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Chapter Overview
Chapter Outline
• The production function
– Short- versus long-run decisions
– Measures of productivity
– Manager’s role in production process
– Production function and productivity algebraic forms
– Isoquants and isocosts
– Cost minimization and optimal input substitution
• The cost function
– Short-run costs
– Average and marginal costs
– Relations among costs
– Fixed and sunk costs
– Cost function algebraic forms
– Long-run costs and economies of scale
• Multiple-output cost functions
– Economies of scope and cost complementarity
5-2
Chapter Overview
Introduction
• Chapter 4 focused on how consumers adjust
consumption decisions in reaction to price
and income changes. The theory developed
illustrates the underlying principles of
individual and market demand curves.
• This chapter examines how managers select
the optimal mix of inputs that minimize
production costs.
5-3
The Production Function
5-4
The Production Function
Short-Run versus Long-Run Decisions:
Fixed and Variable Inputs
• Short-run
– Period of time where some factors of production
(inputs) are fixed, and constrain a manager’s
decisions.
• Long-run
– Period of time over which all factors of production
(inputs) are variable, and can be adjusted by a
manager.
5-5
The Production Function
Measures of Productivity
5-6
The Production Function
5-7
The Production Function
0 Labor input
Marginal product (MPL) (holding capital constant)
5-8
The Production Function
The Manager’s Role in the
Production Process
5-9
The Production Function
Manager’s Role in the Production
Process in Action
5-10
The Production Function
Algebraic Forms of Production Functions
5-11
The Production Function
Algebraic Forms of Production
Functions in Action
5-12
The Production Function
5-13
The Production Function
Algebraic Measures of Productivity in Action
5-14
The Production Function
Isoquants and Marginal Rate of
Technical Substitution
5-15
The Production Function
Isoquants and Marginal Rate of
Capital Input
Technical Substitution in Action
0 Labor Input
5-16
The Production Function
Diminishing Marginal Rate of Technical
Capital Input
Substitution in Action
B
A
0 Labor Input
5-17
The Production Function
5-18
The Production Function
Isocost Line
Capital Input
0 Labor Input
5-19
The Production Function
0 Labor Input
5-20
The Production Function
0 Labor Input
5-21
The Production Function
0 Labor Input
5-22
The Production Function
Cost Minimization and the
Cost-Minimizing Input Rule
5-23
The Production Function
5-24
The Production Function
New cost-minimizing
point due to higher wage
F
B
Initial point of cost minimization
H J
0 G Labor Input
5-25
The Cost Function
The Cost Function
5-26
The Cost Function
Short-Run Costs in Action
Total costs
Variable costs
Fixed costs
0 Output
5-27
The Cost Function
5-28
The Cost Function
The Relationship between Average
and Marginal Costs in Action
ATC, AVC, AFC
and MC ($)
Minimum of ATC
Minimum of AVC
0 Output
5-29
The Cost Function
Fixed and Sunk Costs
• Fixed costs
– Cost that does not change with output.
• Sunk cost
– Cost that is forever lost after it has been paid.
5-30
The Cost Function
Long-Run Costs
• In the long run, all costs are variable since a
manager is free to adjust levels of all inputs.
• Long-run average cost curve
– A curve that defines the minimum average cost of
producing alternative levels of output allowing for
optimal selection of both fixed and variable
factors of production.
5-31
The Cost Function
Long-Run Average Total Costs in Action
LRAC ($)
0 Output
5-32
The Cost Function
Economies of Scale
• Economies of scale
– Declining portion of the long-run average cost
curve as output increase.
• Diseconomies of scale
– Rising portion of the long-run average cost curve
as output increases.
• Constant returns to scale
– Portion of the long-run average cost curve that
remains constant as output increases.
5-33
The Cost Function
Economies and Diseconomies
of Scale in Action
LRAC ($)
0 Output
5-34
The Cost Function
Constant Returns to Scale in Action
LRAC ($)
0 Output
5-35
Multiple-Output Cost Function
5-36
Multiple-Output Cost Function
5-37
Conclusion
5-38
The Production Function
Cost-Minimization In Action
Capital Input
0 Labor Input
5-39
The Production Function
Diminishing Marginal Rate of Technical
Capital Input
Substitution in Action
C
D
0 Labor Input
5-40
The Production Function
5-41
Multiple-Output Cost Function
5-42