Chapter 5

Production Process and Costs

Group 3
JALIL MUJIB TAN ISMAIL 2206023105

JODI SURYA GUSTANTO 2206112823

JONATAN HALOMOAN 2206112836

KRESNA NURDIANTO 2206112880

LINTANG PUTRI ENGGARINGTYAS 2206008565

Managerial Economics
MR - 22 Night Class
 The Production Function
● Technology available for producing output, converting raw inputs into an
output.
● Production process utilize two inputs, capital (K) and labor (L) to produce
output (Q).

● Production Function: engineering relation that defines the maximum

amount of output that can be produced with a given sets of input.
 Short-Run versus Long-Run Decisions

● Short-Run: The time frame in which

there are fixed factors of
production.
● In the short-run, Capital is generally
fixed and labor is called variable
factor of production

● Long-Run: the horizon over which

the manager can adjust all factors
of production.
 Measures of Productivity
● Total product: The maximum
level of output can be produced
with a given amount of inputs
● Average product: A measure of
the output produced per unit of
input

● Marginal product: The change in

total output attributable to the
last unit on an input
Figure 5-1
Increasing, Decreasing and Negative Marginal Returns

● Average Production (AP) is

maximum when the AP and
MP curves intersect
● TPmax when MP=0
● When MP > AP, AP
continuous to increase
● When MP<AP, AP decrease.
The Role of the Manager in Production Process
● Produce on the Production Function → describes the maximum possible
output that can be produce with given inputs.
● Use the Right Level of Inputs

Value marginal product (VMP): value of the output produced by the last unit of an input

VMP>Unit Cost of Labor = profitable

Min. Labor: 2
Max. Labor: 9
 Algebraic Forms of Production Functions

● Linear Production Function

● Leontief Production Function
● Cobb-Douglas Production Function
 Linear Production
Function
Q = f(K, L) = aK + bL

● The linear production function is one where

output is directly proportional to the inputs.
● Capital (K) and Labor (L) are perfect substitutes
● Assumes that marginal product of labor (MPL) is
constant.
 Leontief Production
Function
Q = f(K, L) = min(aK,bL)

● The leontief production function is one where

inputs must be used in fixed proportions to
produce output.
● a and b are fixed coefficients
● A unit of output requires a fixed amount of labor
and capital inputs
 Cobb-Douglas
Production Function
Q = f(K, L) = KaLb
● Output (Q) is a function of labor (L) and
capital (K) inputs, with each input having a
certain elasticity of production
● a and b are the elasticity of output with respect
to each input
● This production function assumes that labor
and capital inputs are substitutable to some
degree and that the marginal product of each
input decreases as the quantity of input
increases
Algebraic Measures of Productivity
Applying the Production Functions to measure a firm’s productivity
Linear Production
Function

Q = f(K, L) = aK + bL
then: MPk = a

and: MPL = b
 Leontief Production
Function
Q = f(K, L) = min(aK,bL)

● The Leontief production function does not have

an algebraic measure of productivity
● Because the function assumes that the inputs
are used in fixed proportions, and there is no
way to vary the input ratios without affecting
output
 Cobb-Douglas
Production Function

Q = f(K, L) = KaLb
then: MPk = aKa-1Lb

and: MPL = bKaLb-1

Given:

1/2 1/2
VMPL = P * MPL MPL = bKaLb-1
Q = F(K,L) = K L
Capital (K) = 1
Price (P) = $10
Wage Rate (VMPL) = $2
a=½
b=½ Solution:

MPL = (1/2)(1)1/2L(1/2)-1 2 = 5/√L

MPL = (½)L-(1/2) 2√L = 5
√L = 5/2
VMPL = 10 * (½)L-(1/2) (√L)2 = (5/2)2
VMPL = 5L-(1/2)

2 = 5L-(1/2) L = 25/4 or L = 6.25

2 = 5/√L
 Isoquants
Combinations of Inputs which equal the same level of output (Q)
Marginal Rate of Technical Substitution
(MRTS)
The rate at which two (2) inputs can be substituted

MPL
____
MRTSLK =
MPK
 Isocosts
Combinations of Inputs which equal the same level of Cost (C)

wL + rK = C

w: Wage Cost (price of Labor)

r: Rental Cost (price of Capital)
Cost Minimization (1) C1 = total cost for mix A
C2 = total cost for mix B
Q0 = isoquant for Q0 units of input.
Cost minimization mean producing output at the lowest
possible cost. a tools developed thus far to see how to choose
the optimal mix of capital and labor.

Cost-minimizing input rule

● The marginal product per dollar spent should be equal
for all input (L and K)

MRTS for Cost

minimization mix :
● to minimize the cost of production, a firm should
employ input such that the MRTS equal to the ratio of
input prices
Cost Minimization (2)
Example :

- Production function (given) : F(K,L) = K1/2L1/2

- Wage rate (w) : 2
- Rental rate (r) : 8
- Output (Q) : 10

what is the cost minimization input mix for this

production function?

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Optimal Input Substitution (1)
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.
Example (for figure):
- Initial condition :
Capital (K) : 40 unit of computer
Labor (L) : 80 unit
wage rate (w0) : $20 / unit
rental rate (r0) : $20 / unit
Total initial cost (C0) :
(w0*L) + (r0*K) = (20*80)+(20*40)
= $2400
Due to decrease of supply of silicon chip, the computer price
is increased to $40 (r1), this condition makes the isocost line
rotated from AB to BD and the output of the production is not
Q0 (expected output).
Figure: Substituting labor for computer, due to higher
To produce the same output, optimal input substitution is computer prices.
performed by creating a new input mix and shift the isocost
line to a produce a new point of cost optimization.
Optimal Input Substitution (2)
Example :
- Initial condition :
Production function : F(K,L) = K1/2L1/2
Wage rate (w0) : 2
Rental rate (r0) : 8
Output (Q) : 10
Capital (K) : 5
Labor (L) : 20

Due to a new government regulation, the wage rate (w1) is

increased to $5 per labor.

● an increase in wage rate, rotating the cost line and the

expected output (Q0) is not achieved
● to achieve the expected output, we need to do the
Optimal Input Substitution by using less input (labor),
and use more input (Capital).
● our new input after doing the substitution is 8L,13K
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The Cost Function
Different isoquants will entail different production costs, even allowing for optimal substitution between
capital and labor. 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.
Since the cost of production increases as higher isoquants are reached, it is useful to let C(Q) denote the
cost to the firm of producing isoquant Q in the cost-minimizing fashion.
The function C is called the cost function. The cost function summarizes information about the production
process, thus reduces the amount of information to process to make optimal output decisions
Short-run Costs
The sum of fixed and variable costs is the firm’s
short run cost function.
● Fixed cost (FC) are costs that do not vary with
output, include the costs of fixed inputs used
in production.
● Variable costs are costs that change when
output is changed, include the costs of inputs
that vary with output.
Short-run cost function summarizes the minimum
possible cost of producing each level of output
when variable factors are being used in the
cost-minimizing way
Average Costs
Marginal Costs
When only one input is variable, the marginal cost
is the price of that input divided by its marginal
product. Since marginal cost is the reciprocal of
marginal product times the input’s price, it
decreases as marginal product increases and
increases when marginal product is decreasing

For example, increasing output from 248 to 492

units (ΔQ = 244) increases costs from 2,800 to
3,200 (ΔC = $400). Thus, the marginal cost of
increasing output to 492 units is ΔC/ΔQ = 400/244
= $1.64.
Relations among Costs
● The marginal cost curve intersects the ATC and AVC
curves at their minimum points. This implies that
when marginal cost is below an average cost curve,
average cost is declining, and when marginal cost is
above average cost, average cost is rising.
● The ATC and AVC curves get closer together as
output increases, This is because the only
difference in ATC and AVC is AFC

…..(1)

…..(2)

…..(3)
Fixed and Sunk
Costs
● Fixed Cost = cost that does not
change when output changes
● Sunk cost = A cost that is forever lost
after it has been paid or the amount
of these fixed costs that cannot be
recouped

CASE 2

CASE 1 _ SUBLEASE REFUND

DAY 1 2 >3 FIXED COST 5000 5000

FIXED COST 5000 5000 5000 CASHBACK 4500 1000

SUNK COST 4000 4000 5000

SINK COST 500 4000
Algebraic Forms of Cost Functions
Cubic cost function = Costs are a cubic function of
output; provides a reasonable approximation to
virtually any cost function.

Marginal cost is simply the derivative of the cost

function with respect to output:
Long-Run Costs
● In the long run, all costs are
variable because the manager is
free to adjust the levels of all
inputs
The long-run average cost curve, denoted LRAC,
defines the minimum average cost of producing
alternative levels of output, allowing for optimal
selection of all variables of production (both fixed
and variable factors). The long-run average cost
curve is the lower envelope of all the short-run
average cost curves

In the long run, however, the firm can adjust the fixed Optimal Plant Size and Long-Run
factors, for example : plant size Average Cost
 Economies of Scale vs Diseconomies of Scale
Economies of scale Diseconomies of scale
Exist whenever long-run average costs decline as Exist whenever long-run average costs increase as
output increases.
output increases.
*increasing the size of the operation decreases the
minimum average cost *further increases in output lead to an increase in
average costs

Optimal point
Constant returns to scale

Exist when long-run average costs

remain constant as output is
increased.
 ● Accounting costs are the
costs most often associated
with the costs of producing
Economic goods
Costs ● Costs that appear on the
vs income statements of firms
● Economics Cost : costs of
production include not
only the accounting costs
but also the opportunities
forgone by producing a
given product (opprotunity
cost)

● Explicit cost + implicit cost

Accounting ● Only explicit cost
Costs
MULTIPLE-OUTPUT COST FUNCTIONS
● A function that defines the cost
of producing given levels of two ● Economies of Scope
or more types of outputs Exist when the total cost of producing two products
assuming all inputs are used
efficiently. within the same firm is lower than when the products
are produced by separate firms.

● C(Q1, Q2), where Q1 is the Total cost of producing Q1 and Q2 together is less than
number of units produced of the total cost of producing Q1 and Q2 separately
product 1 and Q2 is the number
of units produced of product 2.
The multiproduct cost function C( Q 1 , 0) + C(0, Q 2 ) > C( Q 1 , Q 2 )
thus defines the cost of
producing Q1 units of product 1
and Q2 units of product 2 Example : restaurant, pharmaceutical factory, FMCG
assuming all inputs are used
efficiently
*Utilisasi resources
produksi, mengurangi
duplikasi
Cost Complementarity

● Exist when the marginal cost of producing one output is

reduced when the output of another product is increased
● Multiproduct cost function when the marginal cost of
producing one output is reduced when the output of
another product is increased. Let C(Q1, Q2) be the cost
function for a multiproduct firm, and let MC1(Q1, Q2) be the
marginal cost of producing the first output.
MULTIPLE-OUTPUT COST FUNCTIONS
Quadratic Multiproduct Cost Function
● Economic of scope : C( Q 1 , 0) + C(0, Q 2 ) > C( Q 1 , Q 2 )
= C( Q 1 , 0) + C(0, Q 2 ) − C( Q 1 , Q 2 ) > 0
= f + ( Q 1 ) 2 + f + ( Q 2 ) 2 − [ f + a Q 1 Q2+ ( Q 1 ) 2 + ( Q 2 ) 2 ] > 0
=f−aQ1Q2>0

● when a < 0, an increase in Q2 reduces the economies of scope are realized in producing output levels Q1 and Q2 if
marginal cost of producing product 1
f > aQ1Q2
● Thus, if a < 0, this cost function exhibits cost
complementarity
● If a > 0, there are no cost complementarities
Example
Cost function of firm A,

when there are economies

of scope, two firms
producing distinct outputs
could merge into a single
Answer: firm and enjoy a reduction
1. a = -0,5 . Because (a < 0 ), this cost function exhibits cost complementarity in costs. Second, selling off
f − aQ1Q2 > 0, thus, economies of scope exist in producing 5 units of good 1 and 4 an unprofitable subsidiary
could lead to only minor
units of good 2 reductions in costs
2. From C ( 5, 4 ) = 100 − 10 + 25 + 16 = 131
to C ( 5, 0 ) = 100 + 25 = 125
Cost of Firm B : C ( 0, 4 ) = 100 + 16 = 116 ● Total cost awal : 131
● Total cost saat beda perusahaan
yang produksi : 241
THANKS