The Production Process and

Costs
 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
 Linear production function: inputs are
perfect substitutes.
Q  F K , L  aK  bL
 Leontief production function: inputs are
used in fixed proportions.
Q  F K , L  minbK , cL
 Cobb-Douglas production function: inputs
have a degree of substitutability.
 
Q  F K, L  K L
a b
 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
 Average Product of an Input: measure of
output produced per unit of input.
◦ Average Product of Labor: APL = Q/L.
 Measures the output of an “average” worker.
 Example: Q = F(K,L) = K.5 L.5
 If the inputs are K = 16 and L = 16, then the average
product of labor is APL = [(16) 0.5(16)0.5]/16 = 1.
◦ Average Product of Capital: APK = Q/K.
 Measures the output of an “average” unit of capital.
 Example: Q = F(K,L) = K.5 L.5
 If the inputs are K = 16 and L = 16, then the average
product of capital is APK = [(16)0.5(16)0.5]/16 = 1.
 Marginal Product on an Input: change in
total output attributable to the last unit
of an input.
◦ Marginal Product of Labor: MPL = DQ/DL
 Measures the output produced by the last worker.
 Slope of the short-run production function (with
respect to labor).
◦ Marginal Product of Capital: MPK = DQ/DK
 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).
Increasing, Diminishing and
Negative Marginal Returns

Q Increasing Diminishing Negative

Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
 Producing on the production function
◦ Aligning incentives to induce maximum worker
effort.
 Employing the right level of inputs
◦ When labor or capital vary in the short run, to
maximize profit a manager will hire
 labor until the value of marginal product of labor
equals the wage: VMPL = w, where VMPL = P x MPL.
 capital until the value of marginal product of capital
equals the rental rate: VMPK = r, where VMPK = P x MPK
.
 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.
 The rate at which two inputs are
substituted while maintaining the same
output level.
MPL
MRTS KL 
MPK
 Capital and labor K
are perfect Increasing
substitutes Output
◦ Q = aK + bL
◦ MRTSKL = b/a
◦ Linear isoquants imply
that inputs are
substituted at a
constant rate,
independent of the Q1 Q2 Q3
input levels employed. L
 Capital and labor are K
Q3
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
 Inputs are not perfectly K
substitutable. Q3
 Diminishing marginal Increasing
rate of technical Q2
Output
substitution. Q1
◦ As less of one input is
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
 The combinations of K New Isocost Line
inputs that produce a associated with higher
given level of output at C1/r costs (C0 < C1).
the same cost:
wL + rK = C C0/r

 Rearranging,
C0 C1
K= (1/r)C - (w/r)L C0/w C1/w L
 For given input prices, K
isocosts farther from the New Isocost Line for
origin are associated with C/r a decrease in the
higher costs. wage (price of labor:
w0 > w1).
 Changes in input prices
change the slope of the
isocost line.
L
C/w0 C/w1
 Marginal product per dollar spent should be
equal for all inputs:
MPL MPK MPL w
  
w r MPK r
 But, this is just
w
MRTS KL 
r
 K

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

L
 A firm initially
produces Q0 by
employing the K
combination of
inputs represented
by point A at a cost
of C0.
 Suppose w0 falls to A
w1. K0
◦ The isocost curve rotates
counterclockwise; which B
represents the same cost level K1
prior to the wage change.
◦ To produce the same level of
output, Q0, the firm will
produce on a lower isocost line Q0
(C1) at a point B.
◦ The slope of the new isocost
line represents the lower wage
relative to the rental rate of
capital. 0 L0 L1 C0/w0 C1/w1 C0/w1 L
 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
 Total and Variable Costs
C(Q): Minimum total cost zł

of producing alternative C(Q) = VC + FC

levels of output:
VC(Q)

C(Q) = VC(Q) + FC
VC(Q): Costs that vary
with output. FC

FC: Costs that do not vary

0 Q
with output.
 Fixed and Sunk Costs
FC: Costs that do not change as output zł
changes.
C(Q) = VC + FC
Sunk Cost: A cost that is forever lost after
it has been paid.
VC(Q)
Decision makers should ignore sunk costs
to maximize profit or minimize losses

FC

Q
 Some Definitions
Average Total Cost
ATC = AVC + AFC zł
ATC = C(Q)/Q MC ATC
AVC
Average Variable Cost
AVC = VC(Q)/Q

Average Fixed Cost

AFC = FC/Q MR
Marginal Cost
MC = DC/DQ

AFC

Q
 Fixed Cost
Q0(ATC-AVC)
MC
zł
= Q0 AFC ATC

= Q0(FC/ Q0) AVC

= FC
ATC
AFC Fixed Cost
AVC

Q0 Q
 Variable Cost
Q0AVC MC
zł
ATC
= Q0[VC(Q0)/ Q0]
AVC
= VC(Q0)

AVC
Variable Cost Minimum of AVC

Q0 Q
 Total Cost
Q0ATC
MC
zł
= Q0[C(Q0)/ Q0] ATC

AVC
= C(Q0)

ATC

Total Cost Minimum of ATC

Q0 Q
 C(Q) = f + a Q + b Q2 + cQ3
 Marginal Cost?
◦ Memorize:
MC(Q) = a + 2bQ + 3cQ2
◦ Calculus:
dC/dQ = a + 2bQ + 3cQ2
◦ 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
 Long-Run Average Costs
zł

LRAC

Economies Diseconomies
of Scale of Scale

Q* Q
 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.
 The marginal cost of producing good 1
declines as more of good two is produced:

DMC1Q1,Q2) /DQ2 < 0.

 Example:
◦ Cow hides and steaks.
 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.
1. The engineers at Morris Industries obtained
the following estimate of the firm’s
production function: Q=F(K, L)=min {3K, 4L}
How much output is produced when 2 units of
labor and 5 units of capital are employed?
2. A firm produces output that can be sold at a
price of $10. The production function is given
by: Q=F(K, L)=K0,5L0,5. If capital is fixed at 1
unit in the short run, how much labor should
the firm employ to maximize profits if the
wage rate is $2?
3. Temporary Services uses four word processors and two
typewriters to produce reports. The marginal product of a
typewriter is 50 pages per day, and the marginal product
of a word processor is 500 pages per day. The rental price
of a typewriter is $1 per day, whereas the rental price of a
word processor is $50 per day. Is Temporary Services
utilizing typewriters and word processors in a cost-
minimizing manner?
4. ACME Coal paid $5 000 to lease a railcar from the
Reading Railroad. Under the terms of the lease, $1,000 of
this payment is refundable if the railcar is returned within
two days of signing the lease.
a) Upon signing the lease and paying $5,000, how large are
ACME’s fixed costs? Its sunk costs?
b) One day after signing the lease, ACME realizes that it has
no use for the railcar. A farmer has a bumper crop of corn
and has offered to sublease the railcar from ACME at a
price of $4,500. Should ACME accept the farmer’s offer?
5. The cost function for Managerial Enterprises is given
by C(Q) = 20 + 3Q2. Determine the marginal cost,
average fixed cost, average variable cost, and average
total cost when Q=10.
6. Suppose the cost function of firm A, which produces
two goods, is given by: C =100- 0,5Q1Q2+Q12 + Q22
The firm wishes to produce 5 units of good 1 and 4
units of good 2.
a) Do cost complementarities exist? Do economies of
scope exist?
b) Firm A is considering selling the subsidiary that
produces good 2 to firm B, in which case it will
produce only good 1. What will happen to firm A’s
costs if it continues to produce 5 units of good 1?