11th unit of labor hired
labor and 5 units of capital are employed ?
 On 1st unit of labor w > VMPL but it increases up to
F(5, 2) = min {3(5), 4(2)} = min {15, 8}
the 9th unit of labor
Since the minimum of the numbers “15” and “8”
 To maximize the profit, the firm should stop hiring
is 8, we know that 5 units of capital and 2 units
after 9th unit of labor since w < VMPL
of labor produce 8 units of output.
 It is profitable to hire labor as long as VMPL > w
Cobb- Douglas
Profit-Maximization Input Usage
 Assumes some degree of sustainability among
inputs
 𝑄 = 𝐹 𝐾, 𝐿 = 𝐾a𝐿b,
where 𝑎 and 𝑏 are constants.
 Inputs need not be used in fixed proportions
 Implies some degree of substitutability between
the inputs DIMINISHING MARGINAL RATE OF TECHNICAL
SUBSTITUTION
 If the production function is Q = K .5 L .5 and capital
is fixed at 1 unit, when L = 9
o Calculate the units of output produced
o Q = F (K, L)
o Q = (1)0.5 (9)0.5 = 3 units of output
o The average product of labor when L = 36
o The average productivity of Labor = 3/9=
0.333
o Calculate the marginal product of labor
when 9 units of labot are utilized.
o MPL = bKa Lb-1
o MPL = .5 K1/2 L -1/2
o =0.5 (1) ½ (9) -1/2 = 1/6 = 0.167

 A firm can manufacture a product according to the  From A to B as the manager substitute 1 unit of
production function: Capital (K) to 1 unit of Labor (L) can still produce the
Q = F (K, L) = K3/4 L1/4 same level of output MRTS = -1 = -MRTSKL
o Calculate the APL, when the level of capital  As we move on to the C and D, the firm can
is fixed at 81 units and the firm uses 16 units substitute 3 units of Capital (K) to 1 unit of Labor (L),
of L the firm can still produce the same units of outputs
o When K = 81 and L = 16, units of output MRTS = -3 = -MRTSKL
o Q = (K0.75 L 0.75) = (810.75 160.75)  Both Labor (L) and Capital (K) can be substituted
o (K0.75 L 0.75) = 54 (both are variables)
o Thus, APL = Q/L = 54/16 = 3.375  Isoquant curve is convex to the origin, it goes
downside, in relation to the diminishing marginal of
technical substitution
ISOQUANTS AND THE MARGINAL RATE OF
TECHNICAL SUBSTITUTION (MRTS)  MRTS decline thus it is -MRTS
Isoquants
ISOCOSTS AND CHANGES IN ISOCOST LINES
 Capture the tradeoff between combinations of
Isocost
inputs that yield the same output in the long run,
when all inputs are variable. (K, L ) - variable  Combination of inputs that yield cost the same
Marginal rate of technical substitutions (MRTS) cost.
 The rate at which a producer can substitute  Combination of inputs that will yield the same
between two inputs and maintain the same level amount of output. Cost of labor and capital Is
of output. equal to C.
 The substitution between the Capital (K) and  Suppose the firm spends exactly the costs on
Labor (L) inputs. Then the cost of labor + the cost pf capital
exactly equals the said Cost:
 Absolute value of the slope of the isoquant.
MP L 𝑤𝐿 + 𝑟𝐾 = 𝐶
𝑀𝑅𝑇𝑆𝐾𝑆 =  Re-arranging to the intercept-slope formulation
MP K  Synonymous to Indifference Curve (Module 4)
  Produce at a given level of output where the
marginal product per dollar spent is equal for all
input.

CHANGES IN ISOCOSTS
 For given input prices, isocosts farther from the  Equivalently, a firm should employ inputs such
origin are that the marginal rate of technical substitution
equals the ratio of input prices:

 The Higher the isocosts line, the more expensive

the input bundles. Conversely, the lower the
isocosts line, the less expensive the input
bundles
 Producers are interested in Cost Minimization at
 Produce at given level of output where the marginal
a lowest possible cost.
product per money spent is equal for all input
 What is the MRTS between K and L if:
Changes in the Isocost Line
 Changes in input prices change the slopes of
isocosts lines.
o MPL = 20, MPK = 40, w = P16, r = P32
o MRTS between K and L = 1.25
o Shows that marginal product/ money spent is
equal for all inputs.
OPTIMAL INPUT SUBSTITUTION
Optimal Input Substitution
 To minimize the cost of producing a given level of
output, the firm should use less of an input and
more of other inputs when that input’s price rises
 You are an efficient expert hired by a manufacturing
firm that uses K and L as inputs. The firm produces
and sells a given output.
o If w = P40, MPL = 20 and r = 100, MPK = 40
o MPL = 20/40 = 0.5 > MPK 40/100 = 0.4
 The cost of labor will move inward as the cost of o Should use more L and less K in order to
labor is increase thus the slope of isocosts line minimize the cost of the firm.
will be steeper o The higher the marginal product of L/K the more
it should be utilize by the firm
COST MINIMIZATION AND THE COST-
MINIMIZING INPUT RULE  A manager hire a labor and rents capital equipment.
Cost Minimization Currently the wage rate is P12 per hour and capital
 Producing at the lowest possible cost. is rented at P8 per hour.
Cost-Minimizing Input Rule o If the MPL = 60n units of output per hour and
 o MPK is 45 units of output per hour, analyze what  VC(Q) is closer to TC (Q)
should be the combination of the factors of  The difference between the VC(Q) and TC(Q) is
production to minimize the costs. FC.
o MPL = 60/12 = 5 > MPK 45/8 = 5.625
o The firm should use more Capital (K) and less
Labor (L) to minimize the cost of production.
AVERAGE AND MARGINAL COSTS
Average Costs
 Average fixed cost

 Average variable costs

 Average total cost

CHAPTER 5B Marginal cost (MC)

THE PRODUCTION COSTS  The (incremental) cost of producing an additional
THE COST FUNCTION unit of output
 Mathematical relationship that relates cost to the
cost-minimizing output associated with an isoquant.
Short-Run Costs
 Fixed costs TABLE 5-3 THE COST FUNCTION
o Do not change with changes in output include
the costs of fixed inputs used in production
(𝑭𝑪)
o Sunk costs
 Variable costs:
o Costs that change with changes in outputs;
include the costs of inputs that vary with output
𝑽𝑪 (𝑸)
 Total costs:
𝑇𝐶 𝑄 = 𝐹𝐶 + 𝑉𝐶 (Q)

 Capital (K) is fixed while Labor (L) varies/variable

 As the units of labor hired increase the capital
remains the same
 VC = w *L
 TC = VC +FC

TABLE 5-4 DERIVATION OF AVERAGE COST

 As the firm increases its output, fixed cost

remains the same
 While the variable cost increases as the firm
increases its output
 As the firms increases the number of outputs,  MC crosses the ATC and AVC at minimum points of
AFC declines, thus FC is spread out to the ATC and AVC
outputs  When MC is below, AVC is declining
 AVC declines when the fimrs produces 1,952  When MC is higher, AVC is increasing
units but starts to increase again when it  ATC and AVC gets closer as outputs increases (the
difference between the two is AFC)
produces higher than 1,952 (2,124 & 2,200).
 ATC declines as the firms produces up to 2,124 FIXED AND SUNK COSTS
but starts to increase again when it produces Fixed Costs
outputs higher than 2,124 (2,200).  Cost that does not change with output.
Sunk Costs
Long Run Costs
 Cost that is forever lost after it has been paid
 All costs are variable
Irrelevance of Sunk Costs
 No fixed costs
 A decision maker should ignore sunk costs to
maximize profits or minimize loses
TABLE 5-5 DERIVATION OF MARGINAL COST

 Coca cola should ignore the 5M spent. It is only

 There are two ways to calculate MC natural for a firm to invest money to conduct market
o Change in TC/ Change in Quantity research in pursuit of new product line. However,
o Change in VC/ Change in Quantity they should not be affected by this cost in the future.
 TC and VC are the same Instead, they should try new research that will bring
 Change in TC and VC can be computed by getting them more profits.
the subtraction between TC2-TC1 and VC2 – VC1 .
 Likewise, Change in Q can be computed by getting ALGEBRAIC FORMS OF COST FUNCTIONS
the difference between Q2 – Q1 Cubic Cost Function
 Costs are a cubic function of output; provides a
RELATIONSHIP BETWEEN AVERAGE AND reasonable approximation to virtually any cost
MARGINAL COSTS function

Marginal Cost Function

 If the cubic cost function is equal to

 Given: C (Q) = 100 + 2Q + 3Q2
o What is the AFC of producing 2 units of soda at
Nestle?
 o The AFC of producing 2 units of soda at nestle = Economies of Scale
P50 Economies of scale
o What is the total variable cost of producing 2  Declining portion of the long-run average cost curve
units of soda at Nestle? as output increase.
o TVC (2) = 2(2) + 3 (2)2 = 4 +12 = P16.00
o The total variable cost of producing 2 units of
soda at Nestle Diseconomies of scale
 Rising portion of the long-run average cost curve as
 An economist estimated that the cost function of output increases.
a single product: Constant returns to scale
 C(Q) = 100 + 20Q + 15Q2 + 10Q3  Portion of the long-run average cost curve that
remains constant as output increases.
o What is the fixed cost of producing 10 units of
 Usually applied by factories to increase outputs at
output?
minimum point of LRAC
o FC = 100
o The variable cost of producing 10 units of output
o VC (10) = 20(10) + 15 (10)2 +10(10)3 = 11,700

Long-run costs
 All costs are variable
 No fixed 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.

Diseconomies of
Economies of
Scale
Scale

 Under the LRAC, there are three ATC: ATC0 ATC1 ATC2
 ATC = Short Run
 3ATC Average cost of producing in a plant of fixed size
 Declining portion of the LRAC Curve
o As the firm produced up to Q* the ATC declines
(Economies of Scale
 Rising Portion of the long run average cost curve as output
increase
o As the firm produced starting from Q* the ATC gets
higher (Diseconomies of Scale)
 As the firm expands, ATC will lead to LRAC
 When LRAC is achieved, the firm is said to expanded from
short run to long run