Chapter 7 Production and Cost: Many Variable Inputs

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Isoquants and Input Substitution

An

isoquant is a curve composed of all bundles that produce some fixed quantity of output. An example: Y=(1200Z1Z2)1/2 Setting y =120 and simplifying gives 12=Z1Z2 (see Figure 7.1).

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Figure 7.1 Isoquants for courier services

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Marginal Rate of Technical Substitution (MRTS)

The

MRTS measures the rate at which one input can be substituted for the other, with output remaining constant. The MRTS is the absolute value of the slope of the isoquant.

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Perfect Substitutes and Perfect Compliments

Inputs

are perfect substitutes when one output can always be substituted for the other on fixed terms and the MRTS is constant. With perfect compliments, substitution is impossible and the MRTS cannot be defined for the bundle at the kink in the isoquant.
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Figure 7.2 Some illustrative isoquants

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Diminishing Rate of Technical Substitution

Most cases fall between perfect substitutes and perfect compliments. In these cases, one input can be substituted for the other but the MRTS is not constant. In such cases, it becomes increasingly difficult to substitute one input for the other. This means the MRTS diminishes moving fro left to right along the isoquant.

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Figure 7.3 The marginal rate of technical substitution, MRTS

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MRTS as a Ratio of Marginal Products

When

the quantity of input 1 is decreased by Z1, the change in y is (approx) the marginal product of the input times the change in the quantity of input 1. Therefore: y =MP1 yz1 Similarly: y =MP2 yz2

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MRTS as a Ratio of Marginal Products

When

Z1 is very small, MRTS can approximated by z2/z1 Solving for Z1 & Z2 and substituting from above yields MRTS = (y/MP2)(y/MP1) Reducing gives MRTS = MP1/MP2 Therefore MRTS is equal to the marginal product of input 1 divided by the marginal product of input 2.
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Returns to Scale
Increasing

returns to scale occurs when increasing all inputs by X% increases output by more than X%. Constant returns to scale occurs when an increase in all inputs of X% increases output by X%. Decreasing returns to scale occurs when an increasing all inputs by X% increases output by less than X%.
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Figure 7.4 Constant returns to scale

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The Cost Minimization Problem: A Perspective

The

cost function shows the minimum cost of producing any level of output in the long-run. The long-run cost minimizing problem is: minimize w1z1+w2+z2 choosing z1 and z2 subject to constraint y=F(z1, z2)

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Conditional Input Demand Functions

The

solution to the cost minimization problem gives the values of the endogenous variables (z1* & z2*) as a function of the exogenous variables (y, w1 and w2). Since z1* & z2* are dependent upon the level of y chosen, the input demand functions are described as conditional demand functions.
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The Long-run Cost Function

Once

we know the input demand functions, the long-run cost function is the sum of the input quantities and their respective prices. TC(y,w1,w2) = w1z1* +w2z2*

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Solving Cost Minimization Problems

The isocost line shows all bundles of inputs that cost the same. It can be expressed as: c=w1z1 +w2z2. The absolute value of the slope of the isocost line is w1/w2. This slope says that w1/w2 of input 2 must be given up to get an additional unit of input 1. The slope is the opportunity cost of input 1 in terms of input 2.

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Figure 7.5 The cost-minimizing bundle

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Principles of Cost Minimization

1.

2.

The cost minimizing input bundle is on the isoquant: y F(z1* +z2*). The MRTS is equal to w1/w2 at the cost minimizing bundle: MRTS(z1*z2*) w1/w2

The second principle can be generalized by stating the marginal product per dollar must be identical for all inputs.
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Comparative Statics for Input Prices

1.

2.

If all input prices change by the same factor of proportionality (a): The cost of minimizing the input bundle for y units of output does not change. The minimum cost pf producing y units of output changes by (a).

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Figure 7.7 Costs and input prices

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From Figure 7.7

If the cost-minimizing quantity of both inputs (i and j) is positive and there is diminishing MRTS, if pi increases and pj does not, the cost minimizing quantity of i increases and j decreases. If the price of an input increases and the quantity demanded of that input is positive, the minimum cost of producing any level of output rises.
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Comparative Statics: Level of Output

The

expansion path connects the cost minimizing bundles that are generated as output increases. A normal input is one where the quantity demanded increases when output rises. An inferior input is one where the quantity demanded decreases when output rises.
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Figure 7.8 The output expansion path

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Homothetic Production Functions

A

homothetic production function is a type of function where the expansion path is a ray through the origin. For these types of functions the MRTS is constant along any ray from the origin.

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Long-run Costs and Output

Long-run

average costs (LAC) is equal to the total cost of output (TC) divided by the quantity of output (y): LAC(y)=TC(y)/y output rises, LAC is constant, decreasing, or increasing as there are constant, increasing, or decreasing returns to scale.
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As

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Figure 7.9 Costs and returns to scale

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Figure 7.10 More on costs and returns to scale

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Long-run Marginal Cost

Long-run

marginal cost (LMC) is the rate at which costs increase as output increases (the slope of TC). When LMC lies below LAC, LAC is decreasing, when LMC exceeds LAC, LAC is rising, LMC intersects LAC at the LAC minimum.

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Figure 7.11 Deriving LAC and LMC from TC

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Figure 7.12 Comparing TC and STC

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Figure 7.13 Relationships between long-run and short-run cost functions

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Figure 7.14 A cost-based theory of market structure

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From Figure 7.14

U-shaped cost curves reflect initial increasing and subsequent decreasing returns to scale. If LAC attains its minimum at a relatively large level of output, we expect to see a monopoly or oligopoly. If LAC attains its minimum at a relatively small level of output, we expect to see a competitive market.

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