Group 3

Production
and Cost
 Production Function

descriptive This is that

links with relation output.
the inputs
 Production Function
This is the descriptive
relation that links inputs
with output.
 Returns of Scale
Relation of all inputs
between output and taken
together. proportional
variation
 Returns of Scale
Relation between output and
proportional variation of all inputs
taken together
 Returns to a Factor
and variation in a single input,
Relation holding other inputs fixed.
between output
Returns to a Factor
Relation between output
and variation in a single
input, holding other inputs
fixed
Production Function
descriptive relation that links inputs with
output

Returns to Scale
relation between output and proportional
variation of all inputs taken together

Returns to a Factor
relation between output and variation in a
single input, holding other inputs fixed
 constant (%in=%out)

returns to scale increasing (%in<%out)

decreasing (%in>%out)
Production
Function total product

returns to a factor marginal product

average product
 returns to scale
Initial Input Initial input output
output

450 cups of
Constant 2 baristas 6 baristas
coffee

150 cups 750 cups of

Increasing and
of coffee
and
coffee

Decreasing 300 cups of

2 machines 6 machines
coffee
 returns to a factor
# of workers total product marginal product average product

0 0 - -
1 50 50 50
2 90 40 45
3 120 30 40
4 140 20 35
5 150 10 30

law of diminishing returns

Choice of Inputs
Production Isoquants
shows all input combinations that produce the same quantity assuming
efficient production
 ISOCOST LINE
also known as an equal-cost line, is a graphical
representation that shows all the combinations of
inputs that a firm can purchase while spending a
specific total cost
ISOCOST CURVE
ISOCOST LINES AND CHANGES IN INPUT PRICES

RELATIVE PRICES
tells us how much one thing costs compared to another
 COST MINIMIZATION
refers to the process of reducing expenses associated with
producing goods or services while maintaining the desired
level of output or quality.
MARGINAL PRODUCT OF AN INPUT
refers to the change in output
resulting from employing one more
unit of that specific input
OPTIMAL INPUT MIX AND CHANGES IN INPUT PRICES
 SUBSTITUTION EFFECT
The substitution effect refers to the change in consumption
or production patterns that occurs when the price of one
good or factor of production changes, causing individuals or
firms to substitute it for another good or factor that has
become relatively cheaper or more expensive.
COST CURVES
GENERAL RULE OF MARGINAL COST
AND AVERAGE COST
When marginal cost is below average, average cost falls.
When marginal cost is above average cost, average cost rises.
 CONNECTION BETWEEN PRODUCTION
FUNCTIONS AND COST FUNCTIONS

Production Functions - describes how much output can be produced with

given inputs.

Cost Functions - describes how much it costs to produce that output

By understanding both functions, a company or firm can make decisions to

optimize production levels and minimize costs to maximize profits.
 OPPORTUNITY COST
refers the value of the next-highest-valued
alternative use of that resource and it’s what
you have to give up to buy what you want in
terms of other goods or services.
 Long-Run and Short-Run
Short-Run Long-Run
The short run is the The firm has
operating period during complete flexibility
which at least one or
input(capital) is fixed in no inputs are fixed
supply.

The definitions of short run and long run are not based on calendar time
The length of each period depends on how long it takes the firm to vary all inputs
 Fixed and Variable cost
In the short run, some costs are fixed and do not vary with
output. These fixed costs are incurred even if the firm
Short Run produces no output. For instance, the firm has to pay
managers’ salaries, interest on borrowed capital, lease

(Fixed) payments, insurance premiums, and property taxes whether

or not it produces any output.

Variable costs change with the level of output. These

Long-Run costs include items like raw material, fuel, and certain

(changeable)
labor costs
Short-run cost curves

Short-run cost curves sometimes are called operating

curves because they are used in making near-term
production and pricing decisions.
Short-run cost curves or Operating
curves
This figure displays the short-run cost curves of a
hypothetical firm. The upper panel depicts total cost (TC)
and total variable cost (TVC). Fixed costs simply shift the
position of the variable cost curve. The lower panel depicts
marginal and average costs. Average fixed cost declines
with output since the fixed cost is being spread over more
units. Marginal cost (MC) declines to Q1 and then increases
beyond that point due to diminishing returns. Marginal cost
depends only on the variable input factors and is completely
independent of the fixed cost. Average total cost (ATC) and
AVC decline as long as marginal cost is lower than the
average cost and increase beyond that point. Marginal cost
is equal to both ATC and AVC at their respective minimum
points. Average total cost is always larger than AVC, since
ATC=AFC + AVC. However, this difference becomes smaller
as output increases and AFC declines.
Long-run cost curves

Long-run cost curves frequently are referred to as

planning curves, since they play a key role in longer-run
planning decisions relating to plant size and equipment
acquisitions.
Long-run cost curves or planning curves
In the long run, the average cost (LRAC) of
production is less than or equal to the short-run
average cost (SRAC) of production. The LRAC curve
can be thought of as an envelope of the short-run
average cost curves. The figure shows four potential
plant sizes. Each of the four plants provides the low-
cost method of production over some range of
output. For instance, the smallest plant provides the
lowest-cost method of producing any output from
zero to Q1, while the next largest plant provides the
low-cost method of producing output from Q1 to Q2,
and so on. The heavy portion of each curve indicates
the minimum long-run average cost for producing
each level of output, assuming that there are only
these four possible plant sizes.
 Minimum Efficient Scale

Minimum efficient scale is defined as that plant size at which long-run

average cost first reaches its minimum point.

The minimum efficient scale affects both the optimal plant size and the
level of potential competition.
 Economies of Scale

Economies of scale occur when the average cost of

production per unit decreases as a business expands its
output due to spreading fixed costs over a larger volume.
Minimum Efficient Scale
 Learning Curve

A learning curve is a graphical representation of the

relationship between how proficient people are at a task and
the amount of experience they have.

A learning curve displays the relation between average cost

and cumulative production volume.

Cumulative production - is the total amount of the product

produced by the firm across all previous production periods
Learning Effects
Economies of Scale vs. Learning Effects
 ECONOMIES OF SCOPE

Economies of scope exist when the cost of producing the

products jointly within one firm is less than the cost of
producting the products separately acress independent
firms.
 PROFIT MAXIMIZATION

AN ACTION SHOULD BE TAKEN WHENEVER THE

INCREMENTAL BENEFITS OF THAT ACTION EXCEED ITS
INCREMENTAL COST

INCREMENTAL BENEFITS = MARGINAL REVENUE

INCREMENTAL COST = MARGINAL PRODUCTION COST

Changes in Marginal Cost
and Optimal Output

At the profit-maximizing
level of production, the
following condition holds:

MR = MC
 Factor Demand Curves
DISCUSSES THE OPTIMAL INPUT MIX. IN THE OPTIMAL
OUTPUT LEVEL, THE FOLLOWING CONDITION MUST HOLD:

Pi / MPi = MR or Pi = MR X MP
Marginal Revenue product curve

Demand curve for a factor of production

represents the additional revenue that comes from using one more unit
of input
Factor Demand Curve

The firm optimally

employ additional units of
the input up to the point
where the marginal cost
of the input is equal to the
marginal revenue product
of the input. Profits are
maximized when the two
are equal.
 Total Marginal
Marginal Product Marginal
Workers Product Resource
Product Price Revenue
(Output) Cost

1 7 7 10 70 15

2 17 10 10 100 15

3 24 7 10 70 15

4 27 3 10 30 15

5 29 2 10 20 15

6 30 1 10 10 15
 Cost Estimation
A detailed knowledge of costs is important to managerial
decision making. Managers are to incorporate costs in their
analysis with accurate estimates of short-run and long-run costs.

Among the most commonly used statistical techniques for

estimating cost curves is Regression analysis.
 Cost Estimation Problems
Difficulties in obtaining data on relevant cost
Equation Presumes a linear model
Multiple products are produced in a single plant.
 Summary
Constant returns to scale
Production function Increasing returns to scale
Deacreasing returns to scale

Total Law of Diminishing

Returns to a factor Marginal Returns
Average
 Summary
Isoquant
Tangent = Cost Minimization
Isoquant Line
Changes in input prices Price of input increases = substitute effect

Cost curves Average cost falls when marginal cost is

Total cost curve below average cost
Marginal cost Average cost rises when marginal cost is
above average cost
Average cost Average and Marginal costs are equal when
average cost is at minimum

Holding input prices constant, the slopes of cost curves are

determined by the underlying production technology
 Summary
Opportunity Cost - the value of a resource in its next best
alternative use. It’s what you give up when you make a decision.
can be
Short Run (Operating curves)
Cost Curves depicted
Long Run (Planning curves)
for both

Minimum Efficient Scale

Learning Curve Long-run average cost for
Economies of Scope producing a given level of
Production of joint output declines due to
(multiple products) on a significant learning effects
single firm
 Summary
Profit-Maximizing MC = MR -> Maximize level of production

Marginal Revenue
Pi = MRPi -> Profit-maximizing output level
Product of Input i

Difficulties with relevant cost

Cost estimation is
usually done with Presumes linear model
regression but it
Multiple products can be
has problems
produced by a singular plant