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Economis
The Production Process and Costs
© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 5
Learning Objectives
Explain alternative ways of measuring the productivity of inputs and the role of the manager in the production process.
Calculate input demand and the cost-minimizing combination of inputs and use isoquant analysis to illustrate optimal input substitution.
Calculate a cost function from a production function and explain how economic costs differ from accounting costs.
Explain the difference between and the economic relevance of fixed costs, sunk costs, variable costs, and marginal costs.
Calculate average and marginal costs from algebraic or tabular cost data and illustrate the relationship between average and marginal costs.
Distinguish between short-run and long-run production decisions and illustrate their impact on costs and economies of scale.
Conclude whether a multiple-output production process exhibits economies of scope or cost complementarities and explain their significance for managerial decisions.
© 2017 by McGraw-Hill Education. All Rights Reserved.
2
The Production Function
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-3
The Production Function
3
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-4
The Production Function
4
Measures of Productivity
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5-5
The Production Function
5
Measures of Productivity in Action
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5-6
The Production Function
6
Increasing, Decreasing, and Negative Marginal Returns
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5-7
Labor input
(holding capital constant)
0
Total product
Average product
Marginal product
Total product (TP)
Average product (APL)
Marginal product (MPL)
Increasing
marginal
returns to labor
Decreasing
marginal
returns to labor
Negative
marginal
returns to labor
The Production Function
7
The Role of the Manager in the Production Process
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-8
The Production Function
8
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-9
The Production Function
9
Algebraic Forms of Production Functions
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5-10
The Production Function
10
Algebraic Forms of Production Functions in Action
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5-11
The Production Function
11
Algebraic Measures of Productivity
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5-12
The Production Function
12
Algebraic Measures of Productivity in Action
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5-13
The Production Function
13
Isoquants and Marginal Rate of Technical Substitution
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5-14
The Production Function
14
Isoquants and Marginal Rate of Technical Substitution in Action
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5-15
Labor Input
0
A
B
Substituting labor for capital
Increasing output
Capital Input
The Production Function
15
Diminishing Marginal Rate of Technical Substitution
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5-16
Labor Input
0
D
C
Capital Input
B
A
The Production Function
16
Isocost and Changes in Isocost Lines
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5-17
The Production Function
17
Isocosts
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5-18
Labor Input
0
Capital Input
The Production Function
18
Changes in the Isocosts
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5-19
Labor Input
0
Capital Input
The Production Function
Less expensive input
bundles
More expensive input
bundles
19
Changes in the Isocost Line
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-20
Labor Input
0
Capital Input
The Production Function
20
Cost Minimization and the Cost-Minimizing Input Rule
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-21
The Production Function
21
Cost-Minimization Input Rule in Action
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-22
Labor Input
0
Capital Input
The Production Function
22
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.
23
The Production Function
Optimal Input Substitution in Action
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-24
Labor Input
0
B
Capital Input
New cost-minimizing
point due to higher wage
A
Initial point of cost minimization
The Production Function
H
I
F
J
G
24
The Cost Function
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-25
The Cost Function
25
Short-Run Costs
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5-26
Output
0
Total costs
Variable costs
Fixed costs
The Cost Function
26
Average and Marginal Costs
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5-27
The Cost Function
27
The Relationship between Average and Marginal Costs
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5-28
Output
0
ATC, AVC, AFC
and MC ($)
Minimum of ATC
Minimum of AVC
The Cost Function
28
Fixed and Sunk Costs
Fixed costs
Cost that does not change with output.
Sunk cost
Cost that is forever lost after it has been paid.
Irrelevance of Sunk Costs
A decision maker should ignore sunk costs to maximize profits or minimize loses.
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-29
The Cost Function
29
Algebraic Forms of Cost Functions
The cubic cost function: costs are a cubic function of output; provides a reasonable approximation to virtually any cost function.
C(Q) = F + aQ + bQ2 + cQ3
where a, b, c, and f are constants and f represents fixed costs
Marginal cost function is:
MC(Q) = a + 2bQ + 3cQ2
© 2017 by McGraw-Hill Education. All Rights Reserved.
30
The Cost Function
Long-Run Costs
In the long run, all costs are variable since a manager is free to adjust levels of all inputs.
Long-run average cost curve
A curve that defines the minimum average cost of producing alternative levels of output allowing for optimal selection of both fixed and variable factors of production.
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-31
The Cost Function
31
Long-Run Average Cost
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5-32
Output
0
LRAC ($)
The Cost Function
32
Economies of Scale
Economies of scale
Declining portion of the long-run average cost curve as output increase.
Diseconomies of scale
Rising portion of the long-run average cost curve as output increases.
Constant returns to scale
Portion of the long-run average cost curve that remains constant as output increases.
© 2017 by McGraw-Hill Education. All Rights Reserved.
5-33
The Cost Function
33
Economies and Diseconomies of Scale
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5-34
Output
0
LRAC ($)
The Cost Function
Economies of scale
Diseconomies of scale
34
Constant Returns to Scale
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5-35
Output
0
LRAC ($)
The Cost Function
35
Multiple-Output Cost Function
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5-36
Multiple-Output Cost Function
36
Algebraic Form for a Multiproduct Cost Function
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5-37
Multiple-Output Cost Function
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