Let us now see the supply side of the market

How firms make optimal decisions and how their cost

of production changes with changes in input factor
prices and output?
Theory of Production and Cost What is a firm?
A firm is an organization producing goods or services.
Firm is assumed to maximize its goal (profits/social
welfare).
- Firms operate in a market.
Dr. Sanjay K. Singh What is a market?
Indian Institute of Management Lucknow A collection of buyers and sellers organized for the
purpose of exchanging goods and services for money.
Markets can be global, national, regional, or local
1 depending upon the item being bought and sold. 2

Economic Profits
Profit Maximization
Economic profits are the difference between total
revenue and total costs.
profit = total revenue - total cost
Economic total costs include the opportunity costs of
total revenue: all inputs to the production processin particular, the
determined by the level and nature of opportunity costs of the owners time and physical
competition in your market capital (equipment and space).

total cost: Whenever we talk about profit we mean economic

profit [= total revenue (explicit + implicit costs)]
costs are determined by input factor prices
and the firms technology or production Accounting Profits
function
Accounting profits are defined as total revenue minus
explicit costs.
3 4

Economic Profit versus Accounting Profit Production and Cost Structures

How an Economist How an Accountant
Views a Firm Views a Firm There are lots of ways to describe
production and costs.
Economic
profit You need to understand them all.
Accounting
profit For example:
Implicit
Revenue costs
Revenue total, fixed and variable concepts
Total
opportunity
average and marginal concepts
costs
Explicit Explicit long run and short run concepts
costs costs
all related to each other
5 6

1
 Production Technology
Production Theory
A technology is a process by which inputs (e.g.
Production Technology (describes how inputs labor and capital) are converted into output.
can be transformed into outputs) The simplest way to describe the technology of a
firm/industry is the production function.
Cost Constraints The production function states the maximum
amount of output possible from an input bundle.
Input Choices

y = f(x1, x2, , xn)

7 8

Production Function Technology Set or Production Set

Let us start with simple one input case One input case
Output Level Output Level y = f(x) is the production
y = f(x) is the production function i.e.,
y boundary of production set is production fn function.

y
y
y = f(x) is the maximum output level But, y = f(x) is the maximum output
obtainable from x input units. level obtainable from x input units.


y y = f(x) is an output level that

Production set (technology set): the set of all combination of is feasible from x input units.

inputs andoutputs that are technologically feasible

x Input Level x x x
9 Input Level 10

Technology Set or Production Set Technology: Multiple Inputs

One input case What does a technology look like when there
Output Level is more than one input?
The two input case: Input levels are x1 and
Technically x2. Output level is y.
y efficient plans
The technology
y = f ( x1 , x2 ) = 2 x11/ 3 x21/ 3
y Technically set Examples of more than two inputs
inefficient y = f(x1,x2,,xn)
plans (y1,y2,..,ym)= f(x1,x2,,xn)
Y=f(X)
x x
Input Level 11 12

2
 The Technology of Production Production: One Variable Input

Short Run versus Long Run We will begin looking at the short run when only
one input can be varied
Short Run
Period of time in which quantities of one or We assume capital is fixed and labor is variable
more factor inputs cannot be changed Output can only be increased by increasing labor
These inputs are called fixed inputs Must know how output changes as the amount of
Long Run labor is changed

Amount of time needed to make all production

inputs variable

13 14

Production: One Variable Input Total Product, Average Product, and

Observations: Marginal Product
1. When labor is zero,
In case of multiple inputs, when all inputs are kept fixed except
output is zero as well
2. With additional workers,
one (say labor), then
output (q) increases up Total output for given labor input is TP.
to 8 units of labor TP/total labor input is AP of labor.
3. Beyond this point, Extra output when one unit of labor unit is increased is
output declines marginal product of labor.
Increasing labor can
make better use of
existing capital initially
After a point, more
labor is not useful and
can be
counterproductive

15 16

The Slopes of the Product Curve The Slopes of the Product Curve

PRODUCTION WITH PRODUCTION WITH

ONE VARIABLE INPUT ONE VARIABLE INPUT
The total product curve in (a) shows To the left of point E in (b), the
the output produced for different marginal product is above the average
amounts of labor input. product and the average is increasing;
The average and marginal products in to the right of E, the marginal product
(b) can be obtained (using the data) is below the average product and the
from the total product curve. average is decreasing.

At point A in (a), the marginal product As a result, E represents the point at

is 20 because the tangent to the total which the average and marginal
product curve has a slope of 20. products are equal, when the average
product reaches its maximum.
At point B in (a) the average product
of labor is 20, which is the slope of the At D, when total output is maximized,
line from the origin to B. 20
the slope of the tangent to the total 20
product curve is 0, as is the marginal
The average product of labor at point product.
C in (a) is given by the slope of the
line 0C.

3
The Average Product of Labor Curve The Law of Diminishing Marginal Returns

In general, the average product of labor is given by the law of diminishing marginal returns Principle that as the use of
slope of the line drawn from the origin to the corresponding point on the total an input increases with other inputs fixed, the resulting additions to output will
product curve. eventually decrease.

The Marginal Product of Labor Curve

In general, the marginal product of labor at a point is given by the slope of the THE EFFECT OF TECHNOLOGICAL
total product at that point. IMPROVEMENT
Labor productivity (output per unit of
THE RELATIONSHIP BETWEEN THE AVERAGE AND MARGINAL labor) can increase if there are
PRODUCTS improvements in technology, even
though any given production process
Note the graphical relationship between average and marginal products. When exhibits diminishing returns to labor.
the marginal product of labor is greater than the average product, the average As we move from point A on curve O1
product of labor increases. to B on curve O2 to C on curve O3 over
time, labor productivity increases.
At C, the average and marginal products of labor are equal.
Finally, as we move beyond C toward D, the marginal product falls below the
average product. You can check that the slope of the tangent to the total
product curve at any point between C and D is lower than the slope of the line
from the origin.

A PRODUCTION FUNCTION FOR HEALTH CARE MALTHUS AND THE FOOD CRISIS
Health care exp. to GDP ratio in the US (15%), Political economist Thomas Malthus INDEX OF WORLD FOOD
France/Germany (11%), Japan/UK (8%), PRODUCTION PER CAPITA
(1766 -1834) predicted mass hunger
Do increases in health care expenditures
reflect increases in output? and starvation as diminishing returns YEAR INDEX
will limit agricultural output and the 1948-52 100
The US is relatively wealthy, and it is natural for population will continue to grow
consumer preferences to shift toward more 1961 115
Why did Malthus prediction fail?
health care as incomes grow. However, it may 1965 119
be that the production of health care in the
Did not take into account changes in
United States is inefficient. technology 1970 124
Although he was right about 1975 125
A PRODUCTION FUNCTION FOR diminishing marginal returns to labor 1980 127
HEALTH CARE Over the past century, technological
1985 134
Additional expenditures on health care improvements have dramatically altered
(inputs) increase life expectancy food production in most countries 1990 135
(output) along the production frontier. (including developing countries, such as 1995 135
Points A, B, and C represent points at India). As a result, the average product of
labor and total food output have 2000 144
which inputs are efficiently utilized,
although there are diminishing returns increased. 2005 151
when moving from B to C. Hunger remains a severe problem in some 2009 155
Point D is a point of input inefficiency. areas, in part because of the low
productivity of labor there.

MALTHUS AND THE FOOD CRISIS

Production with Two Variable Inputs
Isoquants
isoquants Curve showing all possible combinations of inputs that yield the
same output.

PRODUCTION WITH TWO VARIABLE INPUTS

LABOR INPUT
CAPITAL INPUT 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

CEREAL YIELDS AND THE WORLD PRICE OF FOOD ISOQUANT MAP

Cereal yields have increased. The average world price of food increased isoquant map Graph combining a number of isoquants, used to describe a
temporarily in the early 1970s but has declined since. production function.

4
 Isoquant Map
PRODUCTION WITH TWO
VARIABLE INPUTS
Output increases as we move E
Capital 5
from isoquant q1 (at which 55 Ex: 55 units of output
units per year are produced at can be produced with
points such as A and D), 3K & 1L (pt. A)
to isoquant q2 (75 units per year
4 OR
at points such as B), and 1K & 3L (pt. D)
to isoquant q3 (90 units per year
at points such as C and E).
3
A B C

2
q3 = 90
By drawing a horizontal line at a particular level of capitalsay 3, we can observe D q2 = 75
1
diminishing marginal returns. Reading the levels of output from each isoquant as
labor is increased, we note that each additional unit of labor generates less and q1 = 55
less additional output. 1 2 3 4 5 Labor
26

Properties
Y/
K>0, 2Y/ K2<0; Y/
L>0, 2Y/ L2<0 Production: Two Variable Inputs
Diminishing Marginal Product
Substituting Among Inputs
Capital 5
Increasing labor
holding capital Slope of the isoquant shows how one input can
4
constant (A, B, C) be substituted by the other without changing the
OR
Increasing capital level of output.
holding labor constant
3
A B (E, D, C) The (negative of the) slope of the isoquant = the
C
marginal rate of technical substitution (MRTS) =
D
2 the technical rate of substitution (TRS).
q3 = 90
Amount by which the quantity of one input can be
1 E q2 = 75
reduced when one extra unit of another input is
q1 = 55
used, so that output remains constant.
1 2 3 4 5 Labor
27 28

Marginal Rate of Technical Substitution

Technical Rate-of-Substitution or
The slope is the rate at which input 2 Technical Rate of Substitution
x2 must be given up as input 1s level is Capital 5
MRTS decreases as labor
Capital increased so as not to change the increases (diminishing MRTS)
2 Diminishing MRTS occurs
output level. 4
because of diminishing returns
Change in Capital Input
TRS = 1
MRTS and marginal products
Change in Labor Input interrelated
x'2 TRS = K (for a fixed level of q )
3

L 1
1
2
Q3 =90
100
y100 2/3 1
1/3 Q2 =75
1 1
x'1
Labor x1 Q1 =55
1 2 3 4 5 Labor
29 30

5
 MRTS or TRS MRTS or TRS
y y
dy = dx1 + dx .
How is a technical rate-of-substitution x1 x2 2
computed?
The production function is y = f ( x1 , x 2 ). Along an individual isoquant, dy = 0,
A small change (dx1, dx2) in the input therefore the changes dx1 and dx2 must
bundle causes a change to the output satisfy the following,
level of
y y y y
dy = dx1 + dx 2 . 0= dx1 + dx .
x1 x2 x1 x2 2
31 32

MRTS or TRS Isoquants: Special Cases

y y
0= dx1 + dx 2 Two extreme cases show the possible
x1 x2
range of input substitution in production
which rearranges to
1. Perfect substitutes
y y
dx 2 = dx1 MRTS is constant at all points on isoquant
x2 x1 Same output can be produced with a lot of
capital or a lot of labor or a balanced mix
dx2 y / x1 MP
or = = 1
dx1 y / x2 MP2
MP1
TRS =
MP2 33 34

Perfect Substitutes Isoquants: Special Cases

Capital
per A
Same output can be
2. Perfect Complements
month reached with mostly Fixed proportions production function
capital or mostly labor
(A or C) or with equal There is no substitution available between
amount of both (B)
B inputs
The output can be made with only a specific
proportion of capital and labor
C
Cannot increase output unless increase both
capital and labor in that specific proportion
Q1 Q2 Q3
Labor
per month
35 36

6
 Fixed-Proportions
Production Function
Returns-to-Scale
Capital
per Same output can Marginal product describe the change in
only be produced
month
with one set of output level as a single input level
inputs. changes. (Short-run)
Q3 Returns-to-scale describes how the output
C
Q2
level changes as all input levels change,
B e.g. all input levels doubled. (Long-run)
K1 Q1
A

Labor
per month
L1 37 38

Returns-to-Scale Returns-to-Scale
If, for any input bundle (x1,,xn), One input
Output Level
f (tx1 , tx2 ,L, txn ) = t. f ( x1 , x2 ,L, xn ) y = f(x)
2y
then the technology described by the
production function f exhibits constant Constant
returns-to-scale, e.g. doubling all input y returns-to-scale
levels doubles the output level (t=2).

x 2x x
39 Input Level 40

Returns-to-Scale Returns-to-Scale
If, for any input bundle (x1,,xn), One input
Output Level
f (tx1 , tx2 ,L, txn ) < tf ( x1 , x2 ,L, xn )
2f(x) y = f(x)
then the technology exhibits decreasing f(2x)
Decreasing
returns-to-scale, e.g. doubling all input
f(x) returns-to-scale
levels less than doubles the output level
(t=2).

x 2x x
41 Input Level 42

7
 Returns-to-Scale Returns-to-Scale
One input
If, for any input bundle (x1,,xn),
Output Level
f (tx1 , tx2 ,L, txn ) > tf ( x1 , x2 ,L, xn ) Increasing y = f(x)
then the technology exhibits increasing returns-to-scale
returns-to-scale, e.g. doubling all input f(2x)
levels more than doubles the output level
(t=2). 2f(x)
f(x)

x 2x x
43 Input Level 44

RTS for Perfect Substitutes ? RTS for Perfect Complements ?

Constant Returns to Scale: Show Constant Returns to Scale: Show

Y = Min {aL, bK}

K K

Y=aK + bL
Y=Y1
Y=Yo

L L
45 46

RTS for Cobb-Douglas ?

Returns to scale depends on the value of
(+ )
Y=AKL Cost Constraint / Isocost Line
K

Y=Y1
Y=Yo

L
47 48

8
 COST CONSTRAINT COST CONSTRAINT
C= wL + rK Represents societys
(-) w/r willingness to trade the
w: wage rate (including fringe benefits, K factors of production
holidays, etc)
C/r
r: rental rate of capital C=wL+rK
Rearranging:
K=C/r-(w/r)L Slope of the
isocost =
K/L= K/
L
C/w L = (-) w/r
49 50

EQUILIBRIUM EQUILIBRIUM
We can either
Minimise cost subject to K
Y =Y Y
or
e
Maximise output subject to C = wL + rK
C =C
L
51 52

EQUILIBRIUM IN EQUILIBRIUM
Lagrangian method
Slope of isoquant = Slope of isocost
Minimise cost subject to output
L* = wL + rK + (Y f (K , L )) MRTS = (-) w/r
or
or
MPL/MPK = w/r
Maximise output subject to costs
(condition for optimal outcome)
L* = f ( L, K ) + (C wL + rL )
53 54

9
 An Example Answer
Given the output and input factor prices, firm will
Consider the Beiswanger Company, a small firm
maximize profit iff MPE/PE = MPT/PT
engaged in engineering analysis. Beiswangers
Where MPE = marginal product of an engineer, MPT
president has determined that the firms output = marginal product of a technician, PE = wage of an
per month (Q) is related in the following way to engineer, and PT = wage of a technician.
the number of engineers used (E) and the Since, MPE = 20-2E, MPT = 12-T, PE = 40000, and
number of technicians used (T): PT = 20000.
Q = 20 E E2 + 12 T 0.5 T2. Hence, 20 2E = 2 (12 T). That is, 10 E =
12 T
The monthly wage of an engineer is Rs 40,000/-
So, E + 2 = T --------------------------(1)
and the monthly wage of a technician is Rs
Since, 40000E + 20000T = 280000 --------------(2)
20,000/-. If Beiswanger allots Rs 2,80,000/- per Hence, 4E + 2 (E + 2) = 28; so, 6E = 24
month for the total combined wages of engineers E = 4 and T = 6.
and technicians, how many engineers and Thus, Beiswanger should hire 4 engineers and 6 56
55
technicians should it hire? technicians.

Measuring Cost

Some costs vary with output, while some

remain the same
The Cost of Production Total cost can be divided into:
1. Fixed Cost
Does not vary with the level of output
Some fixed costs are sunk cost (which
cannot be recovered)
2. Variable Cost
Cost that varies as output varies
57 58

Fixed and Variable Costs Fixed and Variable Costs

Total output is a function of variable inputs and Which costs are variable and which are fixed
fixed inputs depends on the time horizon
Therefore, the total cost of production equals the Short time horizon most costs are fixed
fixed cost (the cost of the fixed inputs) plus the
variable cost (the cost of the variable inputs), Long time horizon many costs become
or variable

TC = FC + VC In determining how changes in production will

affect costs, must consider if fixed or variable
costs are affected.

59 60

10
 Industry Example Marginal and Average Cost
Personal Computers
Marginal Cost (MC):
Most costs are variable
The cost of expanding output by one unit
Because computers are very similar, competition is
intense, and profitability depends on the ability to keep Fixed costs have no impact on marginal cost, so it
costs down. Most important are the cost of components can be written as:
and labor.

Software VC TC VC TC
MC = = (or MC = = )
Most costs are fixed
q q q q
A software firm will spend a large amount of money to
develop a new application. The company can recoup its
investment by selling as many copies of the program as
possible.
61 62

A Firms FC, VC, TC, MC, AFC, AVC, and ATC

Average Cost (in the Short Run some cost is fixed cost)

Average Total Cost (ATC)

Cost per unit of output
Also equals average fixed cost (AFC) plus
average variable cost (AVC)
TC TFC TVC
ATC = = +
q q q

TC
ATC = = AFC + AVC
q 63 64

Determinants of Short Run Cost Determinants of Short Run Cost

Can marginal product of labor (variable input) Remembering that
determine the marginal cost of production? Q
MPL =
Yes. L
Assume that the wage rate (w) is fixed. L 1
Then, marginal cost of production would be: =
Q MPL
VC wL
VC wL Since MC =
Q
=
Q
MC = =
Q Q w
Hence MC =
MP L
65 a low marginal product (MPL) leads to a high marginal
66
cost (MC) and vice versa.

11
 The Shapes of the Cost Curves
Determinants of Short Run Costs
Consequently (from the table):
MC decreases initially (since MPL is increasing) COST CURVES FOR A FIRM
0 through 4 units of output In (a) total cost TC is the
MC increases afterwards (since MPL is decreasing) vertical sum of fixed cost FC
and variable cost VC.
5 through 11 units of output In (b) average total cost ATC
is the sum of average variable
cost AVC and average fixed
cost AFC.
Marginal cost MC crosses the
average variable cost and
average total cost curves at
their minimum points.

67

Relationship between Marginal and The Relationship between Productivity and

AC
Average Costs Costs
The shapes of the cost curves are mirror images of the
shapes of the corresponding productivity curves
AC MP and MC curves are mirror images of each other
AP and AVC curves are mirror images of each other
MC
$18 9
16 MC 8
14 7

Output per worker

AC is minimum when MC=AC.
Costs per unit

Why do these curves behave in 12 AVC 6 A

ACop this way? 10 5
See, d ( AC ) = d ( C ) = MC AC 8 4 AP of
dY dY Y Y
6 3 workers
When MC>AC, AC will increase. 4 2
When MC<AC, AC will decrease. 2 1 MP of workers
0 4 8 12 16 20 24 Output 0 4 8 12 16 20 24 Output
O Yop Output 69 70

Long Run Cost Curves Linking Short Run and Long Run Costs
In the short run, some costs are fixed Long-run average cost curve is nothing but lower envelope of
the set of all possible short-run average cost curves.
In the long run, firm can change anything Remember, in the short-run, firm cannot change the plant size
including plant size, production technology but in the long-run, it can opt for best of the short-runs.
Can produce at a lower average cost in the long
run than in the short run
Capital and labor are both flexible

71 72

12
 A Typical Long-Run Average Cost Curve Example: 3 Potential Technologies
Suppose there
Long Run Cost Curves
are three Firm A (Capital investment A) Firm B (Capital Investment B) Firm C (Capital Investment C)
different ways
for a company, Firm A Marginal Firm B Marginal Firm C Marginal
$64 System-fixer, to
Average Cost Average Cost Average Cost
Total Total (midpoint Total Total (midpoint Total Total (midpoint
62 do business. Quantity
0
Costs
80
Cost formula) Quantity Costs
0 160
Cost formula) Quantity Costs
0 240
Cost formula)

60 Firm sizes A, B
Costs per unit

1 100 100.00 15.00 1 161 161.00 1.50 1 250 250.00 7.50

LRAC and C illustrate 2 110 55.00 10.50 2 163 81.50 2.50 2 255 127.50 6.00
58 the possibilities. 3
4
121
137
40.33
34.25
13.50
22.00
3
4
166
169
55.33
42.25
3.00
4.00
3
4
262
268
87.33
67.00
6.50
6.00
56 Minimum efficient Firm A is small, 5
6
165
203
33.00
33.83
33.00
46.50
5
6
174
180
34.80
30.00
5.50
7.00
5
6
274
280
54.80
46.67
6.00
6.50
using only $80
54 level of production in fixed costs.
7
8
258
333
36.86
41.63
65.00
90.00
7
8
188
208
26.86
26.00
14.00
26.00
7
8
287
295
41.00
36.88
7.50
8.50

52 Firm B uses 10
9 438
578
48.67
57.80
122.50
10
9 240
308
26.67
30.80
50.00
84.00 10
9 304
315
33.78
31.50
10.00
13.00
twice the
50 capital.
11
12
11
12
408
558
37.09
46.50
125.00 11
12
330
375
30.00
31.25
30.00
52.50
13 13 13 435 33.46 80.00
48 Firm C uses 14 14 14 535 38.21 140.00
three times the 15 15 15 715 47.67
11 12 13 14 15 16 17 18 19 20 Quantity capital.

73 74

Question Answer
What is the best technology for our It depends on how much System-fixer
system-fixer firm? expects to produce and sell in the market.

75 76

The Firms Long Run Average Total Cost Curve How to compute returns to scale from cost curves?
Rs. Ratio of AC to
1
MC. 1 1 1
ln C C / C C / Q MC AC
Long Run Average Total Cost RTS= ln Q = = C / Q = AC = MC
Q / Q
The firms long run average 60.00

total cost curve consists of

the minimum of the three 50.00
MC
curves illustrated on the right. AC
Increasing Returns to Scale Decreasing Returns to Scale
System-fixers long run 40.00
Cost (dollars/installation)

average total cost curve is

size As (blue) until 6 units, 30.00

size Bs (red) from 6 to 10 Constant Returns to Scale If RTS>1, IRS

units and size Cs (brown) If RTS=1, CRS
20.00 Firm A Average Total Cost
If RTS<1, DRS
from 11 units onward. Minimum Average Total Cost
Firm B Average Total Cost
Minimum Average Total Cost
Firm C Average Total Cost
The lratc is the outer 10.00 Minimum Average Total Cost

envelope of the possible sratc

curves. 0.00
0 1 2 3 4 5 6 7 8 9 10
Quantity (installations/week)
11 12 13
77 14 15
O Output
78

13
 Rs. If Price = MC of production, social welfare is
Why information about RTS is important? maximized.
But MC pricing under IRTS gives rise to financial
During the year 20015-16, every bus-km operated by deficits.
urban bus companies in India resulted a loss of Rs. 25/-.
Is it socially optimal? MC AC
Yes/No depending upon the technical characteristics of
the industry and fare rates.
E C
Social Welfare = Consumer Surplus + Producer Surplus (or
Profit if fixed cost is zero) P B
Consumer Surplus = difference between the willingness to
pay and the actual amount paid Demand
Producer Surplus = difference between total revenue and
total variable cost
79 O A Output 80

Rs. MC PRICING UNDER DRTS GIVES

RISE TO FINANCIAL SURPLUS Question:
Let for a firm, cost function is as follows:
lnC = 1.5 +1.2lnY + 0.4lnW l + 0.3lnW d + 0.3lnW b
MC
What does it reveal about RTS?
Suppose coefficient of lnY is 1.0 or 0.8. Does it reveal
E something else about the technology of this firm?
C AC
Why should sum of coefficients of lnW i be one?
P B
What will happen to cost if labor price increased by
10%,
Demand
diesel prices increased by 5% and bus prices by just
2%?

Total cost of production for the same level of output will

be increased by 6.1%. How?
O A Output 81 82

Production with Two Outputs Production with Two Outputs

Economies of Scope Economies of Scope
Many firms produce more than one product and those The degree of economies of scope (SC) can be measured
products are usually closely linked by percentage of cost saved producing two or more products
jointly:
Firms experience economies of scope if it is cost C(q 1 ) + C(q 2 ) C(q 1 , q 2 )
effective to produce more than one product SC =
C(q 1 , q 2 )
Examples:
Chicken farm--poultry and eggs C(q1) is the cost of producing q1
Automobile company--cars and trucks C(q2) is the cost of producing q2
University--teaching and research/consultancy
C(q1,q2) is the joint cost of producing both products
Interpretation:
Advantages
Both use capital and labor
If SC > 0 Economies of scope
The firms share management resources If SC < 0 Diseconomies of scope
Both use the same labor skills and types of machinery The greater the value of SC, the greater the economies of
83
scope 84

14
 Dynamic Changes in Costs Graphing the Learning Curve
The Learning Curve
THE LEARNING CURVE
As management and labor gain experience with production, the firms
marginal and average costs of producing a given level of output fall for four A firms production cost may
reasons: fall over time as managers
and workers become more
1. Workers often take longer time to accomplish a given task the first few experienced and more
times they do it. As they become more adept, their speed increases. effective at using the
available plant and
2. Managers learn to schedule the production process more effectively, equipment.
from the flow of materials to the organization of the manufacturing itself. The learning curve shows the
extent to which hours of
3. Engineers who are initially cautious in their product designs may gain labor needed per unit of
enough experience to be able to allow for tolerances in design that save output fall as the cumulative
costs without increasing defects. Better and more specialized tools and output increases.
plant organization may also lower cost.
4. Suppliers may learn how to process required materials more effectively
and pass on some of this advantage in the form of lower costs.
The learning curve is based on the relationship
learning curve Graph relating amount of inputs needed by a firm to
produce each unit of output to its cumulative output. where N is the cumulative units of output produced, L is the labor input per unit of
output, and is between 0 and 1. The larger is, the more important the learning
effect.

Learning versus Economies of Scale

A firm producing machine tools knows that its labor requirement per
machine for the first 10 machines is 1.0, the minimum labor requirement
A is equal to zero, and is approximately equal to 0.32. Total labor
requirement for producing 80 machines is

PREDICTING THE LABOR REQUIREMENTS OF PRODUCING A GIVEN OUTPUT

ECONOMIES OF SCALE
VERSUS LEARNING PER-UNIT LABOR
CUMULATIVE OUTPUT
A firms average cost of REQUIREMENT FOR EACH 10 TOTAL LABOR REQUIREMENT
(N)
UNITS OF OUTPUT (L)*
production can decline over
time because of growth of 10 1.00 10.0
sales when increasing returns 20 .80 18.0 = (10.0 + 8.0)
are present (a move from A to
30 .70 25.0 = (18.0 + 7.0)
B on curve AC1),
40 .64 31.4 = (25.0 + 6.4)
or it can decline because
there is a learning curve (a 50 .60 37.4 = (31.4 + 6.0)
move from A on curve AC1 to 60 .56 43.0 = (37.4 + 5.6)
C on curve AC2). 70 .53 48.3 = (43.0 + 5.3)
80 .51 53.4 = (48.3 + 5.1)
*The numbers in this column were calculated from the equation log(L) = 0.322 log(N/10),
where L is the unit labor input and N is cumulative output.

THE LEARNING CURVE IN PRACTICE

Estimating and Predicting Cost
Learning-curve effects can be important in
determining the shape of long-run cost curves and cost function Function relating cost of production to level of output
can thus help guide management decisions. and other variables that the firm can control.
Managers can use learning-curve information to
decide whether a production operation is profitable
and, if so, how to plan how large the plant operation VARIABLE COST CURVE
and the volume of cumulative output need be to FOR THE AUTOMOBILE
generate a positive cash flow. INDUSTRY
An empirical estimate of the
variable cost curve can be
LEARNING CURVE FOR obtained by using data for
AIRBUS INDUSTRIE individual firms in an
The learning curve relates the industry.
labor requirement per aircraft The variable cost curve for
to the cumulative number of automobile production is
aircraft produced. obtained by determining
As the production process statistically the curve that
becomes better organized and best fits the points that
workers gain familiarity with relate the output of each
their jobs, labor requirements firm to the firms variable
fall dramatically. cost of production.

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 Cost Functions and the Measurement of Scale Economies
The scale economies index (SCI) provides an index of whether or not
To predict cost accurately, we must determine the underlying there are scale economies.
relationship between variable cost and output. The curve provides a reasonably
close fit to the cost data. SCI is defined as follows:

But what shape is the most appropriate, and how do we represent that shape
algebraically?
Here is one cost function that we might choose:

If we wish to allow for a U-shaped average cost curve and a marginal

cost that is not constant, we must use a more complex cost function.
One possibility is the quadratic cost function, which relates variable cost
to output and output squared:

If the marginal cost curve is not linear, we might use a cubic cost function:
CUBIC COST FUNCTION
A cubic cost function implies that the average and the marginal cost curves are
U-shaped.

COST FUNCTIONS FOR ELECTRIC POWER COST FUNCTIONS FOR ELECTRIC POWER

In 1955, consumers bought 369 billion kilowatt-hours

(kwh) of electricity; in 1970 they bought 1083 billion.
Was this increase due to economies of scale or to other
factors? AVERAGE COST OF
PRODUCTION IN THE
If it was the result of economies of scale, it would be ELECTRIC POWER
economically inefficient for regulators to break up INDUSTRY
electric utility monopolies.
The average cost of electric
The cost of electric power was estimated by using a cost function that is power in 1955 achieved a
somewhat more sophisticated than the quadratic and cubic functions discussed minimum at approximately
20 billion kilowatt-hours.
earlier.
By 1970 the average cost
Table shows the resulting estimates of the scale economies index. The results of production had fallen
are based on a classification of all utilities into five size categories, with the sharply and achieved a
median output (measured in kilowatt-hours) in each category listed. minimum at an output of
more than 33 billion
SCALE ECONOMIES IN THE ELECTRIC POWER INDUSTRY kilowatt-hours.

Output (million kwh) 43 338 1109 2226 5819

Value of SCI, 1955 .41 .26 .16 .10 .04

THANKS

95

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