Session – 05

The Production Process

and Costs

Dr. Ir. Fajar Sasongko, MM., M.Kom

SEKOLAH TINGGI ILMU EKONOMI GANESHA

YAYASAN PENDIDIKAN GRAHA GANESHA
Jl. Legoso Raya No. 31, Pisangan, Kecamatan Ciputat Timur
Tangerang Selatan – Banten
• Explain alternative ways of measuring the productivity of
inputs and the role of the manager in the production
process.
• Calculate input demand and the cost minimizing
combination of inputs and use isoquant analysis to
illustrate optimal input substitution.
• Calculate a cost function from a production function and
explain how economic costs differ from accounting costs.
• Explain the difference between and the economic
relevance of fixed costs, sunk costs, variable costs, and
marginal costs.
• Calculate average and marginal costs from algebraic or
tabular cost data and illustrate the relationship between
average and marginal costs.
• Distinguish between short-run and long run production
decisions and illustrate their impact on costs and
economies of scale.
• Conclude whether a multiple-output production process
exhibits economies of scope or cost complementarities
and explain their significance for managerial decisions.
 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
III. Multi-Product Cost Functions
 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
Production Function Algebraic
Forms
• 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
 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
 Productivity Measures: Average
Product of an Input
• 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.
Example: Production Function
 Productivity Measures: Marginal
Product of an Input
• Marginal Product on an Input: change in total
output attributable to the last unit of an input.
• Marginal Product of Labor: MPL = ∆Q/∆L
• Measures the output produced by the last worker.
• Slope of the short-run production function (with respect 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).
Increasing, Diminishing and
Negative Marginal Returns

Q Increasing Diminishing Negative

Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
Guiding the Production Process
• 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 .
Example: Value Marginal Product
 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.
 Marginal Rate of Technical
Substitution (MRTS)
• The rate at which two inputs are substituted while
maintaining the same output level.

MPL
MRTS KL =
MPK
 Linear Isoquants

• Capital and labor are

perfect substitutes K
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.

Q Q2 Q3
L
1
 Leontief Isoquants

• Capital and labor are perfect K Q

complements. Q
Q 3
Increasing
• Capital and labor are used in 2 Output
fixed-proportions. 1
• Q = min {bK, cL}
• Since capital and labor are
consumed in fixed
proportions there is no input
substitution along isoquants
(hence, no MRTSKL). L
 Cobb-Douglas Isoquants

• Inputs are not perfectly K

Q3
substitutable. Increasin
Q2
• Diminishing marginal rate g Output
Q1
of technical substitution.
• 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
 Isocost
• The combinations of inputs that K New Isocost Line
produce a given level of output at the associated with higher
C1/r costs (C0 < C1).
same cost:
wL + rK = C C0/r
• Rearranging,
K= (1/r)C - (w/r)L C0 C1
C0/w L
• For given input prices, isocosts C1/w
farther from the origin are associated K
with higher costs. New Isocost Line
C/r for a decrease in
• Changes in input prices change the
the wage (price of
slope of the isocost line. labor: w0 > w1).

L
C/w0 C/w1
 Cost Minimization
• 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
 Cost Minimization

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

L
 Optimal Input Substitution

• A firm initially produces Q0 K

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

C(Q) = VC(Q) + FC VC(Q)

VC(Q): Costs that vary with

output.

FC: Costs that do not vary with

output. FC

0 Q
 Fixed and Sunk Costs
FC: Costs that do not change $
as output changes.
C(Q) = VC + FC

Sunk Cost: A cost that is

forever lost after it has been VC(Q)
paid.

Decision makers should

ignore sunk costs to
maximize profit or minimize
losses FC

Q
 Some Definitions

Average Total Cost $

ATC = AVC + AFC MC ATC
ATC = C(Q)/Q AVC

Average Variable Cost

AVC = VC(Q)/Q
MR
Average Fixed Cost
AFC = FC/Q

Marginal Cost
MC = ∆C/∆Q
AFC

Q
 Fixed Cost
Q0×(ATC-AVC)
MC
$ = Q0× AFC ATC

= Q0×(FC/ Q0) AVC

= FC

ATC
AFC Fixed Cost
AVC

Q0 Q
 Variable Cost
Q0×AVC MC
$
ATC
= Q0×[VC(Q0)/ Q0]
AVC
= VC(Q0)

AVC
Variable Cost Minimum of AVC

Q0 Q
 Total Cost
Q0×ATC MC
$
= Q0×[C(Q0)/ Q0] ATC

= C(Q0) AVC

ATC

Total Cost Minimum of ATC

Q0 Q
 Cubic Cost Function

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

LRAC

Economies Diseconomies
of Scale of Scale
Q* Q
 Multi-Product Cost Function

• C(Q1, Q2): Cost of jointly producing two

outputs.
• General function form:

C (Q1 , Q2 ) = f + aQ1Q2 + bQ + cQ
1
2 2
2
 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.
 Cost Complementarity

• The marginal cost of producing good 1 declines as more

of good two is produced:

∆MC1(Q1,Q2) /∆Q2 < 0.

• Example:
• Cow hides and steaks.
Quadratic Multi-Product Cost Function
• C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
• MC1(Q1, Q2) = aQ2 + 2Q1
• MC2(Q1, Q2) = aQ1 + 2Q2
• Cost complementarity: a < 0
• Economies of scope: f > aQ1Q2
C(Q1 ,0) + C(0, Q2 ) = f + (Q1 )2 + f + (Q2)2
C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
f > aQ1Q2: Joint production is cheaper
 A Numerical Example:

• C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 + (Q2 )2

• Cost Complementarity?
Yes, since a = -2 < 0
MC1(Q1, Q2) = -2Q2 + 2Q1
• Economies of Scope?
Yes, since 90 > -2Q1Q2
 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.