The Cobb-Douglas Production Function

The Cobb-Douglas production function is particularly useful because it captures how inputs
can be substituted for each other and how they contribute to production in a simplified form.
The basic form of the Cobb-Douglas production function is:

where:
 = Output (quantity of goods or services produced).
 = Total factor productivity (a constant that represents technology or efficiency level).
 = Labor input (amount of labor used in production, often measured in hours worked or
the number of employees).
 = Capital input (amount of physical capital, such as machines, buildings, and tools used in
production).
α = Output elasticity of labor (the percentage change in output resulting from a 1% change
in labor, holding capital constant).
β = Output elasticity of capital (the percentage change in output resulting from a 1%
change in capital, holding labor constant).
Key Assumptions of the Cobb-Douglas Production Function
I. Constant Returns to Scale (in its most basic form):
1)

1) If we scale both inputs, labor (L) and capital (K), by the same factor (e.g., doubling both
inputs), the output will also double. This happens when α + β = 1.
2) In more general cases, the sum of α and β can indicate different types of returns to
scale:
a. If α + β = 1 → Constant returns to scale (output changes proportionally with input
changes). For example, 
b. If α + β > 1 → Increasing returns to scale (output increases by a larger percentage
than the increase in inputs). For example, 
c. If α + β < 1 → Decreasing returns to scale (output increases by a smaller
percentage than the increase in inputs). For example, 
II. Diminishing Marginal Returns:
The function assumes that as more and more of one input is added while holding the other
input constant, the additional output generated by the extra input decreases. This is known
as the law of diminishing marginal returns.
For example, if capital (K) is fixed and more labor (L) is added, the additional output from
each new worker will decrease after a certain point.
III. Substitutability between Labor and Capital:
The Cobb-Douglas function assumes that labor and capital are substitutable, meaning a firm
can use more of one input and less of the other to produce the same level of output.
The elasticities α and β indicate how easily labor and capital can be substituted for each
other.
Example of a Cobb-Douglas Production Function
Let’s assume a specific Cobb-Douglas production function for a small factory:

In this example:
A = 2: This reflects the factory's technology level or efficiency.
α = 0.6: A 1% increase in labor will increase output by 0.6%.
β = 0.4: A 1% increase in capital will increase output by 0.4%.
If the factory employs 100 units of labor and 50 units of capital, the output would be:

So, the factory produces approximately 151 units of output.
Average and Marginal Products for the Cobb-Douglas
Production Function
Average Product of Labour, 
Marginal Product of Labour, 
Average Product of Capital, 
Marginal Product of Capital, 
Case II: Fortnite and the Theory
of Production
Background
Fortnite, developed by Epic Games, has become a phenomenon in the gaming industry,
attracting millions of players worldwide. As an online, multiplayer game, Fortnite operates
on a game-as-a-service model, meaning it constantly evolves through updates,
seasonal events, and new content to retain its player base and generate revenue. This case
study explores how the Theory of Production applies to Fortnite's development,
focusing on production functions, the distinction between short-run and long-run decisions,
returns to scale, and optimal resource allocation. It provides a complete picture of how
Fortnite uses these production principles to ensure smooth operations and maintain its
competitive edge.
Fortnite's managers and developers must make strategic decisions about labor
(developers, testers, content creators) and capital (servers,
software tools, cloud infrastructure). Additionally, they need to balance
fixed and variable costs while evaluating returns to scale to determine
whether increasing resources will proportionately improve output.
In this case, we apply production theory concepts to Fortnite to demonstrate how it ensures
optimal performance while controlling costs and planning for future growth.
Fortnite’s output is measured in terms of the number of features or updates released each month. The
company’s primary inputs include:
Labor (L): Developers, testers, artists, content designers, and support staff
Capital (K): Servers, cloud infrastructure, development tools, and software licenses
These inputs influence Fortnite's ability to release timely updates, launch events, and respond to player
feedback, ensuring both player satisfaction and game stability.

Short-Run Production at Fortnite

Fixed Capital (K): Server capacity and cloud resources cannot be adjusted quickly in response to
demand surges.
Variable Labor (L): Fortnite can hire temporary developers or testers during peak periods to release
new updates and events.
Long-Run Production at Fortnite
In the long run, Fortnite can adjust both labor and capital. For example, if the player base grows, Fortnite can
hire more developers and expand its server infrastructure to support more players.
Fortnite’s production function can be expressed using the Cobb-Douglas
production function:

where,
Q = Output (Number of updates or new features per month)
A = Total Factor Productivity (impact of technology, management expertise, and
efficiency)
L = Labor (Developers and testers)
K = Capital (Servers, cloud infrastructure, and software tools)
α and β = Output elasticities of labor and capital, respectively.
In Fortnite’s case, α > β, meaning labor plays a more significant role than capital in the
production process. Creative development, content updates, and bug fixing are labor-
intensive processes, even though sufficient server capacity is essential for game
performance.
Case
Questions

Q.1. The Cobb-Douglas production function for Fortnite is given as:


If labor is increased by 50% and capital is increased by 20%, what will be the new output
(Q')?
Q.2. Using the same production function, calculate the marginal product of labor (MPL)
when L = 100 units and K = 50 units.
Q.3. Assume Fortnite has hired 50 developers and is producing 100 new features per
month. If adding 10 more developers increases production to 110 new features, does
Fortnite experience diminishing marginal returns to labor? Justify your answer with
calculations.
Solutions
(a) 
Initial Labor = L New Labor = 1.5L
Initial Capital = K New Capital = 1.2K
New Output, Q′ = 
(b) 
So, the marginal product of labor is approx. 1.14 units of output per additional unit of labor.
(c) 

Since, MP < AP of the first 50 developers, Fortnite is experiencing diminishing marginal returns to labor.
Question 1: The Noble Widget Corporation produces just one product, widgets. The
company’s new economist has calculated a short-run production function as follows:

where Q is the number of widgets produced per day and V is the number of production
workers working an 8-hour day.
a) Develop a production schedule with V equaling 1 to 10.
b) Calculate average and marginal products.
Solution:

Workers (V) Output (Q) Average Product (AP) Marginal Product (MP)
1 7.5 7.5 7.5
2 15.6 7.8 8.1
3 23.7 7.9 8.1
4 31.2 7.8 7.5
5 37.5 7.5 6.3
6 42.0 7.0 4.5
7 44.1 6.3 2.1
8 43.2 5.4 -0.9
9 38.7 4.3 -4.5
10 30.0 3.0 -8.7
Question 2: The economist for the ABC Truck Manufacturing Corporation has calculated a production
function for the manufacture of their medium-size trucks as follows:

where  is number of trucks produced per week,  is number of labor hours per day, and  is the daily usage of
capital investment.
a) Does the production function exhibit increasing, constant, or decreasing returns to scale? Why?
b) How many trucks will be produced per week with the following amounts of labor and capital?
Labor Capital
100 50
120 60
150 75
200 100
300 150
c) If capital and labor both are increased by 10 percent, what will be the percentage increase in quantity
produced?
d) Assume only labor increases by 10 percent. What will be the percentage increase in production?
e) Assume only capital increases by 10 percent. What will be the percentage increase in production?
(a) Total sum of the exponents = 0.75 + 0.3 = 1.05
Since, the sum of the exponents is greater than 1, the production function exhibits increasing returns to
scale.
(b) The number of trucks produced per week with the given amounts of labor and capital is given by:


For L = 100 and K = 50: 132.93 trucks.

For L = 120 and K = 60: 160.98 trucks.
For L = 150 and K = 75: 203.48 trucks.
For L = 200 and K = 100: 275.24 trucks.
For L = 300 and K = 150: 421.32 trucks.
(c) When both labor and capital are increased by 10%:
New labor, L′ = 1.1L New capital K′ = 1.1K
The new output will be: Q′ = 1.3 × (1.1L)0.75 × (1.1K)0.3
Percentage increase in output = 
(d) In this case, capital remains constant, and only labor increases by 10%.
The new labor is L′ = 1.1L, while capital, K remains the same. The percentage change can be
calculated similarly to part (c).
Percentage increase in output = 
(e) In this case, the new capital is K′ = 1.1K, and labor, L remains the same.
Percentage increase in output = 
 Managerial Economics
(ECON 231)
Instructor: Dr. Ronil Barua (Assistant Professor – Finance)

Email: [email protected]
Office: Room No 208, Kasturba Building (2nd Floor)

Essential reading: Keat P. G., P. K. Y. Young and S. Banerjee - Managerial Economics, Pearson

Unit VI: Theory of Cost

The theory of cost in economics explains the relationship between a firm’s production process
and the associated costs. It focuses on how firms incur costs when producing goods and services, and how
these costs change with output levels. Understanding this theory helps firms make decisions related to
production, pricing, and profitability. The theory of cost is divided into short-run costs and long-run
costs, which reflect different planning horizons.
Fixed Costs (FC):
Costs that remain constant regardless of the level of output.
Examples: Rent for a studio, salaries of permanent staff.
Variable Costs (VC):
Costs that vary directly with the level of output.
Examples: Payment to suppliers, marketing expenses.
In the short run, at least one input is fixed (such as factory size, machinery, or contracts), while other
inputs (like labor or raw materials) are variable. The short run has both fixed and variable costs.
In the long run, all inputs are variable, meaning the firm can change its production capacity entirely.
Firms can build new facilities, purchase advanced technology, or enter new markets. There are no fixed
costs in the long run—every cost becomes variable.
 Historical Vs Replacement Cost
Historical cost refers to the original monetary value of an asset at the time it was acquired. This includes
the purchase price and any additional expenses incurred to get the asset ready for use (such as installation
costs, transportation, etc.). Historical costs remain fixed and do not change over time, regardless of the market
value of the asset. E.g.: A company purchased machinery for $100,000 five years ago. The value recorded in
the financial books will remain $100,000, even if the current market value has changed.
Replacement cost refers to the current cost of replacing an asset with a similar one in the market. This
cost reflects the amount that would need to be spent to obtain an equivalent asset at today's prices, taking
into account factors such as inflation and technological advancements. E.g.: Replacing the same machinery
today may cost $120,000 due to inflation and technological changes. This reflects the replacement cost, not
the historical cost.

Aspect Historical Cost Replacement Cost

Definition Original acquisition cost Current cost to replace the asset
Impact on Financials Fixed on financial statements Fluctuates with market conditions
Used for historical performance Influences future investment
Decision-Making
analysis decisions
 Opportunity Cost Vs Out-of-Pocket Cost
Opportunity cost refers to the potential benefits or returns that are forgone when one alternative is
chosen over another. It represents the value of the next best alternative that is not pursued due to the
decision made. E.g.: A restaurant owner uses $50,000 to renovate the existing space. The opportunity cost is
the income the owner could have earned if the same amount was invested in the equity market instead.
Out-of-pocket costs are actual expenses that a company incurs as a result of a decision or action.
These costs are cash-based and represent the direct expenditures that the company must pay, such as
salaries, materials, and transaction fees. E.g.: A retail store spends $10,000 on salaries, rent, and utilities for
the month. These are out-of-pocket costs since they involve immediate cash outflows.

Aspect Opportunity Cost Out-of-Pocket Cost

Definition Value of the next best alternative Actual cash expenses incurred
Affects strategic choices and trade- Impacts budgeting and financial
Impact on Decision-Making
offs planning
Often theoretical and requires Quantifiable and recorded in
Measurement
estimation financial statements
 Sunk Cost Vs Incremental Cost
Sunk cost refers to expenses that have already been incurred and cannot be recovered. These costs
should not influence future decision-making because they remain constant regardless of the outcomes of
those decisions. E.g.: A software company spent $30,000 developing a product prototype, but after market
testing, it decides to discontinue the project. The $30,000 is a sunk cost.
Incremental cost refers to the additional costs that will be incurred as a result of a decision. It is the
difference in total cost that arises when comparing two alternatives. E.g.: An airline adds a new flight route
from City A to City B. The incremental cost includes extra fuel, crew salaries, airport fees, and maintenance
associated with operating this new route.

Aspect Sunk Cost Incremental Cost

Additional costs incurred from a
Definition Costs that cannot be recovered
decision
Should not influence future Essential for evaluating options and
Impact on Decision-Making
decisions determining profitability
Variable and depends on the
Measurement Fixed once incurred
decision at hand
 The Short-Run Cost
Function
Fixed Costs: Costs that do not vary with the quantity of output produced
Variable Costs: Costs that vary with the quantity of output produced.

Total fixed cost (TFC): The total cost of using the fixed input K.
Total variable cost (TVC): The total cost of using the variable input L.
Total cost (TC): The total cost of using all the firm’s inputs (in this case, L and K).
Average fixed cost (AFC): The average or per-unit cost of using the fixed input K.
Average variable cost (AVC): The average or per-unit cost of using the variable input L.
Average total cost (AC): The average or per-unit cost of using all the firm’s inputs.
Marginal cost (MC): The change in a firm’s total cost (or, for that matter, its total variable cost) resulting
from a unit change in output.





 Effects on Short-Run Cost Structure of Price Changes in Fixed and Variable Inputs

A reduction in the firm’s variable cost

A reduction in the firm’s fixed would cause all three cost curves to
cost would simply cause the shift. Minimum  and  occur at the same
average cost curve to shift output levels as MC and AVC, but
downward minimum occurs at a larger output level
 The Relationship Between
Production and Cost
Production and Cost are inversely related.
 Eq (1)
Because TVC = , we have:
 Eq (2)
Substituting Eq (2) into Eq (1), we have:
 Eq (3)
Recalling the definition of MP, we know that . Incorporating this observation into Eq (3), we have:

The above equation tells us that, assuming a constant wage rate, MC will decrease when MP increases and will
increase when MP decreases (i.e., when the law of diminishing returns takes effect).