Production function
Short run
Long run
Fixed factors
Variable factors
Measures of Productivity
Total Product
Average Product
Marginal Product
Marginal Returns
Increasing Marginal Returns
Decreasing (Diminishing)
Marginal Returns
Negative Marginal Returns
The Roles Of The Manager In The
Production Process
Produce on the Production
Function
Produce on the Production
Function
Value Marginal Product
Profit-Maximizing Input Usage
Algebraic Forms Of Production
Function
Linear Production Function
Algebraic Forms Of Production
Function
Cobb-Douglas Production
Function
Isoquant
Marginal Rate Of Technical
Substitution
Isocosts
Isocost Line
Cost minimization
Cost-Minimizing Input Rule
Optimal Input Substitution
The Cost Function
Short-Run Costs
Fixed Costs
Variable Costs
Average and Marginal Costs
Average Fixed Cost
Average Variable Cost
Marginal (Incremental) Cost
Production function -A function that defines the maximum amount of
output that can be produced with a given set of inputs. The examples of
inputs are wages and price change of a product
Short run - is defined as the time frame in which there are fixed factors
of production
Long run - is defined as the horizon over which the manager can adjust
all factors of production
Fixed factors - are the inputs the manager cannot adjust in the short
run.
Variable factors - are the inputs a manager can adjust to alter
production.
Measures of Productivity
Total Product -The maximum level of output that can be produced with
a given amount of inputs.
Average Product - A measure of the output produced per unit of
input.
Marginal Product - The change in total output attributable to the last
unit of an input.
Marginal Returns
Increasing Marginal Returns - the range of input usage over which
marginal product increases
Decreasing (Diminishing) Marginal Returns - the range of input usage
over which marginal product declines
Negative Marginal Returns - the range of input usage over which
marginal product was negative.
The Roles Of The Manager In The Production Process
Produce on the Production Function - To ensure that workers are in
fact working at full potential, the manager must institute an incentive
structure that induces them to put forth the desired level of effort
Use the Right Level of Inputs - Ensures that the firm operates at the
right point on the production function. Use the "correct" level of
inputs
Value Marginal Product - The value of the output produced by the
last unit of an input.
Profit-Maximizing Input Usage - defines the demand for an input by a
profit maximizing firm. To maximize profits, a manager should use
inputs at levels at which the marginal benefit equals the marginal cost.
Algebraic Forms Of Production Function
Linear Production Function - Assume a perfect linear relationship
between all inputs and total outputs.
Algebraic Forms Of Production Function - assumes that inputs are
used in fixed proportions
Cobb-Douglas Production Function - assumes some degree of
substitutability among inputs
Fixed and Sunk Costs
Sunk Costs
Algebraic Forms of Cost Functions
Cubic Cost Function
Long-Run Average Cost Curve
Economies Of Scale
Diseconomies Of Scale
Constant Returns To Scale
Multiple-Output Cost Functions
Multiproduct Cost Function
Economies Of Scope
Cost Complementarity
Possible Questions:
1. Short-Run versus Long-Run
Decisions
2. Measures of Productivity
3. The Roles Of The Manager In
The Production Process
4. Explain the difference between
Production function and cost
production
5. Isoquant and Isocosts
6. Fixed and Sunk Costs
7. Short-Run Costs, Average and
Marginal Costs
8. Economies Of Scale,
Diseconomies Of Scale, Constant
Returns To Scale
9. Economic Costs versus
Accounting Costs
Isoquant - defines the combinations of inputs that yield the same level of
output.
Marginal Rate Of Technical Substitution - is rate at which one input
can be substituted for another, while maintaining the same level of
output
Isocosts - The curve that shows the combinations of productive inputs that
have the same cost. A budget restrictions for producers
Isocost Line - A line that represents the combinations of inputs that will
cost the producer the same amount of money.
Cost minimization - is the process of reducing expenditures on
unnecessary or inefficient processes. These changes in spending can be
slight or drastic, but any level of reduction in costs will likely have a
dramatic effect on maximizing profits.
Cost-Minimizing Input Rule - To minimize the cost of producing a given
level of output, the marginal product per dollar spent should be equal
for all inputs
Optimal Input Substitution - To minimize the cost of producing a given
level of output, the firm should use less of an input and more of other
inputs when that input’s price rises.
The Cost Function - is extremely valuable because, as we will see in later
chapters, it provides essential information a manager needs to determine
the profit-maximizing level of output
Short-Run Costs - A function that defines the minimum possible cost
of producing each output level when variable factors are employed in
the cost-minimizing fashion
Fixed Costs - Costs that do not change with changes in output;
include the costs of fixed inputs used in production.
Variable Costs Costs that change with changes in output; include
the costs of inputs that vary with output.
Average and Marginal Costs
Average Fixed Cost - Fixed costs divided by the number of units of
output.
Average Variable Cost - Variable costs divided by the number of units
of output.
Marginal (Incremental) Cost - The cost of producing an additional unit
of output.
Relations Among Costs - Each cost is related to each other
Fixed and Sunk Costs
Fixed Cost is a cost that does not change when output changes.
Sunk Cost is a cost that is lost forever once it has been paid.They are
irrelevant to decision making
Algebraic Forms of Cost Functions
Cubic Cost Function Costs are a cubic function of output; provides a
reasonable approximation to virtually any cost function.
 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.
Long-Run Average Cost
Economies Of Scale Exist when longrun average costs decline as output
is increased.
Diseconomies Of Scale Exist when longrun average costs rise as output
is increased.
Constant Returns To Scale Exist when longrun average costs remain
constant as output is increased.
A Reminder: Economic Costs versus Accounting Costs
Accounting costs include direct payments to labor and capital to
produce output. Accounting costs are the costs that appear on the
income statements of firms.
Multiple-Output Cost Functions
Multiproduct Cost Function A function that defines the cost of
producing given levels of two or more types of outputs assuming all
inputs are used efficiently.
Economies Of Scope When the total cost of producing two types of
outputs together is less than the total cost of producing each type of
output separately.
Cost Complementarity When the marginal cost of producing one type
of output decreases when the output of another good is increased.
Methods of Procuring Inputs
Spot Exchange
Contract
Vertical Integration
Transaction Costs
Transaction Costs
Specialized Investment
Relationship-Specific Exchange
Types of Specialized Investments
Site Specificity
Physical-Asset Specificity
Dedicated Assets
Human Capital
Implications of Specialized
Investments
Costly Bargaining
Underinvestment
Opportunism and the “Hold-Up
Problem”
Optimal Input Procurement
Managerial Compensation And The
Principal–Agent Problem
Managerial Compensation
Separation of ownership and
control
Ownership
Control
The Principal–Agent Problem
Solving the Problem Between
Owners and Managers
Incentive Contracts
Stocks or bonuses
External Incentives
Reputation
Takeovers
The Manager-Worker Principal -
Agent Problem
Solutions to the Manager–Worker
Principal–Agent Problem
Profit Sharing
Revenue Sharing
Piece Rates
Time clocks
Spot checks
Methods of Procuring Inputs
1. Purchase the Inputs Using Spot Exchange
Spot Exchange - An informal relationship between a buyer and
seller in which neither party is obligated to adhere to specific
terms for exchange.
- Specialization, avoids contracting costs, avoids costs of vertical
integration.
2. Acquire Inputs under a Contract
Contract - A formal relationship between a buyer and seller that
obligates the buyer and seller to exchange at terms specified in a
legal document. It is a legal document that creates an extended
relationship between a particular buyer and seller of an input.
- Specialization,reduces opportunism, avoids skimping on
specialized investments
3. Produce the Inputs Internally
Vertical Integration - A situation where a firm produces the inputs
required to make its final product.
- Reduces opportunism, avoids contracting
Costs
Transaction Costs
Transaction Costs - Costs associated with acquiring an input that are in
excess of the amount paid to the input supplier. Includes:
 Search costs.
 Negotiation costs.
Specialized Investment - An expenditure that must be made to allow
two parties to exchange but has little or no value in any alternative use.
Relationship-Specific Exchange - A type of exchange that occurs when
the parties to a transaction have made specialized investments.
Types of Specialized Investments
Site Specificity - occurs when the buyer and the seller of an input must
locate their plants close to each other to be able to engage in
exchange.
Physical-Asset Specificity - refers to a situation where the capital
equipment needed to produce an input is designed to meet the needs
of a particular buyer and cannot be readily adapted to produce inputs
needed by other buyers.
Dedicated Assets - are general investments made by a firm that allow it
to exchange with a particular buyer.
Human Capital - In many employment relationships, workers must
learn specific skills to work for a particular firm. If these skills are not
useful or transferable to other employers, they represent a specialized
investment.
Implications of Specialized Investments
Costly Bargaining - transaction costs are low and the desired input is of
uniform quality and sold by many firms, the price of the input is
determined by the forces of supply and demand
Possible Questions: Underinvestment - When specialized investments are required to
1. 3 Methods of Procuring Inputs facilitate exchange, the level of the specialized investment often is
2. Transaction Costs, Specialized lower than the optimal level.
Investment, Relationship-Specific Opportunism and the “Hold-Up Problem” - When a specialized
Exchange investment must be made to acquire an input, the buyer or seller may
3. 4 Types of Specialized attempt to capitalize on the “sunk” nature of the investment by
Investments 4. 3 Implications of engaging in opportunism
Specialized Investments Optimal Input Procurement
5. Explain Optimal Input The Economic Trade-Off -The cost-minimizing method of acquiring an
Procurement input depends on the characteristics of the input. Whether a manager
6. Explain Managerial chooses spot exchange or an alternative method such as a contract or
Compensation And The Principal– vertical integration depends on the importance of the specialized
Agent Problem investments that lead to relationship-specific exchange
7. How to Solve the Problem
Between Owners and Managers
(Incentive Contracts, External
Incentives - Reputation and
Takeovers )
8. Explain The Manager-Worker
Principal - Agent Problem
9. Solutions to the Manager–
Worker Principal–Agent Problem
(Profit Sharing , Revenue Sharing,
Piece Rates , Time clocks and
Spot checks )

Managerial Compensation And The Principal–Agent Problem

Explain how to compensate labor inputs to ensure that they put forth
their “best” effort.
Managerial Compensation - The process of managing, analyzing, and
determining the salary, incentives, or benefits in exchange of their
effort.
Separation of ownership and control
Ownership - owners who often are distantly located
stockholders
Control - Manager who run firm day by day basis
The Principal–Agent Problem - When the incentives of two parties
(owner and manager) in a transaction are not aligned. Emerge when
ownership is separated with control.
* Manager gets the same income regardless of his effort level.
Solving the Problem Between Owners and Managers
Incentive Contracts - is a contract between two parties in which one
party promises to grant an additional remuneration to another party
for outstanding performances.
 Stocks or bonuses
Employee bonuses are one of the most common types of
financial incentives that companies use as regular reward
incentives and to show appreciation
Some companies provide stock incentives that allow
employees to purchase shares of company stocks at a set
price. Stock incentives are beneficial because they offer
employees long-term financial gains as companies profit from
stocks.
External Incentives
Reputation - Gaining a reputation through quality work would
result in better compensation for the managers in future firms he
would work for. These reputations show the personnel's
managerial capabilities, which would sell as a premium in the
market for managers
Takeovers - Takeovers act as an incentive to the managers as they
get threatened by rival investment firms who can buy the existing
firm and replace the existing manager with a new one. Such a
situation arises if the firm does not maximize its profits.
The Manager-Worker Principal - Agent Problem
The principal-agent problem refers to a situation in which the agent,
who is hired to work on behalf of the principal, has different objectives
than the principal. The issue is that the principal cannot directly
monitor the agent's actions, which may lead to the agent behaving in
ways that are not in the principal's best interest. This problem is not
limited to the owner-manager relationship but also exists between
managers and employees.
Solutions to the Manager–Worker Principal–Agent Problem
Profit Sharing - Mechanism used to enhance workers’ efforts that
involves tying compensation to the underlying profitability of the firm.
Revenue Sharing - Mechanism used to enhance workers’ efforts that
involves linking compensation to the underlying revenues of the firm.
Piece Rates - to pay workers based on a piece rate rather than on a
fixed hourly wage.
Time clocks - essentially are designed to verify when an employee
arrives and departs from the job.
Spot checks - allow the manager to verify not only that workers are
physically present but also that worker effort and the quality of the
work are satisfactory.