Managerial Economics & Business

Strategy
Chapter 5
The Production Process and Costs
 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
 5-4

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 L
a b
 5-5
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.

– Average Product of Capital: APK = Q/K.

• Measures the output of an “average” unit of capital.
 5-7
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).
 5-9
Increasing, Diminishing and
Negative Marginal Returns

Increasing Diminishing Negative

Q Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
 5-10

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
.
 5-11

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.
 5-12

Marginal Rate of Technical Substitution

(MRTS)

• The rate at which two inputs are

substituted while maintaining the same
output level.
MPL
MRTSKL =
MPK
 5-13

Linear Isoquants
• Capital and labor are K
perfect substitutes Increasing
– Q = aK + bL Output
– MRTSKL = b/a
– Linear isoquants imply that
inputs are substituted at a
constant rate, independent
of the input levels
employed.
Q1 Q2 Q3
L
 5-14

Leontief Isoquants
• Capital and labor are perfect K Q3
complements. Q2
Q1 Increasing
• Capital and labor are used in Output
fixed-proportions.
• Q = min {bK, cL}
• Since capital and labor are
consumed in fixed
proportions there is no input
substitution along isoquants
(hence, no MRTSKL). L
 5-15

Cobb-Douglas Isoquants
• Inputs are not perfectly K
substitutable. Q3
Increasing
• Diminishing marginal rate Q2
Output
of technical substitution. Q1
– 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
 5-16

Isocost
• The combinations of inputs K New Isocost Line
that produce a given level of associated with higher
C1/r
output at the same cost: costs (C0 < C1).

wL + rK = C C0/r

C0 C1
• For given input prices, isocosts C0/w C1/w L
farther from the origin are K
associated with higher costs. New Isocost Line for
C/r a decrease in the
• Changes in input prices change wage (price of labor:
the slope of the isocost line. w0 > w1).

L
C/w0 C/w1
 5-17

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
MRTSKL =
r
 5-18

Cost Minimization

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

L
 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
 5-20

Total and Variable Costs

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

VC(Q): Costs that vary

with output. FC

FC: Costs that do not vary 0 Q

with output.
 5-21

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
 5-23

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

Average Variable Cost

AVC = VC(Q)/Q

Average Fixed Cost

AFC = FC/Q

Marginal Cost AFC

MC = DC/DQ
Q
The first thing to notice is that the marginal cost curve intersects the ATC and AVC curves at
their minimum points.

This implies that when marginal cost is below an average cost curve, average cost is
declining, and when marginal cost is above average cost, average cost is rising.
 5-25

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

ATC
AFC Fixed Cost
AVC

Q0 Q
 5-26

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

AVC
Variable Cost Minimum of AVC

Q0 Q
 5-27

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

= C(Q0) AVC

ATC

Total Cost Minimum of ATC

Q0 Q
 5-28

Long-Run Average Costs

$

LRAC

Economies Diseconomies
of Scale of Scale
Q* Q
 5-29

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).