Managerial Economics & Business Strategy: The Production Process and Costs
Managerial Economics & Business Strategy: The Production Process and Costs
Managerial Economics & Business Strategy: The Production Process and Costs
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
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
Example: Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 16, then the average
Example: Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 16, then the average
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
Q Increasin DiminishingNegative
g Marginal Marginal
Marginal Returns Returns
Returns
Q=F(K,L)
AP
L
MP
5-9
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)
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
Cost Minimization
K
Point of
Slope of Isocost Cost
=
Slope of Isoquant Minimizatio
n
L
5-23
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
Some Definitions
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
Q0AVC MC
$
ATC
= Q0[VC(Q0)/ Q0]
AVC
= VC(Q0)
AVC
Variable Cost Minimum of AVC
Q0 Q
5-30
Total Cost
Q0ATC
MC
$
= Q0[C(Q0)/ Q0] ATC
= C(Q0)
AVC
ATC
Q0 Q
5-31
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
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:
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.