Managerial Economics Class 2:

Production and Cost

Review Question

0. Point Elasticity
1. Ford Brazil Plant Video
2. The Production Function (5.1)
3. Short Run Production: Diminishing Returns (5.2)
4. Long Run Production: Returns to Scale (5.4)
5. Review of Cost Concepts (6.1, 6.2)
6. Cost Curves (6.2)

Next class: Bring laptop if possible. (We will use Excel.)

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 Clickers

If you have not previously registered your clicker, please do so

now. The clicker registration is available on the course website.

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 Clicker Question 1
We will normally start the class with two
clicker questions that review the previous
class.
Which statement about this diagram is
true?

a. If income rises by $15,000 the equilibrium price falls from $3 to $2.

b. At the initial income level, a price of $2 would cause excess demand.
c. A similar diagram would apply if the price of a complement rises.
d. This good is a normal good as the demand curve shifts out as income
rises.
e. None of the above.

Hint: See “Shocks to the Equilbrium”, pp. 22-27.

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 Point Elasticity
Point elasticity is the elasticity at a point (a single combination
of p and Q).
  %Q / %p.
Q p Q p
  .
Q p p Q

As Δp gets very small, ΔQ also gets very small and ΔQ /Δp

approaches the derivative dQ/dp.
dQ p
It makes sense to define the point elasticity as   .
dp Q
If Q = a + bp, then dQ/dp = b. For a demand curve, b is
negative.
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 Clicker Question 2
Q = 160 – 40p point elasticity =
dQ p

dp Q

a. At a price of $3, the point elasticity of demand is -3.

b. At a price of $2 the point elasticity of demand is -1.
c. The point elasticity is the same at all points on the demand curve.
d. a. and b.
e. None of the above.

Hint: See “The Price Elasticity of Demand”, pp. 46-52

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 Ford Plant in Brazil Video
(Clicker Question 3)

Ford Plant in Brazil Video

a. Compared with US plants, the Brazil plant has a low

capital to labour ratio.
b. The Brazil plant is more flexible than most U.S. plants.
c. Labour relations are more difficult in the Brazil plant
than in U.S. plants
d. All of the above.
e. None of the above.

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 2. The Production Function

The production function shows the maximum output (q) that a

firm can produce for every specified combination of inputs.
We focus on two inputs: capital and labor: q = F(L,K).

Output, q depends on capital, K and labour, L.

For example, q = 10K + 5L is a linear production function.

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 3. Short Run Production

Short Run
Period of time in which quantities of one or more productive
inputs cannot be varied. These inputs are called fixed inputs.

Long Run
Amount of time needed to make all production inputs
variable.

When we work with labour and capital as inputs, we

normally assume that capital is fixed in the short run but
flexible in the long run. Labour is flexible in both the long
run and the short run.

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 Marginal Product and Average
Product
The average product of a factor is total output divided by the
quantity of that factor. The average product of labor, APL, is
q/L.

The marginal product of labor (MPL ) is the derivative (rate of

change) of output with respect to labor: dq/dL.

Roughly speaking, it is the amount output changes when labor

increases by one unit.

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 Derivatives (Calculus)
Calculus is the mathematical study of change. A derivative is a
rate of change. Geometrically a derivative is a slope.

Suppose y = f(x) = axb where a and b are constants and x and y

are variables.

The derivative is written as dy/dx or y’(x) or f’(x).

dy/dx = baxb-1.
If b = 0 then y = ax0 = a and dy/dx = 0a = 0.
(The derivative of a constant is zero as it does not change.)

If b =1 then y = ax1 = ax (linear) and dy/dx = ax0 = a.

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 Derivatives cont’d

y = f(x) = axb

If b = 2 then y = ax2 (quadratic) and dy/dx = 2ax1 = 2ax.

If b = -1 then y = ax-1 = a/x and dy/dx = -ax-2 = -a/x2.

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 Marginal Product
Suppose q = KL0.5 (K times the square root of L).

Then MPL = dq/dL

= 0.5KL-0.5
= 0.5K/L0.5

The marginal product of one factor is based on holding the

other factor constant, such as K = 100. Then MPL = 50/L0.5.

In this case, as L increases, MPL falls – diminishing marginal

product of labour.

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 The Law of Diminishing
Marginal Returns (LDMR)
If a firm keeps increasing an input, holding all other inputs
and technology constant, the corresponding increases in
output will eventually become smaller (diminish).

Based on the LDMR, Thomas Malthus raised concerns about

hunger and starvation in the late 18th century. If land is fixed
and labour grows, MPLabour should decline, leading to less
food per person.

The primary question concerns whether the effects of

diminishing returns can be offset by technological progress.
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 Clicker Question 4
Here are two productions functions. K is fixed (and positive).
1. q = 10K + 5L.
2. q = 10KL0.5

a. Both production functions satisfy the LDMR.

b. Only production function 1 satisfies the LDMR.

c. Only production function 2 satisfies the LDMR.

d. Neither production function satisfies the LDRM.

e. Not enough information is given to answer the question.

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 4. Long Run Production:
Returns to Scale
Increasing returns to scale (IRS): When all inputs increase by
the same proportion, output increases by a greater
proportion.

Constant returns to scale (CRS): When all inputs increase by

some proportion, output increases by the same proportion.

Decreasing returns to scale (DRS): When all inputs increase

by the same proportion, output increases by a smaller
proportion.

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 Example
Assume q = KL.

Therefore q1 = K1L1 where we use the subscript 1 to indicate

specific values of q, K, and L.

Now what happens when we double K and L?

Let L2 = 2L1 and K2 = 2K1.

Then q2 = K2L2 = (2 L1)(2K1) = 4 K1L1 = 4q1.

So doubling the inputs quadrupled the output, which means

increasing returns to scale.

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 Clicker Question 5

Suppose that the production function is given by q = 10K +

5L .

a. This production function has increasing returns to scale.

b. This production function has constant returns to scale.
c. This production function has decreasing returns to scale.
d. The returns to scale vary depending on the amount of
capital and labor used.
e. None of the above.

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 5. The Nature of Costs

There are many types of costs that are important in

decision-making. We will discuss opportunity costs, sunk
costs, and cost curves.

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 Opportunity Cost

The opportunity cost of a resource is the best alternative use

of that resource.
In deciding whether to use a resource, a manager should
always focus on the opportunity cost of that resource.
Example: A city is considering building subsidized housing for
low income people.

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 Opportunity Cost Example
If the land is already owned by the city, the cost of
the land is implicit, but it has an opportunity cost. If
the land has to be purchased or rented, the cost is
explicit. But it should always be taken into account.
It is mistake to say that “the cost is low because the
city already owns the land”.

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 Sunk Costs
A sunk cost is a past cost that cannot be recovered.

Sunk costs should not affect current business decisions

because they are not current opportunity costs.

A firm paid $3,000,000 for a piece of land that now has a

market value of $2,000,000. The value of the land if used
for a production facility is $2,500,000. Should the firm
use the land for its production facility?

Many aphorisms capture the sunk cost idea: “water under

the bridge”, “don’t cry over spilt milk”, “let bygones be
bygones”, “don’t throw good money after bad”, etc.
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 6. Cost Curves

If we minimize cost by choosing the best combination of

inputs for any output level, we get the total cost curve.

The total cost curve shows the minimum cost of reaching

any given output level.

Other cost curves can be derived from the total cost curve.

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 Commonly Used Cost Curves
Total Cost, C – the total cost of producing output, including
all opportunity costs.
Variable Cost, VC – a part of total cost that varies with output
Fixed Cost, FC – a cost that does not vary with output. It
must be incurred if any output is produced.
C = VC + FC.
Average Cost, AC is total cost divided by output.
Marginal Cost, MC is the derivative of C with respect to
output – approximately the cost of producing one more unit
of output.

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 Typical Average and Marginal
Cost Curves
$

AC
MC

AVC

AFC

Output, Q
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 Short Run and Long Run Cost
Curves
All these curves exist in the short run and long run but typically
differ in their precise location. Thus, for example, short run
marginal cost might be different from long run marginal cost.

Note that there can be long run fixed costs – costs that do not
change when we increase output.

However, fixed costs are avoidable in the long run – the firm can
avoid them by shutting down. This might not be true in the short
run.

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 Clicker Question 6
“U-shaped” means going down and then going up. Here are 3
possible cost functions:

i) C = 10 + 10q
ii) C = 10 + q2
iii) C = 10 + 10q – 4q2 + q3

a)All three cost curves yield U-shaped AC curves.

b)Cost curves ii) and iii) yield U-shaped AC curves.
c)Only cost function ii) yields a U-shaped AC curve.
d)Only cost function iii) yields a U-shaped AC curve
e)None of these functions yields a U-shaped AC curve.

Hint: what happens if q = 0, if q = 1, and if q gets very large

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 Economies of Scale

Economies of scale means average cost falls as output rises.

Constant costs means average cost is constant as output rises.
Diseconomies of scale means average cost rises as output
rises.
Economies of scale are normally caused by increasing returns
to scale.

Economies of scale is a cost concept; increasing returns to

scale is a production concept. They are related but are not the
same thing.

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 Summary
1. Production:
a. Production Functions
b. The Law of Diminishing Marginal Returns (Short Run).
c. Returns to Scale (Long Run).
2. Costs:
a. Opportunity Costs (should always be considered)
b. Sunk Costs (should be ignored)
c. Cost curves
3. Economies of scale show how average cost varies with
output.

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