1 SM1.21 Managerial Economics Welcome to session 5 Production and Cost Analysis

2 Objectives To understand the economics of production of the firm and the conditions for an efficient production

3 The Production Function The production function is the relationship between the maximum amount of output that can be produced and the inputs required to make that output

4 Inputs Inputs = resources Land (natural) Labor Capital Variable Inputs Fixed Inputs

5 Fixed and variable Costs The fixed cost do not vary with the firms output The variable cost increase with the output

6 Production function with 2 inputs

7 Total and Marginal Cost The firm’s total cost is the sum off all variable and fixed costs The firm’s marginal cost is the per unit change in total cost that results from a change in total product

8 The Law of diminishing returns As a firm uses more and more of a variable input with the same amount of fixed input, it gets less returns from the variable input after a certain point

9 Returns to scale The degree by which output changes as a result of a given change in the quantity of all inputs used in production

10 Optimal use of variable input The marginal revenue product The marginal resource cost

11 Two variable inputs Isoquants Isoquant’s slope is called Marginal Rate of Technical Substitution

12 Optimal Combination Minimizing cost for given output Maximizing output for given input Profit maximization

13 Change of input prices

14 Product innovation Process Innovation

15 The Marginal Product The marginal product of an input is the extra product or output added by one extra unit of that input while other inputs are held constant

16 Total and Marginal Product

17 The Cobb-Douglas Function Q=AK a L b a= output elasticity of capital b= output elasticity of labor

18 Summary Production Production refers to the transformation of inputs or resources into output of goods and services. Inputs can be fixed or variable. In the long run they are considered as variable. The production function (3D) shows the maximum output that a firm can produce with different sets of one input, while keeping other inputs fixed.

19 Summary Production 2. Total Product-Marginal Product-Average Product The Total product is the output produced by using different quantities of inputs. The marginal product is the change of the total product per unit change in the variable input used. The average product is the total product divided by the quantity of the variable input used Three stages of production: Stage 1: Increasing average product Stage 2: Maximum AP to 0 Stage 3: Negative marginal product

20 Summary Production Marginal Revenue product The optimal use of the variable inputs occurs when MRP(Marginal Revenue Product)=MRC (Marginal resource cost) Isoquants The various combinations of inputs to produce the same output are shown by isoquants

21 Summary Production 5. Isocost lines Once we know the wage rate and the rental price of capital and the total costs of the firm we can draw the isocost lines that shows the various combinations of Labor and Capital a firm can hire. To minimize production cost or maximize output, a firm must produce where an isocost line is tangent to the isoquant.