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**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.

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**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

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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.

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**The Production Function**

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**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.

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**Measures of Productivity**

The Production Function Measures of Productivity

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**Measures of Productivity in Action**

The Production Function Measures of Productivity in Action

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**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)

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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

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**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

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**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

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**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.

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**The Manager’s Role in the Production Process**

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

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**Manager’s Role in the Production Process in Action**

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

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**Algebraic Forms of Production Functions**

The Production Function Algebraic Forms of Production Functions

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**Algebraic Forms of Production Functions in Action**

The Production Function Algebraic Forms of Production Functions in Action

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**Algebraic Measures of Productivity**

The Production Function Algebraic Measures of Productivity

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**Algebraic Measures of Productivity in Action**

The Production Function Algebraic Measures of Productivity in Action

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**Isoquants and Marginal Rate of Technical Substitution**

The Production Function Isoquants and Marginal Rate of Technical Substitution

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**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

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**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

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**Isocost and Changes in Isocost Lines**

The Production Function Isocost and Changes in Isocost Lines

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**The Production Function**

Isocost Line Capital Input Labor Input

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**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

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**Changes in the Isocost Line**

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

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**Cost-Minimization Input Rule in Action**

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

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**Cost Minimization and the Cost-Minimizing Input Rule**

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

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**Cost-Minimizing Input Rule in Action**

The Production Function Cost-Minimizing Input Rule in Action

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**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

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The Cost Function The Cost Function

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**Short-Run Costs in Action**

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

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**Average and Marginal Costs**

The Cost Function Average and Marginal Costs

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**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

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**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.

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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.

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**Long-Run Average Total Costs in Action**

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

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**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.

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**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

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**Constant Returns to Scale in Action**

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

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**Multiple-Output Cost Function**

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**Multiple-Output Cost Function in Action**

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Conclusion

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**Cost-Minimization In Action**

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

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**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

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**Cost-Minimization Input Rule In Action**

The Production Function Cost-Minimization Input Rule In Action

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**Multiple-Output Cost Function in Action**

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