MANAGERIAL ECONOMICS

PRODUCTION AND COST ANALYSIS

(in the Short-Run)

THE PRODUCTION FUNCTION

A production function describes the relationship between a flow of inputs and the resulting flow of outputs in a
production process during a given period of time. The production function describes the physical relationship between
the inputs or factors of production and the resulting outputs of the production process. It is essentially an engineering
concept, as it incorporates al of the technology or knowledge involved with the production process. The production
function illustrates how inputs are combined to produce different levels of output and how different combinations of
inputs may be used to produce any given level of output. It shows the maximum amount of output that can be
produced with different combinations of inputs. This concept rules out any situations where inputs are redundant or
wasted in production. The production function forms the basis for the economic decisions facing a firm regarding the
choice of inputs and the level of outputs to produce.

FIXED INPUTS VERSUS VARIABLE INPUTS

Managers use both fixed inputs and variable inputs in a production function. A fixed input is one whose quantity a
manager cannot change during a given time period, while a variable input is one whose quantity a manager can
change during a given time period.

SHORT-RUN VERSUS LONG-RUN PRODUCTION FUNCTIONS

Two dimensions of time are used to describe production functions: the short run and the long run. These categories do
not refer to specific calendar periods of time, such as a month or a year, they are defined in terms of the use of fixed
and variable inputs.

A short run production function involves the use of at least one fixed input. At any given point in time, managers
operate in the short run because there is always at least one fixed input in the production process.

In a long run production function, all inputs are variable. There are no fixed inputs because the quantity of all inputs
can be changed.

Table 1. A SIMPLE PRODUCTION FUNCTION

Quantity of Quantity of Total product Average Marginal Marginal
capital labor product product Product
10 1 14 14.0 14 18
10 2 35 17.5 21 24
10 3 62 20.7 27 28
10 4 91 22.8 29 30
10 4.5 106 23.6 30 30.25
10 5 121 24.2 30 30
10 6 150 25.0 29 28
10 6.75 170 25.1875 26.67 25.1875
10 7 175 25.0 25 24
10 8 197 24.6 22 18
10 9 212 23.6 15 10
10 10 217 21.7 5 0
10 11 211 19.2 -6 -12

TERMINOLOGIES:
Increasing marginal returns – the results in that region of the marginal product curve where the curve is positive
and increasing, so that total product increases at an increasing rate.

Law of diminishing marginal returns or law of the diminishing marginal product – the phenomenon
illustrated by that region of the marginal product curve where the curve is positive, but decreasing, so that total
product is increasing at a decreasing rate.

Negative marginal returns – the results in that region of the marginal product curve is negative and decreasing, so
that total product is decreasing.

Cost function – a mathematical or graphic expression that shows the relationship between the cost of production and
the level of output, all other factors held constant.

Opportunity cost – the economic measure of cost that reflects the use of resources in one activity, such as a
production process by one firm, in terms of the opportunities forgone in undertaking the next best alternative activity.

Explicit cost – a cost that is reflected in a payment to another individual, such as a wage paid to a worker, that is
recorded in a firm’s bookkeeping or accounting system.

Implicit cost – a cost that represents the vale of using a resource that is not explicitly paid out and is often difficult to
measure because it is typically not recorded in a firm’s accounting system.

Historical cost – the amount of money a firm paid for an input when it was purchased, which for machines and
capital equipment could have occurred many years in the past.
Profit – the difference between the total revenue a firm receives from sale of its output and the total cost of producing
that output.

Accounting profit – the difference between total revenue and total cost where cost includes only the explicit costs of
production.

Economic profit – the difference between total revenue and total cost where cost includes both the explicit and any
implicit costs of production.

Table 2. SHORT-RUN COST FUNCTIONS (BASED ON THE PRODUCTION FUNCTION FROM Table 1. and input
prices Capital = $50 and Labor = $100
Quantity Quantity Total TFC TVC TC AFC AVC ATC MC
of capital of labor product
10 0 0
10 1 14
10 2 35
10 3 62
10 4 91
10 5 121
10 6 150
10 7 175
10 8 197
10 9 212
10 10 217

EXERCISES
Problem 1
The following table shows data for a simple production function.
Quantity of capital Quantity of labor Total product Average product Marginal product
10 0 - -
10 1 25
10 2 75
10 3 120
10 4 83
10 5 54
10 6 35
10 7 22
10 8 10
10 9 4
10 10 1

a. From the information in the table, calculate the total and average products.
b. Graph the three functions (put total product on one graph and marginal and average products on another).
c. For what range of output does this function have diminishing marginal returns?
d. At what output is average product maximized?

PROBLEM 2
The following table shows data for a simple production function.
Quantity of capital Quantity of labor Total product Average product Marginal product
10 0 0 - -
10 1 5
10 2 15
10 3 30
10 4 50
10 5 75
10 6 85
10 7 90
10 8 92
10 9 92
10 10 90

a. From the information in the table, calculate the marginal and average.
b. Graph the three functions (put total product on one graph and marginal and average products on another).
c. For what range of output does this function have diminishing marginal returns?
d. At what output is average product maximized?

PROBLEM 3
Jim is considering quitting his job and using his savings to start a small business. He expects that his costs will consists
of a lease on the building, inventory, wages for two workers, electricity, and insurance.
a. Identify which costs are explicit and which are opportunity (implicit costs).
b. Indentify which costs are fixed and which are variable.
PROBLEM 4
Lauren resigns from her job, at which she was earning $600,000 oer year, and uses her $150,000 savings, on which
she was earning 5% interest to start a business. In the first year, she earns revenue of $200,000 and her costs are as
follows:
Rent $35,000
Utilities 18,000
Wages 40,000
Materials 30,000
a. Calculate Lauren’s accounting profit.
b. Calculate Lauren’s economic profit.

PROBLEM 5
Capital costs of this firm is $50 per unit, and labor cost is $20 per worker.
Quantity Quantity Marginal TFC TVC TC AFC AVC ATC MC
of capital of labor product
10 0 - -
10 1 25
10 2 75
10 3 120
10 4 83
10 5 54
10 6 35
10 7 22
10 8 10
10 9 4
10 10 1

a. Calculate total fixed cost, total variable cost, total cost, average fixed cost, average variable cost and marginal
cost.
b. Graph your results, putting TFC, TVC and TC on one graph and AVC, ATC and MC on another.
c. At what point is average total cost minimized? At what point is average variable cost minimized?

PROBLEM 6
Refer to the table below. Capital cost is $20 per unit and labor cost is $10 per worker.
Quantity Quantity Total TFC TVC TC AFC AVC ATC MC
of capital of labor product
10 0 0 -
10 1 5
10 2 15
10 3 30
10 4 50
10 5 75
10 6 85
10 7 90
10 8 92
10 9 92
10 10 90

a. Calculate total fixed cost, total variable cost, total cost, average fixed cost, average variable cost, average
total cost and marginal cost.
b. Graph your results, putting TFC, TVC and TC on one graph and AFC, AVC, ATC and MC on another.
c. At what point is average total cost minimized? At what point is average variable cost minimized?

PROBLEM 7
Describe how diminishing returns set in for the production process and how management responded to this situation.

The Long-Distance Journey of a Fast-Food Order

By Matt Richtel
New York Times, April 11, 2006

SANTA MARIA, Calif. - Like many American teenagers, Julissa Vargas, 17, has a minimum-wage job in the fast-food
industry -- but hers has an unusual geographic reach.

"Would you like your Coke and orange juice medium or large?" Ms. Vargas said into her headset to an unseen woman
who was ordering breakfast from a drive-through line. She did not neglect the small details --"You Must Ask for
Condiments," a sign next to her computer terminal instructs -- and wished the woman a wonderful day.

What made the $12.08 transaction remarkable was that the customer was not just outside Ms. Vargas's workplace
here on California's central coast. She was at a McDonald's in Honolulu. And within a two-minute span Ms. Vargas had
also taken orders from drive-through windows in Gulfport, Miss., and Gillette, Wyo.
Ms. Vargas works not in a restaurant but in a busy call center in this town, 150 miles from Los Angeles. She and as
many as 35 others take orders remotely from 40 McDonald's outlets around the country. The orders are then sent back
to the restaurants by Internet, to be filled a few yards from where they were placed.

The people behind this setup expect it to save just a few seconds on each order. But that can add up to extra sales
over the course of a busy day at the drive-through.

While the call-center idea has received some attention since a scattered sampling of McDonald's franchises began
testing it 18 months ago, most customers are still in the dark. For Meredith Mejia, a regular at a McDonald's in
Pleasant Hill, Calif., near San Francisco, it meant that her lunch came with a small helping of the surreal. When told
that she had just ordered her double cheeseburger and small fries from a call center 250 miles away, she said the
concept was "bizarre."

And the order-taking is not always seamless. Often customers' voices are faint, forcing the workers to ask for things to
be repeated. During recent rainstorms in Hawaii, it was particularly hard to hear orders from there over the din.

Ms. Vargas seems unfazed by her job, even though it involves being subjected to constant electronic scrutiny.
Software tracks her productivity and speed, and every so often a red box pops up on her screen to test whether she is
paying attention. She is expected to click on it within 1.75 seconds. In the break room, a computer screen lets
employees know just how many minutes have elapsed since they left their workstations.

The pay may be the same, but this is a long way from flipping burgers.

"Their job is to be fast on the mouse -- that's their job," said Douglas King, chief executive of Bronco Communications,
which operates the call center.

The center in Santa Maria has been in operation for 18 months; a print-out tacked to a wall declares, "Over 2,540,000
served." McDonald's says it is still experimental, but it puts an unusual twist on an idea that is gaining traction: taking
advantage of ever-cheaper communications technology, companies are creating centralized staffs of specially trained
order-takers, even for situations where old-fashioned physical proximity has been the norm.

The goals of such centers are not just to cut labor costs but also to provide more focused customer service --
improving the level of personal attention by sending Happy Meal orders on a thousand-mile round trip.

"It's really centralizing the function of not only taking the order but advising the customer on getting more out of the
product, which can sell more -- at least in theory," said Joseph Fleischer, chief technical editor for Call Center
Magazine, an industry trade publication.

McDonald's is joined by the owner of Hardee's and Carl's Jr., CKE Restaurants, which plans to deploy a similar system
later this year in restaurants in California.

Not everyone is sold on the idea. Denny Lynch, a spokesman for Wendy's Restaurants, said that the approach had not
yet proved itself to be cost-effective. "Speed is incredibly important," he said, but "we haven't given this solution any
serious thought."

Mr. Lynch said that Wendy's would need concrete evidence that call centers worked. For example, could remote order-
takers increase sales by asking customers to order dessert?

Then there is the question of whether combining burgers, shakes and cyberspace is an example of the drive for
efficiency run amok -- introducing a mouse where the essential technology is a spatula.

"This is a case of 'if it ain't broke, don't fix it,' " said Sherri Daye Scott, editor of QSR Magazine, a trade journal covering
fast-food outlets, which refer to themselves as quick-service restaurants.

But the backers of the technology are looking to expand into new industries. The operator of one of the McDonald's
centers is developing a related system that would allow big stores like Home Depot to equip carts with speakers that
customers could use to contact a call center wirelessly for shopping advice.

Jon Anton, a founder of Bronco, says that the goal is "saving seconds to make millions," because more efficient service
can lead to more sales and lower labor costs. With a wireless system in a Home Depot, for example, a call-center
operator might tell a customer, "You're at Aisle D6. Let me walk you over to where you can find the 16-penny nails,"
Mr. Anton said.

Efficiency is certainly the mantra at the Bronco call center, which has grown from 15 workers six months ago to 125
today. Its workers are experts in the McDonald's menu; they are trained to be polite, to urge customers to add items to
their order and, above all, to be fast. Each worker takes up to 95 orders an hour during peak times.

Customers pulling up to the drive-through menu are connected to the computer of a call-center employee using
Internet calling technology. The first thing the McDonald's customer hears is a prerecorded greeting in the voice of the
employee. The order-takers' screens include the menu and an indication of the whether it is time for breakfast or lunch
at the local restaurant. A "notes" section shows if that restaurant has called in to say that it is out of a particular item.

When the customer pulls away from the menu to pay for the food and pick it up, it takes around 10 seconds for
another car to pull forward. During that time, Mr. King said, his order-takers can be answering a call from a different
McDonald's where someone has already pulled up.
The remote order-takers at Bronco earn the minimum wage ($6.75 an hour in California), do not get health benefits
and do not wear uniforms. Ms. Vargas, who recently finished high school, wore jeans and a baggy white sweatshirt as
she took orders last week.

The call-center system allows employees to be monitored and tracked much more closely than would be possible if
they were in restaurants. Mr. King's computer screen gives him constant updates as to which workers are not meeting
standards. "You've got to measure everything," he said. "When fractions of seconds count, the environment needs to
be controlled."

Speed and sales volume are not the only factors driving remote order-taking. CKE Restaurants, for instance, wants to
improve customer service. It plans to start taking remote orders in September at five Carl's Jr.'s restaurants in
California, with a broader deployment after that.

CKE said its workers were strained doing numerous tasks at once -- taking orders, helping to fill them, accepting cash
and keeping the restaurants clean.

Accuracy problems at the drive-through "are a result of the fact that the people working them are multitasking to the
point they forget details," said Jeff Chasney, head of technology operations for CKE.

Mr. Chasney said the new system could help lower barriers in language and communication. Often, in California in
particular, he said, the employee may primarily speak Spanish, while the customer speaks only English -- a problem
that can be eliminated with a specialized call-center crew.

"We believe we raise the customer-service bar by having people who are very articulate, have a good command of the
English language, and some who are bilingual," he said.

Some 50 McDonald's franchises are testing remote order-taking, some using Bronco Communications. Others are using
Verety, a company based in Oak Brook, Ill. (also the home of McDonald's), that has taken the concept further by
contracting workers in rural North Dakota to take drive-through orders from their homes.

A spokesman for McDonald's, Bill Whitman, said that the results of the test runs had been positive so far, but that it
had not yet decided whether to expand its use of the technology.

The system does sometimes lead to mix-ups and customer confusion. The surprised customer will say to the cashier,
"You didn't take my order," said Bertha Aleman, manager of the McDonald's in Pleasant Hill. For the last seven months
the franchise has used the Bronco system to help manage its two drive-through lanes at lunch.

Ms. Aleman said that, over all, the system had improved accuracy and helped her cut costs. She said that now she did
not need an employee dedicated to taking orders or, during the lunch rush, an assistant for the order-taker to handle
cash when things backed up. "We've cut labor," she said.

The call-center workers do have some advantages over their on-the-scene counterparts. Ms. Vargas said it was strange
to be so far from the actual food. But after work, she said, "I don't smell like hamburgers."

PRODUCT 8
The following discussion based on Gabriel Kahn, “Made to Measure: Invisible Supplier Has Penney’s Shirts All Buttoned
Up”, Wall Street Journal, September 11, 2003, describes a new inventory system used by J.C, Penney:

In an industry where the goal is rapid turnaround of merchandise, J.C. Penney stores now hold almost
no extra inventory of house-brand shirts. Less than a decade ago, Penney would have stored
thousands of them in warehouses across the U.S., tying up capital and slowly going out of style.

The entire program is designed and operated by TAL Apparel Ltd., a closely held Hong Kong shirt
maker. TAL collects point-of-sale data for Penney's shirts directly from its stores in North America for
analysis through a computer model it designed. The Hong Kong company then decides how many
shirts to make, and in what styles, colors, and sizes. The manufacturer sends the shirts directly to each
Penney store, bypassing the retailer's warehouses and corporate decision makers.

a. Discuss how this case illustrates the concept of the opportunity cost of capital.
b. How does this innovation also help in demand management?

PROBLEM 9
The following information about pharmaceutical manufacturing was reported in Leila Abboud and Scott Hensley, “New
Prescription for Drug Makers: Update the Plants”, Wall Street Journal, September 3, 2003:

The Food and Drug Administration (FDA) has concluded that the pharmaceutical industry needs to
adopt manufacturing innovations, partly to raise quality standards. In other industries, manufacturers
constantly change their production lines to find improvements. But the FDA regulations leave drug-
manufacturing processes virtually frozen in time. As part of the drug approval process, a company’s
detailed manufacturing plan – and even the factory itself, - must obtain FDA approval. After approval,
even a tiny change in how drug is produced requires another round FDA review and authorization that
involves time and paperwork.
 Quality testing is done by hand. Computerized equipment and robots are not used as commonly as in
other high-tech industries. Most pharmaceuticals are made according to recipes that involve many
separate steps. Each step produces an intermediate batch of chemicals that must be stored,
sometimes for long periods. Only then can the process move on to the next step. Gauging the dryness
of a batch requires a technician to stop a dryer, break a vacuum seal and pluck a sample by hand for
testing in a specialized laboratory. Before the concoction can move on, a worker might have to wait
hours for test results.

Under the old system for testing for bacterial contamination, a scientist looked for contamination by
peering through a microscope to count colonies of organisms in a petri dish.

a. Describe how diminishing returns are likely to set in for the pharmaceutical production process.
b. Why do you think the FDA allowed firms to maintain these types of production processes?