1. Managerial Economics Eighth Edition Truett + Truett
Chapter 5: Production Analysis
John Wiley & Sons, Inc.
9/18/2018
Slides by Jim Witsmeer

2. Chapter 5 Outline Theory of Production Long Run Production
Production Function
Least Cost Production
Substitution of Inputs
Economic Region & Expansion Path
Returns to Scale
Short Run Production
Law of Diminishing Returns
Profit Maximization
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3. Corporations and Production
Hollow Corporations
Virtual Corporations
Production Technology
Production efficiency in the:
Long run all inputs can vary
Short run some inputs are fixed
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4. Production Function Where; Q is output quantity L is labor input
K is capital input
E is energy input
C is catalyst input
We will focus on the two primary input variables labor and capital
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5. Least-Cost Production
What is least-cost production and how is it measured and achieved?
Least Cost Production occurs when the inputs are combined in such a way that the cost is minimum.
Marginal Product tells how much output we get from an additional unit of input. Greater marginal product means lower cost per additional unit of output.
NOTE: Unit cost of output varies inversely with input productivity. or
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6. Production Function Plot
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7. Isoquants
An isoquant is a contour, which contains all input combinations yielding the same production output
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8. Marginal Rate of Substitution
Marginal Rate of Substitution (MRS) is the rate at which one input can be substituted for another without changing the production output.
The MRS is related to the slope of the isoquant at any combination of inputs
INCREASED QUANTITY ΔK ΔL
The MRS is the negative of the slope of the isoquant
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9. MRS related to Marginal Product
If we move along an isoquant (Q is constant) then the impact of increasing one input must be offset by the decrease in the other input.
therefore: Or
The rate at which one input can be substituted for another is inversely related to their productivities
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10. Substitution of Inputs
Three categories of substitution
Not substitutes
Perfect substitutes
Imperfect substitutes
See Figure 5-6 of the text
We have been looking at imperfect substitutes where the MRS varies depending on your operating point.
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11. Least-Cost Combination of Inputs
The MRS is the Marginal Rate of (Technical) Substitution because it is substitution while maintaining constant output.
For every production output quantity there is a unique combination of inputs that minimizes cost called the Least-Cost Combination of Inputs.
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12. Isocost Lines
An isocost line is a line containing all input combinations that result in the same cost.
The cost equation is:
PK = $1/unit K
PL = $2/unit L
INCREASED COST
Cost = $6
With constant cost:
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13. Test for Least-Cost Combination
The tangent point between an isocost and an isoquant represents least cost.
With constant cost:
Increase cost until the curves first touch this is the least-cost combination
 With constant quantity:
 Therefore at the least–cost combination:
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14. Economic Region of Production
Ridge lines are lines which connect all the points where MPK and MPL are zero.
The region between the ridge lines is called the economic region of production
In the long run, a profit oriented firm will never employ input combinations outside the ridge lines.
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15. Expansion Path
Given the slope of the isocost line (input price ratio), each isoquant has a unique least-cost combination point.
A least-cost point occurs whenever an isocost line is tangent to an isoquant.
These points can be connected to form an expansion path.
In the long run, the firm will expand by moving out the path that connects these points.
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16. Returns to Scale
If output changes are more proportional to a given proportion of change in all inputs, there are increasing returns to scale.
If output changes are less proportional to a given proportion of change in all inputs, there are decreasing returns to scale.
If output changes are exactly proportional to a given proportion of change in all inputs, there are constant returns to scale.
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17. Short Run Production Optimization
In the long run all inputs are variable while in the short run only a limited number of inputs can be varied due to time and capital constraints.
However the same least-cost approach that we developed for the long run can be used to compare alternative production strategies in the short run.
In our study of the short run, we will assume K is fixed and only L is variable.
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18. Short Run Definitions TOTAL PRODUCT / unit time (with only L variable)
AVERAGE PRODUCT
MARGINAL PRODUCT or
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19. Law of Diminishing Returns
The law of diminishing marginal productivity states in the short run productivity will fall as output is increased.
MPL = 0
A line from the origin is tangent to Total Product curve at the maximum average product.
APL = MPL
APL is maximum
Three significant points are:
MPL is maximum
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20. Cost Savings in the Short Run
The combination L0 and K0 are least cost.
In the short run K is fixed at K0. Any input L other than L0 will result in other than least cost. K
If the input required is I1 then input L can be reduced to point E. KO KO
If the utilization of K is flexible a better option is to operate at point G even though reduction in L,
using only part of the K0 units of K and saving on use of L. L LO
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21. Profit Maximization
The objective is not to minimize cost but to maximize profit: Not the same thing. We will show that for variable L profit is maximum when:
Where:
MRPL is the Marginal Revenue Product of input L.
NMR is the Net Marginal Revenue obtained from each additional unit of production output, Q.
MCL is the Marginal Cost of input L.
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22. End of Chapter 5
Copyright © 2004 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the United States copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for resale. The publisher assumes no responsibilities for errors, omissions, or damages, caused by the use of the information contained herein.
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