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1 Returns to Scale
Lecture 12
Production Functions and Cost of Production
Outline
1. Chap 6: Returns to Scale
2. Chap 6: Production Function Derivation
3. Chap 7: Cost of Production
1 Returns to Scale
Increasing Returns to Scale
(Lecture 11)
Constant Returns to Scale
• Doubling the inputs leads to double the output:
Q(2K,2L) = 2Q(K,L).
• One big firm is as good as many small firms.
• Isoquants are equally distant apart (see Figure 1).
Decreasing Returns to Scale
• Doubling the inputs leads to an output less than twice the original output:
Q(2K,2L) < 2Q(K,L).
• Small firms are more efficient.
• Isoquants become further apart (see Figure 2).
1 Returns to Scale
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Figure 1: Isoquant Curves, Constant Returns to Scale.
Figure 2: Isoquant Curves, Decreasing Returns to Scale.
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2 Production Function Derivation
Example (Cobb-Douglas Production Function.).
Q(K,L) = ALαKβ .
We double both inputs to see what type of returns to scale the production
function has.
Q(2K,2L) = A(2L)α(2K)β = 2α+βALαKβ = 2α+βQ(K,L).
1. If
+
returns to scale is increasing.
2. If
α + β = 1,
returns to scale is constant.
3. If
+
returns to scale is decreasing.
2 Production Function Derivation
Assume that the firm has two technologies A and B, and the corresponding
outputs are
xy
qA = min{ , },
21x
y
qB = min{ , },
1 2
where the inputs x and y are perfect complements (see Figure 3). To derive
production function, we must know which technology the firm chooses. If the
firm choose either A or B, but not both, the isoquant curve for the production
function is the black line (see Figure 3). This isoquant curve is not convex.
However, the firm can adopt technologies at the same time, and this makes the
isoquants convex (see Figure 4).
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Thus the production function is:
x>
y. =
. ,when .
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2 Production Function Derivation
Figure 3: Deriving Production Function, Using Technology A or B.
Figure 4: Deriving Production Function, Using Technology A and B.
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3 Cost of Production
3 Cost of Production
Cost comes from factor price and how many units are used.
Accounting Cost. Actual expenses plus depreciation.
Economic Cost. Cost to a firm of using resources in production. Also called
opportunity cost, the most valuable forgone alternative.
Wage Transportation Cost Accounting Cost Opportunity Cost
Job 1 150 0 0 180
Job 2 200 20 20 150
Table 1: Accounting Cost and Opportunity Cost.
Example (Two job opportunities (see Table 1)). If the person accepts Job
2, the most valuable forgone opportunity is Job 1.
Opportunity cost does not really happen but must be considered.
Sunk Cost. Expenditure that has been made and cannot be recovered.
Example (Two building choices). A firm has two building choices. For
Building 1, they have paid 500,000, and will pay 5,000,000 in the future;
for Building 2, they have not paid anything, and will pay 5,300,000 in the
future. Although Building 2 is cheaper than Building 1, the firm will choose
Building 1 because the 500,000 is sunk.
Total Cost.
Total Cost = Variable Cost + Fixed Cost.
Fixed Cost. A cost that is actually incurred, but independent of the level of
output.
Variable Cost. A cost that is actually incurred, and dependent of the level of
output.
Example (Short Run). Capital K is fixed, and Labor L is variable; hence, the
cost of K is a fixed cost, and the cost of L is a variable cost.
Here is another definition of sunk cost.
Sunk Cost. A fixed cost which is also independent of output, but whose cost is
not incurred, because of no cash outlay and no opportunity cost. Usually
fixed costs are considered sunk costs because they happen before
production begins.
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