CHAPTER 5 Learning Objectives

1. Explain alternative ways of measuring the productivity of inputs and

The Production Process and Costs the role of the manager in the production process.
2. Calculate input demand and the cost-minimizing combination of inputs
and use isoquant analysis to illustrate optimal input substitution.
3. Calculate a cost function from a production function and explain how
economic costs differ from accounting costs.
4. Explain the difference between and the economic relevance of fixed
costs, sunk costs, variable costs, and marginal costs.
5. Calculate average and marginal costs from algebraic or tabular cost
data and illustrate the relationship between average and marginal
costs.
6. Distinguish between short-run and long-run production decisions and
illustrate their impact on costs and economies of scale.
7. Conclude whether a multiple-output production process exhibits
economies of scope or cost complementarities and explain their
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significance for managerial decisions.
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The Production Function The Production Function

Introduction The Production Function

• This module provides the economic • Is the mathematical function that defines the
foundations needed to succeed in managerial maximum amount of output that can be
positions such as production and pricing produced with a given set of inputs
management. 𝑄 = 𝐹 𝐾, 𝐿
• Production and costs are the building blocks – 𝑄 is the level of output.
for business areas that include human – 𝐾 is the quantity of capital input.
resources, operations, managerial accounting, – 𝐿 is the quantity of labor input.
and strategic management.

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The Production Function The Production Function

Short-Run versus Long-Run Decisions: Short-Run versus Long-Run Decisions:

Fixed and Variable Inputs Fixed and Variable Inputs
• Short-run • Fixed Factors of Production
– Time frame where some factors of production – These are the inputs a manager cannot adjust in
(inputs) are fixed, and constrain a manager’s the short run.
decisions. • Variable Factors of Production
• Long-run – There are the inputs a manager can adjust to alter
– Time frame over which all factors of production production.
(inputs) are variable, and can be adjusted by a
manager.

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 The Production Function The Production Function

Measures of Productivity in Action Measures of Productivity in Action

Columns 1, 2 and 4 give values of the
components of a short-run production function
where capital is fixed at k*=2. For this
production function, 5 labor units are needed to
produce 1,100 units of output. Given the
available technology and the fixed level of
capital, if the manager wishes to produce 1,952
units of output, 8 units of labor must be utilized.
In the short run, more labor is needed to
produce more output because increasing capital
is impossible.
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The Production Function The Production Function

Measures of Productivity Measures of Productivity in Action

• Total product (TP) • Consider the following production function
– Maximum level of output that can be produced when 5 units of labor and 10 units of capital
with a given amount of inputs. are combined produce: 𝑄 = 𝐹 10,5 = 150.
• Average product (AP) • Compute the average product of labor.
– A measure of the output produced per unit of 150
input. 𝐴𝑃𝐿 = = 30 units per worker
5
• Average product of labor: 𝐴𝑃𝐿 =
𝑄
• Compute the average product of capital.
𝐿
𝑄 150
• Average product of capital: 𝐴𝑃𝐾 = 𝐴𝑃𝐿 = = 15 units capital unit
𝐾
10

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The Production Function The Production Function

Marginal Product Marginal Product

• Marginal product (MP) • Marginal product (MP)
– The marginal product of an input is the change in – A negative marginal product means that the last
total output attributable to the last unit of an unit of the input reduced the total product. If a
input. manager continues to expand the number of
– The marginal product of capital (MPK) is the workers on an assembly, a point will be reached
change in total output divided by the change in where workers are packed like sardines along the
capital:
∆𝑄
line, resulting in less output than before.
• Marginal product of capital: 𝑀𝑃𝐾 =
∆𝐾 – The figure on the next slide shows graphically the
– The marginal product of labor (MPL) is the change relationship among total product, marginal
in total output divided by the change in labor: product, and average product.
∆𝑄
• Marginal product of labor: 𝑀𝑃𝐿 =
∆𝐿

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 The Production Function The Production Function
Increasing, Decreasing, and Negative Increasing, Decreasing, and Negative
Total product Marginal Returns
Increasing Decreasing Negative Marginal Returns
Average product marginal marginal marginal
Marginal product returns to labor returns to labor returns to labor

Total product (TP)

Average product (APL)

The total product increases, and its slope gets steeper as we move
0 Marginal product (MPL) Labor input from pt. A to E along the total product curve.
(holding capital constant)
As the use of labor increases from A to E, the slope of the total
product curve increases. The marginal product also increases from
points a to e.
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The Production Function The Production Function

Increasing, Decreasing, and Negative Increasing, Decreasing, and Negative

Marginal Returns Marginal Returns

The marginal product reaches its maximum at point e, where 5 unit Marginal product becomes negative when more than 10 units of
labor units of labor are employed. As the usage of labor increases from labor are employed. After some point, using additional units of input
the 5th through the 10th units, total output increases, but at a actually reduces the total product, which is what it means for the
decreasing rate. marginal product to be negative.
This is why marginal product declines between 5 and 10 labor units
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The Production Function The Production Function

Marginal Product The Role of the Manager in the

• Increasing marginal returns Production Process
– The range of input usage over which marginal product
increases. • Produce output on the production function.
• Decreasing marginal returns – This is the most difficult for a manager to perform.
– The range of input usage over which marginal product – This involves aligning incentives to induce
decreases.
maximum worker effort.
• Negative marginal returns
– The range of input usage over which marginal product – More generally, many firms institute profit-sharing
is negative. plans to provide workers with an incentive to
• Phases of marginal returns produce to the production function.
– As the usage of an input increases, marginal product
initially increases, then begins to decline and
eventually becomes negative.

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 The Production Function The Production Function

The Role of the Manager in the Measures of Productivity in Action

Production Process
• Use the right mix of inputs to maximize
profits.
– To maximize profits when labor or capital varies in
the short run, the manager will:
• Use capital until the value of the marginal product of
capital equals the rental rate: 𝑉𝑀𝑃𝐾 = 𝑟, where
𝑉𝑀𝑃𝐾 = 𝑃 × 𝑀𝑃𝐾

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The Production Function The Production Function

Value Marginal Product in Action Value Marginal Product in Action

• In the table, the cost to the firm of an additional
labor unit is $400.
• The first unit of labor generates VMPL = $228, and
the second unit is VMPL = $516. Each worker
between the second and the ninth produces
additional output whose value exceeds the cost of
hiring the worker.
• It is profitable to hire units of labor as long as the
VMPL is greater than $400. Thus, given the data,
the manager should hire nine workers to maximize
profits.

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The Production Function The Production Function

The Role of the Manager in the The Role of the Manager in the
Production Process Production Process
• Law of diminishing returns: The marginal product
• Use the right mix of inputs to maximize of an additional unit of output will at some point
profits. be lower than the marginal product of the
– Ensure that the firm operates at the right point in previous unit.
the production function. • Profit-maximization input usage
– To maximize profits when labor or capital varies in – To maximize profits, use input levels at which marginal
the short run, the manager will: benefit equals marginal cost
• Hire labor until the value marginal product of labor – When the cost of each additional unit of labor is w,
equals the wage rate: 𝑉𝑀𝑃𝐿 = 𝑤, where 𝑉𝑀𝑃𝐿 = 𝑃 × the manager should continue to employ labor up to
𝑀𝑃𝐿 the point where VMPL = w in the range of diminishing
marginal product.

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 The Production Function The Production Function
Algebraic Forms of Production
Algebraic Forms of Production Functions Functions in Action
• Commonly used algebraic production function • Suppose that a firm’s estimated production
forms: function is:
– Linear: Assumes a perfect linear relationship between
all inputs and total output 𝑄 = 3𝐾 + 6𝐿
𝑄 = 𝐹 𝐾, 𝐿 = 𝑎𝐾 + 𝑏𝐿, where 𝑎 and 𝑏 are • How much output is produced when 3 units of
constants.
– Leontief: Assumes that inputs are used in fixed capital and 7 units of labor are employed?
proportions 𝑄 = 𝐹 3,7 = 3 3 + 6 7 = 51 units
𝑄 = 𝐹 𝐾, 𝐿 = min 𝑎𝐾, 𝑏𝐿 , where 𝑎 and 𝑏 are
constants.
– Cobb-Douglas: Assumes some degree of
substitutability among inputs
𝑄 = 𝐹 𝐾, 𝐿 = 𝐾 𝑎 𝐿𝑏 , where 𝑎 and 𝑏 are constants.

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The Production Function The Production Function

Algebraic Forms of Production Algebraic Measures of Productivity
Functions in Action
• Suppose that a firm’s estimated production • Given the commonly used algebraic
function is: production function forms, we can compute
𝑄 = F(𝐾, 𝐿) = min[3𝐾, 4𝐿] the measures of productivity as follows:
– Linear:
• How much output is produced when 3 units of
• Marginal products: 𝑀𝑃𝐾 = 𝑎 and 𝑀𝑃𝐿 = 𝑏
capital and 5 labor units are employed? 𝑎𝐾+𝑏𝐿 𝑎𝐾+𝑏𝐿
• Average products: 𝐴𝑃𝐾 = and 𝐴𝑃𝐿 =
𝑄 = 𝐹 3,5 = min[3(3), 4(5)] 𝐾 𝐿

= min[9,20] – Cobb-Douglas:
• Marginal products: 𝑀𝑃𝐾 = 𝑎𝐾 𝑎−1 𝐿𝑏 and 𝑀𝑃𝐿 =
• Since 9 is the lower value, 3 units of capital 𝑏𝐾 𝑎 𝐿𝑏−1
and 5 units of labor produce 9 units of output. 𝐾𝑎 𝐿𝑏 𝐾𝑎 𝐿𝑏
• Average products: 𝐴𝑃𝐾 = and 𝐴𝑃𝐿 =
𝐾 𝐿

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The Production Function The Production Function

Algebraic Measures of Productivity in Algebraic Forms of Production
Action Functions in Action
A firm produces output that can be sold at $10.
• Suppose that a firm produces output
The production function is given by:
according to the production function
𝑄 = F(𝐾, 𝐿) = 𝐾1/2 𝐿1/2
𝑄 = 𝐹 1, 𝐿 = 1 1Τ4 𝐿3Τ4
• If the capital is fixed at 1 unit in the short run,
• Which is the fixed input?
how much labor should the firm employ to
– Capital is the fixed input.
maximize profits if the wage rate is $2?
• What is the marginal product of labor when
16 units of labor is hired?
3 1 3 1 3
𝑀𝑃𝐿 = 1 × 𝐿−4 = 1 × 16 −
4 =
4 4 8
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 The Production Function The Production Function
Algebraic Forms of Production Isoquants and Marginal Rate of
Functions in Action Technical Substitution
Set VMPL equal to the wage rate and solve for L.
• Isoquants capture the tradeoff between
• Since the production function is Cobb- combinations of inputs that yield the same
Douglas, 𝑀𝑃𝐿 = 𝑏𝐾 𝑎 𝐿𝑏−1 . Here, a = ½, b = ½, output in the long run, when all inputs are
and K = 1. Hence, 𝑀𝑃𝐿 = 1/2𝐿−1/2 . variable.
• Since P = $10, 𝑉𝑀𝑃𝐿 = 𝑃 𝑥𝑀𝑃𝐿 = 5𝐿−1/2 . • An isoquant defines the combinations of
• Setting this equation equal to wage rate, we inputs (K and L) that yield the producer the
get 2 = 5𝐿−1/2 same level of output. Any combination of
2 = 5𝐿−1/2 → 𝐿 = 25/4 = 6.25 capital and labor along an isoquant produces
• The profit maximizing quantity if 6.25 units. that same level of output.
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The Production Function The Production Function

Isoquants and Marginal Rate of Isoquants and Marginal Rate of
Technical Substitution in Action Technical Substitution in Action
Capital Input

𝑄3 = 300 units of output

B
𝑄2 =200 units of output
The figure shows a typical set of isoquants. Bundles A and B will produce
the same output level, Qo, since both lie on the same isoquant. Input mix A 𝑄𝐼 =100 units of output
implies a more capital-intensive plant than does input mix B.
0 Labor Input

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The Production Function The Production Function

Isoquants and Marginal Rate of Isoquants and Marginal Rate of
Technical Substitution in Action Technical Substitution
• Marginal rate of technical substitutions
(MRTS)
– The rate at which a producer can substitute
between two inputs and maintain the same level
of output.
– Absolute value of the slope of the isoquant.
As more of both inputs are used, a higher isoquant is obtained. As we
𝑀𝑃𝐿
𝑀𝑅𝑇𝑆𝐾𝑆 =
move to the northeast direction in the figure, each new isoquant is associated
with higher output levels.
𝑀𝑃𝐾

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 The Production Function The Production Function
Isoquants and Marginal Rate of Marginal Rate of Technical Substitution
Technical Substitution in Action and Production Functions
• The MRTS for 𝑄 = 𝑎𝐾 + 𝑏𝐿 is 𝑏/𝑎 since 𝑀𝑃 = 𝑏 and
𝑀𝑃 = 𝑎.
• The isoquants for the Leontief production function are
L shaped. Inputs must be fixed proportions, the
manager cannot substitute between capital and labor
and maintain the same level of output. There is no
MRTS.
The isoquants are convex since inputs such as capital and labor typically
are not perfectly substitutable. If we begin substituting labor for capital
starting at point A, it takes increasing amounts of labor to replace each unit of
capital taken away. The rate at which labor and capital can substitute for
each other is called the marginal rate of technical substitution (MRTS).

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The Production Function The Production Function

Diminishing Marginal Rate of Diminishing Marginal Rate of

Technical Substitution Capital Input Technical Substitution
From C to D, the manager substitutes 3 units
• The production function satisfies the law of D of K to 1 unit of L to produce Q = 100.
diminishing marginal rate of technical substitution. Slope:
∆𝐾
∆𝐿
3
= − 1 = −3 = −𝑀𝑅𝑇𝑆𝐾𝐿

• As a producer uses less of an input, increasingly ∆𝐾 =3

From A to B, the manager substitutes 1 unit
more of the other input must be employed to C of K to 1 unit of L to produce Q = 100.
∆𝐾 1
produce the same level of output. B
Slope:
∆𝐿
= − 1 = −1 = −𝑀𝑅𝑇𝑆𝐾𝐿

• The Cobb-Douglas production function implies ∆𝐾 = 1 A

isoquants have a diminishing MRTS. 𝑄0 =100 units

• Isoquants that are convex from the origin exhibits a 0 Labor Input
diminishing MRTS. ∆𝐿 = −1 ∆𝐿 = −1

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The Production Function The Production Function

Isocost and Changes in Isocost Lines Isocost and Changes in Isocost Lines
• Isocost Line • Along an isocost line, K is a linear function
– A line that represents the combinations of inputs with a vertical intercept of C/r and a slope of
that will cost the producer the same amount of –w/r. Capital Input
money.
– Combination of inputs that yield cost the same 𝐶
cost. 𝑟
𝐶 𝑤
𝐾= − 𝐿
𝑤𝐿 + 𝑟𝐾 = 𝐶 𝑟 𝑟

or, re-arranging to the intercept-slope formulation:

𝐶 𝑤
𝐾= − 𝐿
𝑟 𝑟 𝐶
0 𝐿 Labor Input
𝑤

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 The Production Function The Production Function

Isocost and Changes in Isocost Lines Changes in the Isocosts

• Changes in isocosts Capital Input
𝐶1
– For given input prices, isocosts farther from the 𝑟

origin are associated with higher costs. 𝐶0 More expensive input

𝑟 bundles
– Changes in input prices change the slopes of
isocost lines.

Less expensive input

bundles

0 𝐶0 𝐶1
Labor Input
𝑤 𝑤

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The Production Function The Production Function

Changes in the Isocost Line Cost Minimization

Capital Input
𝐶 • The isocosts and the isoquants may be used to
𝑟 determine the input usage that minimizes
Due to increase in wage rate production costs. Because scarcity is an
𝑤1 > 𝑤 0
economic reality, producers are interested in
cost minimization.
• Cost minimization is producing output at the
lowest possible costs.
• At the cost-minimizing input mix, the slope of
𝐶 𝐶
0
𝑤1 𝑤0
Labor Input the isoquant is equal to the slope of the
isocost line.
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The Production Function The Production Function

Cost Minimization and the Cost-Minimization Input Rule in Action

Cost-Minimizing Input Rule Capital Input Input mix A is not the cost minimizing
𝐶1
• Cost-minimizing input rule 𝑟
way to produce the given level of
output since by using Input mix B, the
producer could produce the same
– Produce at a given level of output where the 𝐶2 𝐴
amount of output at a lower cost, C2.

marginal product per dollar spent is equal for all 𝑟

𝑤
input: 𝑀𝑅𝑇𝑆𝐾𝐿 =
𝑟
𝑀𝑃𝐿 𝑀𝑃𝐾
=
𝑤 𝑟 𝐵
– Equivalently, a firm should employ inputs such
𝑄𝐼 =100 units
that the marginal rate of technical substitution
equals the ratio of input prices: 0 𝐶 2 𝐶1
Labor Input
𝑀𝑃𝐿 𝑤 𝑤 𝑤
=
𝑀𝑃𝐾 𝑟
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 The Production Function The Production Function

Cost-Minimization Input Rule in Cost-Minimization Input Rule in

Action Action
Terry’s Lawn Service rents 5 small push Let MPS and MPL be the marginal product of small and large
mowers and 2 large riding mowers to cut the mowers, respectively, and PS and P L be the rental prices.
Cost minimization requires that
lawns of neighborhood households. Additional MPS MPL
information are as follows: =
PS PL
Small mower Large mower Substitution leads us to:
Marginal product 3 lawns/day 6 lawns/day 3 6
>
Rental cost $10/day $25/day 10 25
Is Terry’s Lawn Service utilizing small and This shows that the firm is not minimizing costs since the
MP per dollar spent on small mowers exceeds the MP per
large mowers in a cost-minimizing manner? dollar spent on large mowers. They should use more small
push mowers than large riding mowers.

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The Production Function The Production Function

Optimal Input Substitution in Action

Optimal Input Substitution
Capital Input
I Isoquant
• A change in the price of an input will lead to a
New cost-minimizing
change in the cost-minimizing input bundle. point due to higher wage

• To minimize the cost of producing a given level

of output, the firm should use less of an input F
B
𝐾2 Initial point of cost minimization
and more of other inputs when that input’s
A
price rises. 𝐾1
𝑄0
H J
0 𝐿2 𝐿1 G Labor Input

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The Cost Function The Cost Function

The Cost Function The Cost Function

• For given input prices, different isoquants will • The cost function reduces the amount of information
entail different production costs, even allowing the manager has to process to make optimal output
for optimal substitution between capital and decisions.
labor. • Short-run costs
• Each isoquant corresponds to a different level of – Fixed costs (𝑭𝑪): do not change with changes in output;
include the costs of fixed inputs used in production
output, and the isocost line tangent to higher – Sunk costs
isoquants will imply higher costs of production, – Variable costs [𝑽𝑪 𝑸 ]: costs that change with changes in
even assuming the firm uses the cost-minimizing outputs; include the costs of inputs that vary with output
input mix. – Total costs: 𝑇𝐶 𝑄 = 𝐹𝐶 + 𝑉𝐶 𝑄
• The costs function is a mathematical relationship • The short-run cost function summarizes the minimum
that relates cost to the cost-minimizing output possible cost of producing each level of output when
associated with an isoquant. variable factors are being used in the cost-minimizing
way.

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 The Cost Function The Cost Function

The Cost Function Short-Run Costs

• The cost function reduces the amount of Total costs
Variable costs
𝑇𝐶 𝑄 = 𝐹𝐶 + 𝑉𝐶 𝑄

information the manager has to process to Fixed costs

𝑉𝐶 𝑄
make optimal output decisions.
• Long-run costs 𝐹𝐶

– All costs are variable

𝐹𝐶
– No fixed costs
𝐹𝐶

0 Output

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The Cost Function The Cost Function

Average and Marginal Costs The Relationship between Average

• Average costs ATC, AVC, AFC
and Marginal Costs
and MC ($) 𝐴𝑇𝐶
𝐹𝐶 𝑀𝐶
– Average fixed cost: 𝐴𝐹𝐶 = A𝑉𝐶
𝑄
Minimum of ATC
𝑉𝐶 𝑄
– Average variable costs: 𝐴𝑉𝐶 =
𝑄
𝐶 𝑄
– Average total cost: 𝐴𝑇𝐶 =
𝑄

• Marginal cost (MC)

Minimum of AVC
– The (incremental) cost of producing an additional 𝐴𝐹𝐶
unit of output. 0 Output
∆𝐶
– 𝑀𝐶 =
∆𝑄
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The Cost Function The Cost Function

Relations Among Costs Fixed and Sunk Costs

• Total costs, TC(Q) • Fixed costs
𝐶 𝑄 – Cost that does not change with output.
𝑇𝐶 𝑄 = 𝐹𝐶 + 𝑉𝐶 𝑄 , 𝑇𝐶 =
𝑄 • Sunk cost
• Average total cost (ATC) – Cost that is forever lost after it has been paid. It is
𝐴𝑇𝐶 = 𝐴𝑉𝐶 + 𝐴𝐹𝐶 also the amount of the fixed costs that cannot be
recouped or recovered.
• Irrelevance of Sunk Costs
– A decision maker should ignore sunk costs to
maximize profits or minimize losses.

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 The Cost Function The Cost Function
Fixed and Sunk Costs in Action Fixed and Sunk Costs in Action
ACME Coal paid $5,000 to lease a railcar from the ACME Coal paid $5,000 to lease a railcar from the
Reading Railroad. Under the lease terms, $1,000 of this Reading Railroad. Under the lease terms, $1,000 of this
payment is refundable if the railcar is returned within two
payment is refundable if the railcar is returned within days of signing the lease.
two days of signing the lease. 2. One day after signing the lease, ACME realizes it has no
1. How large are ACME's fixed costs after signing the use for the railcar. A farmer has a crop of corn and has
lease and paying $5,000? Sunk costs? offered to sublease the railcar from ACME at $4,500.
Should ACME accept the farmer’s offer?
Answer: ACME’s fixed costs are $5,000. For the first
Answer:
two days, its sunk costs are $4,000 (the amount that
Yes, ACME should sublease the railcar. Note that its
cannot be recouped). After two days, the entire $5,000 total loss is $500 if it accepts the farmer’s offer. If it does
becomes a sunk cost. not, its losses will equal $4,000 (assuming it returns the
railcar by the end of the next business day).

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The Cost Function The Cost Function

Cubic Cost Functions Cubic Cost Function in Action

• The cubic cost function: costs are a cubic • The cost function for Managerial enterprises is
function of output; provides a reasonable given by:
approximation to virtually any cost function. C(Q) = 20 + 3Q2
C(Q) = F + aQ + bQ2 + cQ3
where a, b, c, and f are constants and f Determine the marginal cost, average fixed
represents fixed costs costs, average variable cost, and the average total
• Marginal cost function is: cost when Q = 10 units.
MC(Q) = a + 2bQ + 3cQ2

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The Cost Function The Cost Function

Long-Run Costs
Cubic Cost Function in Action
• In the long run, all costs are variable since a
A. MC(Q) = 6Q, MC(10) = $60 manager is free to adjust levels of all inputs.
B. Total Cost, TC(10) = 20 + 3(10)^2 = $320 • Long-run average cost curve
The fixed cost, FC(10) = $20 – A curve that defines the minimum average cost of
The variable cost, VC(10) = 3(10)^2=$300 producing alternative levels of output allowing for
optimal selection of both fixed and variable
factors of production.
Hence, AFC = 20/10 = $2, AVC = $300/10 = $30
and ATC = $320/10 = $32

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 The Cost Function The Cost Function
Long-Run Average Cost Long-Run Costs
LRAC ($)
𝐴𝑇𝐶2
• Long-run average cost curve
𝐴𝑇𝐶0 𝐿𝑅𝐴𝐶 – This curve, denoted as LRAC in the figure on the
previous slide, is the lower envelope of all the
𝐴𝑇𝐶1
short-run average cost curves.
– This means that the long-run average cost curve
lies below every point on the short-run average
cost curves, except that it equals each short-run
average cost curve at the points where the short-
run cost curve uses fixed factors optimally.
0 𝑄∗ Output

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The Cost Function The Cost Function

Economies of Scale Economies and Diseconomies of Scale

• Economies of scale LRAC ($)

– Declining portion of the long-run average cost 𝐿𝑅𝐴𝐶

curve as output increase.

• Diseconomies of scale
– Rising portion of the long-run average cost curve
as output increases.
• Constant returns to scale Economies of scale Diseconomies of scale
– Portion of the long-run average cost curve that
remains constant as output increases. 0 𝑄∗ Output

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The Cost Function The Cost Function

Economies of Scale Constant Returns to Scale

• In the previous slide, the long-run average LRAC ($) Sometimes, the technology in an industry allows a firm to
produce different output levels at the same minimum
cost curve is U-shaped. This implies that an average cost, a condition called constant returns to scale.

expansion of output initially allows the firm to 𝐴𝑇𝐶2 𝐴𝑇𝐶3

𝐴𝑇𝐶1
produce at a lower long-run average cost. This
condition is known as economies of scale.
• After a certain point, further increases in
output lead to an increase in average costs. 𝐿𝑅𝐴𝐶
This condition is called diseconomies of scale.
0 Output

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5-70 5-71
 Multiple-Output Cost Function Multiple-Output Cost Function
Algebraic Form for a Multiproduct Algebraic Form for a Multiproduct
Cost Function Cost Function
2 2 2 2
𝐶 𝑄1, 𝑄2 = 𝑓 + 𝑎𝑄1𝑄2 + 𝑄1 + 𝑄2 𝐶 𝑄1, 𝑄2 = 𝑓 + 𝑎𝑄1𝑄2 + 𝑄1 + 𝑄2
• For this cost function:
• The multiproduct cost function is a function that MC1 = aQ2 + 2Q1
defines the cost of producing given levels of two - When a < 0, an increase in Q2 reduces the marginal
or more types of outputs assuming all inuts are cost of producing product 1.
used efficiently. - If a < 0, this cost function exhibits cost
complementarity
- If a > 0, there are no cost complementarities
- Exhibits economies of scope whenever f - 𝑎𝑄1𝑄2 > 0
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Multiple-Output Cost Function

Multiple-Output Cost Function

• Economies of scope
– Exist when the total cost of producing 𝑄1 and 𝑄2
together is less than the total cost of producing
each of the type of output separately.
𝐶 𝑄1 , 0 + 𝐶 0, 𝑄2 > 𝐶 𝑄1 , 𝑄2
• Cost complementarity
– Exist when the marginal cost of producing one
type of output decreases when the output of
another good is increased.
∆𝑀𝐶1 𝑄1 , 𝑄2
<0
∆𝑄2
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