Price Theory

Lecture 6: Production & Costs

 Topics for today's lecture . . .

• Production functions

• Multiple-input production functions

• Cost minimisation

• Cost curves
Production functions
 Production as a process of transformation
Input Output

Labour
Goods
Capital
Raw Materials The Firm
Intermediate goods Services
Services
Factor markets Production technology Product markets
Definition: Production technology

• The process by which inputs (factors of production), are

transformed by a firm into goods and services.

• A firm's production function describes the maximum

quantity of a good or service that can be produced by a
firm, from a given bundle of inputs, given the firm's
production technology.
 Production functions
• We will typically assume that the inputs into the production
process are labour (L) and capital (K).

o Labour represents the productive effort of the workers hired

by the firm.

o Capital represents the assets used in, but not consumed by,
the production process.
 Production functions (2)
• We will typically exclude all other inputs from the
production function because we only need two inputs to
understand the nature of the trade-offs faced by firms.

• The maximum quantity of a good or service that can be

produced by a given bundle of inputs is written Q = f(L,K).
A production function with one input
• Consider the production function , in which the only input is
•  
labour.
o This is a production function in which the firm's capital stock
is fixed.

• If Q represents the number of cars the firm can service per

day then:
o L = 2 workers can service Q = 16 cars.

o L = 3 workers can service Q = 27cars.

A production
function with
one input (2)
 Technical efficiency
• The production function illustrates the maximum quantity of
output that can be produced.

• If the firm is producing at a point on its production function

we say that it is technically efficient.

• If the firm is producing inside its production function we say

that it is technically inefficient.
Technical
efficiency (2)
 Exercise: Inputs & production
Using the production function illustrated in the figure, answer
the following questions:

1. Suppose that this firm hires 5 workers. If the firm services

25 cars per day, is it technically efficient? Briefly explain.

2. Would this firm be willing to hire 5 workers? Briefly

explain.
Exercise: Inputs
& production (2)
 Definition: Marginal product
• The rate at which total output changes as the usage of an
input rises, holding constant the usage of all other inputs.

• The marginal product of an input is the partial derivative

(slope) of the production function, with respect to the input
in question.
 The marginal product of labour
• For a single input production function, the marginal
•  
product of labour is written as:
The marginal
product of
labour (2)
 Increasing marginal returns
• This example has a number of features common to many
production functions:
o If no labour is employed (L = 0), nothing can be produced (Q
= 0).
o Initially, as additional workers are employed, output rises at
an increasing rate.

• Increasing marginal returns occur at low levels of labour

usage, as more workers allows greater specialisation.
Increasing
marginal returns
(2)
Definition: Law of diminishing marginal returns

• The principle that as the usage of one input increases, past

some point the marginal product of that input will decrease.
 Diminishing marginal returns
• Diminishing marginal returns set in once the gains to
specialisation have been exhausted.
o As workers are added to a fixed capital stock, they begin to
get in one and other's way, creating congestion.
o With many workers, coordinating their activities also
becomes more difficult.

• In extreme cases, the production function may reach a

region where there are diminishing total returns to labour.
Diminishing
marginal returns
(2)
 Quiz 1
Gregory owns and runs a cafe. When Gregory employs a third
staff member he notices that the cafe is able to serve 100
additional customers each day. When he employs a fourth
staff member the cafe is able to serve a further 80 additional
customers each day. From the information provided, we can
conclude that Gregory's cafe is experiencing:
 Quiz 1 (2)
a) Increasing marginal returns to labour, and increasing total
returns.
b) Increasing marginal returns to labour, and decreasing total
returns.
c) Decreasing marginal returns to labour, and increasing total
returns.
d) Decreasing marginal returns to labour, and decreasing
total returns.
A production function with labour & capital

• The single-input production function is drawn for a given

•  
quantity of capital.
• Varying the firm's capital stock also affects the quantity of
output that can be produced.
• The marginal product of labour is the slope (partial
derivative) of the production function in the direction of an
increase in labour, .
A production
function with
labour & capital
(2)
 Marginal product of capital
• The marginal product of capital is the slope (partial
•  
derivative) of the production function in the direction of an
increase in capital,
• Past some point, capital experiences diminishing
marginal returns.
• In extreme cases the marginal product of capital may
become negative.
Marginal
product of
capital (2)
Discussion: The marginal product of capital

Consider a firm that services cars. How might we explain the

following phenomena? (Note: In each of the following, the
number of mechanics employed by the firm is held fixed.)
• Increasing marginal product of capital, when a firm's capital
stock is relatively low.
• Diminishing marginal returns to capital.
• Diminishing total returns to capital, when a firm's capital
stock is relatively high.
 Definition: Isoquant
• A curve that shows all combinations of labor and capital
that can produce a given level of output.

• Using isoquants we can illustrate the shape of the

production function in the input-space.
 Isoquants
• Isoquants are the contour lines of the production function;
the set of all points at the same height.

• Higher isoquants correspond to larger quantities of output.

• Isoquants illustrate the trade-off between labour and capital

in the production function.
Isoquants (2)
 Isoquants in labour-capital space
• Isoquants illustrate production possibilities on the space of
inputs.

• Notice that these isoquants are backward bending.

• This occurs if there is a point beyond which there are

diminishing total returns to labour.
Isoquants in
labour-capital
space (2)
The economic region of production
• A profit maximising firm never wants to waste inputs.
• This firm will not employ 5 workers if it can produce the
same output with 3.
• The economic region is the region in which isoquants are
downward sloping.
• A firm will not produce in the uneconomic region, as the
same output can be produced with fewer inputs in the
economic region.
The economic
region of
production (2)
Definition: Marginal rate of technical substitution

•  The rate at which a firm can substitute labour for capital,

while maintaining a constant level of output.

• The marginal rate of technical substitution of labour for

capital (written ) is the negative of the slope of an isoquant.
Marginal rate of technical substitution
• The marginal rate of technical substitution can be written
•  
as the ratio of marginal products,
• An isoquant displays a diminishing marginal rate of
technical substitution if it becomes flatter as we move
down along the curve.
• Diminishing implies that substituting labour for capital
becomes progressively less effective.
Marginal rate of
technical
substitution (2)
 Quiz 2
Winston's Widgets has the production function Q = 200LK.
For this production function the marginal returns to labour
are,
a) diminishing.
b) constant.
c) increasing.
d) not possible to assess with the information provided.
 Quiz 3
Winston's Widgets has the production function Q = 200LK.
For this production function the marginal rate of technical
substitution are,
a) diminishing.
b) constant.
c) increasing.
d) not possible to assess with the information provided.
Cost minimisation
A firm's cost minimisation problem
• Winston's Widgets has the production function Q = 200LK.
•  
The associated marginal products are = 200K and = 200L.
• Suppose that the wage (the price of labour) is w = $180 per
day, and that the rental price of capital is r = $240 per day.
• What is the lowest cost at which Winston's Widgets can
produce Q = 2400 widgets per day?
 The cost of a bundle of inputs
•  The bundle A, with = 8 workers and = 1.5 units of capital,
lies on the required isoquant as,
.

• The total cost of bundle A is,

• Does A minimise the firm's costs?

The cost of a
bundle of inputs
(2)
 Definition: Isocost line
• The set of all bundles of inputs with the same total cost.

• The slope of an isocost line is the negative of the ratio of

input prices (-w/r ).
 The isocost line through bundle A
• The bundles of inputs with the same total cost as A are
•  
described by the equation,

• The L-intercept of the isocost line is,

• The K-intercept of the isocost line is,
The isocost line
through bundle
A (2)
 Comparing costs
• Bundles lying above the isocost line (such as B) are more
expensive than A.

• Bundles lying below the isocost line (such as C) are less

expensive than A.

• A bundle of inputs does not minimise a firm's cost if it lies

on an isocost line that crosses the isoquant.
Comparing
costs (2)
The cost-minimising bundle of inputs

•  The cost-minimising bundle lies on the isocost line that

touches the isoquant at a single point.

• Diminishing marginal rate of technical substitution implies

that the isocost line passing through the cost minimising
bundle A is tangent to the isoquant, .
• At most one bundle of inputs can satisfy these conditions.
The cost-
minimising
bundle of inputs
(2)
Exercise: Two conditions for an interior optimum

•Winston's
  Widgets has the production function Q = 200LK.
The price of labour is w = $180 per day, and that the rental
price of capital is r = $240 per day.

Consider the bundle of inputs A in which = 4 workers, and =

3 units of capital.
Exercise: Two conditions for an interior optimum (2)

• Show that A lies on the Q = 2400 isoquant.

• Show that the isocost line is tangent the to the isoquant at

A.

• What is the total cost of the bundle A?

 Marginal product per dollar
• An alternative way of stating the tangency condition is,
•  
.
• In words, at an interior optimum the marginal product per
dollar must be equal for all inputs.
o This condition must hold for every pair of inputs that a firm
utilises, regardless of the number of inputs to the firm's
production process.
 Marginal product per dollar (2)
• Intuitively, if the marginal product per dollar is higher for
labour than for capital, the firm can reduce its costs by
reducing usage of capital, and increasing usage of labour.
 A change in the price of labour
• How does an increase in the wage, from = $180 to = $320
•  
per day, alter the cost-minimising bundle of inputs?
• After the increase in the wage, isocost lines are steeper,

• The firm substitutes capital for labour.

• The total cost increases to,
A change in the
price of labour
(2)
 Abundant opportunity for substitution

•  Along the isoquants of this production function, labour and

capital are relatively interchangeable.

• If the changes gradually, the production function offers

abundant input substitution opportunities.

• The firm responds to an increase in the wage by significantly

increasing the automation of the production process.
Abundant
opportunity for
substitution (2)
Minimal opportunity for substitution

•  Along the isoquants of this production function, there is

little potential to substitute labour for capital.

• When the changes rapidly, the production function offers

limited input substitution opportunities.

• The firm is unable to significantly reorganise production in

response to an increase in the wage.
Minimal
opportunity for
substitution (2)
Fixed proportions production functions
• The production function requires inputs to be used in fixed
•  
proportions (the inputs are perfect complements).
• The economic region of production corresponds to the
corners of the isoquants.
• The fixed proportions production function offers no
opportunities to substitute labour for capital.
Fixed proportions
production
functions (2)
 Discussion: Isoquants in different industries

What would you expect the isoquants to look like for the
following firms?

• A manufacturer of motor vehicles.

• A cafe selling espresso coee.

• A firm operating a call centre.

 Exercise: Corner solutions
•  A paint manufacturing company has a production function
where the firm's output is measured in thousands of litres.

• The firm faces a price of labour w = $300 per worker, and a

price of capital services r = $15,000 per machine.
 Exercise: Corner solutions (2)
1. Verify that the firm's cost-minimising input bundle, for Q =
10, is a corner solution. Which input is not utilised by the
firm?

2. Below what point must the price of capital fall, in order for
the firm to use a positive amount of capital?
Cost curves
 Expanding production
•  In order for a firm to expand production, it must select a
bundle of inputs on a higher isoquant.

• The new cost-minimising bundle B has a higher total cost

than A.

• Given that the input prices have not changed, the isocost
line must have the same slope as .
Expanding
production (2)
 Definition: Total cost curve
• A curve that shows how total cost varies with output,
holding input prices fixed and choosing all inputs to
minimise cost.

• The total cost curve indicates the lowest cost at which each
quantity can be produced.
 Plotting the total cost curve
• The quantity of output produced by bundle A, can be
plotted against the total cost of the bundle.

• Increasing output requires moving to a higher isocost line.

• It follows that the total cost curve must be upward sloping.

Plotting the total
cost curve (2)
 Total cost & input prices
• Suppose that the wage increases.

• The firm substitutes capital for labour.

• Given that the price of capital has not changed, the vertical
intercepts of the isocost lines show that total cost has
increased.

• The total cost curve shifts up.

Total cost &
input prices (2)
 Definition: Average cost curve
• The firm's total cost per unit of output; the total cost of
production divided by total quantity produced.

• Average cost can be interpreted as a measure of the

resource intensity of the firm's production.
 Average cost
• A firm's average cost can be derived from its total cost as
•  
follows,
.
• For any point on the firm's total cost curve, average cost is
the slope of a ray from the origin.
• A firm's average cost curve is typically U-shaped.
Average cost (2)
 Definition: Marginal cost curve
• The rate at which total cost changes as output increases.

• A firm's marginal cost plays an important role in

determining a firm's profit maximising behaviour in a
market.
 Marginal cost
• A firm's marginal cost is the derivative (slope) of the total
•  
cost function, .
• Where marginal cost is less than average cost, average
cost is downward sloping.
• Marginal cost crosses average cost at the minimum of the
average cost curve.
• Where marginal cost is greater than average cost, average
cost is upward sloping.
Marginal cost (2)
 Quiz 4
Suppose that a firm's total cost curve is described by the
•  
function . This firm's average cost curve can be expressed as,
a) .
b) .
c) .
d) .
 Quiz 5
Which of the following statements regarding a firm's marginal cost is
false?

a) A firm's marginal cost is equal to its average cost at the quantity

that minimises its average cost.

b) A firm's marginal cost cannot be negative.

c) If a firm has a constant marginal cost of MC = $5, then increasing

production by seven units will increase total cost by $35.

d) Where a firm's marginal cost is decreasing, the firm's total cost

curve is downward sloping.
Questions?
Key concepts from today's lecture

• You can use these concepts (as search terms) to conduct

further research into the topics covered in today's lecture:

• Inputs (factors of production)

• Production technology

• Production function
 Key concepts from today's lecture (2)

• Marginal rate of technical

• Technical efficiency
substitution
• Marginal product • Cost minimisation
• Isocost line
• Isoquant
• Total cost
• Economic region of
• Marginal cost
production
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