Production, Inputs,

Cost, Output , Price

and Profit. Marginal
analysis

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Production, Inputs, Cost, Output ,
Price and Profit: Marginal Analysis

Slides based on
Chapter 7 and 8 Economics Principles and Policy by
Baumol and Blinder
Chapter 13 Principles of Economics by N. Gregory
Mankiw
Quantitative Methods for Business by Waters, Donald
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Contents
 Short-run versus Long-run Costs: What Makes an
Input Variable?
 Production and Input Choice, with One Variable
Input
 Multiple Input Decisions: The Choice of Optimal
Input Combinations
 Cost and Its Dependence on Output

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Contents (continued)
 Economies of Scale
 Appendix: Production Indifference Curves

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 Short-run versus Long-run
Costs
 The Economic Short Run vs the Long Run
Short run
• a period of time during which some of the
firm’s cost commitments will not have
ended.
• In the short run, output can change but
production processes are fixed.
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 Short-run versus Long-run
Costs
 TheEconomic Short Run vs the Long Run
Long run
a period of time long enough for all of
the firm’s commitments to come to an
end.
 In the long run, all inputs can be varied
and production processes can be
changed.
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 Short-run versus Long-run
Costs
Fixed Costs (FC) and Variable Costs (VC)
In the production of commodities and services the
firms have Fixed Cost and Varible Costs. Fixed costs
are for instance the buildings and the machinery.
Variable costs are for instance labour force and raw
material involved in the production.
Fixed costs = costs that cannot be changed
Variable costs = costs that can be changed
In the short run, some costs are fixed. In the long
run, all costs are variable.
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 Production and Input choice,
with 1 Variable Input

 Totalphysical product (TPP) is

the amount of output that can
be produced as one input
changes, with all other inputs
held constant

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 Total Physical Product for
Al’s Building Company

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 Total physical product with
Different Quantities of Carpenters
40
F
35 E
32 G
30
TPP
Garages per Year
Total Output in

25 D

20

15
C
10

5 B
A
0 1 2 3 4 5 6 7

Quantity of Carpenters
per Year
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 Production and Input Choice,
with 1 Variable Input
 Average Physical Product (APP) = measures the
output produced per unit of input. Is the total physical
product (TPP) divided by the quantity of input.
(APP=TPP/X where X is que quantity of input)
 Marginal physical product (MPP) = ∆ output per ∆
input (is the increase in total output that results from an
additional unit increase in the input, holding the amounts
of all other inputs constant)

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 Al’s Product Schedule
The
TheMPP
MPPof ofthe
thefourth
fourthcarpenter
carpenterisisthe
thetotal
totaloutput
output(garages)
(garages)when
whenAl
Al
(the
(theowner)
owner)employes
employes44carpenters
carpentersminus
minusthe thetotal
totaloutput
outputwhen
whenhehe
employes
employes33carpenters
carpenters(32-24=8)
(32-24=8)

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Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

 Al’s Marginal Physical Product
(MPP) Curve -
14
12 Increasing Diminishing Negative
marginal marginal marginal
10 returns returns returns

8
Garages per Year

4
MPP in

–2

–4 MPP
–6
0 1 2 3 4 5 6 7
Number of Carpenters
This
Thisgraph ofofMarginal
graph13 MarginalPhysical
PhysicalProduct
Productshows
showshow
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howmuch muchadditional
additionaloutput
output
(garages
(garagesper
peryear)
year)AlAlgets
getsfrom
fromeach
eachadditional
additionalcarpenter
carpenter he
Copyright © 2003he employes.
employes. Learning. All rights reserved.
South-Western/Thomson
MPP and the “Law” of Diminishing
Marginal Returns
 The law of dimishing marginal returns states than
an increase in an input (holding the amounts of all
other constants) ultimately leads to lower marginal
returns to the expanding input (↑ one input ⇒ ↓
additional output created by each additional unit of
the input)
 The law of dimishing marginal returns explains the
shape of the marginal physical product (MPP)
curve.
 The so-called law is simply based on some
observed facts; it is not a theorem deduced
analytically.
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Marginal Physical Product (MPP) and the
“Law” of Diminishing Marginal Returns
 MRP (Marginal revenue product) = marginal
physical product (MPP)× output price
 It means that the MRP of an input is the additional
revenue that the producer earns from the increased
sales when it uses an additional unit of the input.
 The amount of an input is optimal when marginal
revenue product (MRP) = (P) price of the input.
 It means when the marginal revenue product of an
input exceeds its price it pays the firm to use more
of that input.
 When the marginal revenue product of the input is
less than
15 its price it pays the firm to use less.
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 The optimal quantity of input and
dimishing returns
 When the marginal physical product (MPP)of input
begins to decline, the money value of that product
falls, as well; that is the marginal revenue product
(MRP)also declines.
 The producer always profits by expanding input use
until dimishing returns set in and reduce the MRP to
the price of the input. The firm has employed the
proper amount of input only when dimishing returns
reduce the marginal revenue product of the input to
the level of its price, because then the firm will be
wasting no opportunity to add to its total profit.
 Thus, the optimal quantity of an input is that at which
MRP equals its price. IN SYMBOLS: MRP= P of input
(marginal16
revenue product equals Price of input)
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 COST CURVE AND INPUT
QUANTITIES
 How much to produce? The quantity of output that
is most desiderable for firm depends on the way in
which costs change when output varies. Such
information is typically displayed in the form of cost
curves.
 We need three cost curves: TOTAL COST
CURVE, AVERAGE COSTS CURVE, AND THE
MARGINAL COST CURVE

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 TOTAL COST, AVERAGE
COST AND MARGINAL COST
 For any given output TOTAL COST is
defined as a total input quantities per prices
of the input needed .
 For any given output AVERAGE COST is
defined as a total cost divided by quantity
produced.
 MARGINAL COST is defined as the
increase in total cost that results from the
production of an additional unit of output.
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 TOTAL COST, MARGINAL COST
AND AVERAGE COST (AN
EXAMPLE)
 Suppose, for example, we know the total cost of making
a number of units of a product. We can divide this TOTAL
COST by the number of units to get the AVERAGE
COST. But it is often more useful to look at the
MARGINAL COST which is defined as the cost of making
one extra unit.
 Suppose we have already made 100 units at a TOTAL
COST of 50.000 euro. The AVERAGE COST is
50.000/100 =500. But the MARGINAL COST is the cost
of making the 101st unit. Because all investment in
equipment may already have been recovered, and we
have a lot of experience in making the product, this
MARGINAL COST might be considerably lower than the
AVERAGE 19 COST. Harcourt, Inc.
 A BIT OF CALCULUS…Marginal
Cost and Total Cost
 The marginal cost MC of a product is defined as
the additional cost of making one extra unit.
 In making this extra unit the total cost will
increase by MC, so the marginal cost is the rate
at which the total cost is changing
 If we know the equation for the total cost curve we
can differenciate it to get the marginal cost

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 A bit of calculus…

 Then
 TOTAL COST (TC)=y (it means, it is a
function that usually can be obtained
from analysis of empirical data)
 MARGINAL COST (MC)=dy/dx
(derivative of y divided by derivative of x)

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 WORKED EXAMPLE

 The total cost of making a quantity X of product

is calculated as TC= 2x2 + 4x + 500.
 What are the expressions for TOTAL, FIXED,
VARIABLE MARGINAL AND AVERAGE
COSTS?
 What are these costs if 500 units of the
product are made?

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WORKED EXAMPLE: solution

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 WORKED EXAMPLE: solution

 Fixed Cost: remain unchanged (500)

 VC=2×500²+ 4×500=502.000

 MC =4×500+4=2004

 AC= 2×500+4+500:500=1005

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 Multiple Input Decisions
Substitutability: The Choice of Input Proportions

Firms usually have a variety of techological options

and can substitute one input for another.

Given a target level of production, a firm that cuts

down on the use of one input (say labour) will normally
have to increase its use of another input (say
machinery)
The combination of inputs that represents the least
costly way to product the desired level of output
depends 25 on the relative prices of the various inputs.
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 Multiple Input Decisions

 The Marginal Rule for Optimal Input Proportion

 A firm can reduce the cost of producing a given
output by using less of some input A and making up
for it by using more of another input B, whenever the
ratio of Marginal Physical Product of A to the price of
A is less than the ratio of the Marginal Physical
Product of B to the price of B, that is, whenever
MPPa/Pa is less than MPPb/PB

 (MPP it means Marginal Physical Product and P means price)

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 Multiple Input Decisions
 Rule for optimal input proportions = the ratio of
marginal physical product to price should be the same
for all inputs

 MPPa/Pa = MPPb/Pb Where a and b means input a and input b

 If the ratio is higher for one input (for instance the

price of raw material, the price of machinery…)
more of that input should be used, and less of the
others, 27until the ratios are equal. Harcourt, Inc.
 Multiple Input Decisions

 Changes in Input Prices and Optimal Input

Proportions
 ↑ inputprice ⇒ ↓ ratio of marginal physical
product to price
 To maximize profits, the firm should switch away
from that input until its marginal physical product
rises enough to equalize the ratios again.

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 Cost and Its Dependence on
Output …I repeat again…
 Input Quantities and Total, Average, and Marginal
Cost Curves
 Total cost = the total cost (including opportunity
cost) of producing any level of output when inputs
are optimally employed
 Average cost = total cost per unit of output
 Marginal cost = increase in total cost from producing
an additional unit of output
 LETS SEE WHAT HAPPENS WHEN WE DRAW
THE CURVEs of Total Cost, Average Cost and
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29
Marginal Cost curves (Al’s firm)
 Al’s (Variable) Cost
Schedules

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(a) Al’s Total Cost Curve

200
180 TC
Total Cost per Year

160
(thousands $)

140
120
100
80
60
40
20
0 2 4 6 8 10

Quantity of Garages
(a)
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(b) Al’s Average Cost Curve
30 C
Average Cost per Garage

25
(thousands $)

20 AC
15 D
10

5
0 2 4 6 8 10

Quantity of Garages
(b)
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(c) Al’s Marginal Cost Curve
Marginal Cost per Added Garage

50 MC
45
40
(thousands $)

35
30
25
20
15
10
5
0 2 4 6 8 10

Quantity of Garages
(c)
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Input Quantities and Total, Average
Cost, and Marginal Cost Curves
 Total cost = total fixed cost + total
variable cost

 Total fixed cost: are constant over all

levels of output.

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Fixed Costs: Total
14
TFC
12
Total Fixed Cost per Year
(thousands of $)

10

0
1 2 3 4 5 6 7 8 9 10
Output
(a)
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Input Quantities and Total, Average
Cost, and Marginal Cost Curves
 Average fixed cost = total fixed
cost per unit of output

 Average fixed cost falls as output

rises

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 Al’s Fixed Costs

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 Fixed Costs: Average
14
Average Fixed Cost per Garage

12

10
(thousands $)

6
4

2 AFC

0
1 2 3 4 5 6 7 8 9 10
Output
(b)
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 The Average Cost Curve in
the Short and Long Run
 A typical average cost curve declines
at first because average fixed costs
decline.
 It then reaches a minimum and begins
to rise because the law of decreasing
marginal returns.

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The Average Cost Curve in the
Short and Long Run
 Costs differ in the short and long runs,
because in the long run, more adjustments
can be made.
 The long-run average cost curve shows the
lowest possible short-run average cost
corresponding to each output level.

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 Economies of Scale
 The law of diminishing returns holds in the case of the
expansion of a single input, holding other inputs constant.
 Returns to scale are relevant when all inputs increase at
the same rate.
 Economies of scale affect operations in many modern
industries. Where the exists they give larger firms cost
advantages over smaller ones and thereby foster large firm
sizes. Automobile production and telecommunications are
two good examples of industries with important economies of
scale.
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 Short-run and Long-Run
Average Cost Curves
The producer has a choice of 2 sizes of chicken coop, a small
Average Cost per Pound of Chicken one with the Average Curve SL and a big one with the Average
Curve BG. These are the short-run curves that apply as long as
the farm is stuck with its chosen coop.

In the long run, however, it can pick any point on the orange
lower boundary of these curves. This lower boundary STG is
the long-run Average Cost Curve
S

U B V L
$0.40
0.35 G
T
W

0 40 100

Output in Pounds of Chicken

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 Economies of Scale
 Production is said to involve ECONOMIES OF
SCALE, also referred to as to as INCREASING
RETURNS TO SCALE, if, when all input quantities are
doubled, the quantity of output is more than doubled
 Then
 a) Economies of scale = output rises faster than the
common rate of growth of all the inputs.
 b) Economies of scale = increasing returns to scale
 C) Economies of scale ⇒ long-run declining average
cost curves
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 Economies of Scale: the shapes of
the long-rung average cost curve
 Production functions with economies of scale lead to
long-run average cost curves (AC) that decline as
output expands (graph a)
 Next graph represents the shapes that the long-run
average cost curve can take.
 Remember that AC(average cost)=TC(total cost)/Q
(output).
 Sometimes the firm have constant returns of scale
that leads to a long run Average Cost curve flat
(graph b) . Also is possible that the firm has
decreasing returns of scale when long-run average
cost rise
44 as output expands (graph c)
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 3 Possible Shapes for the
Long-Run AC Curve

AC
Increasing returns Constant returns Decreasing returns
Long-Run Average Cost

Long-Run Average Cost

Long-Run Average Cost

to scale to scale to scale

AC

AC

Quantity of Output Quantity of Output Quantity of Output

(a) (b) (c)

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 Historical Costs versus
Analytical Costs Curves
 All points on the analytical cost curve (used
in economic analysis) refer to the same
period of time.
 An historical cost curve, showing the actual
relationship between cost and output at
different periods of time, is probably not a
good indicator of the analytical cost curve.

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 Declining HCC (historical cost
curve) ACC (analytical cost curve)
Cost per Unit

$100
A 1942 analytical
75 cost curve

50
Historical 2002 analytical
cost curve cost curve
25
B
0

Quantity of Output
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 Declining HCC (historical cost
curve) with /U-shaped Analytical
ACC

$100 1942 analytical

cost curve
Cost per Unit

75
Historical
50 cost curve
2002 analytical
25 cost curve B
A
0

Quantity of Output

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 Cost Minimization in Theory
and Practice
 Real business situations are more complex than
those outlined in this lecture, and the quality of
the available information is less precise.
 Yet when managers are doing their jobs well and
the market is functioning smoothly, these models
are a good approximation to the real world.

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 Some conclusions
 A firms total cost curve shows its lowest possible cost of
producing any given level of output. This curve is
derived from the input combination that the firm uses to
produce any given output and the prices of the input.

 The marginal physical product of an input is the increase

in total output resulting from a 1-unit increase in that
input, holding the quantities of all other inputs constant.

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 Cost Minimization in Theory
and Practice
 The law of dimishig maginal returns states that if a
firm increases the amount of one input (holding all
other input quantities constant) the marginal
physical product of the expanding input will
eventually begin to decline.

 To maximize profits, a firm must purchase an input

up to the point at which dimishing returns reduce the
input’s marginal revenue product to equal its price.
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 Some conclusions
 The long rung is a period sufficiently long for the firm’s
plant to require replacement and for all of its current
contractual commitments to expire. The short run is any
period briefer than that.
 TC (Total Cost) =TFC (Total Fixed Cost) +TVC (Total
Variable Cost)
 AC (Average Cost) =AFC (Average Fixed Cost) +AVC
(Average Variable Cost)
 It is possible to produce the same quantity of output in a
variety of ways by substituting more of one input for less of
another. Firms normally seek the least costly way to produce
any given output.
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 Some conclusions
 A firm that wants to minimize costs will select input quantities
at which the ratios of the marginal physical product of each
input to its price are equal for all inputs.
 If a doubling of all the firm’s inputs just doubles its output,
the firm is said to have constant returns to scale.
 If a doubling of all inputs leads to more than twice as much
output, it has increasing returns to scale (or economies of
scale).
 If a doubling of inputs produces less than a doubling of
output the firm has decreasing returns of scale.

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 ….and a bit of calculus more…i know I am
a bad guy

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 This figure shows a graph of the
equation y= ax² +bx+c. This is a
continuous function with a clear
minimum. If you look at the gradient at
point A it is clearly negative, showing
that y is falling in value as x increase.

At point B the gradient is positive,

showing that y is increasing in value as
x increases. The most interesting point
comes between these at point C where
the gradient is zero, in other words the
tangent to the curve is parallel with the
x axis. This only happens at one
specific point and this is the minimum
valuee of the graph.

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WORKED EXAMPLE:
What can you say about the minimum of y=2x²-4x+10?

We can diferénciate y=2x²-4x+10 to find the gradient at

any point. Then: dy/dx= 2×2×x-4=4x-4
For a minimum value of y this gradient is equal to
zero. In other words:
4x-4=0 or x=1
Substituting x=1 into the equation for y gives the
minimum value:
y=2x²-4x+10=2×1²-4×1+10=8
So the minimum value of the graph is y=8 which
occurs when
56 x=1 Harcourt, Inc.
57 Harcourt, Inc.
58 Harcourt, Inc.


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WORKED EXAMPLE 1
If y=4x²+3x – 2, what are a) the derivative, b) the
second derivative?

Solution:
If y=4x² +3x-2 then differenciating in the usually
way gives the first derivative dy/dx= 8x+3

If dy/dx= 8x+3 then differenciating in the usual

way gives the second derivative d²y/dx²=8
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WORKED EXAMPLE 2
The total cost of a manufacturing process is found to be
3x²-12x +30 where x is the number of units produced in
hundreds each week. What production level minimizes
the total cost?
We know that y= 3x²-12x+`30. This has a gradient given
by dy/dx=6x-12. There is a turning point when this
gradient has a value 0: that is 6x-12=0 or x=2. At this
point the function has the value
Y=3x²-12x+30=3×2²-12×2+30=18. The second derivative
d²y/dx²=6. This is positive, so the turning point has to
bea minimum. Then the total cost of production is a
minimum 61
of 18 when production
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is 200 units a week.