1. CHAPTER 5 The Production Process and Costs Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Chapter Outline The production function – Short- versus long-run decisions – Measures of productivity – Manager’s role in production process – Algebraic forms of the production function and productivity – 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 – Algebraic forms of cost functions – Long-run costs and economies of scale Multiple-output cost functions – Economies of scope and cost complementarity 5-2 Chapter Overview

3. 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 Chapter Overview

4. The Production Function 5-4 The Production Function

5. 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

6. Measures of Productivity 5-6 The Production Function

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8. Measures of Productivity in Action 5-8 The Production Function

9. Relation between Productivity Measures in Action 5-9 Labor input (holding capital constant) 0 Total product Average product Marginal product Total product (TP) Average product (AP L ) Marginal product (MP L ) Increasing marginal returns to labor Diminishing marginal returns to labor Negative marginal returns to labor The Production Function

10. The Manager’s Role in the Production Process 5-10 The Production Function

11. Manager’s Role in the Production Process in Action 5-11 The Production Function

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13. Algebraic Forms of Production Functions 5-13 The Production Function

14. Algebraic Forms of Production Functions in Action 5-14 The Production Function

15. Algebraic Measures of Productivity 5-15 The Production Function

16. Algebraic Measures of Productivity in Action 5-16 The Production Function

17. Isoquants and Marginal Rate of Technical Substitution 5-17 The Production Function

18. Isoquants and Marginal Rate of Technical Substitution in Action 5-18 Labor Input 0 A B Substituting labor for capital Increasing output Capital Input The Production Function

19. Diminishing Marginal Rate of Technical Substitution in Action 5-19 Labor Input (L) 0 D C Capital Input (K) B A The Production Function

20. Isocost and Changes in Isocost Lines 5-20 The Production Function

21. Isocost Line 5-21 Labor Input (L) 0 Capital Input (K) The Production Function

22. Changes in the Isocost Line 5-22 Labor Input (L) 0 Capital Input (K) The Production Function Less expensive input bundles More expensive input bundles

23. Changes in the Isocost Line 5-23 Labor Input (L) 0 Capital Input (K) The Production Function

24. Cost-Minimization Input Rule in Action 5-24 Labor Input (L) 0 Capital Input (K) The Production Function

25. Cost Minimization and the Cost-Minimizing Input Rule 5-25 The Production Function

26. Cost-Minimizing Input Rule in Action Suppose that labor and capital are hired at a competitive wage of $10 and $25, respectively. If the marginal product of capital is 6 units and the marginal product of labor is 3 units, is the firm hiring the cost-minimizing units of capital and labor? 5-26 The Production Function

27. Optimal Input Substitution in Action 5-27 Labor Input (L) 0 B Capital Input (K) New cost-minimizing point due to higher wage A Initial point of cost minimization The Production Function H I F J G

28. The Cost Function 5-28 The Cost Function

29. Short-Run Costs in Action 5-29 Output 0 Total costs Variable costs Fixed costs The Cost Function

30. Average and Marginal Costs 5-30 The Cost Function

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33. The Relationship between Average and Marginal Costs in Action 5-33 Output 0 ATC, AVC, AFC and MC ($) Minimum of ATC Minimum of AVC The Cost Function

34. 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. 5-34 The Cost Function

35. 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. 5-35 The Cost Function

36. Long-Run Average Total Costs in Action 5-36 Output 0 LRAC ($) The Cost Function

37. Economies of Scale Economies of scale – Portion of the long-run average cost curve where long-run average costs decline as output increases. Diseconomies of scale – Portion of the long-run average cost curve where long-run average costs increase as output increases. Constant returns to scale – Portion of the long-run average cost curve that remains constant as output increases. 5-37 The Cost Function

38. Economies and Diseconomies of Scale in Action 5-38 Output 0 LRAC ($) The Cost Function Economies of scale Diseconomies of scale

39. Constant Returns to Scale in Action 5-39 Output 0 LRAC ($) The Cost Function

40. Multiple-Output Cost Function 5-40 Multiple-Output Cost Function

41. Multiple-Output Cost Function in Action 5-41 Multiple-Output Cost Function

42. Conclusion 5-42

43. 5-43 Labor Input (L) 0 Capital Input (K) The Production Function Cost-Minimization In Action

44. Diminishing Marginal Rate of Technical Substitution in Action 5-44 Labor Input (L) 0 A B Capital Input (K) C D The Production Function