MANAGERIAL ECONOMICS

Lecture 3: Production and Cost

Analysis in the Short-Run
by
Angeline Chivapathy
Production Function
A production
function describes the
relationship between a
flow of inputs and the
resulting flow of
outputs in a production
process during a given
period of time.
Q = f(L, K, M, )
where
Q = quantity of output
L = quantity of labor
input
K = quantity of capital
input
M = quantity of materials
input
2
Fixed and Variable Inputs
A fixed input is an
input whose quantity
a manager cannot
change during a
given period of time.
A variable input is an
input whose quantity
a manager can
change during a
given period of time.
3
1.3
Short-Run vs. Long-Run
The short-run is a period of time during which
at least one input is fixed, while the long-run is
a period of time during which all inputs are
variable.
4
4
Total Product
The total quantity of
output produced with
given quantities of
fixed and variable
inputs.
TP or Q = f(L, K ), where
TP or Q = total product
or total quantity
produced
L = quantity of labor
input (variable)
K = quantity of capital
(fixed)
5
1.5
Average Product
The amount of output
per unit of variable
input.

AP
L
= TPL or QL,
where
AP
L
= average product
of labor

6
1.6
Marginal Product
The additional output
produced with an
additional unit of
variable input.
MP
L
= TPL or
QL
where
MP
L
= marginal
product of labor

7
1.7
Total Product Curve
8
Average and Marginal Product
Curves
9
Law of Diminishing Marginal
Returns
The phenomenon illustrated by that region of
the marginal product curve where the curve is
positive, but decreasing, so that total product is
increasing at a decreasing rate.
10
Cost Function
A mathematical or graphic expression that
shows the relationship between the cost of
production and the level of output, all other
factors held constant.
11
Opportunity Cost
The economic measure of cost that reflects the
use of resources in one activity, such as a
production process by one firm, in terms of the
opportunities forgone in undertaking the next
best alternative activity.
12
Explicit and Implicit Costs
A cost is explicit if it is
reflected in a payment
to another individual,
such as a wage paid to
a worker, that is
recorded in a firms
bookkeeping or
accounting system.
A cost that represents
the value of using a
resource that is not
explicitly paid out and
is often difficult to
measure because it is
typically not recorded
in a firms accounting
system.
13
1.13
Profit
The difference between the total revenue a firm
receives from the sale of its output and the
total cost of producing that output.
14
Accounting vs. Economic Profit
Accounting profit is
the difference
between total
revenue and total
cost where cost
includes only the
explicit costs of
production.
Economic profit is
the difference
between total
revenue and total
cost where cost
includes both the
explicit and any
implicit costs of
production.
15
1.15
Short Run Cost Function
A cost function for a short-run production
process in which there is at least one fixed
input of production.
16
Fixed vs. Variable Costs
Fixed cost is the total
cost of using the
fixed input, which
remains constant
regardless of the
amount of output
produced.
Variable cost is the
total cost of using
the variable input,
which increases as
more output is
produced.
17
1.17
Short Run Costs

COST FUNCTION

DEFINITION

Total fixed cost

TFC = (P
K
) x (K)
Total variable cost TVC = (P
L
) x (L)
Total cost TC = TFC + TVC
Average fixed cost AFC = TFC Q
Average variable cost AVC = TVC Q
Average total cost ATC = TC Q = AFC + AVC
Marginal cost MC = TC Q = TVC Q
18
Total Cost Curves
19
Average and Marginal Cost Curves
20
Relationship Between Short Run
Production and Cost
21
AC
MC

Q
1

Q
2
21