The Production Process and Costs

Murat Issabayev, PhD, Associate Professor of Economics

Date: October 11 - 18, 2022
 Learning Objectives
1. Explain alternative ways of measuring the productivity of inputs and
the role of the manager in the production process.
2. Calculate input demand and the cost-minimizing combination of inputs
and use isoquant analysis to illustrate optimal input substitution.
3. Calculate a cost function from a production function and explain how
economic costs differ from accounting costs.
4. Explain the difference between and the economic relevance of fixed
costs, sunk costs, variable costs, and marginal costs.
5. Calculate average and marginal costs from algebraic or tabular cost
data and illustrate the relationship between average and marginal
costs.
6. Distinguish between short-run and long-run production decisions and
illustrate their impact on costs and economies of scale.
7. Conclude whether a multiple-output production process exhibits
economies of scope or cost complementarities and explain their
significance for managerial decisions.
© 2017 by McGraw-Hill Education. All Rights Reserved. 2
 The Production Function
The Production Function
• Mathematical function that defines the maximum
amount of output that can be produced with a given
set of inputs.
𝑸 = 𝑭 𝑲, 𝑳
• 𝑸 is the level of output.
• 𝑲 is the quantity of capital input.
• 𝑳 is the quantity of labor input.

5-3
©2017 by McGraw-Hill Education. All Rights Reserved.
 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.

5-4
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Measures of Productivity
• Total product (TP)
• Maximum level of output that can be produced with a given
amount of inputs.
• Average product (AP)
• A measure of the output produced per unit of input.
𝑸
• Average product of labor: 𝑨𝑷𝑳 =
𝑳
𝑸
• Average product of capital: 𝑨𝑷𝑲 =
𝑲

• Marginal product (MP)

• The change in total product (output) attributable to the last
unit of an input.
∆𝑸
• Marginal product of labor: 𝑴𝑷𝑳 =
∆𝑳
∆𝑸
• Marginal product of capital: 𝑴𝑷𝑲 =
∆𝑲

5-5
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Measures of Productivity in Action

• Consider the following production function when 5
units of labor and 10 units of capital are combined
produce: 𝑸 = 𝑭 𝟏𝟎, 𝟓 = 𝟏𝟓𝟎.
• Compute the average product of labor.
𝟏𝟓𝟎
𝑨𝑷𝑳 = = 𝟑𝟎 units per worker
𝟓
• Compute the average product of capital.
𝟏𝟓𝟎
𝑨𝑷𝑲 = = 𝟏𝟓 units of capital.
𝟏𝟎

5-6
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function
Increasing, Decreasing, and Negative
Total product
Marginal Returns
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 Marginal product (MPL) Labor input

(holding capital constant)

5-7
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

The Role of the Manager in the

Production Process
• Produce output on the production function.
• Aligning incentives to induce maximum worker effort.
• Use the right mix of inputs to maximize profits.
• To maximize profits when labor or capital vary in the short
run, the manager will hire:
• Labor until the value of the marginal product of labor equals the
wage rate: 𝑽𝑴𝑷𝑳 = 𝒘, where 𝑽𝑴𝑷𝑳 = 𝑷 × 𝑴𝑷𝑳
• Capital until the value of the marginal product of capital equals the
rental rate: 𝑽𝑴𝑷𝑲 = 𝒓, where 𝑽𝑴𝑷𝑲 = 𝑷 × 𝑴𝑷𝑲

5-8
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function
The Role of the Manager in the
Production Process
• Value marginal product: The value of the output
produced by the last unit of an input.
• Law of diminishing returns: The marginal product of an
additional unit of output will at some point be lower
than the marginal product of the previous unit.
• Profit-Maximization input usage
• To maximize profits, use input levels at which marginal
benefit equals marginal cost
• When the cost of each additional unit of labor is w, the
manager should continue to employ labor up to the point
where VMPL = w in the range of diminishing marginal
product.
5-9
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Algebraic Forms of Production Functions

• Commonly used algebraic production function forms:
• Linear: Assumes a perfect linear relationship between all
inputs and total output
𝑸 = 𝑭 𝑲, 𝑳 = 𝒂𝑲 + 𝒃𝑳 , where 𝒂 and 𝒃 are
constants.
• Leontief: Assumes that inputs are used in fixed proportions
𝑸 = 𝑭 𝑲, 𝑳 = 𝐦𝐢𝐧 𝒂𝑲, 𝒃𝑳 , where 𝒂 and 𝒃 are
constants.
• Cobb-Douglas: Assumes some degree of substitutability
among inputs
𝑸 = 𝑭 𝑲, 𝑳 = 𝑲𝒂 𝑳𝒃 , where 𝒂 and 𝒃 are constants.

5-10
© 2017 by McGraw-Hill Education. All Rights Reserved.
 Cobb-Douglas Production Function
• It is given by 𝑸 = 𝑭 𝑲, 𝑳 = 𝑲𝒂 𝑳𝒃
• The coefficient “a” is the output elasticity with respect to capital
• “a” is also the share of total costs spent on capital
• The coefficient “b” is the output elasticity with respect to labor
• “b” is also the share of total costs spent on labor

11
 Cobb-Douglas Production Function
Let
𝑸𝟎 = 𝑭 𝑲, 𝑳 = 𝑲𝒂 𝑳𝒃
• If a+b>1, then increasing returns to scale. It means if all the inputs
increase by constant “t>1”, then output will increase by more than
“t”. That is, let 𝑸𝟏 = 𝑭(𝒕𝑲, 𝒕𝑳)
• So 𝑸𝟏 = 𝒕𝑲 𝒂 𝒕𝑳 𝒃 = 𝒕𝒂 𝑲𝒂 𝒕𝒃 𝑳𝒃 = 𝒕𝒂+𝒃 𝑲𝒂 𝑳𝒃 = 𝒕𝒂+𝒃 𝑸𝟎
• since 𝒂 + 𝒃 > 𝟏, then 𝒕𝒂+𝒃 > 𝒕

12
 Cobb-Douglas Production Function
Let
𝑸𝟎 = 𝑭 𝑲, 𝑳 = 𝑲𝒂 𝑳𝒃
• If a+b<1, then decreasing returns to scale. It means if all the inputs
increase by constant “t>1”, then output will increase by less than “t”.
That is, let 𝑸𝟐 = 𝑭(𝒕𝑲, 𝒕𝑳)
• So 𝑸𝟐 = 𝒕𝑲 𝒂 𝒕𝑳 𝒃 = 𝒕𝒂 𝑲𝒂 𝒕𝒃 𝑳𝒃 = 𝒕𝒂+𝒃 𝑲𝒂 𝑳𝒃 = 𝒕𝒂+𝒃 𝑸𝟎
• since 𝒂 + 𝒃 < 𝟏, then 𝒕𝒂+𝒃 < 𝒕

13
 Cobb-Douglas Production Function
Let
𝑸𝟎 = 𝑭 𝑲, 𝑳 = 𝑲𝒂 𝑳𝒃
• If a+b=1, then constant returns to scale. It means if all the inputs
increase by constant “t>1”, then output will also increase by “t”. That
is, let 𝑸𝟑 = 𝑭(𝒕𝑲, 𝒕𝑳)
• So 𝑸𝟑 = 𝒕𝑲 𝒂 𝒕𝑳 𝒃 = 𝒕𝒂 𝑲𝒂 𝒕𝒃 𝑳𝒃 = 𝒕𝒂+𝒃 𝑲𝒂 𝑳𝒃 = 𝒕𝒂+𝒃 𝑸𝟎 = 𝒕𝑸𝟎
• since 𝒂 + 𝒃 = 𝟏, then 𝒕𝒂+𝒃 = 𝒕.

14
 The Production Function
Algebraic Forms of Production
Functions in Action
• Suppose that a firm’s estimated production function is:
𝑸 = 𝟑𝑲 + 𝟔𝑳
• How much output is produced when 3 units of capital
and 7 units of labor are employed?
𝑸 = 𝑭 𝟑, 𝟕 = 𝟑 𝟑 + 𝟔 𝟕 = 𝟓𝟏 units

5-15
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Algebraic Measures of Productivity

• Given the commonly used algebraic production
function forms, we can compute the measures of
productivity as follows:
• Linear:
• Marginal products: 𝑴𝑷𝑲 = 𝒂 and 𝑴𝑷𝑳 = 𝒃
𝒂𝑲+𝒃𝑳 𝒂𝑲+𝒃𝑳
• Average products: 𝑨𝑷𝑲 = and 𝑨𝑷𝑳 =
𝑲 𝑳
• Cobb-Douglas:
• Marginal products: 𝑴𝑷𝑲 = 𝒂𝑲𝒂−𝟏 𝑳𝒃 and 𝑴𝑷𝑳 = 𝒃𝑲𝒂 𝑳𝒃−𝟏
𝑲 𝒂 𝑳𝒃 𝑲 𝒂 𝑳𝒃
• Average products: 𝑨𝑷𝑲 = and 𝑨𝑷𝑳 =
𝑲 𝑳

5-16
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function
Algebraic Measures of Productivity in
Action
• Suppose that a firm produces output according to the
production function
𝑸 = 𝑭 𝟏, 𝑳 = 𝟏 𝟏Τ𝟒 𝑳𝟑Τ𝟒
• Which is the fixed input?
• Capital is the fixed input.
• What is the marginal product of labor when 16 units of
labor is hired?
𝟑 −𝟏 𝟑 𝟏
−𝟒 𝟑
𝑴𝑷𝑳 = 𝟏 × 𝑳 𝟒 = 𝟏 × 𝟏𝟔 =
𝟒 𝟒 𝟖

5-17
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Isoquants and Marginal Rate of

Technical Substitution
• Isoquants capture the tradeoff between combinations
of inputs that yield the same output in the long run,
when all inputs are variable.
• Marginal rate of technical substitutions (MRTS)
• The rate at which a producer can substitute between two
inputs and maintain the same level of output.
• Absolute value of the slope of the isoquant.
𝑴𝑷𝑳
𝑴𝑹𝑻𝑺𝑲𝑺 =
𝑴𝑷𝑲

5-18
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function
Isoquants and Marginal Rate of
Technical Substitution in Action
Capital Input

𝑄3 = 300 units of output

B
𝑄2 =200 units of output

𝑄𝐼 =100 units of output

0 Labor Input

5-19
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function
Diminishing Marginal Rate of
Capital Input
Technical Substitution
D
∆𝑲 𝟑
Slope: = − = −𝟑 = −𝑴𝑹𝑻𝑺𝑲𝑳
∆𝑳 𝟏
∆𝑲 =3

C
∆𝑲 𝟏
Slope: = − = −𝟏 = −𝑴𝑹𝑻𝑺𝑲𝑳
∆𝑳 𝟏
B
∆𝑲 = 𝟏 A

𝑸𝟎 =100 units

0 Labor Input
∆𝑳 = −𝟏 ∆𝑳 = −𝟏

5-20
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Isocost and Changes in Isocost Lines

• Isocost
• Combination of inputs that yield cost the same cost.
𝒘𝑳 + 𝒓𝑲 = 𝑪
or, re-arranging to the intercept-slope formulation:
𝑪 𝒘
𝑲= − 𝑳
𝒓 𝒓
• Changes in isocosts
• For given input prices, isocosts farther from the origin are
associated with higher costs.
• Changes in input prices change the slopes of isocost lines.

5-21
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Isocosts
Capital Input

𝑪
𝒓
𝑪 𝒘
𝑲= − 𝑳
𝒓 𝒓

0 𝑳 𝑪
Labor Input
𝒘

5-22
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Changes in the Isocosts

Capital Input
𝐶1
𝑟

𝐶0 More expensive input

𝑟 bundles

Less expensive input

bundles

0 𝐶0 𝐶1
Labor Input
𝑤 𝑤

5-23
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Changes in the Isocost Line

Capital Input
𝐶
𝑟

Due to increase in wage rate

𝑤1 > 𝑤 0

𝐶 𝐶
0 Labor Input
𝑤1 𝑤0

5-24
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Cost Minimization and the

Cost-Minimizing Input Rule
• Cost minimization
• Producing at the lowest possible cost.
• Cost-minimizing input rule
• Produce at a given level of output where the marginal
product per dollar spent is equal for all input:
𝑴𝑷𝑳 𝑴𝑷𝑲
=
𝒘 𝒓
• Equivalently, a firm should employ inputs such that the
marginal rate of technical substitution equals the ratio of
input prices:
𝑴𝑷𝑳 𝒘
=
𝑴𝑷𝑲 𝒓

5-25
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Cost-Minimization Input Rule in Action

Capital Input
𝐶1
𝑟

𝐶2 𝐴
𝑟
𝒘
𝑴𝑹𝑻𝑺𝑲𝑳 =
𝒓

𝑄𝐼 =100 units

0 𝐶2 𝐶1
Labor Input
𝑤 𝑤

5-26
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Production Function

Optimal Input Substitution

ഥ , the firm
• To minimize the cost of producing a given level of output,𝑸
should use less of an input and more of other inputs when that
input’s price rises. That is,
𝐦𝐢𝐧 𝑪 = 𝒘𝑳 + 𝒓𝑲 𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝑸 ഥ = 𝑸(𝑲, 𝑳)
𝑲,𝑳
ℒ 𝐿, 𝐾, 𝜆 = 𝒘𝑳 + 𝒓𝑲 + 𝝀 𝑸ഥ − 𝑸 𝑲, 𝑳

ℒ𝑳 = 𝒘 − 𝝀𝑸𝑳 = 𝟎 (𝟏)
ℒ𝑲 = 𝒓 − 𝝀𝑸𝑲 = 𝟎 (𝟐)
ഥ − 𝑸 𝑲, 𝑳 = 𝟎
ℒ𝝀 = 𝑸 (𝟑)

© 2017 by McGraw-Hill Education. All Rights Reserved. 27

 Optimal Input Substitution
𝝏𝑸
• Here the 𝑸𝑳 = 𝑴𝑷𝑳 = holding capital fixed. Similarly, 𝑸𝑲 =
𝝏𝑳
𝝏𝑸
𝑴𝑷𝑲 = holding labor fixed.
𝝏𝑲
𝒘 𝒓 𝑴𝑷𝑳 𝒘
• From (1) and (2), we have 𝝀 = = => =
𝑴𝑷𝑳 𝑴𝑷𝑲 𝑴𝑷𝑲 𝒓
𝑴𝑷𝑳
• So, 𝑀𝑅𝑇𝑆 =- , which is the slope of isoquant curve.
𝑴𝑷𝑲
𝒘
• And - is the slope of isocost curve.
𝒓
𝑴𝑷𝑳 𝒘
• Notice: the condition = for cost minimization works only for
𝑴𝑷𝑲 𝒓
Cobb-Douglas function.
28
 Optimal Input Substitution
• For linear production function where K and L are perfect substitutes,
such as 𝑸 = 𝒂𝑲 + 𝒃𝑳, the optimal level of inputs in cost
minimization is found as follows:

𝑴𝑷𝑳 𝒘
• If > , isoquant is steeper than isocost, then producer will use
𝑴𝑷𝑲 𝒓
∗ 𝑸
ONLY labor in production. That is, 𝑸 = 𝒃𝑳 ⇒ 𝑳 = .
𝒃

𝑴𝑷𝑳 𝒘
• If < isoquant is flatter than isocost, then producer will use
𝑴𝑷𝑲 𝒓
∗ 𝑸
ONLY capital in production. That is, 𝑸 = 𝒂𝑲 ⇒ 𝑲 = .
𝒂

29
 The Production Function
Optimal Input Substitution in Action
Capital Input
I

New cost-minimizing
point due to higher wage

F
B
𝐾2 Initial point of cost minimization

A
𝐾1
𝑄0
H J
0 𝐿2 𝐿1 G Labor Input

5-30
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Cost Function
The Cost Function
• Mathematical relationship that relates cost to the cost-
minimizing output associated with an isoquant.
• Short-run costs
• Fixed costs (𝑭𝑪): do not change with changes in output;
include the costs of fixed inputs used in production
• Sunk costs
• Variable costs [𝑽𝑪 𝑸 ]: costs that change with changes in
outputs; include the costs of inputs that vary with output
• Total costs: 𝑻𝑪 𝑸 = 𝑭𝑪 + 𝑽𝑪 𝑸
• Long-run costs
• All costs are variable
• No fixed costs

5-31
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Cost Function

Short-Run Costs
Total costs 𝑻𝑪 𝑸 = 𝑭𝑪 + 𝑽𝑪 𝑸
Variable costs
Fixed costs
𝑽𝑪 𝑸

𝐹𝐶

𝑭𝑪

𝑭𝑪

0 Output

5-32
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Cost Function

Average and Marginal Costs

• Average costs
𝑭𝑪
• Average fixed cost: 𝑨𝑭𝑪 =
𝑸
𝑽𝑪 𝑸
• Average variable costs: 𝑨𝑽𝑪 =
𝑸
𝑻𝑪 𝑸
• Average total cost: 𝑨𝑻𝑪 =
𝑸

• Marginal cost (MC)

• The (incremental) cost of producing an additional unit of
output.
∆𝑻𝑪
• 𝑴𝑪 =
∆𝑸

5-33
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Cost Function
The Relationship between Average
ATC, AVC, AFC
and Marginal Costs
and MC ($) 𝐴𝑇𝐶
𝑀𝐶 A𝑉𝐶

Minimum of ATC

Minimum of AVC
𝐴𝐹𝐶
0 Output

5-34
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Relationship between Average
and Marginal Costs
• So, if 𝑻𝑪 𝑸 = 𝑭𝑪 + 𝑽𝑪 𝑸 , then
𝑻𝑪(𝑸) 𝑭𝑪+𝑽𝑪 𝑸 𝑭𝑪 𝑽𝑪(𝑸)
• 𝑨𝑻𝑪 𝑸 = = = + = 𝑨𝑭𝑪 𝑸 + 𝑨𝑽𝑪(𝑸)
𝑸 𝑸 𝑸 𝑸
𝒅𝑨𝑭𝑪(𝑸) 𝒅 𝑭𝑪 𝟎−𝑭𝑪
• The slope of AFC(Q) is = = 𝟐 < 𝟎. This implies,
𝒅𝑸 𝒅𝑸 𝑸 𝑸
as Q increases, the AFC will decline. On the other hand, the slope of
the AVC(Q) is
𝑽𝑪 𝑸
𝒅𝑨𝑽𝑪(𝑸) 𝑽𝑪′ 𝑸 𝑸−𝑽𝑪(𝑸) 𝑽𝑪′ 𝑸 − 𝑴𝑪 𝑸 −𝑨𝑽𝑪(𝑸)
𝑸
= = =
𝒅𝑸 𝑸𝟐 𝑸 𝑸

35
 The Relationship between Average
and Marginal Costs
𝒅𝑨𝑽𝑪 𝑸
if 𝑴𝑪 𝑸 > 𝑨𝑽𝑪 𝑸 , then >𝟎
𝒅𝑸
𝑴𝑪 𝑸 −𝑨𝑽𝑪(𝑸) 𝒅𝑨𝑽𝑪 𝑸
• So 𝑸
if 𝑴𝑪 𝑸 = 𝑨𝑽𝑪 𝑸 , then
𝒅𝑸
=𝟎
𝒅𝑨𝑽𝑪 𝑸
if 𝑴𝑪 𝑸 < 𝑨𝑽𝑪 𝑸 , then <𝟎
𝒅𝑸
𝒅𝑨𝑽𝑪 𝑸
• > 𝟎 means AVC(Q) is increasing as Q increases
𝒅𝑸
𝒅𝑨𝑽𝑪 𝑸
• = 𝟎 means AVC(Q) reaches its’ minimum
𝒅𝑸
𝒅𝑨𝑽𝑪 𝑸
• < 𝟎 means AVC(Q) is decreasing as Q increases
𝒅𝑸

36
 The Relationship between Average
and Marginal Costs
𝒅𝑨𝑻𝑪(𝑸) 𝒅𝑨𝑭𝑪(𝑸) 𝒅𝑨𝑽𝑪(𝑸)
• Then = +
𝒅𝑸 𝒅𝑸 𝒅𝑸
𝒅𝑨𝑽𝑪(𝑸) 𝑴𝑪(𝑸)−𝑨𝑽𝑪 𝑸 −𝑨𝑭𝑪(𝑸) 𝑴𝑪 𝑸 −𝑨𝑻𝑪(𝑸)
• = =
𝒅𝑸 𝑸 𝑸
𝒅𝑨𝑻𝑪 𝑸
if 𝑴𝑪 𝑸 > 𝑨𝑻𝑪 𝑸 , then >𝟎
𝒅𝑸
𝑴𝑪 𝑸 −𝑨𝑻𝑪(𝑸) 𝒅𝑨𝑻𝑪 𝑸
• if 𝑴𝑪 𝑸 = 𝑨𝑻𝑪 𝑸 , then
𝒅𝑸
=𝟎
𝑸
𝒅𝑨𝑻𝑪 𝑸
if 𝑴𝑪 𝑸 < 𝑨𝑻𝑪 𝑸 , then <𝟎
𝒅𝑸

37
 The Relationship between Average
and Marginal Costs
𝒅𝑨𝑻𝑪 𝑸
• > 𝟎 means ATC(Q) is increasing as Q increases
𝒅𝑸
𝒅𝑨𝑻𝑪 𝑸
• = 𝟎 means ATC(Q) reaches its’ minimum
𝒅𝑸
𝒅𝑨𝑻𝑪 𝑸
• < 𝟎 means ATC(Q) is decreasing as Q increases
𝒅𝑸

38
 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.

• Irrelevance of Sunk Costs

• A decision maker should ignore sunk costs to maximize
profits or minimize loses.

5-39
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Cost Function

Algebraic Forms of Cost Functions

• The cubic cost function: costs are a cubic function of
output; provides a reasonable approximation to virtually
any cost function.
C(Q) = F + aQ + bQ2 + cQ3
where a, b, c, and F are constants and F
represents fixed costs
• Marginal cost function is:
MC(Q) = a + 2bQ + 3cQ2

© 2017 by McGraw-Hill Education. All Rights Reserved. 40

 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.

5-41
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Cost Function
Long-Run Average Cost
LRAC ($)
𝐴𝑇𝐶2
𝐴𝑇𝐶0 𝐿𝑅𝐴𝐶

𝐴𝑇𝐶1

0 𝑄∗ Output

5-42
© 2017 by McGraw-Hill Education. All Rights Reserved.
 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.

5-43
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Cost Function

Economies and Diseconomies of Scale

LRAC ($)

𝐿𝑅𝐴𝐶

Economies of scale Diseconomies of scale

0 𝑄∗ Output

5-44
© 2017 by McGraw-Hill Education. All Rights Reserved.
 The Cost Function

Constant Returns to Scale

LRAC ($)

𝐴𝑇𝐶2 𝐴𝑇𝐶3
𝐴𝑇𝐶1

𝐿𝑅𝐴𝐶

0 Output

5-45
© 2017 by McGraw-Hill Education. All Rights Reserved.
 Multiple-Output Cost Function

Multiple-Output Cost Function

• Economies of scope
• Exist when the total cost of producing 𝑸𝟏 and 𝑸𝟐 together is
less than the total cost of producing each of the type of
output separately.
𝑪 𝑸𝟏 , 𝟎 + 𝑪 𝟎, 𝑸𝟐 > 𝑪 𝑸𝟏 , 𝑸𝟐
• Cost complementarity
• Exist when the marginal cost of producing one type of
output decreases when the output of another good is
increased.
∆𝑴𝑪𝟏 𝑸𝟏 , 𝑸𝟐
<𝟎
∆𝑸𝟐

5-46
© 2017 by McGraw-Hill Education. All Rights Reserved.
 Multiple-Output Cost Function

Algebraic Form for a Multiproduct

Cost Function
𝟐 𝟐
𝑪 𝑸𝟏, 𝑸𝟐 = 𝒇 + 𝒂𝑸𝟏𝑸𝟐 + 𝑸𝟏 + 𝑸𝟐
• For this cost function:
MC1 = aQ2 + 2Q1
- When a < 0, an increase in Q2 reduces the marginal cost of
producing product 1.
- If a < 0, this cost function exhibits cost complementarity
- If a > 0, there are no cost complementarities
- Exhibits economies of scope whenever f - 𝒂𝑸𝟏𝑸𝟐 > 0

5-47
© 2017 by McGraw-Hill Education. All Rights Reserved.