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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?

The Technology of Production

A production function, indicates the


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

Production functions describe the


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

•An example of SR production:

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.

Law of Diminishing Marginal Returns

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.

Production Functions and Isoquants

•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).

•Consider the following isoquant:

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
could have received.

•Sunk Costs: an expenditure that has been


made and cannot be recovered
⇒ 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
incurred by producing an additional
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

B: min. TC, ATC


MC = ATC

C: MC = AFC

•TC, VC curves are drawn this way


because we have assumed diminishing
marginal returns to labour.

The Producer’s LR Problem (K, L vary)

⇒ similar to consumer choice problem.

Given input prices firms must choose


inputs to produce a given output at
minimum cost.

The Isocost Line

•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

Cost-minimising Input Choice

•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 ⇒

The isoquant is given by


1 1
36  K L 2 2

The isocost line is given by


C  4L  2K

Now derive the equation for the MRTS:


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

Remember that at the optimum,


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.

Comparing SR and LR Cost Curves

•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

1. The technology of production

•production functions and isoquants

2. Production in the SR and LR

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

4. Measuring costs

5. Costs in the SR

6. The producer’s LR problem

7. Comparing SR and LR cost curves