Topic on Production and Cost Functions and Their Estimation

Production function
A table, graph, or equation showing the maximum output rate of the product that can be achieved from any specified set of usage rates of inputs

Production function Thomas Machine Company

Amount of Labor (annual # units) 1 2 3 4 5 6 7 8 Output of Parts (hundreds/year) 12 27 42 56 68 76 76 74 AP Labor 12.0 13.5 14.0 14.0 13.6 12.7 10.9 9.3 MP Labor 1 15 15 14 12 8 0 -2

Production function Thomas Machine Company

80
Parts

60 40 20 0 0 2 4 Labor 6 8 10

Production function Thomas Machine Company

20 15
Parts

10 5 0 -5 0 5 Labor 10

AP Labor MP Labor

Law of diminishing marginal returns

If equal increments of an input are added to a production process, and the quantities of other inputs are held constant, eventually the marginal product of the input will diminish Note: 1) This is an empirical generalization. 2) Technology remains fixed. 3) The quantity of at least one input is held fixed.

Marginal revenue product

The amount that an additional unit of the variable input adds to the firms total revenue

MRPY = DTR/DY

Marginal expenditure
The amount that an additional unit of the variable input adds to the firms total costs.

MEY = DTC/DY

Optimal level of input use

MRPY = MEY

Production functions with two variable inputs

Amount of Labor 1 2 3 4 5 Number of Machine Tools 3 4 5 6 5 11 18 24 14 30 50 72 22 60 80 99 30 81 115 125 35 84 140 144

Q = f (labor, machine Tools)

150 100 50 0 1 2 3 4 5 Number of Machine Tools

Labor

Isoquant
A curve showing all possible (efficient) combinations of inputs that are capable of producing a certain quantity of output
Iso same quant quantity

Capital

K2 K1 100 0 L2 L1
Labor

300
200

Marginal rate of technical substitution

Shows the rate at which one input can be substituted for another input, if output remains constant. (Slope of the isoquant.)
Given Q = f(X1, X2) MRTS = -dX2 / dX1 = -MP1 / MP2

Isocost curves
Various combinations of inputs that a firm can buy with the same level of expenditure PLL + PKK = M where M is a given money outlay.

Capital

M/PK

Slope = -PK /PL

M/PL

Labor

Maximization of output for given cost

Capital

300 200
100

Labor

MPL/PL = MPK/PK
Capital

300 200
100

Labor

Optimal Lot Size

To consider the size of inventory Find the relationship between size of lot and total annual cost.

What Toyota Taught the World?

Lower the cost per setup Reduce the optimal lot size Just-in-time production system

Returns to scale
If the firm increases the amount of all inputs by the same proportion: Increasing returns means that output increases by a larger proportion Decreasing returns means that output increases by a smaller proportion Constant returns means that output increases by the same proportion

Output elasticity
The percentage change in output resulting from 1 percent increase in all inputs. e > 1 ==> increasing returns e < 1 ==> decreasing returns e = 1 ==> constant returns

Example: Xerox
Sending out teams of engineers and technicians to visit other firms to obtain information concerning best-practice methods and procedures. Competitive Benchmarking

Measurement of Production Functions

Three types of statistical analysis

Time series data Cross section data Technical information

The Analysis of Costs

Opportunity costs
The value of the other products that the resources used in production could have produced at their next best alternative

Historical costs
The amount the firm actually paid for a particular input

Explicit vs. implicit costs

Explicit costs include the ordinary items that an accountant would include as the firms expenses Implicit costs include opportunity costs of resources owned and used by the firms owner

Short run
A period of time so short that the firm cannot alter the quantity of some of its inputs Typically plant and equipment are fixed inputs in the short run Fixed inputs determine the scale of the firms operation

Three concepts of total costs

Total fixed costs = FC Total variable costs = VC Total costs = FC + VC

Fixed, variable, and total costs Media Corp.

OUTPUT 0 1 2 3 4 5 6 7 8 9 10 11 12 FC 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000 VC 0 100 180 280 392 510 650 800 960 1140 1340 1560 2160 TC 2000 2100 2180 2280 2392 2510 2650 2800 2960 3140 3340 3560 4160

Fixed, Variable, and Total Costs -- Media Corp.

5000 4000 3000 2000 1000 0 0 10 Units of Output 20

FC VC TC

dollars

Average and marginal costs Media Corp.

OUTPUT 0 1 2 3 4 5 6 7 8 9 10 11 12 AFC 2000.0 1000.0 666.7 500.0 400.0 333.3 285.7 250.0 222.2 200.0 181.8 166.7 AVC 100.0 90.0 93.3 98.0 102.0 108.3 114.3 120.0 126.7 134.0 141.8 180.0 ATC 2100.0 1090.0 760.0 598.0 502.0 441.7 400.0 370.0 348.9 334.0 323.6 346.7 MC 100 80 100 112 118 140 150 160 180 200 220 600

Average and marginal costs Media Corp.

2000 1500 1000 500 0 0 2 4 6 8 10 12 Units of output

$$$

AFC AVC ATC MC

Long-run cost functions

Often considered to be the firms planning horizon Describes alternative scales of operation when all inputs are variable Average cost

Quantity of output

Long-run average cost function

Shows the minimum cost per unit of producing each output level when any scale of operation is available Average cost
SR average cost functions LR average cost

Quantity of output

Key steps: Cost estimation process

Definition of costs Correction for price level changes Relating cost to output Matching time periods Controlling product, technology, and plant Length of period and sample size

Minimum efficient scale

The smallest output at which long-run average cost is a minimum.
Average cost

Qmes

Quantity of output

The survivor technique

Classify the firms in an industry by size and compute the percentage of industry output coming from each size class at various times If the share of one class diminishes over time, it is assumed to be inefficient These firms are then operating below minimum efficient scale

Economies of scope
Exist when the cost of producing two (or more) products jointly is less than the cost of producing each one alone.
S = C(Q1) + C(Q2) - C(Q1+ Q2) C(Q1+ Q2)

Break-even analysis
Dollars
Total Revenue Total Cost

Profit Loss

Quantity of output