Chapter 5

The Production Process and

Costs
 Learning Objectives
Explain Explain alternative ways of measuring the productivity of inputs and the role of the manager in the production process.

Calculate Calculate input demand and the cost-minimizing combination of inputs and use isoquant analysis to illustrate optimal input substitution.

Calculate Calculate a cost function from a production function and explain how economic costs differ from accounting costs.

Explain Explain the difference between and the economic relevance of fixed costs, sunk costs, variable costs, and marginal costs.

Calculate Calculate average and marginal costs from algebraic or tabular cost data and illustrate the relationship between average and marginal
costs.

Distinguish Distinguish between short-run and long-run production decisions and illustrate their impact on costs and economies of scale.

Conclude Conclude whether a multiple-output production process exhibits economies of scope or cost complementarities and explain their
significance for managerial decisions.

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 The Production Function

Mathematical function that defines the maximum amount of output

that can be produced with a given set of inputs.


 is the level of output.
 is the quantity of capital input.
 is the quantity of labor input.

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 Short-Run versus Long-Run Decisions: Fixed and
Variable Inputs

Short-run
Period of time where some factors of production (inputs) are fixed and constrain
a manager’s decisions.

Long-run
Period of time over which all factors of production (inputs) are variable and can
be adjusted by a manager.

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 Measures of Productivity

Total product (TP)

Maximum level of output that can be produced with a given amount of inputs.
Average product (AP)
A measure of the output produced per unit of input.
Average product of labor: 
Average product of capital: 
Marginal product (MP)
The change in total product (output) attributable to the last unit of an input.
Marginal product of labor: 
Marginal product of capital: 

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 Measures of Productivity in Action

Consider the following production function when 5 units of labor and 10

units of capital are combined produce: .
Compute the average product of labor.
 units per worker
Compute the average product of capital.
 units capital unit

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Increasing, Decreasing, and Negative Marginal Returns (Figure 5-
1)

Total product Increasing Decreasing Negative

marginal marginal marginal
Average product returns to returns to returns to
Marginal labor labor labor
product
Total product
(TP)

Average product
(APL)
0 Marginal product Variable Labor
(MPL) input
(holding capital
constant)

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 The Role of the Manager in the Production Process

Produce output on the production function.

Aligning incentives to induce maximum worker effort.
Use the right mix of inputs to maximize profits.
To maximize profits when labor or capital vary in the short run, the manager will
hire:
Labor until the value of the marginal product of labor equals the wage rate: ,
where 
Capital until the value of the marginal product of capital equals the rental rate:
, where 

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 The Role of the Manager in the Production Process

Value marginal product: The value of the output produced by the last
unit of an input.
Law of diminishing returns: The marginal product of an additional unit
of output will at some point be lower than the marginal product of the
previous unit.
Profit-Maximization input usage
To maximize profits, use input levels at which marginal benefit equals marginal
cost
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.

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 Algebraic Forms of Production Functions

Commonly used algebraic production function forms:

Linear: Assumes a perfect linear relationship between all inputs and total output
, where and are constants.

Leontief: Assumes that inputs are used in fixed proportions

, where and are constants.

Cobb-Douglas: Assumes some degree of substitutability among inputs

, where and are constants.

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 Algebraic Forms of Production Functions in Action

Suppose that a firm’s estimated production function is:



How much output is produced when 3 units of capital and 7 units of

labor are employed?

 units

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 Algebraic Measures of Productivity

Given the commonly used algebraic production function forms, we can

compute the measures of productivity as follows:
Linear:
Marginal products:  and 
Average products:  and 
Cobb-Douglas:
Marginal products: and 
Average products:  and 

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 Algebraic Measures of Productivity in Action

Suppose that a firm produces output according to the production

function

Which is the fixed input?
Capital is the fixed input.
What is the marginal product of labor when 16 units of labor is hired?


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 Isoquants and Marginal Rate of Technical Substitution

Isoquants capture the tradeoff between combinations of inputs that

yield the same output in the long run, when all inputs are variable.

Marginal rate of technical substitutions (MRTS)

The rate at which a producer can substitute between two inputs and maintain the
same level of output.
Absolute value of the slope of the isoquant.


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 Family of Isoquants (Figure 5-3)
Capital Input
(K)

Substituting Increasing
labor for capital output
A

 300 units of output

B
200 units of output

=100 units of
output
0 Labor Input
(L)

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Diminishing Marginal Rate of Technical Substitution (Figure 5-5)

Capital Input
(K)
D
Slope: 
3

C
Slope: 
B
∆𝐾 = 1 A

=100
units

0 Labor Input
∆𝐿 = − 1 ∆𝐿 = − 1 (L)

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 Isocost and Changes in Isocost Lines

Isocost
Combination of inputs that yield the same cost.

or, re-arranging to the intercept-slope formulation:

Changes in isocosts
For given input prices, isocosts farther from the origin are associated with higher
costs.
Changes in input prices change the slopes of isocost lines.

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 Isocosts (Figure 5-6)
Capital Input
(K)

𝐶
𝑟
𝐶 𝑤
𝐾= − 𝐿
𝑟 𝑟

𝐶
0 Labor Input
𝑤 (L)

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 Changes in the Isocosts (Figure 5-7)
Capital Input
(K) 𝐶1
𝑟

𝐶0 More expensive
𝑟 input
bundles

Less expensive
input
bundles

0 𝐶0 𝐶1 Labor Input
𝑤 𝑤 (L)

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 Changes in the Isocost Line (Figure 5-7)
Capital Input
(K) 𝐶
𝑟

Due to increase in wage

rate


𝐶 𝐶
0 Labor Input
𝑤1 𝑤0 (L)

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Cost Minimization and the Cost-Minimizing Input Rule

Cost minimization
Producing at the lowest possible cost.
Cost-minimizing input rule
Produce at a given level of output where the marginal product per dollar spent is
equal for all inputs:

Equivalently, a firm should employ inputs such that the marginal rate of technical
substitution equals the ratio of input prices:


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Cost-Minimization Input Rule in Action (Figure 5-8)
Capital Input
(K)
𝐶1
𝑟

𝐶2 𝐴
𝑟
𝑤
𝑀𝑅𝑇𝑆𝐾𝐿 =
𝑟

=100
units

0 𝐶2 𝐶1 Labor Input
𝑤 𝑤 (L)

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 Optimal Input Substitution

To minimize the cost of producing a given level of

output, the firm should use less of an input and more
of other inputs when that input’s price rises.

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Optimal Input Substitution in Action (Figure 5-9)
Capital Input
(K)
I

New cost-minimizing
point due to higher
wage

F
B
𝐾2 Initial point of cost
minimization
A
𝐾1
𝑄0
H J
0 𝐿2 𝐿1 G Labor Input
(L)

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 The Cost Function

Mathematical relationship that relates cost to the cost-minimizing output

associated with an isoquant.
Short-run costs
Fixed costs (): do not change with changes in output; include the costs of fixed inputs
used in production
Variable costs []: costs that change with changes in outputs; include the costs of inputs
that vary with output
Total costs: 
Long-run costs
All costs are variable
No fixed costs

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 Short-Run Costs (Figure 5-11)
Total costs 𝑇 𝐶(𝑄) = 𝐹𝐶 + 𝑉𝐶(𝑄)
Variable
costs
Fixed costs 𝑉 𝐶(𝑄)

𝐹𝐶

𝐹𝐶

𝐹𝐶
𝐹𝐶

0 Output
(Q)

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 Average and Marginal Costs (Figure 5-12)
Average costs 𝐴𝑇 𝐶
Average fixed cost:  𝑀𝐶
A
Average variable costs:  
Average total cost: 

Marginal cost (MC)

The (incremental) cost of producing an
additional unit of output.

A
T
C,
A
V 𝐴𝐹𝐶
C,
A 0 Output
F
C,
M
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The Relationship between Average and Marginal Costs (Figure 5-12)

ATC, AVC, 𝐴𝑇 𝐶
AFC 𝑀𝐶
and MC ($) A

Minimum of
ATC

Minimum of
AVC 𝐴𝐹𝐶
0 Outp
ut
*the MC curve intersects the ATC and AVC
curves at their minimum points
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 Fixed and Sunk Costs

Fixed costs
Cost that does not change with output.
Sunk cost
Cost that is forever lost after it has been paid.

Irrelevance of Sunk Costs

A decision maker should ignore sunk costs to maximize profits or minimize loses.

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 Algebraic Forms of Cost Functions
The cubic cost function: costs are a cubic
function of output; provides a reasonable
approximation to virtually any cost function.
C(Q) = f + aQ + bQ2 + cQ3
where a, b, c, and f are constants; f
represents fixed costs.

Marginal cost function is:

MC(Q) = a + 2bQ + 3cQ2

Managers can use regression analysis to

estimate these parameters (see Table05-07.xls)
 Long-Run Costs

In the long run, all costs are variable since a manager is free to adjust
levels of all inputs.

Long-run average cost curve

A curve that defines the minimum average cost of producing alternative levels of
output allowing for optimal selection of both fixed and variable factors of
production.

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Optimal Plant Size and Long-Run Average Cost (Figure 5-13)
LRAC
($) 𝐴𝑇 𝐶2
𝐴𝑇 𝐶0 𝐿𝑅𝐴𝐶

𝐴𝑇 𝐶1

0 𝑄∗ Outp
ut

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 Economies of Scale (Figure 5-14)

Economies of scale LRAC

($) 𝐿𝑅𝐴𝐶
Declining portion of the long-run
average cost curve as output increase.
Diseconomies of scale
Rising portion of the long-run average
cost curve as output increases.
Constant returns to scale
Portion of the long-run average cost
curve that remains constant as output
increases.
Economies of Diseconomies of
scale scale

0 𝑄∗ Out
put
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Constant Returns to Scale (Figure 5-14)
LRAC
($)

𝐴𝑇 𝐶2 𝐴𝑇 𝐶3
𝐴𝑇 𝐶1

𝐿𝑅𝐴𝐶

0 Outp
ut

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 Multiple-Output Cost Function

Economies of scope
Exist when the total cost of producing  and  together is less than the total
cost of producing each of the type of output separately.

Cost complementarity
Exist when the marginal cost of producing one type of output decreases when the
output of another good is increased.


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 Algebraic Form for a Multiproduct Cost Function


For this cost function:
MC1 = aQ2 + 2Q1
When a < 0, an increase in Q2 reduces the marginal cost of producing product 1.
If a < 0, this cost function exhibits cost complementarity
If a > 0, there are no cost complementarities
Exhibits economies of scope whenever f -  > 0

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