The Production Process and Costs

• Introduction
o Provides economic foundations needed to succeed in managerial positions such as
production and pricing management
o Maximize the given inputs in producing a certain output
o Inputs
▪ Capital = K
▪ Labor = L
o Output = Q

PRODUCTION FUNCTION
• The maximum amount of output that can be produced with a given set of inputs
• Q = F (K, L)
• Short Run vs Long Run Decisions
o How much of each input should be used to produce an output
o Factors of Production:
▪ Fixed
• Limits your choices in making input decisions
▪ Variable
• Can adjust their use of inputs such as labor and steel
o Short Run
▪ The time frame in which there are fixed factors of production
▪ Q = f (L) = F (K* , L)
▪ In short run, more labor is needed to produce more output because increasing
capital is not possible
o Long Run
▪ The horizon over which the manager can adjust all factors on production
▪ If it takes a company three years to acquire additional capital machines:
• The long run for its manaagement is three years
• The short run is less than three years
• Measures of Productivity
o Evaluates the effectiveness of a production process and for making input decisions that
maximize profits
▪ Asks if the production process is effective
o Total Product
▪ The maximum level of output that can be produced with a given amount of inputs
▪ With all the inputs, how many outputs can be produced
▪ How many units would be produced if the laborers produced maximal effort.
o Average Product
▪ Interested in the average productivity of an input
• Each unit's contribution
▪ Average Product of Labor
𝑄
• APL =
𝐿
▪ Average Product of Capital
𝑄
• APK =
𝐾
o Marginal Product
▪ Based on lecture:
• Gaano kadami yung contributions nung output na huling ginamit or
dinagdag
 • Total output attributable to the last unit of an output
▪ Marginal Product of Capital
Δ𝑄
• MPK =
ΔK
▪ Marginal Product of Labor
ΔQ
• MPL =
ΔL
▪ Negative Marginal Product
• The marginal product of each additional unit of labor declines and
eventually become negative
• A negative marginal product means that the last unit of the input actually
reduced the total product
▪ Phases of Marginal Returns
• Increasing
• Decreasing or Diminishing Marginal Returns
• Range over which marginal product is positive but declining
• Negative Marginal Returns
• After a point, using additional units of input actually reduces
total product
• Shows the marginal product to be negative
• Range over which marginal product is negative

• The Role of the Manager in the Production Process

o Ensures that the firm operates at the right point on the prodution function
o Two Fold
▪ The firm operate on the production function
▪ The firm uses the correct level of inputs
o Produce on the Production Function
▪ Main Goal:
• To produce maximum output with given input
▪ For Labor:
• Wokers must exert maximum effort
• Managers use incentive structure
o Use the Right Level of Inputs
▪ Ensure that the firm operates at the right point on the production function
▪ Value Marginal Product of Labor
• Value of the output produced by the last unit of the input
• Value of Marginal Product of Labor
• VMPL = P × MPL
• Value of Marginal Product of Capital
• VMPK = P × MPK
• It is profitable to hire units of labor so long as the VMPL is greater than the
wages
• Illustration
• It would not pay for the firm to hire this unit of labor because the
cost of hiring it would exceed the benefits. The same is true for
additional units of labor. Thus, given the data in Table 5–2, the
manager should hire nine workers to maximize profits.

▪ Profit Maximizing Input Usage

• To maximize profits, marginal benefits equals the marginal cost
• MB = MC
 • When the cost of each additional unit of labor is w, the manager should continue
to employ labor up to the point where VMPL = w in the range of diminishing
marginal product
• It will be profitable to hire or add new units of L as long as VMPL > Unit Cost of
L or w
▪ Law of Diminishing (or Decreasing) Marginal Returns
• Demand for an input slopes downward because of the Law of Diminishing
Marginal Returns
• The marginal product of an additional unit of an input will at some point
be lower than the marginal product of the previous unit

• Profits are maximized when MB = MC or VMPL = w

• Algebraic Forms of Production Functions

o Linear Production Function
▪ Inputs are perfect substitutes
▪ Perfect linear relationship between all the inputs and total outputs
▪ Q = F (K, L) = aK + bL
▪ Example:
• Q = F (K, L) = 4K + L
• Capital is always 4 times as productive as labor
o Leontief Production Function
▪ Also called: Fixed Proportions Production Function"
▪ Implies that inputs are used in fixed proportions
• One keyboard for each keyboarder
▪ Additional keyboards are useful only to the extent that additional keyboards are
available to use them
▪ Q = F (K, L) =min{aK, bL}
o Cobb - Douglas
▪ Relationship between output and inputs are not linear
▪ Not to be used in fixed proportions
▪ Some degree of substitutability between the inputs, albeit not perfect substitutability
▪ Q = F (K, L) = KaLb

• Algebraic Measures of Productivity

o Marginal Product for Linear Productivity
▪ Does not obey Law of Diminishing Marginal Product
▪ Q = F (K, L) = aK + bL
• MPK = a
• MPL = b
▪ The marginal product of an input is independent of the quantity of the input used
whenever the production function is linear
o Marginal Product for a Cobb - Douglas
▪ Q = F (K, L) = KaLb
• MPL = bKaLb-1
 • MPK = aKa-1Lb
• Isoquants
o Shows the level of output
o To minimize the costs of producing 1,000 cars, the manager must determine the efficient
combination of inputs to use to produce them. The basic tool for misundertanding how
akternative inputs can be used to produce output is an isoquant.
o Isoquant
▪ The combinations of inputs (K and L) that yield the producer the same level of
output; that is, any combination of capital and labor along an isoquant produces the
same level of output.
o Same Isoquant = Same level of output
o Higher levels of output = Moving in the northeast direction
o Marginal Rate of Technical Substitution
▪ Isoquants are typically drawn with a convex shape is that inputs, such as capital and
labor, typically are not perfectly substitutable
▪ The rate at which labor and capital can substitute for each other
MPL
▪ MRTSKL =
MP K
• Also considered the SLOPE OF THE ISOQUANT
▪ Linear Isoquant
• Inputs are perfect substitutes for each other and the rate at which the
producer can substitute between the inputs is independent of the level of
input usage
b
• MRTS =
a
• MPL = b
• MPK = a

▪ Leontief Isoquants
• Inputs must be used in fixed proportions
• The manager cannot substitute between capital and labor and
maintain the same level of output
• NO MRTS

▪ Cobb - Douglas
• Convex
 •

• Law of Diminishing Marginal Rate of Technical Substitution

• As a producer uses less of an input, increasingly more of the other
input must be employed to produce the same level of output
• Isocost
o Cost of producing the output
o Describe the combinations of inputs that produce a given level of output
o Isocost Line
▪ Combinations of inputs that will cost the firm the same amount compromise
▪ wL + rK = C
𝐶 𝑤
▪ K= − 𝐿
𝑟 𝑟
𝐶
• Intercept:
𝑟
𝑤
• Slope: − 𝑟

▪ Higher costs lie above those with lower costs

▪ Input Price Constant = Isocost Lines are Parallel
▪ ↑ Price of labor (w), Curve is Steeper
▪ ↑ Price of K (r), Curve is Flatter
▪ Isocosts farther from the origin are associated with higher costs
• Changes in input prices the slopes of the isocost lines

• Cost Minimization
o Isocosts and Isoquants just defined may be used to determine the input usage that
minimizes production costs
o Producing output at the lowest possible cost
o Cost Minimizing Input Mix
▪ Slope of Isoquant = Slope of Isocost Line
𝑤
▪ MRTSKL =
𝑟

• Optimal Input Substitution

o A change in the price of an input will lead to a change in the cost-minimizing input
bundle
o If the firm spends the amount it spent prior to the increase in the wage rate, it cannot
produce the same level of output
COST FUNCTION
• Each isoquant corresponds to a different level of output, and the isocost line tangent to higher
isoquants will imply higher costs of production, even assuming the firm uses the cost-minimizing
input mix
• Cost of production increases as higher isoquants are reached
• It provides essential information a manager needs to determine the profit-maximizing level of
output
• Reduces the amount of information the manager has to process to make optimal output decisions
• Short Run Costs
o Summarizes the minimum possible cost of producing each level of output when variable
factors are being used in the cost-minimizing way
o Fixed costs
▪ Do not change with output, they are constant for all output levels and must be
paid even if zero units of output are produced
o Variable Costs
▪ Are zero if ni output is produced but increase as output increases above zeron
o Total Cost is the sum of fixed costs and variable costs

▪ Curves look closer together as they get steeper

o Average Marginal Costs
▪ The overhead is spread out over a larger level of output
▪ Average Fixed Costs
FC
• AFC = Q
• ↓AFC ↑Q
• Average fixed costs decline continuously as output is expanded
• Fixed costs are allocated over a greater quantity of output
▪ Average Variable Costs
VC
• AVC = Q
• Declines at first and then increases
▪ Average Total Costs
C (Q)
• ATC = Q
• ATC = AFC + AVC
• Declines at first then rises
▪ Marginal Cost (MC)
• Most important cost concept
• Cost of producing an additional unit of output
• Change in cost attributable to the last unit of output
ΔC
• MC = ΔQ
• Marginal Product
 • Increases initially, reaches a maximum point, THEN
DECREASES
• Marginal Cost
• Reciprocal of MP times the Input Price
• ↓MC ↑MP
o Relations Among Costs
▪ The marginal cost curve intersects the ATC and AVC curves at their minimum
points
• Marginal cost is below an average cost curve, average cost is declining
• Marginal cost is above an average cost curve, average cost is rising
▪ Illustration:
• Quiz Scores and Average
• When the marginal is above the average, the average increases; when the
marginal is below the average, the average decreases.
▪ The ATC and AVC curves get closer together as output increases
• Their only difference is AFC
▪ C(Q) =VC(Q) + FC
• ATC = AFC + AVC
o Fixed and Sunk Costs
▪ Sunk Costs
• Is a cost that is lost forever once it has been paid
• Amoung of the fixed costs that cannot be recouped
• Irrelevant to decision making
• Ignore sunk costs to maximize profits or minimize losses
o Algebraic Forms of Cost Functions
▪ Cubic Cost
• C(Q) = f + aQ + bQ2 + cQ3
• f is fixed costs
▪ Marginal Cost
• Derivative of Cubic Cost
• MC (Q) = a + 2bQ + 3cQ2
• Long Run Costs
o Long Run Average Cost Curve (LARC)
▪ Defines the minimum average cost of producing alternative levels of output
▪ Allows optimal selection of all variables of production
• Both fixed and variable
▪ Lies below every point on the short-run average cost curves
• It equals each short-run average cost curve at the points where the short-
run curve uses fixed factors optimally
o Economies of Scale
▪ Economies of Scale
• Initially, an expansion of output allows the firm to produce at lower
long-run average cost
• Increasing the size of operation decreases the minimum average costs
▪ Diseconomies of Scale
• Increases in output lead to an increase in average costs
▪ Constant Returns to Scale
• Producing different levels of output at the same minimum average costs
 •

• Multiple Output Costs Functions

• C (Q1 , Q2)
• Defines the cost of producing Q1 units of product 1 and Q2 units of product 2 assuming
all inputs are used efficiently
• Depends on how much of each type of output is produced
• Economies of Scope
o Total cost of producing Q1 and Q2 together is less than the total cost of
producing Q1 and Q2 separately
o C(Q1, , 0) + C(0 , Q2) > C(Q1 , Q2)
o C(Q1, , 0) + C(0 , Q2) - C(Q1 , Q2) > 0
o f - aQ1Q2 > 0
o Illustration
▪ Two restaurants serving chicken only and steak only
▪ Producing dinners separately would require duplication of many
common factors of production, such as ovens, refrigerators, tables, the
building, and so forth
• Cost Complementary
o The marginal cost of producing one output is reduced when the output of another
product is increased
o ↓MC1 ↑Q2
ΔMC1 (Q1, Q2)
o
ΔQ2
o Illustration
▪ Donuts and Donut Holes
o Quadratic Multiproduct Cost Function
▪ C(Q1 , Q 2 ) = 𝑓 + aQ1 Q 2 + (Q1 )2 + (Q 2 )2
▪ MC1 = aQ 2 + 2Q1
▪ MC2 = aQ1 + 2Q 2
• If a > 0, there is NO COST COMPLEMENTARY
• When there are economies of scope, two firms producing distinct outputs could
merge into a single firms and enjoy reduction in cost
o Selling off unprofitable subsidiary could lead to only minor reduction in
costs