Chapter 8 Production Function & Cost Function

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Contents: Short Run and Long Run Production Function Cost Accounting of Factor Inputs Cost Function Short Run Cost Curves Long Run Cost Curves Theory of Production Cost by A. Alchian Advanced Material 8.1: Costs Related to an Owned Durable Equipment
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Short Run & Long Run

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Reasons for the existence of different production runs:

Whenever a market situation changes a firm has to make a new decision so as to maximize wealth.

At the beginning
The firm is uncertain if the change in the market situation is temporary or permanent. It will make only the minimal and necessary change in factors to minimize cost.

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Reasons for the existence of different production runs:

Afterwards Even if the change is certain to be permanent, the adjustment in factors should still be slow and gradual because hasty change involves a larger cost.

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Reasons for the existence of different production runs:

Since adjustment is gradual, according to the completeness in the adjustment in factors, three different production runs are classified.

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Classification of production runs

Very short run (VSR) all factors are fixed (remains unchanged).
Short run (SR) some factors are varied but some are fixed. Long run (LR) all factors are variable and
all required variations have been made.
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Variable factors versus fixed factors

Variable factors: are factors of which the employment varies with output. Fixed factors: are factors of which the employment does not vary with output.

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Q8.1 Fill in the table.

VSR
Any change in factor employment? Any change in output level? Reasons

SR

LR

No

All factors are Some factors are variable and all varied but some required changes are are fixed made

No

Yes

Yes

No adjustment Temporary adjust. Time is needed Time is needed Final adjustment to recognize the to identify if the Time is long enough for the final adjust. change, make change is permanent decision & & to make gradual to be determined & implemented. implement adjustment to adjustment minimize cost

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Q8.2: Some economists define the very long run as the period over which the technology changes. Comment..

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Production Function

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Production function () describes the relationship between inputs () and output ().

Inputs

Output

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Production function in the short run

Assumptions:

only two factors are involved capital & labour

Capital

Variable factor

Fixed Factor
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Three variables are defined to measure the output: Total product (TP) ____________________ : is the whole amount of output produced by all the factors employed. Average product (AP) : is the output per unit of the ____________________ variable factor employed. ____________________ Marginal product (MP) : the change in output resulting from employing an additional unit of the variable factor.

TP = Q

TP Q AP L L

MP

TP L
L 1

Q L
L 1

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The law of diminishing marginal productivity

Law of diminishing marginal productivity () [or the law of diminishing returns () or the law of variable proportions ()]
states that if a _________ variable factor is added continuously to a

given amount of _________ fixed factors, the marginal product

(and the average product) of the _________ variable factor must finally decrease, ceteris paribus.
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Derivation of the law:

With a given amount of fixed factors, when one worker is employed, he can use only some of the fixed factors each time. When more workers are employed, they can specialize and raise the productivity. (Both MP & AP ). However, after all the fixed factors have been efficiently used, additional workers can help the preceding workers only. Hence MP which will finally drag down AP (and even TP).
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Graphical illustration:

Variable factors Fixed factor

MP AP

MP

AP

Once the MP curve passes through the AP curve and lies below it, the AP curve will also be dragged down. Why?

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When AP rises, MP must lie above AP.

When AP falls, MP must lie below AP. How can MP lying above AP become lying below it? (If MP curve is continuous, it must pass through the maximum point of AP curve.)

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Features:
The slope of TP curve is MP. The slope of the line joining the origin and a point on TP is AP. Notice the points where MP = maxi.; MP=AP & MP = 0.
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Implications of the law (if the law is violated)

By adding units of fertilizer or worker continuously to a given plot of land, no matter how small its size is, TP can be increased continuously. Enough food can be produced to feed all the people in the world.
An infinitesimal piece of land is adequate to supply the amount of food required. Hence the supply of land is no longer scarce. Land price would drop to zero. MP of workers cultivating superior land does not fall and is always larger than MP of workers cultivating inferior land. No inferior land would be cultivated.
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Implications of the law (if the law holds)

If the amount of land is fixed, TP cannot be increased significantly ( MP & AP ) to feed all the people in the world.
Hence to raise production, more land is needed. However, as the supply of land is limited and scarce, under competition, land price must be positive.

Once MP of superior land falls below MP of inferior land, inferior land will also be cultivated.
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Production Function in the long run

Returns to scale ()
refers to the change in output when all factors are increased by the same proportion.

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Production Function in the long run

There are three kinds of returns to scale: Increasing returns to scale Constant returns to scale

Decreasing returns to scale

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Increasing returns to scale ()

when all factors are increased by the same proportion, the total product increases more than proportionately.

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Constant returns to scale ()

when the production scale increases, the total product increases proportionately.

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Decreasing return to scale ()

when the production scale increases, the total product increases less than proportionately.

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Assumptions (in the LR):

At the beginning
the production function has increasing returns to scale

At the end
the production function has decreasing returns to scale

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Cost Accounting of Factor Inputs

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For factors hired or employed by a firm:

The costs are (the value of) the highestvalued alternative use of the money spent in hiring them.
They are called explicit costs (), as they involve a transfer of money.

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For factors owned by a firm:

The costs of using these factors are (the value of) the highest-valued alternative uses of the factors. They are called implicit costs () or imputed costs (), as they do not involve a transfer of money.

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Q8.4: What is the cost to a firm of using an owned property as an office for a year, if the premise can be leased at $20 000 a month or sold at $5 million, given a market interest rate of 4% per annum?

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Classification of costs of different factor inputs Sunk cost (historical cost)

The cost of a past act.
As past options are not available at present, sunk cost cannot be avoided now. Sunk cost is not a (present or future) cost. Bygone is bygone. It should have no effect on any present or future decisions.

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Fixed cost
The cost of employing fixed factors.

It does not change with output.

It has no effect on MC & no effect on the determination of the wealth-maximizing output level. It is a present cost paid for the use of fixed factors and hence it affects the net receipt.

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Variable cost
The cost of employing variable factors. It changes with output. It affects marginal cost & hence it affects the wealthmaximizing output. It is a present cost paid for the use of variable factors & hence it affects the net receipt.

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Q8.6: A restaurant is making a short run decision for its production next month. Identify if the following costs are sunk costs (SC), fixed costs (FC) or variable costs (VC). (a) Rent of the restaurant under a 2-year contract ( ) (b) Wage payments ( ) (c) Expenditure on meat and vegetables ( ) (d) Water charges ( ) (e) Electricity charges ( ) (f) Acquisition cost of machines ( ) (g) Continuing possession cost of machines ( ) (h) Operating cost of machines ( )
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Cost Function

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Cost function () describes the relationship between output and cost.

Output

= ???
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Short-run Cost Curves

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Measure of costs

Output changes Cost changes Change in cost can be expressed in three ways: Total cost (TC)
Average cost (AC)

Marginal cost (MC)

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Total cost
is the whole amount of payments to all factors used in producing a given amount of output (Q), composed of:

Total fixed cost (TFC): is the whole amount of

payments to fixed factors. Total variable cost (TVC): is the whole amount of payments to variable factors.

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Formula:
Assume two factors only: Capital (fixed factor) and labour (variable factor) L units of labour are employed at a wage rate of w.

Total Cost:
total fixed cost:

TC = TFC +TVC
a constant independent of output TVC = w x L

total variable cost:

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Average cost/average total cost (ATC)

is the cost per unit of output, composed of : average fixed cost (AFC): the fixed cost per unit of output. average variable cost (AVC): the variable cost per unit of output.

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Formula:
Average Total Cost:
ATC TC TFC TVC AFC AVC Q Q AFC TFC Q

average fixed cost:

average variable cost:
AVC TVC Q
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w L L Q L w w Q AP L

w L Q

Features:
AFC curve drops continuously. (AFC = TFC/Q) AVC curve is Ushaped. ( AVC = w/AP and AP is inverted-U shaped.) ATC curve and AVC curve will come closer and closer as the amount of output increases (ATC = AFC + AVC and AFC drops continuously).
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The turning point of ATC curve (b) occurs at a larger output than the turning point of AVC curve (a). Why?

At (a), the fall in AFC is > the rise in AVC initially

but at (b), the fall in AFC is < the rise in AVC eventually

(a) (b)
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Marginal Cost is the change in total cost for producing an additional unit of output, composed of :
marginal fixed cost (MFC): is the change in fixed cost for producing an additional unit of output marginal variable cost (MVC): is the change in variable cost for producing an additional unit of output.

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Formula:
Marginal cost:
TC TFC TVC MC MFC MVC Q Q

marginal fixed cost:

MFC

TFC 0 Q

marginal variable cost:

w L MVC TVC Q w w L Q Q Q MP L L w L

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As TFC is a constant, MFC = 0. So MC = MVC. MC = MVC = w/MP. As MP curve is inverted-U shaped, MC or MVC curve is U-shaped. MC curve passes through the minimum points of AVC curve and ATC curve.

MC or MVC curve is U-shaped

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Derivation of total cost curves:

MC curve (= MVC curve) = Slope of TC curve & TVC curve. Notice the points where MC = mini.; MC = AVC and MC = ATC.

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Q8.7: The following table is composed of product items and cost items of a firm. Suppose the unit cost of capital and labour are $10 and $20 respectively. Fill in the missing columns..
Units Units of of capital labour TP AP MP TFC TVC TC ATC

4 4 4 4 4 4

1 2 3 4 5 6

2 5 10 14 14 12

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Q8.8 (a) When output increases, if AP of a variable factor rises, what will happen to AVC and ATC?

(b) When output increases, if AP of a variable factor falls, what will happen to AVC and ATC?

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Long-run Cost Curves

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The firm enjoys economies of scale at the beginning

LRAC & LRMC

As the scale of production further, the firm suffers diseconomies of scale

LRAC & LRMC

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Optimum scale
The production scale (combination of factors) with the lowest LRAC. U-shaped LRAC curve LRAC curve with a horizontal region

Optimum scale
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Derivation of total cost curves:

LRMC = slope of LRTC

Slope =LRMC =LRAC

Notice the points where LRMC = mini. and LRMC = LRAC.

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Theory of Production Cost by A. Alchian

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Volume = Rate x Time Duration

Rate effect: To produce the same volume of output, the faster the rate, the higher the average cost. Why? Volume effect: At the same rate of production, the larger the volume, the lower the average cost. Why?

Proportionate increase in both the rate and volume: If both the rate and the volume are increased proportionately, the average cost may fall at the beginning but it must rise eventually. Why?
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Advanced Material 8.1 Cost related to an owned durable equipment

1. Present value and future value

Present value
Computing the present value (PV) of a future sum ($X) is called discounting ().

Future value
Computing the future value (FV) of a present sum ($Y) is called compounding ().

PV = $X / (1+r)t
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FVt = $Y (1+r)t

2. Classification of costs related to an owned durable equipment

Acquisition cost () is the amount forgone in acquiring the ownership of an asset.

Continuing possession cost () is the amount forgone in keeping an asset without using it.

Operating cost () is the amount forgone in using an asset.

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Worked example:
-Purchase price of machine A = $10 000 -Immediate resale value = $9 600 -Resale value if machine A has been laid idle for a year = $8 000 -Resale value if machine A has been operated for a year = $4 000 -Additional expense for operating machine A (e.g., labour cost) = $1 000 -Market interest rate = 10% (a) Acquisition cost = ? (b) Continuing possession cost = ? (c) Operating cost = ?

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Correcting Misconceptions:
1. In the long run, all factors are variable and are varied gradually so as to minimize cost.
2. The law of diminishing returns states that when all inputs increase, output will increase at a decreasing rate eventually.

3. If the law of diminishing marginal productivity does not hold, scarcity no longer exists and production involves zero cost.
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Correcting Misconceptions:
4. The cost of using a factor is equal to zero if no explicit payment is involved. 5. The cost of using an owned asset is equal to the purchase price of the asset.

6. Fixed cost is the same as sunk cost.

7. When output increases, if AP of the variable factor falls, the AC rises.
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Survival Kit in Exam

Question 8.1: In a recession, an employer can earn enough revenue to cover the rent, labour cost, water and electricity charges and the maintenance cost of machines. However, the remaining revenue cannot cover their repayment to bank loans for buying machines. Suppose the machines have zero resale value. Is it irrational for the employer (a) to continue the running of the firm, and (b) to buy the machines?

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