Lahore Leads University

Department of Economics
Spring 2023

Course Title: Advanced Managerial Economics Class: MPhil Economics

Resource Person: Dr. Bushra Pervaiz Marks: 10

Course Code: ECON Quiz No 1 Date:

Question No 1: (10)

What is the relation between production functions and cost functions? Be sure to include in your
discussion the effect of competitive condition in input factor markets.

Production functions and cost functions are the cornerstones of business and managerial
economics. A production function is a mathematical relationship that captures the essential
features of the technology by means of which an organization metamorphoses resources such as
land, labour and capital into goods or services such as steel or cement. It is the economist’s
distillation of the salient information contained in the engineer’s blueprints.  Mathematically, let
Y denote the quantity of a single output produced by the quantities of inputs denoted (x1…, xn).
Then the production function f(x1,,xn) describes how a given  output can be produced by an
infinite combinations of inputs (x1,., xn), given the technology  in use. Several important
features of the structure of the technology are captured by the shape of the production function.
Relationships among inputs include the degree of substitutability or complementarily among
pairs of inputs, as well as the ability to aggregate groups of inputs into a shorter list of input
aggregates. Relationships between output and the inputs include economies of scale and the
technical efficiency with which inputs are utilized to produce a given output.

Each of these features has implications for the shape of the cost function, which is  intimately
related to the production function.

A cost function is also a mathematical relationship, one that relates the expenses an organization
incurs on the quantity of output it produces and to the unit prices it pays. Mathematically, let E
denote the expense an organization incurs in the production of output quantity Y when it pays
unit prices (p1… pn) for the inputs it employs. Then the cost function C (y, p1, …, pn) describes
the minimum expenditure required to produce output quantity Y when input unit prices are (p1,,
pn),  given the technology in use and so E ‰¥C(y, p1,…,pn). A cost function is an increasing
function of (y, p1…, pn), but the degrees to which minimum cost increases with an increase in
the quantity of output produced or in any input price depends on the features describing the
structure of production technology. For example, scale economies enable output to expand faster
than input usage. In other words, proportionate increase in output is larger than the proportionate
increase in inputs. Such a situation is also denoted as elasticity of production  in relation to inputs
being greater than one scale economies thus create an incentive for  large-scale production and
by analogous reasoning scale  dis-economies  create a  technological deterrent to large-scale
production. For another example, if a pair of inputs is a close substitute and the unit price of one
of the inputs increases, the resulting increase in cost is less than if the two inputs were poor
substitutes or complements. Finally, if wastage in the organization causes actual output to fall
short of maximum possible output or if inputs are misallocated in light of their respective unit
prices, then actual cost exceeds minimum cost; both technical and allocative inefficiency are
costly.

As these examples suggest, under fairly general conditions the shape of the cost function is a
mirror image of the shape of the production function. Thus, the cost function and the
production function generally afford equivalent information concerning the structure of
production technology. This equivalence relationship between production functions and cost
functions is known as ‘duality’ and it states that one of the two functions has certain features if
and only if, the other has certain features. Such a duality relationship has a number of important
implications. Since the production function and the cost function are based on different data,
duality enables us to employ either function as the basis of an economic analysis of production,
without fear of obtaining conflicting inferences. The theoretical properties of associated output
supply and input demand equations may be inferred from either the theoretical properties of the
production function or, more easily, for those of the dual cost function.

Empirical analysis aimed at investigating the nature of scale economies, the degree of input
substitutability or complementarily, or the extent and nature of productive inefficiency can be
conducted using a production function or again more easily using a cost function.

If the time period under consideration is sufficiently short, then the assumption of a given
technology is valid. The longer-term effects of technological progress or the adaptation of
existing superior technology can be introduced into the analysis. Technical progress increases the
maximum output that can be obtained from a given collection of inputs and so in the presence of
unchanging unit prices of the inputs technical progress reduces the minimum cost that must be
incurred to produce a given quantity of output. This phenomenon is merely an extension to the
time dimension of the duality relationship that links production functions and cost functions. Of
particular empirical interest are the magnitude of technical progress and its cost-reducing effects
and the possible labor-saving bias of technological progress and its employment effects that are
transmitted from the production function, to the cost function and then to the labor demand
function.