Managerial Economics &

Business Strategy
Chapter 5
The Production Process and Costs

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 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
 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.
• 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.
 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).
 5-8
Increasing, Diminishing and
Negative Marginal Returns

Q Increasing Diminishing Negative

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 .
 5-10

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.
 5-11

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 are perfect K
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
 5-13

Leontief Isoquants
• Capital and labor are perfect K Q3
complements. Q2
Q1
• Capital and labor are used in Increasing
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
 5-14

Cobb-Douglas Isoquants
• Inputs are not perfectly substitutable. K
Q3
• Diminishing marginal rate of technical Increasing
substitution. Q2
Output
• As less of one input is used in the Q1
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 that K New Isocost Line
produce a given level of output associated with higher
at the same cost: C1/r costs (C0 < C1).
wL + rK = C C0/r
• Rearranging,
C0 C1
K= (1/r)C - (w/r)L L
C0/w C1/w
• For given input prices, isocosts K
farther from the origin are New Isocost Line for
associated with higher costs. C/r a decrease in the
wage (price of labor:
• Changes in input prices change w0 > w1).
the slope of the isocost line.

L
C/w0 C/w1
 5-16

Cost Minimization
• Marginal product per dollar spent should be equal for all inputs:

• But, this is just MPL MPK

 
MPL w

w r MPK r

w
MRTS KL 
r
 5-17

Cost Minimization
K

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

L
 5-18

Optimal Input Substitution

• A firm initially K
produces Q0 by
employing the
combination of inputs
represented by point A
at a cost of C0. K0
A
• Suppose w0 falls to w1.
• The isocost curve rotates
counterclockwise; which B
represents the same cost level K1
prior to the wage change.
• To produce the same level of
output, Q0, the firm will produce Q0
on a lower isocost line (C1) at a
point B.
• The slope of the new isocost line
represents the lower wage relative
L1 C0/w0 C1/w1 C0/w1 L
to the rental rate of capital. 0 L0
 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 forever lost
after it has been paid.
VC(Q)
Decision makers should ignore sunk
costs to maximize profit or minimize
losses

FC

Q
 5-22

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

AFC = FC/Q MR
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
 5-24

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

AVC
Variable Cost Minimum of AVC

Q0 Q
 5-25

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

AVC
= C(Q0)

ATC

Total Cost Minimum of ATC

Q0 Q
 5-26

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
 5-27

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

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.
 5-30

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.
 5-31

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.