BUS 525: Managerial

Economics
Lecture 5
The Production Process and Costs

Activity Schedule:BUS525:2

Originally scheduled classes

Makeup classes (Announced
by University)
Makeup classes proposed
(To be finalized in consultation
with students)

Class

Date

28 May

4 June

6 June

11 June

20 June

23 July

25 July (Thu)

30 July

2 August (Fri)

10

13 August

11

16 August
(Fri)

12

20 August

13

TBA

Exams

Cases

Case 1
Mid 1

Case 2

Mid 2
Case 3
Final

Activity Schedule:BUS525:3
Originally scheduled classes
Makeup class (Announced
by University)
Makeup classes proposed (To
be finalized in consultation
with
students)

Class

Date

29 May

5 June

12 June

19 June

26 June

24 July

26 July (Fri)

31 July

1 August (Thu)

10

14 August

11

16 August (Fri)

12

21 August

13

TBA

Exams

Cases

Case 1
Mid 1

Case 2

Mid 2
Case 3
Final

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
A function that defines the maximum amount
output that can be produced with a given set
of inputs
Q = F(K,L)
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 Factors of Production

1-6

Table 5-1 The Production Function

K

MPL

APL

Fixed
Input

Variable Input

Change in
Labor

Output

Marginal Product of
Labor

Average Product
of Labor

76

76

76

248

172

124

492

244

164

784

292

196

1100

316

220

1,416

316

236

1,708

292

244

1,952

244

244

2,124

172

236

10

2,200

76

220

10

2,156

-44

196

Measures of Productivity: Total

Product
The maximum level of output that can be
produced with a given amount of input
Cobb-Douglas Production Function
Example: Q = F(K,L) = K.5 L.5
K is fixed at 16 units.
Short run production function:

Q = (16).5 L.5 = 4 L.5

Production when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units

Measures of Productivity: Average

Product

Average Product of Labor: A measure of the output produced per

unit of input
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 = 4, then the average product of
capital is APK = [(16)0.5(4)0.5]/16 = 1/2.

Measures of Productivity:
Marginal Product
Marginal product : The 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 long run, MPK is the
slope of the production function (with respect to capital).

Increasing, Diminishing and

Negative Marginal Returns
Q

Increasing
Marginal
Returns

Diminishing
Marginal
Returns

Negative
Marginal
Returns

TP

Q=F(K,L)

MP

AP
L

Guiding the Production Process

Producing on the production function
Aligning incentives to induce maximum worker
effort, tips, profit sharing.

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 .

The Profit Maximizing Usage of Inputs

= R- C,
Q = F (K,L), C = wL + rK
= P. F(K,L) - wL - rK

F(K, L)
P.
r 0
K
K

F(K, L)
P.
w 0
L
L
F(K, L)
F(K, L)
Since
MPk and

K
L
P. MP K r and P. MP L w

MP

V MP K r and V MP L w
i.e each input must be used up to the point
where its value of marginal product equals its price

Table 5-2 The Value of Marginal Product of Labor

L

MPL

VMPL

Variable Input

Price of Output

Marginal Product
of Labor

P x MPl

Unit Cost of Labor

$3

$400

$3

76

$228

$400

$3

172

516

$400

$3

244

732

$400

$3

292

876

$400

$3

316

948

$400

$3

316

948

$400

$3

292

876

$400

$3

244

732

$400

$3

172

516

$400

10

$3

76

228

$400

11

$3

-44

-132

$400

Isoquant
The 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.

Slope of Isoquant

Slope of isoquants
Q F (K, L)
F(K, L)
F(K, L)
dQ
.dK
.dL 0
K
L
[Since output do not change along an isoqua
dQ 0]
dK
F(K, L)/L
MPK
or,

dL
F(K, L)/K
MPL

Marginal Rate of Technical Substitution

(MRTS)
The rate at which a producer can substitute between
two inputs and maintain the same output level.

MRTS KL

MPL

MPK

The production function satisfies the law of diminishing

marginal rate of technical substitution: As a producer
uses less of an input, increasingly more of the other
input must be employed to produce the same level of
output

The Marginal Rate of Technical Substitution

Linear Isoquants
Capital and labor are
perfect substitutes
K
Q = aK + bL
MRTSKL = b/a
Linear isoquants imply
that inputs are substituted
at a constant rate,
independent of the input
levels employed.

Increasing
Output

Q1

Q2

Q3

Leontief Isoquants
Capital and labor are
K
perfect complements.
Capital and labor are used
in fixed-proportions.
Q = min {bK, cL}
What is the MRTS?

Q3
Q2
Q1

Increasing
Output

Cobb-Douglas Isoquants

Inputs are not perfectly

substitutable.
Diminishing marginal rate 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.

Q3
Q2
Q1

Increasing
Output

Q = KaLb
MRTSKL = MPL/MPK
L

Isocost
The combinations of inputs
that produce a given level of
output at the same cost:
wL + rK = C
Rearranging,
K= (1/r)C - (w/r)L
For given input prices,
isocosts farther from the
origin are associated with
higher costs.
Changes in input prices
change the slope of the
isocost line.

K
C1/r

New Isocost Line

associated with higher
costs (C0 < C1).

C0/r
C0
C0/w
K
C/r

C1
C1/w

New Isocost Line for

a decrease in the
wage (price of labor:
w0 > w1).

C/w0

C/w1

Slope of isocost
wL rK C
1
w
K (C ) L
r
r
w
Slope r

Cost Minimization
K

Slope of Isocost
=
Slope of Isoquant

Point of Cost
Minimization
A

Cost minimization
C wL rK, Q F(K, L)
Minimize wL rK subject to Q F(K, L)
H

Lagrangian
wL rK [Q- F(K,L)]

H
F(K,L)
w
0........( 1 )
L
L
H
F(K,L)
r
0........( 2 )
K
K
H
Q F(K,L) 0...............( 3 )

dividing 1 by 2
w
F(K,L)/L

r
F(K,L)/K

MP
MP

MRTS

KL

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

MRTS KL

w
r

Optimal Input Substitution

A firm initially produces Q0 by

employing the combination of
inputs represented by point A
at a cost of C0.
Suppose w0 falls to w1.
The isocost curve rotates
counterclockwise; which
represents the same cost
level prior to the wage
change.
To produce the same level of
output, Q0, the firm will
produce on a lower isocost
line (C1) at a point B.
The slope of the new isocost
line represents the lower
wage relative to the rental
rate of capital.

K0

K1

Q0
0 L0

L1 C0/w0

C1/w1

C0/w1 L

Cost Analysis
Types of Costs
Fixed costs (FC)
Variable costs (VC)
Total costs (TC)
Sunk costs
A cost that is forever lost after it has been
incurred. Once paid they are irrelevant to decision
making

Table 5.3 The Cost Function

K

FC

VC

TC

Fixed Input

Variable Input

Output

Fixed Cost

Variable Cost

Total Cost

$2,000

$0

$2000

76

$2,000

400

$2400

248

$2,000

800

$2800

492

$2,000

1,200

$3200

784

$2,000

1,600

$3600

1100

$2,000

2,000

$4000

1,416

$2,000

2,400

$4400

1,708

$2,000

2,800

$4800

1,952

$2,000

3,200

$5200

2,124

$2,000

3,600

$5600

10

2,200

$2,000

4,000

$6000

Total and Variable Costs

C(Q): Minimum total cost $
of producing alternative
levels of output:

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

C(Q) = VC(Q) + FC
VC(Q): Costs that vary
with output.
FC: Costs that do not vary
with output.

FC

Fixed and Sunk Costs

FC: Costs that do not
change as output
changes.
Sunk Cost: A cost that is
forever lost after it has
been paid.

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

FC

Some Definitions
Average Total Cost
ATC = AVC + AFC
ATC = C(Q)/Q

MC

ATC
AVC

Average Variable Cost

AVC = VC(Q)/Q
MR

Average Fixed Cost

AFC = FC/Q
Marginal Cost
MC = C/Q

AFC

Fixed Cost
Q0(ATC-AVC)

= Q0 AFC
= Q0(FC/ Q0)

MC
ATC
AVC

= FC

ATC
AFC

Fixed Cost
AVC
Q0

Variable Cost
$

Q0AVC
= Q0[VC(Q0)/ Q0]

MC
ATC
AVC

= VC(Q0)

AVC
Variable Cost
Q0

Total Cost
Q0ATC

= Q0[C(Q0)/ Q0]
= C(Q0)

MC
ATC
AVC

ATC
Total Cost

Q0

Table 5.4 Derivation of Average Costs

O

FC

VC

TC

AFC

AVC

ATC

Output

Fixed Cost

Variable Cost

Total Cost

Average
Fixed Cost

Average
Variable
Cost

Average Total
Cost

$2,000

$0

$2000

76

$2,000

400

$2400

$26.32

$5.26

$31.58

248

$2,000

800

$2800

8.06

3.23

11.29

492

$2,000

1,200

$3200

4.07

2.44

6.5

784

$2,000

1,600

$3600

2.55

2.04

4.59

1100

$2,000

2,000

$4000

1.82

1.82

3.64

1,416

$2,000

2,400

$4400

1.41

1.69

3.11

1,708

$2,000

2,800

$4800

1.17

1.64

2.81

1,952

$2,000

3,200

$5200

1.02

1.64

2.66

2,124

$2,000

3,600

$5600

0.94

1.69

2.64

2,200

$2,000

4,000

$6000

0.91

1.82

2.73

Table 5.4 Derivation of Marginal Costs

O

VC

VC

TC

TC

MC

Output

Change in
Output

Change in
Variable Cost

Total Cost

Average
Fixed Cost

Average
Variable
Cost

Marginal Cost

$0

$2000

76

76

400

400

$2400

400

$5.26

248

172

800

400

$2800

400

2.33

492

244

1,200

400

$3200

400

1.64

784

292

1,600

400

$3600

400

1.37

1100

316

2,000

400

$4000

400

1.27

1,416

316

2,400

400

$4400

400

1.27

1,708

292

2,800

400

$4800

400

2.81

1,952

244

3,200

400

$5200

400

2.66

2,124

172

3,600

400

$5600

400

2.64

2,200

76

4,000

400

$6000

400

2.73

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

Class Exercise
Total Cost: C(Q) = 10 + Q + Q2
Find:
the variable cost function.
variable cost of producing 2 units.
fixed costs.
marginal cost function.
marginal cost of producing 2 units:

Long Run Cost: Economies of Scale

$

LRAC

Economies
of Scale

Diseconomies
of Scale
Q

Multi-Product Cost Function

A function that defines the cost of
producing given levels of two or more
types of outputs assuming all inputs are
used efficiently
C(Q1, Q2): Cost of jointly producing two
outputs.
General multi-product cost function
2
2
C Q1 , Q2 f aQ1Q2 bQ1 cQ2

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 Citycell 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 2 is produced:

MC1Q1,Q2) /Q2 < 0.

Example:
Bread and biscuits

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

Class Exercise II
C(Q1, Q2) = 100 1/2Q1Q2 + (Q1 )2 + (Q2 )2

The firm wishes to produce 5 units of

good 1 and 4 units of good 2.
Find whether
(a) cost complementarity exists?
(b) the cost function demonstrates
economies of scope?

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.