Chapter 3 Production & Cost Theories

Abiot Tsegaye Managerial Economics/MBA
7/3/2021 1
What is production?
 Production is a process of combining
various material inputs and immaterial
inputs (plans, know-how) in order to
make something for consumption
(output).
 It is the act of creating an output which
has value and contributes to the utility
(Form, Place, Time, and Possession) of
individuals
7/3/2021 Abiot Tsegaye Managerial Economics/MBA 2
What is production theory?
 Production theory examines the physical
relationships between inputs and outputs.
◦ By physical relationships we mean relationships in
terms of the variables in which inputs and outputs are
measured:
◦ number of workers, tons of steel, barrels of
oil, megawatts of electricity, hectares of land,
and so on
 Inmore succinct terms, production theory
deals with production function.
◦ Production function has certain terms which are
commonly used in production function evaluations
Basic Concepts in production theory
 Production function
◦ Maximum amount of output that can be produced
from any specified set of inputs, given existing
technology
 Technical efficiency
◦ Achieved when maximum amount of output is
produced with a given combination of inputs
 Economic efficiency
◦ Achieved when firm is producing a given output
at the lowest possible total cost

Basic Concepts in production theory
 Short run
◦ At least one input is fixed
◦ All changes in output achieved by changing usage of
variable inputs
 Long run
◦ All inputs are variable
◦ Output changed by varying usage of all inputs
 Sunk cost
◦ Payment for an input that, once made, cannot be
recovered should the firm no longer wish to employ
that input
◦ Not part of the economic cost of production
◦ Should be ignored for decision making purposes
Expressing Production Function
 A production function can be expressed in
a functional form Q = f(x1, x2, x3, x4,…xn)
◦ where Q is the quantity of output and f(x , x x 1 2, 3,
x ,…x are the quantities of factor inputs (such as

4 n
capital, labor, land or raw materials)

 Production function can be represented in
linear function or non-linear function.
◦ Q = a 0 + a 1 x 1 + a 2 x 2 + a 3x 3 + … a nx n
◦ Q = a0 • ( x1)a1• ( x2)a2 . (X2)a3 … (Xn)an

Short--run Production Function
Short
 Short run shows the time span in
which at least one of the factors of
production is fixed Q = f (L, K) = f (L)
 Average Product of labor = Q / L
◦ output per labor
 Marginal Product of labor = Q /  L
◦ output attributable to last unit of
labor applied

Short
 Average product of labor
◦ AP = Q/L
 Marginal product of labor
◦ MP = Q/L
 When AP is rising, MP is greater than
AP
 When AP is falling, MP is less than AP
 When AP reaches it maximum, AP = MP

Function, K = 2
Short--run Production Function,
Short
Number of Total product Average product Marginal product

workers (L) (Q) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4

Short
Q2
Q1 Total
product
Panel A
Q0
L0 L1 L2
Panel B
Average product
L0 L1 L2
Marginal product
Law of Diminishing Returns
 As the quantity of the variable input
(labor) increases, the capital to labor
ratio declines
 Eventually an incremental increase in
the variable input adds less to output
than the previous incremental increase
in the variable input
7/3/2021 Abiot Tsegaye Managerial Economics/MBA

8-11
Law of Diminishing Returns
 Usually,when we increase one factor
of production while keeping other
factors fixed, after some point, the
marginal product starts to diminish.
MP
point of
diminishing
returns
Variable input
Optimal Use of the Variable Input
 Marginal output per one input
signals what to do.
 Hire, if TR/  L > TC/  L
 Or, what is the same thing, if
marginal revenue product >
marginal factor cost
MRP L > MFC L
 At the optimum,
MRP L = W = MFC7/3/2021 Abiot Tsegaye Managerial Economics/MBA 13
Optimal Use of the Variable Input
MRP L  MP L • P Q = W
W • W  MFC
MRPL
MPL
L
wage optimal labor
Example, assume that price is 10
MRPL MRPL – W

Long Run Production Functions
 All inputs are variable
◦ greatest output from any set of inputs
 Q = f( K, L ) is two input example
 MP of capital and MP of labor are the
derivatives of the production function
MPL = Q/L
 MP of labor declines as more labor is
applied. Also the MP of capital declines
as more capital is applied.

Production Isoquants
 In the long run, all inputs are variable &
isoquants are used to study production
decisions
 An isoquant is a curve showing all
possible input combinations capable of
producing a given level of output
 Isoquants are downward sloping; if
greater amounts of labor are used,
less capital is required to produce a
given output
Production Isoquants

Marginal Rate of Technical Substitution
 The MRTS is the slope of an isoquant &

measures the rate at which the two inputs can be
substituted for one another while maintaining a
constant level of output
K
MRTS  
L
The minus sign is added to make MRTS a positive number since
∆K / ∆L, the slope of the isoquant, is negative

Marginal Rate of Technical Substitution(MRTS
Substitution(MRTS))
 The MRTS can also be expressed as the ratio
of two marginal products:
MPL
MRTS 
MPK
As labor is substituted for capital, MPL

declines & MPK rises causing MRTS to
diminish
K MPL
MRTS   
L MPK
Marginal Rate of Technical Substitution
K
MRTS    Slope of production
L isoquant
 Y  ( MP L   L )  ( MP K   K )
0  ( MP L   L )  ( MP K   K )
MP L K
   MRTS
MP k L
Slope of production isoquant reflects relative

marginal product of labor and capital

6–21
Isocost Curves
Show various combinations of inputs that may be
purchased for given level of expenditure (C) at
given input prices (w, r)
C w
K   L
r r
Slope of an isocost curve is the negative of the
input price ratio (-w/r)
• K-intercept is C/r
Represents amount of capital that may be purchased if
zero labor is purchased
Isocost curve
r  $ 10
w  $ 5
C  $ 100
C  wL  rK
C  5 L  10 K
C w
K   L
r r
100 5
K   L
10 10
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Isocost
 Isocost line shows all combinations of inputs
which cost the same total amount.
 The slope of the isocost is the ratio of the
value of the two inputs. That is w/r.

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Optimal Combination of Inputs
Minimize total cost of producing Q by
choosing the input combination on the
isoquant for which Q is just tangent to an
isocost curve
◦ Two slopes are equal in equilibrium
◦ Implies marginal product per dollar spent
on last unit of each input is the same
M PL w M PL M PK
 or 
M PK r w r
Output Maximization for Given Cost

Optimal Combination of Inputs
 The objective is to minimize
Equimarginal Criterion:
cost for a given output
Produce where
 Isocost lines are the MPL/CL =
combination of inputs for a MPK/CK where
given cost, C0 marginal products per
 C0 = CL·L + CK·K dollar are equal
 K = C0/CK - (CL/CK)·L at D, slope of isocost =
slope of isoquant
 Optimal where:
D
◦ MPL/MPK = CL/CK·
K
◦ Rearranged, this becomes the Q(1)
C(1)
equimarginal criterion
L
Optimal Allocation of Inputs
Suppose
MP L  2 , w  $ 1
MP K  3 , r  $ 2
•Is the firm using the right combination of inputs?, if not, how
should the firm reallocate its expenditure? Use the last dollar rule
MP L 2 MP K 3
  2, and   1 .5
w $1 r $2
Last dollar spent on labor increases output by more
than the last dollar spent on capital
Increase use of labor relative to capital
Decrease use of capital relative to labor
Use of the Equimarginal Criterion
 Q: Is the following firm A dollar spent on labor

EFFICIENT? produces 3 outputs, while
a dollar spent on capital
 Suppose that: produces only 2.
◦ MP L = 30 So we should use relatively
◦ MPK = 50 more labor!
◦ W = 10 (cost of labor)  If spend $1 less in capital,
output falls 2 units, but
◦ R = 25 (cost of rises 3 units when spent
capital) on labor.
 Labor: 30/10 = 3  Shift to more labor until
 Capital: 50/25 = 2 the equimarginal
 A: No! condition holds.
 That is peak efficiency.

Allocative & Technical Efficiency
 Allocative Efficiency – asks if a firm is using the
least cost combination of input
◦ It satisfies: MPL/CL = MPK/CK
 Technical Efficiency – asks if the firm is
maximizing potential output from a given set of
inputs
◦ When a firm produces at point T rather than point D on
a lower isoquant, the firm is not producing as much as
is technically possible.
D
T Q(1)
Q(0)

Expansion path
 Expansion path gives the efficient
(least-cost) input combinations for
every level of output
 Derived for a specific set of input
prices
 Along expansion path, input-price
ratio is constant & equal to the
marginal rate of technical substitution
Expansion Path

Returns to Scale
 If multiplying all inputs by  (lambda)
increases the dependent variable by ,
the firm has constant returns to scale
(CRS).
◦Q = f ( K, L)
◦So, f(K,  L) =  • Q is
Constant Returns to Scale
◦ Also, if 10% more all inputs leads to
10% more output the firm is constant
returns to scale.
Cobb--Douglas Production Functions
Cobb
 Q = A . K .L is a Cobb-Douglas
production function
 The exponents α and β are elasticities
◦ α is the capital elasticity of output: % change in
Q / % change in K
◦ β is the labor elasticity of output: % change in Q
/ % change in L
 These elasticities can be written as EK and
EL
 The Cobb-Douglas Production Functions
can be interpreted as:
if    1, then constant returns to scale
if   < 1, then decreasing returns to scale
if   > 1, then increasing returns to scale
Examples
Example One: Q = 1.4 K .35 L .80
Is this production function constant returns to
scale?
No, it is Increasing Returns to Scale,
because 1.15 > 1.
Example 2: Q = 1.4 K .35 L .70
1. What is the production elasticity of capital?
2. What is the production elasticity of labor?
3. What happens to Q, if L increases 5% and capital
is cut 10%?
1. .35; 2. .70; 3. % ∆ Q = EL• % ∆ L+ EK • % ∆ K
= .7(+5%) + .35(-10%) = 3.5% -3.5% = 0%. Note
that this may reduce costs without reducing output.35
Theory and estimation of Cost
 Costs refer to the money expenses incurred by
a firm in the production process.
 Here, costs include imputed value of the
entrepreneur’s own resources and services, as
well as the salary of the owner-manager.
 To make a better business decision, it is
essential to know the fundamental differences
and uses of the main concepts of cost.
 There are various concepts of cost that a firm
considers relevant under various
circumstances.

Accounting and Economic Costs
 Accounting costs (Explicit): are costs which an
entrepreneur takes into consideration in making
payments to the various factors of production.
◦ They are costs that an accountant records in the firm’s
books.
 wages and salaries of labor; cost of raw materials;
expenditures on machines and equipment; depreciation and
obsolescence charges on machines; buildings and other capital
goods; rent on buildings; interest on capital borrowed;
expenses on power, light, fuel, advertisement and
transportation; insurance charges, and all types of taxes.

Accounting and Economic Costs
 Economic costs (Explicit cost plus Implicit
costs):
◦ Implicit costs are the imputed value of the
entrepreneur’s own resources and services.
 salary of the owner-manager who is content with having
normal profits but does not receive any salary, estimated
rent of the building if it belongs to the entrepreneur, and
interest on capital invested by the entrepreneur himself at
the market rate of interest.
◦ Thus economic costs include accounting costs plus
implicit costs, that is, both explicit and implicit
costs.

The Importance of Cost Analysis
 Managers seek to produce the highest
quality products at the lowest possible
cost.
 Cost analysis is helpful in the task of
finding lower cost methods to produce
goods and services.
 Cost of production provides the floor to
pricing.
 It helps managers to take correct decisions,
such as what price to quote, whether to
place a particular order for inputs or not
whether to abandon or add a product to the
existing product line and so on.
Short Run Production Costs
 Total variable cost (TVC)
◦ Total amount paid for variable inputs
◦ Increases as output increases
 Total fixed cost (TFC)
◦ Total amount paid for fixed inputs
◦ Does not vary with output
 Total cost (TC)
TC = TVC + TFC

Short--Run Total Cost Schedules
Short
Output (Q) Total fixed cost Total variable Total Cost
(TFC) cost (TVC) (TC=TFC+TVC)
0 $6,000
$ 0 $ 6,000
100 6,000 10,000
4,000
200 6,000
6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000

Total Cost Curves

Average Costs
• Average variable cost (AVC)
TVC
AVC 
Q
• Average fixed cost (AFC)
TFC
AFC 
Q
• Average total cost (ATC)

TC
ATC   AVC  AFC
Q
Short Run Marginal Cost
 Short run marginal cost (SMC) measures
rate of change in total cost (TC) as output
varies
TC TVC
SMC  
Q Q

Average & Marginal Cost Schedules
Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/Q (AVC=TVC/Q) (ATC=TC/Q= (SMC=TC/Q)
) AFC+AVC)
0 -- -- -- --
100 $60 $40 $100 $40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120

Short Run Cost Curve Relations
 AFC decreases continuously as output
increases
◦ Equal to vertical distance between ATC &
AVC
 AVC is U-shaped
◦ Equals SMC at AVC’s minimum
 ATC is U-shaped
◦ Equals SMC at ATC’s minimum

Short Run Cost Curve Relations
 SMC is U-shaped
◦ Intersects AVC & ATC at their minimum
points
◦ Lies below AVC & ATC when AVC &
ATC are falling
◦ Lies above AVC & ATC when AVC &
ATC are rising

Short Run Average & Marginal Cost Curves

Relations Between Short-
Short-Run Costs & Production
 In the case of a single variable input, short-

run costs are related to the production
function by two relations
w w
AVC  and SMC 
AP MP
Where w is the price of the variable input

Marginal Cost and Marginal Product
C
MC 
q
VC ( wL) wL
MC   
q q q
 L   1 
MC  w   w 
 q   MPL 
Marginal cost is inversely related to marginal product

Average Variable Cost and Average Product
C
AVC 
q
VC wL
AVC  
q q
 L  1 
AVC  w   w 
q  APL 
Average variable cost is inversely related to average product

Short--Run Production and Total Cost
Short

8-52
Short--Run Production and Marginal cost
Short

8-53
Short--Run Production & Cost Relations
Short

Relations Between Short-
Short-Run Costs & Production
 When marginal product (average

product) is increasing, marginal cost
(average cost) is decreasing
 When marginal product (average
product) is decreasing, marginal cost
(average variable cost) is increasing
 When marginal product = average
product at maximum AP, marginal cost
= average variable cost at minimum
AVC
Long--Run Costs
Long
 Long-run total cost (LTC) for a
given level of output is given by:
LTC = wL* + rK*
Where w & r are prices of labor & capital,
respectively, & (L*, K*) is the input
combination on the expansion path that
minimizes the total cost of producing that
output

Long--Run Costs
Long
 Long-run average cost (LAC) measures the cost
per unit of output when production can be
adjusted so that the optimal amount of each input
is employed
◦ LAC is U-shaped
◦ Falling LAC indicates economies of scale
◦ Rising LAC indicates diseconomies of scale
LTC
LAC 
Q
Long--Run Costs
Long
 Long-run marginal cost (LMC) measures the rate
of change in long-run total cost as output changes
along expansion path
◦ LMC is U-shaped
◦ LMC lies below LAC when LAC is falling
◦ LMC lies above LAC when LAC is rising
◦ LMC = LAC at the minimum value of LAC
LTC
LMC 
Q
Derivation of a Long-
Long-Run Cost Schedule
Least-cost
combination of
Output Labor Capital Total cost LAC LMC

LMC
(units) (units) (w = $5, r = $10)
100 10 7 $120 $1.20 $1.20

200 12 8 140 0.70 0.20
300 20 10 200 0.67 0.60
400 30 15 300 0.75 1.00
500 40 22 420 0.84 1.20
600 52 30 560 0.93 1.40
700 60 42 720 1.03 1.60
Long--Run Total, Average, & Marginal Cost
Long

Long--Run Average & Marginal Cost Curves
Long

Economies of Scale
 Larger-scale firms are able to take
greater advantage of opportunities for
specialization & division of labor
 Scale economies also arise when
quasi-fixed costs are spread over more
units of output causing LAC to fall
 Variety of technological factors can
also contribute to falling LAC

Returns to Scale
 Ifall inputs are increased by a factor of c
& output goes up by a factor of z then, in
general, a producer experiences:
◦ Increasing returns to scale if z > c; output goes up
proportionately more than the increase in input
usage
◦ Decreasing returns to scale if z < c; output goes up
proportionately less than the increase in input usage
◦ Constant returns to scale if z = c; output goes up by
the same proportion as the increase in input usage
f(cL, cK) = zQ
9-63
Economies & Diseconomies of Scale

Constant Long-
Long-Run Costs
 Absence of economies and diseconomies of
scale
◦ Firm experiences constant costs in the long run
◦ LAC curve is flat & equal to LMC at all output
levels

Economies of Scope
 Exist for a multi-product firm when the joint cost
of producing two or more goods is less than the
sum of the separate costs for specialized, single-
product firms to produce the two goods:
LTC(X, Y) < LTC(X,0) + LTC(0,Y)
 Firms already producing good X can add
production of good Y at a lower cost than a single-
product firm can produce Y:
LTC(X, Y) – LTC(X,0) < LTC(0,Y)
 Arise when firms produce joint products or employ
common inputs in production

Purchasing Economies of Scale
 Purchasing economies of scale arise when
large-scale purchasing of raw materials
enables large buyers to obtain lower input
prices through quantity discounts

Learning or Experience Economies
 “Learning by doing” or
“Learning through experience”
 As total cumulative output
increases, learning or
experience economies cause
long-run average cost to fall at
every output level
Break--even Analysis
Break
 We can have multiple B/E
Total (break-even) points with non-
Cost linear costs & revenues.
 If linear total cost and total
revenue:
◦ TR = P•Q
Total ◦ TC = F + V•Q
Revenue
 where V is Average
Variable Cost
 F is Fixed Cost
 Q is Output
Q  cost-volume-profit analysis
B/E B/E
Break-even Quantity: Q B/E
The Break-
 At break-even: TR =
TC TR
◦ So, P•Q = F + V•Q
 Q B/E = F / ( P - V) =
F/CM
TC
◦ where contribution
margin is: CM = ( P - V)
Q
B/E
Break-even Quantity: Q B/E
The Break-
A garage contractor has the following
information but wants to find Q B/E
 if: P = $9,000 per garage
 V = $7,000 per garage
 & F = $40,000 per year
Answer: Q = 40,000/(2,000)= 40/2 = 20

garages at the break-even point.

Break-even Sales Volume
 Amount of sales revenues that breaks

even
 P•Q B/E = P•[F/(P-V)] = F / [ 1 - V/P ]
Ex: At Q = 20, B/E Sales Volume is

$9,000•20 = $180,000 Sales Volume

Text and References Books
 Luke M. Froeb and Brian T. McCann, Managerial
Economics: A Problem Solving Approach,
Thomson South-Western, 2008.
 Nick Wilkinson 2005: Managerial Economics: A
problem Solving approach. Cambridge University
Press
 E. Mansfield, Managerial Economics, Sixth
Edition, 2006
 Any other text in Managerial Economics
73

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Abiot Tsegaye Managerial Economics/MBA

7/3/2021 Abiot Tsegaye Managerial Economics/MBA 4

x ,…x are the quantities of factor inputs (such as

capital, labor, land or raw materials)

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Number of Total product Average product Marginal product

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 The MRTS is the slope of an isoquant &

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As labor is substituted for capital, MPL

Slope of production isoquant reflects relative

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400 6,000 14,000 20,000

500 6,000 22,000 28,000

600 6,000 34,000 40,000

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• Average total cost (ATC)

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Output Average Average Average total Short-run

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 In the case of a single variable input, short-

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 When marginal product (average

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Output Labor Capital Total cost LAC LMC

100 10 7 $120 $1.20 $1.20

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7/3/2021 Abiot Tsegaye Managerial Economics/MBA 67

Answer: Q = 40,000/(2,000)= 40/2 = 20

7/3/2021 Abiot Tsegaye Managerial Economics/MBA 71