CHAPTER 5

The Production
Process and
Costs

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Chapter Outline

Chapter Overview

The production function

Short- versus long-run decisions
Measures of productivity
Managers role in production process
Algebraic forms of the production function and productivity
Isoquants and isocosts
Cost minimization and optimal input substitution

The cost function

Short-run costs
Average and marginal costs
Relations among costs
Fixed and sunk costs
Algebraic forms of cost functions
Long-run costs and economies of scale

Multiple-output cost functions

Economies of scope and cost complementarity
5-2

The Production Function

The Production Function

Mathematical function that defines

the maximum amount of output that
can be produced with a given set of
inputs.
, where
is the level of output.
is the quantity of capital input.
is the quantity of labor input.

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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 managers decisions.

Long-run
Period of time over which all factors of
production (inputs) are variable, and can
be adjusted by a manager.

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The Production Function

Measures of Productivity
Total
product (TP)

Maximum level of output that can be produced

with a given amount of inputs.

Average product (AP)

A measure of the output produced per unit of
input.
Average product of labor:
Average product of capital:

Marginal product (MP)

The change in total product (output) attributable
to the last unit of an input.
Marginal product of labor:
Marginal product of capital:
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The Production Function

5-6

The Production Function

Relation between Productivity
Measures

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

input
Marginal product (MPLabor
L)

(holding capital constan

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The Production Function

The Managers Role in the

Production Process
output on the production
Produce

function.

Aligning incentives to induce maximum

worker effort.

Use the right mix of inputs to maximize

profits.
To maximize profits when labor or capital
vary in the short run, the manager will hire:
Labor until the value of the marginal product of
labor equals the wage rate: , where
Capital until the value of the marginal product of
capital equals the rental rate: , where
5-8

The Production Function

5-9

The Production Function

Labour Demand Curve

Maximize profit => VMPL(L) = w =>
L = L(w)
The downward-sloping portion of
VMPL curve is the labour demand
curve.

5-10

The Production Function

Algebraic Forms of Production Functions

Commonly used algebraic production

function forms:
Linear: , where and are constants.
Leontief: , where and are constants.
Cobb-Douglas: , where and are
constants.

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The Production Function

Algebraic Forms of Production Functions

Linear production function: K and L

are perfect substitutes
Leontief production function: K and L
are perfect complements (used in
fixed proportions)
Cobb-Douglas production function: K
and L are imperfect substitutes

5-12

The Production Function

Algebraic Measures of Productivity

Given the commonly used algebraic
production function forms, we can
compute the measures of
productivity as follows:
Linear:
Marginal products: and
Average products: and

Cobb-Douglas:
Marginal products: and
Average products: and
5-13

The Production Function

Short-Run Labour Input Determination

Production function: Q = F(K,L) =

K1/2L1/2
K = 1 in the short run. P = $10, w =
$2.
How much L should the firm employ
to maximize profit?

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The Production Function

Long-Run Input Determination

In long run all inputs are variable.
Choose an input combination (K,L) that
can produce a given output level at
minimum cost
- Isoquants
- Isocosts

5-15

The Production Function

Isoquants and Marginal Rate of

Technical Substitution
Isoquants
capture the tradeoff

between combinations of inputs that

yield the same output in the long run,
when all inputs are variable.
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.

5-16

The Production Function

Isoquants and Marginal Rate of

Technical Substitution MRTS

Capital Input

A
Su
bs
tit
ut
in
g
la
bo
rf

ut
p
t
ou
g
sin
a
re
Inc

300 units of output

B
or
ca
pi
ta

200 units of output

l

= 100 units of output

Labor Input

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The Production Function

Isoquants: Linear vs. Leontief

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The Production Function

Diminishing MRTS
Capital Input (K)
D

Slope (at C):

3
C

Slope (at A):

A
=100 units
0

Labor Input (L)

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The Production Function

Isocost and Changes in Isocost Lines

Isocost

Combination of inputs that yield cost the same

cost.

or, re-arranging to the intercept-slope

formulation:

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.
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The Production Function

Isocost Line
Capital Input (K)

Labor Input (L)

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The Production Function

Changes in the Isocost Line

Capital Input (K)

More expensive input

bundles

Less expensive input

bundles
0

Labor Input (L)

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The Production Function

Changes in the Isocost Line

Capital Input (K)

Due
to increase in wage rate

Labor Input (L)

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The Production Function

Cost-Minimization Input Rule in

Action
Capital Input (K)

=
100 units
0

Labor Input (L)

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The Production Function

Cost-Minimizing Input Rule

Cost
minimization

Producing at the lowest possible cost.

Cost-minimizing input rule

Produce at a given level of output where
the marginal product per dollar spent is
equal for all inputs:
Equivalently, a firm should employ inputs
such that the marginal rate of technical
substitution equals the ratio of input
prices:
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The Production Function

Cost-Minimizing Input Rule in Action

that labor and capital are hired
Suppose

at a competitive wage of $10 and $25,

respectively. If the marginal product of
capital is 6 units and the marginal product
of labor is 3 units, is the firm hiring the
cost-minimizing units of capital and labor?
Since , the marginal product per dollar spent
on labor exceeds the marginal product per
dollar spent on capital.
The firm is not minimizing costs and should
use fewer units of capital and more labor.
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The Production Function

Optimal Input Substitution

Capital Input (K)
I
New cost-minimizing
point due to higher wage

Initial point of cost minimization

A

H
0

G Labor Input (L)

5-27

The Cost Function

The Cost Function

relationship that relates cost

Mathematical

to the cost-minimizing output associated

with an isoquant.
Short-run costs
Fixed costs:
Sunk costs
Short-run variable costs:
Short-run total costs:

Long-run costs
All costs are variable
No fixed costs
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The Cost Function

5-29

The Cost Function

Short-Run Costs in Action

Total costs
Variable costs
Fixed costs

Output

5-30

The Cost Function

Average and Marginal Costs

Average costs
Average fixed:
Average variable costs:
Average total cost:

Marginal cost
The (incremental) cost of producing an
additional unit of output.

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The Cost Function

5-32

The Cost Function

The Relationship among Average

and Marginal Costs
ATC, AVC, AFC
and MC ($)

Minimum of ATC

Minimum of AVC

Output

5-33

The Cost Function

Relation of MC to AVC and ATC

When MC < current AVC (ATC)
AVC (ATC) will fall

When MC > current AVC (ATC)

AVC (ATC) will rise

MC intersects AVC and ATC at their

minimum points

5-34

Average Product and

Marginal Product

The Cost Function

Production Curves

AP
MP
Quantity of
Labor

Cost (Dollars)

MC

AVC

Cost Curves
Quantity of Output
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The Cost Function

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.

Principle of Irrelevance of Sunk Costs

A decision maker should ignore sunk
costs to maximize profits or minimize
loses.
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The Cost Function

Algebraic Forms of Cost Functions

Cubic cost function: C(Q) = f + aQ +
bQ2 + cQ3
Example: C(Q) = 30 + 2Q + 3Q2 + Q3
Calculate FC, VC, MC, AFC, AVC and
ATC when Q = 4.

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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.

5-38

The Cost Function

Optimal Plant Size and LRAC

LRAC ($)

Output

5-39

The Cost Function

Economies of Scale
Economies of scale

Portion of the long-run average cost curve

where long-run average costs decline as
output increases.

Diseconomies of scale
Portion of the long-run average cost curve
where long-run average costs increase as
output increases.

Constant returns to scale

Portion of the long-run average cost curve
that remains constant as output increases.
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The Cost Function

Economies of Scale and Diseconomies

of Scale
LRAC ($)

Diseconomies of scale

Economies of scale
0

Output

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The Cost Function

Constant Returns to Scale

LRAC ($)

Output

5-42

Multiple-Output Cost Function

Multiple-Output Cost Function

Economies of scope
Exist when the total cost of producing
and together is less than the total cost
of producing each of the type of output
separately.

Cost complementarity
Exist when the marginal cost of
producing one type of output decreases
when the output of another good is
increased.
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Multiple-Output Cost Function

Multiple-Output Cost Function in

Action
Suppose
a firm produces two goods and has

cost function given by

If the firm plans to produce 4 units of and 6
units of
Does this cost function exhibit cost
complementarities?
Yes, cost complementarities exist since

Does this cost function exhibit economies of

scope?
Yes, economies of scope exist since

5-44

Conclusion
To
maximize profits (minimize costs)

managers must use inputs such that

the value of marginal product of each
input reflects the price the firm must
pay to employ the input.
The optimal mix of inputs is achieved
when the .
Cost functions are the foundation for
helping to determine profit-maximizing
behavior in future chapters.
5-45