CHAPTER 5

The Production Process and Costs

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 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.
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
significance for managerial decisions.
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 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.
𝑄 = 𝐹 𝐾, 𝐿
– 𝑄 is the level of output.
– 𝐾 is the quantity of capital input.
– 𝐿 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 manager’s
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.
𝑄
• Average product of labor: 𝐴𝑃𝐿 =
𝐿
𝑄
• Average product of capital: 𝐴𝑃𝐾 =
𝐾
• Marginal product (MP)
– The change in total product (output) attributable to
the last unit of an input.
∆𝑄
• Marginal product of labor: 𝑀𝑃𝐿 =
∆𝐿
∆𝑄
• Marginal product of capital: 𝑀𝑃𝐾 =
∆𝐾

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 The Production Function

Measures of Productivity in Action

• Consider the following production function
when 5 units of labor and 10 units of capital
are combined produce: 𝑄 = 𝐹 10,5 = 150.
• Compute the average product of labor.
150
𝐴𝑃𝐿 = = 30 units per worker
5
• Compute the average product of capital.
150
𝐴𝑃𝐿 = = 15 units capital unit
10

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 The Production Function
Increasing, Decreasing, and Negative
Total product Marginal Returns
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)

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 The Production Function

The Role of the Manager in the

Production Process
• Produce output on the production 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: 𝑉𝑀𝑃𝐿 = 𝑤, where 𝑉𝑀𝑃𝐿 = 𝑃 × 𝑀𝑃𝐿
• 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 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.
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 The Production Function

Algebraic Forms of Production Functions

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

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 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: 𝑀𝑃𝐾 = 𝑎 and 𝑀𝑃𝐿 = 𝑏
𝑎𝐾+𝑏𝐿 𝑎𝐾+𝑏𝐿
• Average products: 𝐴𝑃𝐾 = and 𝐴𝑃𝐿 =
𝐾 𝐿
– Cobb-Douglas:
• Marginal products: 𝑀𝑃𝐾 = 𝑎𝐾 𝑎−1 𝐿𝑏 and 𝑀𝑃𝐿 =
𝑏𝐾 𝑎−1 𝐿𝑏
𝐾𝑎 𝐿𝑏 𝐾𝑎 𝐿𝑏
• Average products: 𝐴𝑃𝐾 = and 𝐴𝑃𝐿 =
𝐾 𝐿

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 The Production Function
Algebraic Measures of Productivity in
Action
• Suppose that a firm produces output
according to the production function
𝑄 = 𝐹 1, 𝐿 = 1 1Τ4 𝐿3Τ4
• Which is the fixed input?
– Capital is the fixed input.
• What is the marginal product of labor when
16 units of labor is hired?
3 −1 3 1
−4 3
𝑀𝑃𝐿 = 1 × 𝐿 4 = 1 × 16 =
4 4 8
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 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.
𝑀𝑃𝐿
𝑀𝑅𝑇𝑆𝐾𝑆 =
𝑀𝑃𝐾

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 The Production Function
Isoquants and Marginal Rate of
Technical
Capital Input
Substitution in Action

𝑄3 = 300 units of output

B
𝑄2 =200 units of output

𝑄𝐼 =100 units of output

0 Labor Input

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 The Production Function
Diminishing Marginal Rate of
Capital Input Technical Substitution
D
∆𝐾 3
Slope: = − 1 = −3 = −𝑀𝑅𝑇𝑆𝐾𝐿
∆𝐿
∆𝐾 =3

C
∆𝐾 1
Slope: = − 1 = −1 = −𝑀𝑅𝑇𝑆𝐾𝐿
B ∆𝐿

∆𝐾 = 1 A

𝑄0 =100 units

0 Labor Input
∆𝐿 = −1 ∆𝐿 = −1

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 The Production Function

Isocost and Changes in Isocost Lines

• Isocost
– Combination of inputs that yield cost the same cost.
𝑤𝐿 + 𝑟𝐾 = 𝐶
or, re-arranging to the intercept-slope formulation:
𝐶 𝑤
𝐾= − 𝐿
𝑟 𝑟
• 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

Isocosts
Capital Input

𝐶
𝑟
𝐶 𝑤
𝐾= − 𝐿
𝑟 𝑟

0 𝐿 𝐶
Labor Input
𝑤

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 The Production Function

Changes in the Isocosts

Capital Input
𝐶1
𝑟

𝐶0 More expensive input

𝑟 bundles

Less expensive input

bundles

0 𝐶0 𝐶1
Labor Input
𝑤 𝑤

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 The Production Function

Changes in the Isocost Line

Capital Input
𝐶
𝑟

Due to increase in wage rate

𝑤1 > 𝑤 0

𝐶 𝐶
0 Labor Input
𝑤1 𝑤0

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 The Production Function

Cost Minimization and the

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 input:
𝑀𝑃𝐿 𝑀𝑃𝐾
=
𝑤 𝑟
– Equivalently, a firm should employ inputs such that
the marginal rate of technical substitution equals the
ratio of input prices:
𝑀𝑃𝐿 𝑤
=
𝑀𝑃𝐾 𝑟
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 The Production Function

Cost-Minimization Input Rule in Action

Capital Input
𝐶1
𝑟

𝐶2 𝐴
𝑟
𝑤
𝑀𝑅𝑇𝑆𝐾𝐿 =
𝑟

𝑄𝐼 =100 units

0 𝐶2 𝐶1
Labor Input
𝑤 𝑤

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 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.

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 The Production Function

Optimal Input Substitution in Action

Capital Input
I

New cost-minimizing
point due to higher wage

F
B
𝐾2 Initial point of cost minimization

A
𝐾1
𝑄0
H J
0 𝐿2 𝐿1 G Labor Input

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 The Cost Function

The Cost Function

• Mathematical relationship that relates cost to the cost-
minimizing output associated with an isoquant.
• Short-run costs
– Fixed costs (𝑭𝑪): do not change with changes in output;
include the costs of fixed inputs used in production
– Sunk costs
– Variable costs [𝑽𝑪 𝑸 ]: costs that change with changes in
outputs; include the costs of inputs that vary with output
– Total costs: 𝑇𝐶 𝑄 = 𝐹𝐶 + 𝑉𝐶 𝑄
• Long-run costs
– All costs are variable
– No fixed costs

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 The Cost Function

Short-Run Costs
Total costs 𝑇𝐶 𝑄 = 𝐹𝐶 + 𝑉𝐶 𝑄
Variable costs
Fixed costs
𝑉𝐶 𝑄

𝐹𝐶

𝐹𝐶

𝐹𝐶

0 Output

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 The Cost Function

Average and Marginal Costs

• Average costs
𝐹𝐶
– Average fixed cost: 𝐴𝐹𝐶 =
𝑄
𝑉𝐶 𝑄
– Average variable costs: 𝐴𝑉𝐶 =
𝑄
𝐶 𝑄
– Average total cost: 𝐴𝑇𝐶 =
𝑄

• Marginal cost (MC)

– The (incremental) cost of producing an additional
unit of output.
∆𝐶
– 𝑀𝐶 =
∆𝑄
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 The Cost Function
The Relationship between Average
ATC, AVC, AFC
and Marginal Costs
and MC ($) 𝐴𝑇𝐶
𝑀𝐶 A𝑉𝐶

Minimum of ATC

Minimum of AVC
𝐴𝐹𝐶
0 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.

• 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

• 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

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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.

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 The Cost Function
Long-Run Average Cost
LRAC ($)
𝐴𝑇𝐶2
𝐴𝑇𝐶0 𝐿𝑅𝐴𝐶

𝐴𝑇𝐶1

0 𝑄∗ Output

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 The Cost Function

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.

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5-33
 The Cost Function

Economies and Diseconomies of Scale

LRAC ($)

𝐿𝑅𝐴𝐶

Economies of scale Diseconomies of scale

0 𝑄∗ Output

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 The Cost Function

Constant Returns to Scale

LRAC ($)

𝐴𝑇𝐶2 𝐴𝑇𝐶3
𝐴𝑇𝐶1

𝐿𝑅𝐴𝐶

0 Output

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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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 Multiple-Output Cost Function
Algebraic Form for a Multiproduct
Cost Function
2 2
𝐶 𝑄1, 𝑄2 = 𝑓 + 𝑎𝑄1𝑄2 + 𝑄1 + 𝑄2
• For this cost function:
MC1 = aQ2 + 2Q1
- When a < 0, an increase in Q2 reduces the marginal
cost of producing product 1.
- 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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