Managerial Economics & Business

Strategy

Chapter 2
The Production
Process and
Costs
 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

5-5
 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 = Q/L
• Measures the output produced by the last worker.
• Slope of the short-run production function (with respect to
labor).
– Marginal Product of Capital: MPK = Q/K
• 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).

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Increasing, Diminishing and
Negative Marginal Returns
Increasing Diminishing Negative
Q Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
5-8
 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.
MRTS KL 
MPK
MPL

5-11
 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 in Q1 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

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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

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 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,
K= (1/r)C - (w/r)L C0 L
 For given input prices, K C1
isocosts farther from the New Isocost Line for
C0/wa decrease
C1/w in the
C/r
origin are associated with 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
MRTS w MPK
KL 
r r
 But, this is just
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 Cost Minimization

Point of Cost
Slope of Isocost
=
Minimization
Slope of Isoquant

5-17
 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
counterclockwise; which A
K0
represents the same cost
level prior to the wage
change. B
– To produce the same level K1
output,
of 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 rate of
capital. 0 L0 C1/w1 C0/w1 L
L1 C0/w0

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 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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 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
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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 vary FC

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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 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

Total Cost Minimum of ATC

Q0 Q

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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
5-26
 Long-Run Average Costs
$

LRAC

Economies Diseconomies
of Scale of Scale
Q* Q

5-27
 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.

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