CHAPTER 5

The Production Process

and Costs

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 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

The Production Function

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 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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 The Production Function

Measures of Productivity

5-6
 The Production Function

Measures of Productivity in Action

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 The Production Function

Relation between Productivity Measures in Action

Total product
Increasing Decreasing Negative
Average product marginal marginal marginal
Marginal product returns to labor returns to labor returns to labor

Total product (TP)

Average product (APL)

0 Labor input
Marginal product (MPL) (holding capital constant)

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

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

5-10
 The Production Function
Algebraic Forms of Production Functions

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 The Production Function
Algebraic Forms of Production
Functions in Action

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 The Production Function

Algebraic Measures of Productivity

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 The Production Function
Algebraic Measures of Productivity in Action

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 The Production Function
Isoquants and Marginal Rate of
Technical Substitution

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 The Production Function
Isoquants and Marginal Rate of
Capital Input
Technical Substitution in Action

0 Labor Input

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 The Production Function
Diminishing Marginal Rate of Technical
Capital Input
Substitution in Action

B
A

0 Labor Input

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 The Production Function

Isocost and Changes in Isocost Lines

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 The Production Function

Isocost Line
Capital Input

0 Labor Input

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 The Production Function

Changes in the Isocost Line

Capital Input

More expensive input

bundles

Less expensive input

bundles

0 Labor Input

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 The Production Function

Changes in the Isocost Line

Capital Input

0 Labor Input

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 The Production Function

Cost-Minimization Input Rule in Action

Capital Input

0 Labor Input

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

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 The Production Function

Cost-Minimizing Input Rule in Action

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 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

H J
0 G Labor Input

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 The Cost Function
The Cost Function

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

0 Output

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 The Cost Function

Average and Marginal Costs

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 The Cost Function
The Relationship between Average
and Marginal Costs in Action
ATC, AVC, AFC
and MC ($)

Minimum of ATC

Minimum of AVC

0 Output

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

0 Output

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 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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 The Cost Function
Economies and Diseconomies
of Scale in Action
LRAC ($)

Economies of scale Diseconomies of scale

0 Output

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

0 Output

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 Multiple-Output Cost Function

Multiple-Output Cost Function

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 Multiple-Output Cost Function

Multiple-Output Cost Function in Action

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Conclusion

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 The Production Function

Cost-Minimization In Action
Capital Input

0 Labor Input

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 The Production Function
Diminishing Marginal Rate of Technical
Capital Input
Substitution in Action

C
D

0 Labor Input

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 The Production Function

Cost-Minimization Input Rule In Action

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 Multiple-Output Cost Function

Multiple-Output Cost Function in Action

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