Chapter 5
The Production Process and
Costs
Learning Objectives
1. Explain alternative ways of measuring the
productivity of inputs and 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.
2
Introduction
• Companies are in the business of producing goods
and services
• Successful operation requires to optimally choose the
quantity and types of inputs to use in the production
process
• This chapter provides the economic foundations
needed to succeed in managerial positions
• Concepts of production and costs are the building
blocks for business areas
5-3
The Production Function
The Production Function
• Technology summarizes the feasible means of
converting raw inputs into an output
• Technology effectively summarizes engineering
knowhow
• Managerial decisions (expenditures for R&D) can
affect the available technology
• How a manager can exploit an existing technology to
its greatest potential
5-4
The Production Function
The Production Function
5-5
.
The Production Function
Short-Run versus Long-Run Decisions:
Fixed and Variable Inputs
• Short-run
• Period of time where some factors of production (inputs)
are fixed, and constrain a manager’s decisions.
• Long-run
• Period of time over which all factors of production (inputs)
are variable, and can be adjusted by a manager.
5-6
.
The Production Function
Measures of Productivity
5-7
The Production Function
Measures of Productivity in Action
5-8
Law of Diminishing Returns
• Law of diminishing returns
• Resources are of equal quality
• Technology is fixed
• Variable resources are added to fixed
resources
• At some point, marginal product will fall
LO2
The Production Function
Increasing, Decreasing, and Negative Marginal Returns
Total product Increasing Decreasing Negative
Average product marginal marginal marginal
Marginal product returns to labor returns to labor returns to labor
Total product (TP)
Average product (APL)
0 Marginal product (MPL) Labor input
(holding capital constant)
5-11
The Production Function
The Role of the Manager in the
Production Process
5-12
Variable Price of MPL VMPL Unit Cost of
Input Output Labor
The value of the
output produced by
the last unit of an
0 3 - input. - 400
1 3 76 228 400
2 3 marginal product
The 172 516 400
3 of3an additional unit 244 732 400
of output will at some
4 3 be lower than
point 292 876 the manager 400
should
5 3 marginal product
the 316 948 400labor up
continue to employ
of the previous unit. to the point where VMPL =
6 3 316 948 400of
w in the range
7 3 292 876 diminishing 400
marginal
product.
8 3 244 732 400
9 3 172 516 400
10 3 76 228 40013
The Production Function
The Role of the Manager in the Production Process
• Value marginal product: The value of the output
produced by the last unit of an input.
• Law of diminishing returns: The marginal product of
an additional unit of output will at some point be
lower than the marginal product of the previous unit.
• Profit-Maximization input usage
• To maximize profits, use input levels at which marginal
benefit equals marginal cost
• When the cost of each additional unit of labor is w, the
manager should continue to employ labor up to the point
where VMPL = w in the range of diminishing marginal
product.
5-14
The Production Function
Algebraic Forms of Production Functions
5-15
.
The Production Function
Algebraic Forms of Production Functions
5-17
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The Production Function
Algebraic Forms of Production Functions in Action
5-18
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The Production Function
Algebraic Forms of Production Functions
5-19
Demonstration Problem
The engineers at Morris Industries obtained the following estimate of
the firm’s production function:
Q = F (K, L) = min {3K, 4L}
How much output is produced when 2 units of labor and 5 units of
capital are employed ?
F( 5, 2) = min {3(5), 4(2)} = min {15, 8}
The Production Function
Algebraic Forms of Production Functions
5-21
The Production Function
Algebraic Forms of Production Function in Action
5-22
The Production Function
Algebraic Measures of Productivity
5-23
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The Production Function
Algebraic Measures of Productivity
5-24
The Production Function
Algebraic Measures of Productivity
5-25
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The Production Function
Algebraic Measures of Productivity
5-26
• Linear production function- MP of the input is simply the coefficient
of the input which implies that the MP of the input is independent of
the input used . Linear production functions do not follow the LDMR
• Cobb-Douglas production function – MP of an input depends on the
amount of input used
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Demonstration Problem 5-2
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The Production Function
Algebraic Measures of Productivity in Action
5-29
.
The Production Function
Isoquants
• Isoquants capture the tradeoff between
combinations of inputs that yield the same output in
the long run, when all inputs are variable.
• 1,000 cars can be produced using 10 workers & 1
robot or 2 workers and 3 robots
• To minimize costs of producing 1,000 cars, the
manager must choose the efficient combination of
inputs
5-30
Properties of Isoquant Maps
• There are an infinite number of combinations of labor
and capital that can produce each level of output.
• Every point lies on some isoquant.
• The slope of an isoquant is equal to: -
MPlabour / MPcapital = - MPL / MPK = ΔK / ΔL
• The slope of the isoquant is called the marginal rate of
technical substitution which can be defined as the rate
at which a firm can substitute capital for labour and
hold output constant.
31
The Production Function
Isoquants and Marginal Rate of Technical Substitution in
Action
Capital Input
0 Labor Input
5-32
The Production Function
Marginal Rate of Technical Substitution
5-33
The Production Function
Diminishing Marginal Rate of Technical Substitution
Capital Input
B
A
0 Labor Input
5-34
Isocost
5-35
The Production Function
Changes in Isocost Lines
• Changes in isocosts
• For given input prices, isocosts farther from the origin are
associated with higher costs.
• Changes in input prices change the slopes of isocost lines.
5-36
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The Production Function
Changes in the Isocosts
Capital Input
More expensive input
bundles
Less expensive input
bundles
0 Labor Input
5-37
The Production Function
Changes in the Isocost Line
Capital Input
0 Labor Input
5-38
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The Production Function
Cost-Minimization Input Rule in Action
Capital Input
0 Labor Input
5-39
The Production Function
Cost Minimization and the Cost-Minimizing Input Rule
5-40
The Production Function
Optimal Input Substitution
•To minimize the cost of producing a given
level of output, the firm should use less of
an input and more of other inputs when
that input’s price rises.
© 2017 by McGraw-Hill Education. All Rights Reserved. 41
Conclusion: Buy resources such that
the last dollar spent on K adds the
same amount to output as the last
dollar spent on L.
• The |slope| of the isocost line = W/R.
• The |slope| of the isoquant = MPL/MPK
42
Accounting Costs and Economic Costs
• Accounting costs are explicit costs (those stated costs that occur in
exchange for a defined good or service).
• Economic costs include accounting costs and opportunity
costs. Opportunity costs are the benefits you could have received if
you had chosen one course of action, but that you didn't because you
went with another option.
• [Link]
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functions/5120
• [Link]
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