Chap 010

Chapter 10: Production and
Cost Estimation
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Empirical Production Function
• An empirical production function is the
mathematical form of the production
function to be estimated
10-2
• Long-run production function
• A production function in which all inputs are
variable
• Short-run production function
• A production function in which at least one
input is fixed
10-3
• Cubic empirical specification for a short-
run production function is derived from a
long-run cubic production function
• Cubic form of the long-run production
function is expressed as
Q  aK L  bK L
3 3 2 2
10-4
Properties of a Short-Run Cubic
Production Function
Q  AL  BL
3 2
• Holding capital constant, short-run cubic

production function is derived as follows:
Q  aK L  bK L
3 3 2 2
 AL  BL
3 2
Where A  aK 3 and B  bK 2
10-5
Production Function
Q  AL  BL
3 2
• The average & marginal products of

labor are, respectively:
AP  Q L  AL  BL
2
MP  Q L  3 AL  2 BL
2
10-6
Production Function
Q  AL  BL
3 2
• Marginal product of labor begins to

diminish beyond Lm units of labor
• Average product of labor begins to
diminish beyond La units of labor
B B
Lm   and La  
3A 2A
10-7
MP & AP Curves for the Short-Run Cubic
Production Function (Figure 10.1)
Q = AL3 + BL2
10-8
Production Function
Q  AL  BL
3 2
• To have necessary properties of a

production function, parameters must
satisfy the following restrictions:
A < 0 and B > 0
10-9
Estimation of a Short-Run
Production Function
• To use linear regression analysis, the
cubic equation must be transformed into
linear form
• Q = AX + BW
• Where X = L3 and W = L2
• Estimated regression line must pass
through the origin
• Specify in computer routine
10-10
Production Function
• Estimate using data for which the level
of usage of one or more inputs is fixed
• Usually time series data are used
10-11
Production Function
• Data collection may be complicated by
the fact that accounting data do not
include firm’s opportunity costs
• Capital costs should reflect not only
acquisition cost but any foregone rental
income, depreciation, & capital gains/losses
10-12
Production Function
• Nominal cost data
• Data that have not been corrected for the
effects of inflation
• Must eliminate effects of inflation
• Correct for the influence of inflation by
dividing nominal cost data by an
appropriate price index (or implicit price
deflator)
10-13
Cost Function
TVC  aQ  bQ  cQ
2 3
• Average variable cost & marginal cost

functions are, respectively:
AVC  a  bQ  cQ 2
SMC  a  2bQ  3cQ 2
10-14
Cost Function
2 3
• Average variable cost reaches its

minimum value at:
Qm   b 2c
10-15
Cost Function
2 3
• To conform to theoretical properties,

parameters must satisfy the following
restrictions:
a > 0, b < 0, and c > 0
10-16
Cost Function
• Cubic specification produces S-shaped
TVC curve & U-shaped AVC & SMC
curves
10-17
Cost Function
• All three cost curves employ the same
parameters
• Only necessary to estimate one of these
functions to obtain estimates of all three
• In the short-run cubic specification, input
prices are assumed constant
• Not explicitly included in cost equation
10-18
Summary of Short-Run Empirical
Production Functions
Short-run cubic
production equations
Total product Q  AL3  BL2
Average product of labor AP  AL  BL
2
Marginal product of labor MP  3 AL2  2 BL

Diminishing marginal B
begin at Lm  
returns 3A
Restrictions on parameters A < 0 and B > 0
10-19
Summary of Short-Run Empirical
Cost Functions
Short-run cubic
cost equations
Total variable cost TVC  aQ  bQ 2  cQ 3
Average variable cost AVC  a  bQ  cQ 2
Marginal cost SMC  a  2bQ  3cQ 2
Average variable cost b
Qm  
reaches minimum at 2c
Restrictions on parameters a > 0, b < 0, and c > 0
10-20

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Chap 010

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Chapter 10: Production and

• Holding capital constant, short-run cubic

• The average & marginal products of

• Marginal product of labor begins to

• To have necessary properties of a

A < 0 and B > 0

• Average variable cost & marginal cost

SMC  a  2bQ  3cQ 2

• Average variable cost reaches its

• To conform to theoretical properties,

a > 0, b < 0, and c > 0

Marginal product of labor MP  3 AL2  2 BL

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