Economics for Managers

by Paul Farnham

Chapter 5:
Production and Cost Analysis
in the Short Run

5.1
 Defining the
Production Function
A production function describes the relationship
between a flow of inputs and the resulting flow of
outputs in a production process during a given period
of time. The formula can be read as “quantity of
output is a function of the inputs listed inside the
parentheses”
Q = f (L, K, M…)
where
Q = quantity of output
L = quantity of labor input
K = quantity of capital input
5.2
M = quantity of materials input
 Fixed Inputs Versus
Variable Inputs

• Fixed input: quantity a manager

cannot change during a given
time
• Variable input: quantity a manager
can change during a given time
• Amount of output would vary as
managers made decisions
regarding amounts of input
5.3
 Short-run Versus
Long-run Production

• Not expressed in terms of

calendar time, but in terms of
fixed and variable inputs
• Short-run production function:
involves at least one fixed input
• Long-run production function:
production process in which all
inputs are variable
5.4
 Managerial Rule of Thumb:
Short-run Production and
Long-run Planning

• Managers operate in the short

run, but must have long-run
vision
• They need to be aware that the
current amount of fixed inputs
may not be appropriate as market
conditions change
• Managers make more long run
economic decisions

5.5
 Model of the Short-run
Production Function
Total product: total quantity of output
produced with a given quantity of fixed and
variable inputs

ഥ)
TP or Q = f (L, 𝑲
where
TP or Q = total product or quantity of
output
L = quantity of labor input(variable)
K = quantity of capital input(fixed) 5.6
 Average Product

Average product: amount of

output per unit of variable input

AP = TP / L or Q / L

where
AP = The average product of labor

5.7
 Marginal Product

Marginal product: the additional

output produced with an
additional unit of variable input

MP = Δ TP / Δ L = Δ Q / Δ L
where
MP = The marginal product of labor

5.8
Problem:

Land Labour Q (or) TP AP=TP/L MP=TP/ L

2 0 0 - -

2 1 10 10/1=10 (10-0)/(1-0)= 10

2 2 24 24/2=12 (24-10)/(2-1)= 14

2 3 45 45/3= 15 (45-24)/(3-2)= 21

2 4 65 65/4= 16.2 (65-45)/(4-3)= 20

2 5 65 65/5= 13 (65-65)/(5-4)= 0

2 6 52 52/6= 8.6 (52-65)/(6-5)= (-)13

2 7 42 42/7= 6 (42-52)/(7-6)= (-)10

TP,AP,MP
70

60

50

40
Stage I II Stage III
30 TP
20

10
AP
Labour
0 1 2 3 4 5 6 7
-10
MP
-20
Total Product: Short-run
Production Function
Figure 5.1a

Law of diminishing
returns where marginal
product eventually
decreases

TP

L
0 L1 L2 L3
5.1
2
 TP: Short-run
Production Function

• TP increases rapidly up to level of

labor input L1 then increases at a
slower rate as labor input increases
• TP curve becomes flatter and flatter
until it reaches maximum output
level at L3
• Curve implies that marginal product
of labor first increases rapidly then
decreases, eventually becoming
zero or less
5.10
AP and MP: Short-run
Production Function
Figure 5.1b

MP

AP

B
L
0 L1 L2 L3
5.14
 AP and MP: Short-run
Production Function

• Between zero and L2, MP curve

lies above AP curve, causing AP
curve to increase
• Beyond L2 , MP curve is below
AP curve, causing AP curve to
decrease
• Therefore, MP curve must
intersect AP curve at maximum
point of AP curve(AP=MP)
5.15
 Relationships Among TP,AP,MP
INPUT RANGE EFFECT ON TOTAL AND/OR EFFECT ON MARGINAL
AVERAGE PRODUCT PRODUCT

Input values : zero to 𝐿1 TP increases at MP is positive and

increasing rate increasing
Input values : 𝐿1 to 𝐿3 TP increases at MP is positive and
decreasing rate decreasing
Input values : beyond TP decreases MP is negative and
𝐿3 decreasing
Input value : 𝐿3 TP is at a maximum MP equals zero

Input values : zero to AP increases MP is greater than AP

𝐿2
Input values : beyond AP decreases MP is less than AP
𝐿2
Input values :𝐿2 AP is at a maximum MP = AP
 Economic Explanation
• Increasing marginal returns: region where
MP curve is positive and increasing (0 to
𝑳𝟏 )so that TP increases at an increasing rate
• Law of diminishing returns: region where
marginal product curve is positive but
decreasing ( 𝑳𝟏 to 𝑳𝟑 ) so that TP is
increasing at a decreasing rate
• Negative marginal returns: region where
marginal product curve is negative so that
TP is decreasing( beyond 𝑳𝟑 ) so that TP is
decreasing

5.18
 Law of Diminishing
Returns

• Additional output generated by

additional units of variable input
(MP) is decreasing

• Occurs because capital input and

technologies are held constant

5.19
Productivity Changes
Across Industries

Q = f (K, L, E, M, t)
where
Q = industry output
K = capital services
L = labor services
E = energy use
M = materials use
t = level of technology
5.20
 Model of Short-run
Costs Functions

• Cost function: shows relationship

between cost of production and level of
output
Opportunity cost: The economic measure
of cost that reflects the use of resources in
one activity, such as a production process by
one firm, in terms of the opportunities
forgone in undertaking the next best
alternative activity. 5.23
 Model of Short-run
Costs Functions

• Explicit cost: payment to an

individual that is recorded in an
accounting system
• Implicit costs: value of using a resource
that is not explicitly paid out, is often
difficult to measure, and not recorded in
an accounting system
5.24
• If Firm A could rent the office space it owns to
Firm B for $100,000 per year, then the
opportunity cost to Firm A of using that space
in its own production is $100,000 per year. This
is an implicit cost if it is not actually included in
the firm’s accounting system.
• Another example of an implicit cost is the
valuation of the owner’s or family member’s
time in a family-operated business.
 Measuring
Opportunity Cost
Prices that a firm pays for input reflects
opportunity cost
• If managers do not recognize
opportunity costs, they may have too
much invested in buildings or other
assets
• Historic cost: amount of money a firm
paid for an input when it was
purchased, which for machines and
capital equipment could have occurred
many years in the past. 5.26
 Accounting Profit and
Economic Profit

• Profit: difference between total revenue

and total cost of production ( = TR-TC)
• Accounting profit: difference between
total revenue and total explicit cost
• Economic profit: difference between
total revenue and total costs, both
implicit and explicit Costs
5.27
 Managerial Rule of Thumb:
Importance of Opportunity Costs

• Measuring opportunity costs can be

difficult because accountants are
trained to examine explicit costs
• Managers need to take into
account both types of costs
(explicit and opportunity costs)

5.20
Short-run Cost Functions

• Short-run cost function: shows

relationship between output and
costs based on underlying short- run
production function
• It is a cost function for short-run
production process in which there is
at least one fixed input of production

5.29
 Costs

• Total fixed cost: cost of using fixed

input (TFC)
• Total variable cost: price per unit of
labor times quantity of labor input
(TVC)
• Total cost: sum of total fixed cost plus
total variable costs (TC=TFC+TVC)
5.30
 Costs
• Average fixed cost: total fixed cost per
unit of output (AFC)
• Average variable cost: total variable
cost per unit of output(AVC)
• Average total cost: total cost per unit
of output= average fixed cost plus
average variable cost (ATC)(AC)
ATC = AFC + AVC
• Marginal cost: additional cost of 5.31
producing additional units of output (MC)
Short-run Cost Function

COST FUNCTION DEFINITION

Total fixed cost ഥ
TFC = (𝑃𝑘 )(𝐾)
Total variable cost TVC = (𝑃𝐿 )(L)
Total cost TC = TFC + TVC
Average fixed cost AFC = TFC/Q
Average variable cost AVC = TVC/Q
Average total cost ATC = AC = TC/Q = AFC + AVC
Marginal cost MC =  TC/ Q = (TFC + TVC)/ Q
= TVC/Q
 Total, Average, and
Marginal Cost

• AFC decreases continuously as

more output is produced
• Since TFC is constant, AFC must
decline as output increases
• AVC and ATC first decrease then
increase
• ATC always equals AFC plus AVC
5.34
TC, TCV, TFC Functions
Figure 5.2a

TC TVC
Cost

TFC

0 Q
Q1 Q2 Q3
5.35
 MC, ATC, AVC,
and AFC FunctionsFigure 5.2b

Cost
MC
ATC
AVC

AFC
0 Q1 Q2 Q3 Q
5.36
Relationships ATC, AVC and MC

• AVC, ATC and MC curve are U-shaped

curves, showing that these costs first
decrease, reach a minimum point, and
then increase very rapidly as output
increases.
• The MC curve intersects the AVC curve and
the ATC curve at its minimum point.
 Short-run
Production and Cost

MP MC

AVC
AP

0
0 L1 L2 L Q1 Q2 Q
5.38
 Short-Run Production and Cost Function

COST/PRODUCTION DERIVATION
RELATIONSHIP

Relationship between MC and ∆ 𝑇𝑉𝐶 (𝑃𝐿 )(∆𝐿)

MC = =
∆𝑄 ∆𝑄
marginal product of labour( 𝑀𝑃𝐿 )
𝑃𝐿 𝑃𝐿
MC = ∆𝑄 =
( ) 𝑀𝑃𝐿
𝐿
Relationship between average 𝑇𝑉𝐶 (𝑃𝐿 )(𝐿)
AVC = =
𝑄 𝑄
variable cost
( AVC) and average product of 𝑃𝐿 𝑃𝐿
labour( 𝐴𝑃𝐿 ) AVC = 𝑄 =
(𝐿) 𝐴𝑃𝐿
 Managerial Rule of Thumb:
Understanding Your Costs

Managers need to understand

• Technology and prices paid for
inputs of production
• Difference between variable and fixed
costs
• Difference between average costs (costs
per unit of output) and marginal costs
(additional costs of producing additional
units of output)
5.42
Econometric Estimation
of Cost Functions
• Dean’s studies of a furniture factory, a
leather belt shop, 1976
• Johnston’s study of British electric
generating plants, road passenger
transport, and food processing firm,
1960
• Hall, 1986
• Blinder, et al, 1990s
5.43
 Summary of Key Terms

• Accounting profit • Explicit cost

• Average fixed • Fixed input
cost • Historic cost
• Average product • Implicit cost
• Average total cost • Marginal returns
• Average variable • Diminishing returns
cost
• Long-run production
• Cost function functions
• Economic profit
5.30
 Summary of Key Terms

• Marginal cost • Total cost

• Marginal product • Total fixed cost
• Negative marginal • Total product
returns
• Production function • Opportunity
cost
• Short-run
production function • Total variable
• Short-run cost cost
function • Variable input

5.31