1. The Production Process and Costs
Chapter 5
The Production Process and Costs
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline The production function The cost function
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

3. 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.

4. The Production Function

5. Short-Run versus Long-Run Decisions: Fixed and Variable Inputs
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.

6. Measures of Productivity
The Production Function
Measures of Productivity

7. Measures of Productivity in Action
The Production Function
Measures of Productivity in Action

8. Relation between Productivity Measures in Action
The Production Function
Relation between Productivity Measures in Action
Total product
Average product
Marginal product
Increasing
marginal
returns to labor
Decreasing
marginal
returns to labor
Negative
marginal
returns to labor
Total product (TP)
Average product (APL)
Labor input
(holding capital constant)
Marginal product (MPL)

9. Law of Diminishing Returns: As additional units of a variable input are combined with a fixed input, at some point the additional output (i.e., marginal product) starts to diminish.
Nothing says when diminishing returns will start to take effect, only that it will happen at some point.
All inputs added to the production process are exactly the same in individual productivity

10. The Three Stages of Production in the Short Run
Stage I: From zero units of the variable input to where AP is maximized (where MP=AP)
Stage II: From the maximum AP to where MP=0
Stage III: From where MP=0 on

11. In the short run, rational firms should only be operating in Stage II.
Why not Stage III?
Firm uses more variable inputs to produce less output
Why not Stage I?
Underutilizing fixed capacity
Can increase output per unit by increasing the amount of the variable input

12. What level of input usage within Stage II is best for the firm?
The answer depends upon how many units of output the firm can sell, the price of the product, and the monetary costs of employing the variable input.

13. The Manager’s Role in the Production Process
The Production Function
The Manager’s Role in the Production Process

14. Manager’s Role in the Production Process in Action
The Production Function
Manager’s Role in the Production Process in Action

15. Algebraic Forms of Production Functions
The Production Function
Algebraic Forms of Production Functions

16. Algebraic Forms of Production Functions in Action
The Production Function
Algebraic Forms of Production Functions in Action

17. Algebraic Measures of Productivity
The Production Function
Algebraic Measures of Productivity

18. Algebraic Measures of Productivity in Action
The Production Function
Algebraic Measures of Productivity in Action

19. Isoquants and Marginal Rate of Technical Substitution
The Production Function
Isoquants and Marginal Rate of Technical Substitution

20. Isoquants and Marginal Rate of Technical Substitution in Action
The Production Function
Isoquants and Marginal Rate of Technical Substitution in Action
Capital Input
Increasing output A
Substituting labor for capital B
Labor Input

21. Diminishing Marginal Rate of Technical Substitution in Action
The Production Function
Diminishing Marginal Rate of Technical Substitution in Action
Capital Input D C B A
Labor Input

22. Isocost and Changes in Isocost Lines
The Production Function
Isocost and Changes in Isocost Lines

23. The Production Function
Isocost Line
Capital Input
Labor Input

24. Changes in the Isocost Line
The Production Function
Changes in the Isocost Line
Capital Input
More expensive input
bundles
Less expensive input
bundles
Labor Input

25. Changes in the Isocost Line
The Production Function
Changes in the Isocost Line
Capital Input
Labor Input

26. Cost-Minimization Input Rule in Action
The Production Function
Cost-Minimization Input Rule in Action
Capital Input
Labor Input

27. Cost Minimization and the Cost-Minimizing Input Rule
The Production Function
Cost Minimization and the Cost-Minimizing Input Rule

28. Cost-Minimizing Input Rule in Action
The Production Function
Cost-Minimizing Input Rule in Action

29. Optimal Input Substitution in Action
The Production Function
Optimal Input Substitution in Action
Capital Input I
New cost-minimizing
point due to higher wage F B
Initial point of cost minimization A H J G
Labor Input

30. The Cost Function
The Cost Function

31. Short-Run Costs in Action
The Cost Function
Short-Run Costs in Action
Total costs
Variable costs
Fixed costs
Output

32. Average and Marginal Costs
The Cost Function
Average and Marginal Costs

33. The Relationship between Average and Marginal Costs in Action
The Cost Function
The Relationship between Average and Marginal Costs in Action
ATC, AVC, AFC
and MC ($)
Minimum of ATC
Minimum of AVC
Output

34. Fixed and Sunk Costs Fixed costs Sunk cost
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.
Principle of Irrelevance of Sunk Costs
A decision maker should ignore sunk costs to maximize profits or minimize loses.

35. 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.

36. Long-Run Average Total Costs in Action
The Cost Function
Long-Run Average Total Costs in Action
LRAC ($)
Output

37. Economies of Scale Economies of scale Diseconomies of scale
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.

38. Economies and Diseconomies of Scale in Action
The Cost Function
Economies and Diseconomies of Scale in Action
LRAC ($)
Economies of scale
Diseconomies of scale
Output

39. Constant Returns to Scale in Action
The Cost Function
Constant Returns to Scale in Action
LRAC ($)
Output

40. Multiple-Output Cost Function

41. Multiple-Output Cost Function in Action

42. Conclusion

43. Cost-Minimization In Action
The Production Function
Cost-Minimization In Action
Capital Input
Labor Input

44. Diminishing Marginal Rate of Technical Substitution in Action
The Production Function
Diminishing Marginal Rate of Technical Substitution in Action
Capital Input A B C D
Labor Input

45. Cost-Minimization Input Rule In Action
The Production Function
Cost-Minimization Input Rule In Action

46. Multiple-Output Cost Function in Action