Managerial Economics &

Business Strategy
Chapter 5
The Production Process and Costs

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 5-2

Overview
I. Production Analysis
 Total Product, Marginal Product, Average
Product
 Isoquants
 Isocosts
 Cost Minimization
II. Cost Analysis
 Total Cost, Variable Cost, Fixed Costs
 Cubic Cost Function
 Cost Relations
 5-3

Production Analysis
 Production Function
 Q = F(K,L)
 Q is quantity of output produced.
 K is capital input.
 L is labor input.
 F is a functional form relating the inputs to output.
 The maximum amount of output that can be
produced with K units of capital and L units of
labor.
 Short-Run vs. Long-Run Decisions
 Fixed vs. Variable Inputs
 5-4

Production Function Algebraic Forms

 Linear production function: inputs are perfect
substitutes.
Q  F K , L   aK  bL
 Leontief production function: inputs are used in
fixed proportions.
Q  F K , L   minbK , cL
 Cobb-Douglas production function: inputs have
a degree of substitutability.
Q  F K , L   K L
a b
 5-5

Productivity Measures:
Total Product
 Total Product (TP): maximum output produced
with given amounts of inputs.
 Example: Cobb-Douglas Production Function:
Q = F(K,L) = K.5 L.5
 K is fixed at 16 units.
 Short run Cobb-Douglass production function:
Q = (16).5 L.5 = 4 L.5
 Total Product when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units
 5-6

Productivity Measures: Average

Product of an Input
 Average Product of an Input: measure of
output produced per unit of input.
 Average Product of Labor: APL = Q/L.
 Measures the output of an “average” worker.


Example: Q = F(K,L) = K.5 L.5
 If the inputs are K = 16 and L = 16, then the average

product of labor is APL = [(16) 0.5(16)0.5]/16 = 1.

 Average Product of Capital: APK = Q/K.
 Measures the output of an “average” unit of capital.


Example: Q = F(K,L) = K.5 L.5
 If the inputs are K = 16 and L = 16, then the average

product of capital is APK = [(16)0.5(16)0.5]/16 = 1.

 5-7
Productivity Measures: Marginal
Product of an Input
 Marginal Product on an Input: change in total
output attributable to the last unit of an input.
 Marginal Product of Labor: MPL = Q/L
 Measures the output produced by the last worker.
 Slope of the short-run production function (with respect

to labor).
 Marginal Product of Capital: MPK = Q/K
 Measures the output produced by the last unit of capital.
 When capital is allowed to vary in the short run, MPK is
the slope of the production function (with respect to
capital).
 5-8

Increasing, Diminishing and Negative Marginal Returns

Q Increasin DiminishingNegative
g Marginal Marginal
Marginal Returns Returns
Returns

Q=F(K,L)

AP
L
MP
 5-9

Guiding the Production Process

 Producing on the production function
 Aligning incentives to induce maximum worker
effort.
 Employing the right level of inputs
 When labor or capital vary in the short run, to maximize
profit a manager will hire
 labor until the value of marginal product of labor equals

the wage: VMPL = w, where VMPL = P x MPL.

 capital until the value of marginal product of capital

equals the rental rate: VMPK = r, where VMPK = P x MPK

 Algebraic Forms of Production
Functions
 The linear production function is:
Q = F(K, L) = aK + bL
Where a and b are constant. With a linear production function,
inputs are perfect substitutes. There is a perfect relationship
between all the inputs and total output. For instance, suppose
it takes workers at a plant four hours to produce what a
machine can make in one hour. In this case the production
function is linear with a = 4 and b = 1:
Q = F(K, L) = 4K + L
That means capital is always 4 times as productive as labor. Since
F(5,2) = 4(5) + 1(2) = 22, we know that 5 units of capital and
2 units labor will produce 22 units of output.
 The Leontief Production
Functions
The Leontief Production Functions is given by
Q = F(K, L) = min {aK, bL}
Where a and b are constants. The Leontief production
function is also called the fixed proportions. For
instance, the engineers at Morris Industry 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?
 The Leontief Production
Functions (Continued)
Answer: we simply calculate F(5, 2). But
F(5, 2) = min {3(5), 4(2)} = min {15, 8}.
Since the minimum of the numbers “15”
and “8” is 8, we know that 5 units of
capital and 2 units of labor produce 8
units of output.
 Cobb-Douglas Production
Function
 A production function that lies between the extremes of the
linear production function and the Leontief production function
is the Cobb-Douglas Production Function. The Cobb-Douglas
Production Function is given by
Q = F(K, L) = KaLb
Where a and b are constant. Unlike in the case of the linear
production function, the relationship between output and inputs
is not linear. Unlike in the Leontief production function , inputs
need be used in fixed proportion. The Cobb-Douglas Production
Function assumes some degree of substitutability between
inputs, though not perfect substitutability.
 Algebraic Measure of
Productivity
We learned that the average product of an input is the output produced
divided by the number of units used of the input.

Suppose a consultant provides you with the following estimate of your

firm’s Cobb-Douglas production function:
Q = F(K, L) = K1/2 L1/2
What is the average product of labor when 4 units of labor and 9 units
of capital are employed ? Since F(9,4) = 91/241/2=(3((2)=6, we know that
9 units of capital and 4 units of lablr produce 6 units of output. Thus
the average product of 4 units of labor APL = 6/4 1.5 units. Notice that
when output is produced with both capital and labor, the average
product of labor will depend not only on how many units of labor are
used but also on how much capital is used.
 5-15

Isoquant
 Illustrates the long-run combinations of
inputs (K, L) that yield the producer the
same level of output.
 The shape of an isoquant reflects the
ease with which a producer can
substitute among inputs while
maintaining the same level of output.
 5-16
Marginal Rate of Technical
Substitution (MRTS)

 The rate at which two inputs are

substituted while maintaining the same
output level.
MPL
MRTS KL 
MPK
 5-17

Linear Isoquants
 Capital and labor are
K
perfect substitutes Increasing
 Q = aK + bL Output
 MRTSKL = b/a
 Linear isoquants imply
that inputs are
substituted at a constant
rate, independent of the
input levels employed.
Q1 Q2 Q3
L
 5-18

Leontief Isoquants
 Capital and labor are Q3
K
perfect complements. Q2
 Capital and labor are used Q1 Increasing
in fixed-proportions. Output
 Q = min {bK, cL}
 Since capital and labor are
consumed in fixed
proportions there is no
input substitution along
isoquants (hence, no
MRTSKL). L
 5-19

Cobb-Douglas Isoquants
 Inputs are not perfectly K
substitutable. Q3
 Diminishing marginal rate of Increasing
technical substitution. Q2
Output
 As less of one input is Q1
used in the production
process, increasingly
more of the other input
must be employed to
produce the same
output level.
 Q = KaLb
 MRTSKL = MPL/MPK

L
 5-20

Isocost
 The combinations of inputs
that produce a given level of K New Isocost Line
output at the same cost: C1/r associated with
wL + rK = C higher costs (C0
C0/r < C1).
 Rearranging,
K= (1/r)C - (w/r)L C C
 For given input prices, C0/w
0 C11/w L
isocosts farther from the K
origin are associated with New Isocost
higher costs. C/r Line for a
 Changes in input prices decrease in the
change the slope of the wage (price of
isocost line. labor: w0 >
w1). L
C/w0 C/w1
 5-21

Cost Minimization
 Marginal product per dollar spent
should be equal for all inputs:
MPL MPK MPL w
  
w r MPK r

 But, this is just

w
MRTS KL 
r
 5-22

Cost Minimization
K

Point of
Slope of Isocost Cost
=
Slope of Isoquant Minimizatio
n

L
 5-23

Optimal Input Substitution

 A firm initially K
produces Q0 by
employing the
combination of
inputs represented
by point A at a cost
of C0. K0 A

Suppose w0 falls to
w1. B
 The isocost curve rotates
counterclockwise; which K1
represents the same cost level
prior to the wage change.
 To produce the same level of
output, Q0, the firm will produce
on a lower isocost line (C1) at a
Q0
point B.
 The slope of the new isocost line
represents the lower wage relative
to the rental rate of capital.
0 L0 L1C0/w0 C1/w1 C0/w1 L
 5-24

Cost Analysis
 Types of Costs
 Short-Run
 Fixed costs (FC)

 Sunk costs

 Short-run variable

costs (VC)
 Short-run total costs

(TC)
 Long-Run
 All costs are variable

 No fixed costs
 5-25

Total and Variable Costs

$
C(Q): Minimum total cost C(Q) = VC +
of producing alternative FC
levels of output: VC(
C(Q) = VC(Q) + FC Q)

VC(Q): Costs that vary

with output. F
C
FC: Costs that do not vary
0 Q
with output.
 5-26

Fixed and Sunk Costs

FC: Costs that do not change $
as output changes. C(Q) = VC +
FC
Sunk Cost: A cost that is VC(
forever lost after it has been Q)
paid.

Decision makers should

ignore sunk costs to F
maximize profit or minimize C
losses
Q
 5-27

Some Definitions

Average Total Cost $

ATC = AVC + AFC MC ATC
AVC
ATC = C(Q)/Q

Average Variable Cost

AVC = VC(Q)/Q MR

Average Fixed Cost

AFC = FC/Q
Marginal Cost AF
MC = C/Q C
Q
 5-28

Fixed Cost
Q0(ATC-AVC)
MC
$ = Q0 AFC ATC
= Q0(FC/ Q0) AVC

= FC
ATC
AFC Fixed Cost
AVC

Q0 Q
 5-29

Variable Cost
Q0AVC MC
$
ATC
= Q0[VC(Q0)/ Q0]
AVC
= VC(Q0)

AVC
Variable Cost Minimum of AVC
Q0 Q
 5-30

Total Cost
Q0ATC
MC
$
= Q0[C(Q0)/ Q0] ATC

= C(Q0)
AVC

ATC

Total Cost Minimum of ATC

Q0 Q
 5-31

Cubic Cost Function

 C(Q) = f + a Q + b Q2 + cQ3
 Marginal Cost?
 Memorize:
MC(Q) = a + 2bQ + 3cQ2
 Calculus:
dC/dQ = a + 2bQ + 3cQ2
 5-32

An Example
 Total Cost: C(Q) = 10 + Q + Q2
 Variable cost function:
VC(Q) = Q + Q2
 Variable cost of producing 2 units:
VC(2) = 2 + (2)2 = 6
 Fixed costs:
FC = 10
 Marginal cost function:
MC(Q) = 1 + 2Q
 Marginal cost of producing 2 units:
MC(2) = 1 + 2(2) = 5
 5-33

Long-Run Average Costs

$

LRAC

Economies Diseconomies
of Scale of Scale
Q* Q
 5-34

Economies of Scope
 C(Q1, 0) + C(0, Q2) > C(Q1, Q2).
 It is cheaper to produce the two outputs
jointly instead of separately.
 Example:
 It is cheaper for Time-Warner to produce
Internet connections and Instant
Messaging services jointly than separately.
 5-35

Cost Complementarity
 The marginal cost of producing good 1
declines as more of good two is produced:

MC1Q1,Q2) /Q2 < 0.

 Example:
 Cow hides and steaks.
 5-36

Conclusion
 To maximize profits (minimize costs) managers
must use inputs such that the value of
marginal of each input reflects price the firm
must pay to employ the input.
 The optimal mix of inputs is achieved when the
MRTSKL = (w/r).
 Cost functions are the foundation for helping
to determine profit-maximizing behavior in
future chapters.