Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 5: Production and Cost Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved. McGraw-Hill/Irwin

Managerial Economics and Organizational Architecture, 5e Production Functions A production function specifies maximum output from given inputs: 5-2

Managerial Economics and Organizational Architecture, 5e Returns to Scale The relation between output and a proportional variation of all inputs together Increasing returns to scale - if inputs double, output more than doubles Decreasing returns to scale - if inputs double, output less than doubles Constant returns to scale- if inputs double, output doubles 5-3

Managerial Economics and Organizational Architecture, 5e Returns to a Factor The relation between output and the variation in only one input, holding all other inputs constant Total product - amount of output, Q, obtained when an input, L, increases Average product Q/L Marginal product  Q/  L 5-4

Managerial Economics and Organizational Architecture, 5e Returns to a Factor SAQMP S AP S Production function: Q=S 1/2 A 1/2 5-5

Managerial Economics and Organizational Architecture, 5e Returns to a Factor: A Common Case Law of diminishing returns – at some point, S 1, the marginal product of a variable factor will decline as its use is increased Quantity of steel Total product Average product Marginal product S1S1 S2S2 S Quantity of auto parts per unit of steel Q/S S Quantity of auto parts Q 5-6

Managerial Economics and Organizational Architecture, 5e Illustrating Production Choices with Isoquants Isoquants show all combinations of two inputs that produce the same level of output, assuming efficient production Shape of isoquants indicates substitutability between inputs 5-7

Managerial Economics and Organizational Architecture, 5e Isoquants show all combinations of two inputs that produce the same level of output Moving to the northeast implies greater output S Quantity of Aluminum Quantity of Steel A

Managerial Economics and Organizational Architecture, 5e Differing Input Substitutability Isoquants A S Quantity of Steel Quantity of Aluminum Quantity of Steel Fixed proportionsNormal casePerfect substitutes AA SS 5-9

Managerial Economics and Organizational Architecture, 5e Isocost Lines Isocosts show all combinations of two inputs that have the same cost The slope of an isocost line changes as input prices change 5-10

Managerial Economics and Organizational Architecture, 5e Isocost Lines Quantity of aluminum Quantity of steel $100 line $200 line 5-11

Managerial Economics and Organizational Architecture, 5e Isocost Lines Changes in Input Prices Quantity of aluminum 100 Quantity of steel 200 P S = $1.00 per pound P S = $.50 per pound 100 A S 5-12

Managerial Economics and Organizational Architecture, 5e Optimal Input Mix Equilibrium occurs when the isoprofit curve is tangent to the isocost curve If the price of one input increases, the firm will reduce its use and substitute relatively cheaper inputs in its place 5-13

Managerial Economics and Organizational Architecture, 5e Cost Minimization Quantity of aluminum Quantity of steel S S’S* A* A’ Q* 5-14

Managerial Economics and Organizational Architecture, 5e Optimal Input Mix Input Price Changes Quantity of aluminum High steel price Low steel price Quantity of steel S S2S2 S1S1 A2A2 A1A1 Q* 5-15

Managerial Economics and Organizational Architecture, 5e Cost Concepts Total cost –relation between total cost and output Marginal cost –change in total cost when output rises one unit Average cost –total cost divided by total output Opportunity cost –value of a resource in it next best alternative 5-16

Managerial Economics and Organizational Architecture, 5e Cost Curves Total costs (in dollars) Total cost Q $ Quantity of output Cost per unit of output (in dollars) Marginal cost Average cost Q1Q1 Q2Q2 Q $ 5-17

Managerial Economics and Organizational Architecture, 5e Short Run versus Long Run Short run –at least one input is fixed –cost curves are operating curves Long run –all inputs are variable –cost curves are planning curves 5-18

Managerial Economics and Organizational Architecture, 5e Fixed versus Variable Costs Fixed costs –incurred even if firm produces nothing Variable costs –change with the level of output 5-19

Managerial Economics and Organizational Architecture, 5e Short-Run Cost Curves Quantity of output Total costs (in dollars) Total cost Total variable cost $ Cost per unit of output (in dollars) Average fixed cost Q1Q1 Q2Q2 Q3Q3 Marginal cost Average total cost Average variable cost $ Q 5-20

Managerial Economics and Organizational Architecture, 5e Long-Run Average Cost envelope of short-run average cost curves $ Q SRAC 1 SRAC 2 SRAC 3 SRAC 4 SRAC

Managerial Economics and Organizational Architecture, 5e Cost Concepts Economies of scale –Average costs fall as output expands Economies of scope –cost of producing a joint set of products is less than cost of producing separately in separate firms 5-22

Managerial Economics and Organizational Architecture, 5e Additional Cost Concepts Minimum efficient scale –plant size at which long-run average cost first reaches its minimum point (Q*) –Helps determine the number of firms in an industry and therefore the level of competition Learning curves –costs decline with production experience 5-23

Managerial Economics and Organizational Architecture, 5e Learning Curve Average cost of producing Q* units $ Cost per unit of output (in dollars) Cumulative quantity of output produced Learning curve ΣQΣQ 5-24

Managerial Economics and Organizational Architecture, 5e Economies of Scale versus Learning Effects Quantity of output Cost per unit of output (in dollars) $ Learning effect Average cost with low cumulative volume Average cost with high cumulative volume Q 5-25

Managerial Economics and Organizational Architecture, 5e Profit Maximization A firm should increase output as long as marginal revenue exceeds marginal cost A firm should not increase output if marginal cost exceeds marginal revenue At the profit-maximizing level of output, MR=MC 5-26

Managerial Economics and Organizational Architecture, 5e Optimal Output and Changes in Marginal Cost Cost/revenue per unit (in dollars) Quantity of output MR MC 1 MC 0 Q Q1Q1 Q0Q0 $ 5-27

Managerial Economics and Organizational Architecture, 5e Factor Demand Efficient production requires that MP i /P i = MP j /P j From which we derive the demand curve (marginal revenue product) for input i P i =MR  MP i Marginal revenue product, MRP, is the addition to revenue from using one more unit of an input 5-28

Managerial Economics and Organizational Architecture, 5e Factor Demand Curve Quantity of input i Cost/revenue per unit of input (in dollars) Q*iQ*i QiQi P*iP*i MRP i $ 5-29

Managerial Economics and Organizational Architecture, 5e Cost Estimation Effective management decisions should incorporate estimates of short- and long- run costs Use regression analysis Short-run costs may be approximately linear VC = a + bQ 5-30