You are on page 1of 22

Production and Costs

•How do firms decide how much to

produce?
•How does a firm decide how much of
each input to use in production?

output, Q, that a firm produces for every

possible combination of inputs, i.e.
Q  F  K , L
where K = capital and L = labour.

e.g. The Cobb-Douglas production

function:
 
QK L ;0   ,   1

maximum output feasible for a given set

of inputs ⇒ technical efficiency.
Production in the Short Run (SR)

•SR production function:

Q  F K, L 
i.e. there is only one variable input, L.
The amount of K is fixed.

Definitions
•Total Product (TP): total output, Q.
•Marginal Product of L (MPL): additional

output produced as the L input is increased

by 1 unit (holding K fixed), i.e.

MPL 
Q F K , L

 
L L
e.g.
1 1
QK L 2 2

1
1  12 12 1  K  2
 MPL  L K   
2 2 L 

•Average Product of L (APL): output per

unit of labour input, i.e.
Q
APL 
L
1 1
e.g. Q  K L 2 2

1 1 1
K L 1
21
 K
2 2
 APL   K L 
2 2

L  L

K L Q MPL APL
8 0 0 - -
8 1 5 5 5
8 2 18 13 9
8 3 36 18 12
8 4 56 20 14
8 5 75 19 15
8 6 90 15 15
8 7 98 8 14
8 8 104 6 13
8 9 108 4 12
8 10 110 2 11
8 11 110 0 10
8 12 108 -2 9
8 13 104 -4 8
Q
110

90

56

0 L
4 6 11

APL, MPL

20

15

APL
MPL

0 L
4 6 11
NB:

1. MPL > APL ⇒ APL ↑

MPL < APL ⇒ APL ↓.

2. MPL > 0 ⇒ Q ↑
MPL < 0 ⇒ Q ↓.

3. The slope of a line drawn from the

origin to a point on the TP curve gives
APL at that point.

4. The slope of the TP curve at any point

gives the MPL at that point.

As more of an input is used (holding

other inputs fixed), a point is eventually
reached beyond which the output level
begins to fall.
Production in the LR

•The production function is now:

Q  F  K , L
Both K and L can be varied.

•Isoquant: a curve that shows all possible

combinations of inputs that yield the same
output.

•Special isoquant shapes:

Deriving Isoquants

1 1 Q
QK L 2 2

Q=10
K

Q=5

0 L
K

1 1
K L  10
2 2

1 1
K L 5
2 2

0 L
Returns to Scale

Say that a firm increases all inputs in the

same proportion (e.g. doubles the
amount of K and L). Then,

(a)Increasing returns to scale (IRS) ⇒ If

output increases by proportionally more
(i.e. Q more than doubles).
(b)Constant returns to scale (CRS) ⇒ If
output increases in the same proportion
(i.e. Q doubles too)
(c)Decreasing returns to scale (DRS) ⇒
If output increases by proportionally
less (i.e. Q less than doubles).

•IRS ⇒ firms become larger

⇒ mergers / takeovers

Isoquant Slopes

•Marginal rate of technical substitution

(MRTS)
= the slope of the isoquant at a given
combination of inputs
K
=
L
= the amount by which K can be
reduced when an extra unit of L is
employed (holding Q constant).

Say we move from A to B:

• ↑ L ⇒ MPL (> 0)

⇒ Q ↑ by (∆L) MPL
• ↓ K ⇒ MPK (< 0)
⇒ Q ↓ by (∆K) MPK

But A & B represent the same output;

they lie on the same isoquant.

∴ total change in output is given by:

∆Q = (∆L) MPL + (∆K) MPK = 0

Rearranging yields:
(∆K) MPK = - (∆L) MPL

K  MPL
  MRTS
L MPK

Mathematically …
Q
MRTS   L
Q
K
Measuring Costs

•Opportunity Cost: the value of the best

alternative use of a resource.
e.g.
Say a firm owns a building and so pays
no rent for office space:
⇒ accounting cost = 0
⇒ opportunity cost = amount of rent firm

•Sunk Costs: an expenditure that has been

⇒ does NOT influence firm decisions
⇒ opportunity cost = 0.
Costs in the SR

Definitions

1. Total cost = fixed cost + variable cost

TC  FC  VC  Q 
2. Marginal cost (MC) = the extra cost
unit of output.
TC VC
MC  
Q Q
3. Average total cost:
TC FC  VC
ATC  
Q Q
SR Cost Curves
TC
Cost
VC

FC

0 Q

Cost
MC ATC

AVC

AFC
0 Q
A: min. VC, AVC
MC = AVC

MC = ATC

C: MC = AFC

•TC, VC curves are drawn this way

because we have assumed diminishing
marginal returns to labour.

Given input prices firms must choose

inputs to produce a given output at
minimum cost.

•All possible combinations of L and K

that can be purchased for a given total
cost, i.e.
C  wL  rK
where C = total cost, w = wage and
r = rental cost of capital (the interest rate).

 rK  C  wL
C w
 K  L
r r

•Say firm wishes to produce QQ.

•It can do this at points B and A. But A
is cheaper!
•The firm cannot produce Q by
spending only C0 (e.g. at point C).

•At A:
w
MRTS  
r
MPL w

MPK r
MPL MPK

w r

⇒ at the optimum, an additional unit of

output costs the same regardless which
input is used.

An Example Problem

Assume a firm has a production function

1 1
given by Q  K L . Also, w = 8, r = 2.
2 2

How much (K,L) should the firm use if it

wishes to produce 36 units of output?
Also calculate the minimum cost of
producing 36 units of output?

*** Solution ⇒

1 1
36  K L 2 2

C  4L  2K

1
Q 1 1 1
1 K 
 2
MPL   K L  
2 2

L 2 2 L 
1

Q 1 1

1
1 K  2
MPK   LK 2 2
  
K 2 2 L 

MPL K
 MRTS  
MPK L

w
MRTS 
r
K 8
 4
L 2
 K  4L

Now solve the optimum condition and

the isoquant simultaneously for K and L,
i.e.
1 1
36  K L 2 2

1 1
  4L  L
2 2

 2L
∴ L*  18  K *  72

and hence,
C *   4  18    2  72 
 72  144
 216
Expansion Path

•The expansion path traces out the least-

cost combinations of K and L needed to
produce each level of output in the LR.

•The cost of producing Q units of output

in the LR must be less than or equal to
the cost of producing Q units in the SR.
Why??
Economies of Scale

•Returns-to-scale dealt with the changes

in output when input quantities are
varied in proportion.

•However, say one input is doubled and

another is tripled. How can we describe
the change in output that results?

•Economies of Scale → when output

increases proportionally more than an
increase in cost.

•If output doubles for less than twice the

cost ⇒ economies-of-scale.
•If doubling output requires more than
twice the cost ⇒ diseconomies-of-scale.
Relating SR & LR Costs

•LAC is the envelope of the SAC. Why?

•LMC flatter than SMC. Why?
Summary

3. Production in the LR: returns-to-scale.

4. Measuring costs

5. Costs in the SR