Managerial Economics
Basic Concepts of Production
Theory
• Production function
• Maximum amount of output that can be
produced from any specified set of inputs,
given existing technology
• Technical efficiency
• Achieved when maximum amount of output is
produced with a given combination of inputs
• Economic efficiency
• Achieved when firm is producing a given
output at the lowest possible total cost
8-1
Managerial Economics
Basic Concepts of Production
Theory
• Inputs are considered variable or fixed
depending on how readily their usage can be
changed
• Variable input
• An input for which the level of usage may be changed
quite readily
• Fixed input
• An input for which the level of usage cannot readily be
changed and which must be paid even if no output is
produced
• Quasi-fixed input
• An input employed in a fixed amount for any positive
level of output that need not be paid if output is zero
8-2
Managerial Economics
Basic Concepts of Production
Theory
• Short run
• At least one input is fixed
• All changes in output achieved by
changing usage of variable inputs
• Long run
• All inputs are variable
• Output changed by varying usage of all
inputs
8-3
Managerial Economics
Short Run Production
• In the short run, capital is fixed
• Only changes in the variable labor
input can change the level of output
• Short run production function
Q = f ( L,K ) = f ( L )
8-4
Managerial Economics
Average & Marginal Products
• Average product of labor
• AP = Q/L
• Marginal product of labor
• MP = Q/L
• When AP is rising, MP is greater than AP
• When AP is falling, MP is less than AP
• When AP reaches it maximum, AP = MP
• Law of diminishing marginal product
• As usage of a variable input increases, a point is
reached beyond which its marginal product
decreases
8-5
Managerial Economics
Total, Average, & Marginal
Products of Labor, K = 2 (Table 8.2)
Number of Total product (Q) Average product Marginal product
workers (L) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4
8-6
Managerial Economics
Total, Average & Marginal
Products, K = 2 (Figure 8.1)
8-7
Managerial Economics
Total, Average & Marginal
Product Curves
Q2
Q1 Total
product
Panel A
Q0
L0 L1 L2
Panel B
Average
product
L0 L1 L2
Marginal
8-8 product
Managerial Economics
Short Run Production Costs
• Total variable cost (TVC)
• Total amount paid for variable inputs
• Increases as output increases
• Total fixed cost (TFC)
• Total amount paid for fixed inputs
• Does not vary with output
• Total cost (TC)
• TC = TVC + TFC
8-9
Managerial Economics
Short-Run Total Cost Schedules
(Table 8.4)
Output (Q) Total fixed cost Total variable cost Total Cost
(TFC) (TVC) (TC=TFC+TVC)
0 $6,000 $ 0 $ 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000
8-10
Managerial Economics
Total Cost Curves (Figure 8.3)
8-11
Managerial Economics
Average Costs
• Average variable cost ( AVC )
TVC
AVC =
Q
• Average fixed cost ( AFC )
TFC
AFC =
Q
• Average total cost ( ATC )
TC
ATC = = AVC + AFC
Q
8-12
Managerial Economics
Short Run Marginal Cost
• Short run marginal cost (SMC)
measures rate of change in total
cost (TC) as output varies
TC TVC
SMC = =
Q Q
8-13
Managerial Economics
Average & Marginal Cost Schedules
(Table 8.5)
Output Average Average Average total Short-run
(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/Q) (AVC=TVC/Q) (ATC=TC/Q= (SMC=TC/Q)
AFC+AVC)
0 -- -- -- --
100 $60 $40 $100 $40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120
8-14
Managerial Economics
Average & Marginal Cost Curves
(Figure 8.3)
8-15
Managerial Economics
Short Run Average & Marginal
Cost Curves (Figure 8.5)
8-16
Managerial Economics
Short Run Cost Curve Relations
• AFC decreases continuously as
output increases
• Equal to vertical distance between
ATC & AVC
• AVC is U-shaped
• Equals SMC at AVC’s minimum
• ATC is U-shaped
• Equals SMC at ATC’s minimum
8-17
Managerial Economics
Short Run Cost Curve Relations
• SMC is U-shaped
• Intersects AVC & ATC at their
minimum points
• Lies below AVC & ATC when AVC &
ATC are falling
• Lies above AVC & ATC when AVC &
ATC are rising
8-18
Managerial Economics
Relations Between Short-Run
Costs & Production
• In the case of a single variable
input, short-run costs are related to
the production function by two
relations
w w
AVC = and SMC =
A
MP MP
Where w is the price of the variable input
8-19
Managerial Economics
Short-Run Production & Cost
Relations (Figure 8.6)
8-20
Managerial Economics
Relations Between Short-Run
Costs & Production
• When marginal product (average
product) is increasing, marginal cost
(average cost) is decreasing
• When marginal product (average
product) is decreasing, marginal cost
(average variable cost) is increasing
• When marginal product = average
product at maximum AP, marginal
cost = average variable cost at
minimum AVC
8-21