13

Session 3.Production Function;

Production in the short and the long
run-returns to scale-economies of
scale- Producers equilibrium
 The Costs of Production
• cost-benefit analysis a study that compares
the costs and benefits to society of providing a
public good
The Costs of Production
What is the need production function?

• Production function the relationship

between quantity of inputs used to make
a good and the quantity of output of that
good
• Marginal product the increase in output
that arises from an additional unit of
input
 Basic Concepts of
Production Theory
• Production function
• Maximum amount of output that can be produced
from any specified set of inputs, given existing
technology
• Technical efficiency
• Achieved when maximum amount of output is
produced with a given combination of inputs
• Economic efficiency
• Achieved when firm is producing a given output at
the lowest possible total cost
8-5
 Basic Concepts of
Production Theory
• Inputs are considered variable or fixed depending
on how readily their usage can be changed
• Variable input
• An input for which the level of usage may be changed quite
readily
• Fixed input
• An input for which the level of usage cannot readily be
changed and which must be paid even if no output is
produced
• Quasi-fixed input
• A “lumpy” or indivisible input for which a fixed amount must
be used for any positive level of output
• None is purchased when output is zero
8-6
 Basic Concepts of
Production Theory
• Short run
• At least one input is fixed
• All changes in output achieved by changing
usage of variable inputs
• Long run
• All inputs are variable
• Output changed by varying usage of all inputs

8-7
 Sunk Costs
• Sunk cost
• Payment for an input that, once made, cannot
be recovered should the firm no longer wish
to employ that input
• Not part of the economic cost of production
• Should be ignored for decision making
purposes

8-8
 Avoidable Costs
• Avoidable costs
• Input costs the firm can recover or avoid
paying should it no longer wish to employ that
input
• Matter in decision making and should not be
ignored
• Reflect the opportunity costs of resource use

8-9
 Short Run Production
• In the short run, capital is fixed
• Only changes in the variable labor input can
change the level of output
• Short run production function

Q = f (L, K) = f (L)

8-10
 Average & Marginal Products
• Average product of labor
• AP = Q/L
• Marginal product of labor
• MP = Q/L
• When AP is rising, MP is greater than AP
• When AP is falling, MP is less than AP
• When AP reaches it maximum, AP = MP
• Law of diminishing marginal product
• As usage of a variable input increases, a point is
reached beyond which its marginal product decreases
8-11
Total, Average, & Marginal Products
of Labor, K = 2 (Table 8.2)
Number of Total product (Q) Average product Marginal product
workers (L) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4
8-12
Total, Average, & Marginal Products
K = 2 (Figure 8.1)

8-13
 Total, Average, & Marginal
Product Curves
Q2

Q1 Total
product
Panel A
Q0

L0 L1 L2

Panel B

Average
product

L0 L1 L2
Marginal 8-14
product
 Short Run Production Costs
• Total variable cost (TVC)
• Total amount paid for variable inputs
• Increases as output increases
• Total fixed cost (TFC)
• Total amount paid for fixed inputs
• Does not vary with output
• Total cost (TC)
TC = TVC + TFC
8-15
 Short-Run Total Cost Schedules
(Table 8.4)

Output (Q) Total fixed cost Total variable cost Total Cost
(TFC) (TVC) (TC=TFC+TVC)
0 $6,000 $ 0 $ 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000

8-16
Total Cost Curves (Figure 8.3)

8-17
 Average Costs
• Average variable cost (AVC)
TVC
AVC 
Q
• Average fixed cost (AFC)
TFC
AFC 
Q
• Average total cost (ATC)
TC
ATC   AVC  AFC
Q 8-18
 Short Run Marginal Cost
• Short run marginal cost (SMC) measures
rate of change in total cost (TC) as output
varies

TC TVC
SMC  
Q Q

8-19
Average & Marginal Cost Schedules
(Table 8.5)

Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/Q) (AVC=TVC/Q) (ATC=TC/Q= (SMC=TC/Q)
AFC+AVC)
0 -- -- -- --
100 $60 $40 $100 $40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120

8-20
Average & Marginal Cost Curves
(Figure 8.4)

8-21
The Costs of Production

Production cost
 The Costs of Production
Cost Curve
 The Costs of Production

Production cost
The Costs of Production

Production cost
The Costs of Production

Production cost
The Costs of Production

Production cost
Short Run Average & Marginal
Cost Curves (Figure 8.5)

8-28
Short Run Cost Curve Relations
• AFC decreases continuously as output
increases
• Equal to vertical distance between ATC &
AVC
• AVC is U-shaped
• Equals SMC at AVC’s minimum
• ATC is U-shaped
• Equals SMC at ATC’s minimum
8-29
Short Run Cost Curve Relations
• SMC is U-shaped
• Intersects AVC & ATC at their minimum
points
• Lies below AVC & ATC when AVC & ATC
are falling
• Lies above AVC & ATC when AVC & ATC
are rising

8-30
 Relations Between Short-Run
Costs & Production
• In the case of a single variable input,
short-run costs are related to the
production function by two relations

w w
AVC  and SMC 
AP MP
Where w is the price of the variable input

8-31
Short-Run Production & Cost
Relations (Figure 8.6)

8-32
 Relations Between Short-Run
Costs & Production
• When marginal product (average product)
is increasing, marginal cost (average cost)
is decreasing
• When marginal product (average product)
is decreasing, marginal cost (average
variable cost) is increasing
• When marginal product = average product
at maximum AP, marginal cost = average
variable cost at minimum AVC

8-33
 The Costs of Production

Production cost
 Session 4. Costs curves in the short
and the long run
Revenue curve in the short and long
run
Session 5. Production and costs
estimation techniques- optimum
size

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 Production Isoquants
• In the long run, all inputs are variable &
isoquants are used to study production
decisions
– An isoquant is a curve showing all possible input
combinations capable of producing a given level of
output
– Isoquants are downward sloping; if greater
amounts of labor are used, less capital is required
to produce a given output
A Typical Isoquant Map (Figure 9.1)
 Marginal Rate of Technical
Substitution
• The MRTS is the slope of an isoquant &
measures the rate at which the two inputs can
be substituted for one another while
maintaining a constant level of output

K
MRTS  
L
The minus sign is added to make MRTS a positive
number since ∆K / ∆L, the slope of the isoquant, is
negative
 Marginal Rate of Technical
Substitution
• The MRTS can also be expressed as the ratio
of two marginal products:
MPL
MRTS 
MPK
As labor is substituted for capital, MPL declines & MPK
rises causing MRTS to diminish

K MPL
MRTS   
L MPK
 Isocost Curves
• Show various combinations of inputs that
may be purchased for given level of
expenditure (C) at given input prices (w, r)
C w
K  L
r r
• Slope of an isocost curve is the negative of
the input price ratio (-w/r)
• K-intercept is C/r

• Represents amount of capital that may be

purchased if zero labor is purchased
Isocost Curves (Figures 9.2 & 9.3)
Optimal Combination of Inputs
• Minimize total cost of producing Q by
choosing the input combination on the
isoquant for which Q is just tangent to an
isocost curve
– Two slopes are equal in equilibrium
– Implies marginal product per dollar spent on last unit of
each input is the same

MPL w MPL MPK

 or 
MPK r w r
Optimal Input Combination to Minimize Cost for
Given Output (Figure 9.4)
Output Maximization for Given Cost (Figure 9.5)
 Optimization & Cost
• Expansion path gives the efficient (least-cost)
input combinations for every level of output
– Derived for a specific set of input prices
– Along expansion path, input-price ratio is constant
& equal to the marginal rate of technical
substitution
Expansion Path (Figure 9.6)
 Long-Run Costs
• Long-run total cost (LTC) for a given level of
output is given by:
LTC = wL* + rK*
Where w & r are prices of labor & capital, respectively, &
(L*, K*) is the input combination on the expansion path
that minimizes the total cost of producing that output
 Long-Run Costs
• Long-run average cost (LAC) measures the cost per
unit of output when production can be adjusted so
that the optimal amount of each input is employed
– LAC is U-shaped
– Falling LAC indicates economies of scale
– Rising LAC indicates diseconomies of scale

LTC
LAC 
Q
 Long-Run Costs
• Long-run marginal cost (LMC) measures the rate of
change in long-run total cost as output changes
along expansion path
– LMC is U-shaped
– LMC lies below LAC when LAC is falling
– LMC lies above LAC when LAC is rising
– LMC = LAC at the minimum value of LAC
LTC
LMC 
Q
 Derivation of a Long-Run Cost Schedule
(Table 9.1)
Least-cost
combination of

Output Labor Capital Total cost LAC LMC

LMC
(units) (units) (w = $5, r = $10)

100 10 7 $120 $1.20 $1.20

200 12 8 140 0.70 0.20
300 20 10 200 0.67 0.60
400 30 15 300 0.75 1.00
500 40 22 420 0.84 1.20
600 52 30 560 0.93 1.40
700 60 42 720 1.03 1.60
Long-Run Total, Average, & Marginal Cost
(Figure 9.8)
Long-Run Average & Marginal Cost
Curves (Figure 9.9)
 Economies of Scale
• Larger-scale firms are able to take greater
advantage of opportunities for specialization
& division of labor
• Scale economies also arise when quasi-fixed
costs are spread over more units of output
causing LAC to fall
• Variety of technological factors can also
contribute to falling LAC
Economies & Diseconomies of Scale
(Figure 9.10)
 Constant Long-Run Costs
• Absence of economies and diseconomies of
scale
– Firm experiences constant costs in the long run
– LAC curve is flat & equal to LMC at all output
levels
Constant Long-Run Costs (Figure 9.11)
 Minimum Efficient Scale (MES)
• The minimum efficient scale of operation
(MES) is the lowest level of output needed to
reach the minimum value of long-run average
cost
Minimum Efficient Scale (MES) (Figure
9.12)
MES with Various Shapes of LAC (Figure
9.13)
 Economies of Scope
• Exist for a multi-product firm when the joint cost of
producing two or more goods is less than the sum of the
separate costs for specialized, single-product firms to
produce the two goods:
LTC(X, Y) < LTC(X,0) + LTC(0,Y)
• Firms already producing good X can add production of
good Y at a lower cost than a single-product firm can
produce Y:
LTC(X, Y) – LTC(X,0) < LTC(0,Y)
• Arise when firms produce joint products or employ
common inputs in production
 Purchasing Economies of Scale
• Purchasing economies of scale arise when
large-scale purchasing of raw materials
enables large buyers to obtain lower input
prices through quantity discounts
Purchasing Economies of Scale (Figure 9.14)
 Learning or Experience Economies
• “Learning by doing” or “Learning through
experience”
• As total cumulative output increases, learning
or experience economies cause long-run
average cost to fall at every output level
Learning or Experience Economies (Figure
9.15)
 Relations Between Short-Run & Long-
Run Costs
• LMC intersects LAC when the latter is at its
minimum point
• At each output where a particular ATC is tangent to
LAC, the relevant SMC = LMC
• For all ATC curves, point of tangency with LAC is at
an output less (greater) than the output of minimum
ATC if the tangency is at an output less (greater)
than that associated with minimum LAC
Long-Run Average Cost as the Planning
Horizon (Figure 9.16)
 The Costs of Production

Production cost – Long & short

 Restructuring Short-Run Costs
• Because managers have greatest flexibility to
choose inputs in the long run, costs are lower in
the long run than in the short run for all output
levels except that for which the fixed input is at
its optimal level
– Short-run costs can be reduced by adjusting fixed
inputs to their optimal long-run levels when the
opportunity arises
Restructuring Short-Run Costs (Figure
9.14)
Session 4. Revenue curve in short run
and long run
Session 6.Marginal Analysis for optimal
decisions in production- equilibrium of
firm and industry
Revenue - Firms in Competitive Markets

Revenue
Revenue - Firms in Competitive Markets

Revenue
Firms in Competitive Markets

Profit maximization
 Firms in Competitive Markets

Profit maximization
Firms in Competitive Markets

Profit maximization
Firms in Competitive Markets

Profit maximization
Firms in Competitive Markets

Profit maximization
 Firms in Competitive Markets

Profit maximization
Firms in Competitive Markets

Profit maximization
 Firms in Competitive Markets

Profit maximization
Profit maximization Firms in Competitive Markets
 Economics Help
Monopoly diagram short run and long run
 Sum
Healthy Harry’s Juice Bar has the following cost
schedules:
Q (VATS) VARIABLE COST TOTAL COST
0$ 0$ 30
1 10 40
2 25 55
3 45 75
4 70 100
5 100 130
6 135 165
a. Calculate average variable cost, average total cost,
and marginal cost for each quantity.
b. Graph all three curves. What is the relationship
between the marginal-cost curve and the averagetotal-
cost curve? Between the marginal-cost curve
and the average-variable-cost curve? Explain.
 Sum
Consider the following table of long-run total cost for
three different firms:

Does each of these firms experience economies of scale

or diseconomies of scale?
THANK YOU
• Calculate
Profit MC,MR
Change in profit
Make graph