S16+Cost+and+Production+ Handout

10/31/19
Cost and Production
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-W estern, a division of Thom son Learning. All rights reserved. Slide
1
The Organization of
Production
• Inputs
– Labor, Capital, Land
• Fixed Inputs
• Variable Inputs
• Short Run
– At least one input is fixed
• Long Run
– All inputs are variable
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-W estern, a division of Thom son Learning. All rights reserved. Slide 2
1
10/31/19
Production Function
With Two Inputs
Q = f(L, K)
K Q
6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36
3 10 23 33 36 36 33
2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6 L
Production Function
With Two Inputs
Discrete Production Surface
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Production Function
With Two Inputs
Continuous Production Surface
Production Function
With One Variable Input
Total Product TP = Q = f(L)
DTP
Marginal Product MPL =
DL
Average Product TP
APL =
L
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Output elasticity of labor
7
Law of Diminishing Returns
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Optimal Use of the

Variable Input
Marginal Revenue
MRPL = (MPL)(MR)
Product of Labor
Marginal Resource DTC
MRCL =
Cost of Labor DL
Optimal Use of Labor MRPL = MRCL
Optimal Use of the

Variable Input
10
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Production With Two

Variable Inputs
Isoquants show combinations of two inputs
that can produce the same level of output.
Firms will only use combinations of two
inputs that are in the economic region of
production, which is defined by the portion
of each isoquant that is negatively sloped.
11
Production With Two

Variable Inputs
Isoquants
12
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Production With Two

Variable Inputs
Economic
Region of
Production
13
Production With Two

Variable Inputs
MRTS = -(-2.5/1) = 2.5
14
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Optimal Combination of Inputs

Isocost lines represent all combinations of
two inputs that a firm can purchase with
the same total cost.
C = wL + rK C = Total Cost
w = Wage Rate of Labor ( L)
C w
K= - L r = Cost of Capital ( K )
r r
15
Optimal Combination of Inputs

MRTS = w/r
16
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Returns to Scale
Production Function Q = f(L, K)
lQ = f(hL, hK)
If l = h, then f has constant returns to scale.

If l > h, then f has increasing returns to scale.
If l < h, the f has decreasing returns to scale.
17
Returns to Scale
Constant Increasing Decreasing

Returns to Returns to Returns to
Scale Scale Scale
18
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Production Functions
Cobb-Douglas Production Function
19
19
Basic Cost Concepts
• Explicit vs Implicit Costs

• Opportunity Costs
• Economic vs Accounting Costs
20
20
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Basic Cost Concepts

Incremental Costs Sunk Costs
Change in Total costs Not affected by

due to managerial managerial decision-
decisions making
21
21
Short-Run Cost Functions
Total Cost = TC = f(Q)

Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC
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Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = DTC/DQ = DTVC/DQ
23

Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
24
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25
Relationship Between Long-Run

and Short-Run Average Cost Curves
26
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Economies of Scale
Economies of Scope
27
27
Break Even Analysis
28
28
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Break Even Analysis
29
29
Accounting Profit Break Even
Sales Price = 2 M
VC = 1 M
FC = 1791 M
Depreciation = 300 M
Sales Price 2
VC 1 APBE = ?
FC 1791
Depreciation 300
APBE 2091
30
30
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Present Value Break Even

Initial Investment = 1500 M
Investment years = 5
DR = 15%
FC = 1791 M
t = 34%
Depreciation = 300 M
Sales price = 2 M
VC = 1 M
Annuity Factor = 3.352
PVBE = ?
31
31
32
32
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Initial Investment 1500

Annuity factor 3.35216
EAC 447.472674
t 0.34
FC 1791
FC(1-t) 1182.06
Depreciation 300
DTC 102
Sales Price 2
VC 1
CM(1-t) 0.66
PVBE 2314.44345
33
33
Operating Leverage
34
34
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35
35
Degree of operating Leverage
36
36
18

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10/31/19

Cost and Production

Output elasticity of labor

Law of Diminishing Returns

Optimal Use of the

Optimal Use of Labor MRPL = MRCL

Optimal Use of the

Production With Two

Production With Two

Production With Two

Production With Two

Optimal Combination of Inputs

Optimal Combination of Inputs

If l = h, then f has constant returns to scale.

Constant Increasing Decreasing

Cobb-Douglas Production Function

Basic Cost Concepts

• Explicit vs Implicit Costs

• Economic vs Accounting Costs

Basic Cost Concepts

Change in Total costs Not affected by

Short-Run Cost Functions

Total Cost = TC = f(Q)

Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Short-Run Cost Functions

Relationship Between Long-Run

Break Even Analysis

Break Even Analysis

Accounting Profit Break Even

Present Value Break Even

Initial Investment 1500

Degree of operating Leverage

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