Topic 5/6

Production and Costs

COMM 295
Ratna K. Shrestha
 Introduction
⚫ How managers can determine which inputs
and how much of each input to use to
produce a desired level of output at the
minimum cost?
⚫ This requires the knowledge of production
technology or production function.
⚫ The production function gives us the
maximum level of output that a given
combination of inputs can produce (for a
given technology).
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5.1/2 Technology of Production
⚫ If technology improves, more output can be
produced for a given level of input
combination (say capital K and labor L).
Mathematically,
q = f (L, K )
⚫ Short Run versus Long Run
 In the short run some factors of
production are fixed. For example it can
take a several years for Ford to build a
new assembly line.
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 Technology of Production
Thus the level of capital (K) is generally
fixed in the short run. Short-run production
function may be written as: q = f(K*, L),
where K* is fixed.
⚫ However in the long run, managers can
adjust all factors of production. So managers
have better flexibility in the long run to
minimize the costs of producing a given level
of output than in the short run.

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 Measure of Productivity
⚫ Average Products of Labor (APL):

APL = q / L
⚫ Marginal Products (MP): measures how
much more q one extra L (keeping K fixed)
can produce.

⚫ In the next graph, MP increases from 0 to A

and then decreases. MP = 0 at B and then it
is negative.
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 Graphing the Production Curve

⚫ AP at (L=6) = slope of the line from the origin

to A = 90/6.
⚫ MP at a point = slope of the tangent at that
point. MP (at B) = 0 where q is maximized.
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 Measure of Productivity
⚫ Assume a production function:Q = 2K2 L0.5
⚫ By how much Q increases when K increases
by 1 unit, keeping L constant?
⚫ MP of K, MPK = ∂Q/∂K = 4K L0.5
⚫ By how much MP changes when K
changes by 1 unit = ∂MPK /∂K =4L0.5>0
MP of K is increasing.
⚫ Repeat this for L: ∂Q/∂L = K2/L0.5
⚫ ∂MPL/∂L = ∂Q2/∂L2= - 0.5 K2/L-1.5 < 0.
diminishing MP of labor!
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5.4 Returns to Scale
 5.4 Returns to Scale
⚫ Rate at which output increases as all inputs
are increased by the same proportion
⚫ Suppose q = f(K, L). Increase both inputs by t
(t >1) times, then new production qn = f(tK, tL)
 If qn > tq, increasing returns to scale (IRS)
 If qn = tq, constant returns to scale (CRS)
 If qn < tq, decreasing returns to scale
(DRS)

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 Returns to Scale (Example)
⚫ Assume q = K L2. Now let’s increase both K
and L by 2 times (that is t = 2).
Then qn = (2K) (2L)2 = 8 KL2 = 8q.
Note new K = 2K and new L = 2L.
⚫ In this example, when both K and L are
doubled, q increases by 8 times (more than
double). Hence this production function
exhibits IRS.
⚫ General Rule: Given q = Ka Lb , if a+b > 1,
IRS, but if <1, then DRS.
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Question 1

A production technology that uses two inputs, L

and K, exhibits increasing returns to scale if
A. Doubling the amount of L and K exactly doubles
the output.
B. Doubling L and K more than doubles the output.
C. Doubling L and K does not affect output.
D. Doubling L and holding fixed K exactly doubles
the output.
E. None of the above.
Question 2
Suppose that a production function is given by
q = 10K + 5L.
A. This function has IRS at all output levels.
B. This function has CRS at all output levels.
C. This function has DRS at all output levels.
D. The returns to scale vary depending on the
amount of capital and labour used.
E. None of the above.
 6. Cost Function

⚫ Production technology, together with

prices of inputs, determines the firm’s cost
of producing a desired level of output.
⚫ In a production process, a manager’s
objective is to choose the levels of inputs
(such as K and L) to minimize the cost of
producing a desired level of output (with a
given production technology).

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 6.1 Nature of Costs
◆ Explicit Costs involve a direct money
outlay for factors of production. For
example if you hire a worker and pay
his/her wage that is an explicit cost.
◆Implicit Costs do not involve a direct
money outlay. For example, if you work
for your own company, you don’t pay to
yourself. However you could have worked
for somebody else and earned your wage.

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 Nature of Costs
◆ This sacrificed wage is implicit cost of working
for your own company.
◆ Opportunity Cost: explicit + implicit costs.
◆ Economic Profit = Revenue – opportunity costs
= Revenue - Explicit Costs - Implicit Costs
◆ Accounting Profits = Revenue – Explicit Costs.
It does not include implicit costs. So
accounting profits is higher than economic
profits by implicit costs.

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 Opportunity Costs: Example
◆ Meredith’s value for a conference = $70 and
the registration fee = $20. She has an option
of attending Warren Buffet talk for which she
is willing to pay $100. If the admission fee for
this talk is $60, what is her opportunity cost of
attending the conference?
◆ Opportunity costs of an activity
= implicit cost + explicit cost
= what you give up + price/cost of the activity
= (100 – 60) + 20 = $60.
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 Nature of Costs
◆In this example, Meredith gives up WB talk,
the net value of which = 100 - 60 = 40. And
the cost of her activity (conference) = 20.
◆A third, not so obvious, cost is sunk costs.
Sunk costs are costs that have already been
committed and cannot be recovered.. The
opportunity cost of sunk cost = zero (and is
not a part of cost of production) because
such investment/cost has no alternative use
as, once invested, it cannot be recovered.
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 Question 3
Joanna owns a business. She pays herself $2,500 per month as
salary and keeps any profits made by the firm. Two other
firms have offered her jobs. She would earn $7,500 per month
at one firm or $8,500 at the other. She could take one of these
other jobs but not both. The opportunity cost of running her
own business is: (Hint: she could have earned 8,500 but she
makes 2,500; so what she gives up is only 6,000)
A. $2,500
B. $7,500
C. $8,500
D. $16,000
E. $2,500 + the profit of Joanna’s firm
 Question 4
Which of the following is true about sunk costs?
A. Sunk costs are costs which have an opportunity
cost of zero.
B. If you pay $100,000 for a piece of machinery and
can sell it for $25,000 then $25,000 is the
opportunity cost and $75,000 is sunk.
C. Once sunk costs have been incurred, profit-
maximizing decisions do not depend on those
costs.
D. Only A and B.
E. All of the above.
 Nature of Costs
o Consider a firm paid $300k for a parcel of
land but the market value is now $200k.
o So, the land’s opportunity cost is $200k and
the market value loss of $100k is a sunk cost.

o Assume if you spend $50k

extra in beautifying the land,
you can sell it for $280k.
Should you beautify?
o Yes! as you make 30K extra!

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 6.2 Short Run Costs

In the short run, producer cannot change the

level of some of the inputs. For example, it takes
time for a firm to expand its factory size.
In such a case, factory size or K is fixed and the
cost associated with K is FC.
 VC includes the cost of labor and raw materials.

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 Short-Run Costs
⚫ FC = the portion of the cost that a producer
incurs even if his/her production is zero.
⚫ VC increases as you produce more.
If a cost function is given by C = 200 + 2q,
then $200 is fixed cost (note even when
q = 0, C = $200) and 2q is variable cost.
This variable portion of the cost, 2q,
increases as q increases.

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 Measuring Costs
⚫ Marginal Cost (MC): is the cost of producing
one more unit of q.
⚫ MC = dC/dq = d(VC)/dq. Note dFC/dq = 0!
⚫ Example: C = 10+4q+6q2
MC = dC/dq = 4+12q.

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 Measuring Costs
⚫ Example: C = a+bq+cq2
MC = b + 2cq
⚫ If c = 0, then MC = b constant. The constant
MC is due to constant MP.
⚫ If c < 0, MC decreases as q increases. The
source behind declining MC is increasing
MP.

.
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 Table 1: How Cost Varies with Output
Output, q Fixed Variable Total Marginal Average Fixed Average Average Cost,
C over q
A C=

Cost, F Cost, VC Cost, C Cost, MC Cost, Variable Cost,

AC = C /q
A F C = F over q A V C = V C over q

AFC = F /q AVC = VC /q
0 48 0 48 blank Blank Blank blank
1 48 25 73 25 48 25 73
2 48 46 94 21 24 23 47
3 48 66 114 20 16 22 38
4 48 82 130 16 12 20.5 32.5
5 48 100 148 18 9.6 20 29.6
6 48 120 168 20 8 20 28
7 48 141 189 21 6.9 20.1 27
8 48 168 216 27 6 21 27
9 48 198 246 30 5.3 22 27.3
10 48 230 278 32 4.8 23 27.8
11 48 272 320 42 4.4 24.7 29.1
12 48 321 369 49 4 26.8 30.8
Cost Curves (Based on Table 1)
 Determinants of Short-run Costs
⚫ In the example given in the table, one of
the inputs K is fixed and L is variable:
MC decreases initially with increasing
Marginal Product of L (MPL) through 4 units.
And MC increases with decreasing MPL for q
= 5 to 12 units.
So the source of increasing MC is decreasing
MPL.

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 Cost Functions: Examples
⚫ Suppose C = 50 + 2q2, where fixed cost (FC)
= 50 and VC = 2q2 . In this cost function,
MC = dC/dq = 4q. MC is a straight line with slope
= 4 and y-intercept = 0.
ATC = 50/q + 2q. As q increases, ATC decreases
and reaches its minimum at q = 5.
 ATC is minimum where MC = ATC. So set ATC =
MC to find q where ATC is minimum.
Beyond q = 5, ATC increases again.

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 Cost Curves
⚫ When MC < AVC, AVC is falling
⚫ When MC > AVC, AVC is rising
⚫ When MC < ATC, ATC is falling
⚫ When MC > ATC, ATC is rising
⚫ Therefore, MC crosses AVC and ATC at
their respective minimums.
⚫ If you can produce one more at a lower
cost than the existing ATC (MC < ATC),
then that extra production will lower your
ATC.
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 Shape of Typical Cost Curves

MC
Cost ($)

ATC

The MC curve always crosses

the ATC curve at the min ATC.
So, q that minimizes ATC can
be found by solving MC = ATC.

Quantity of output

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 Marginal Productivity (Example)
⚫ Question: Does q = K0.5 L exhibit
diminishing marginal productivity in K or L?
⚫ Marginal productivity of L, dq/dL(with K
constant) = K0.5. It does not depend on L.
⚫ dq/dK (with L constant) = 0.5L/K0.5. As K
increases dq/dK decreases. There is
diminishing marginal productivity in K. you
may take second derivative to show this.
d2q/dK2 = - 0.25L/K1.5 < 0, which means
dq/dK decreases as K increases.
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 Economies of Scale
⚫ A cost function exhibits Economies of Scale
(ES) if the AC of production falls as output
expands.
⚫ It can be also measured in terms of cost-
output elasticity, EC. When we increase
output by 1% by how much % will cost
increase?
%C dC / C dC / dQ MC
EC = = = =
%Q dQ / Q C /Q AC

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Long Run Costs
⚫ With ES, AC of production falls as the
fixed cost is spread over a large volume
of production.
⚫ EC = 1 when MC = AC; neither economies
nor diseconomies of scale.
⚫ EC < 1 when MC < AC. When Q
increases by 1%, C increases by less
than 1%  Economies of scale.
⚫ EC > 1 when MC > AC Diseconomies
of scale.
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Question 5
Which statement about cost is false?
A. An increase in fixed cost shifts up the marginal
cost (MC) curve.
B. A cost that stays the same regardless of the
amount produced is a fixed cost.
C. Wages are a component of variable cost.
D. For a U-shaped average cost (AC) curve, the MC
curve cuts the AC curve at the minimum of AC.
E. MC = dC/dq.
Question 6
Suppose a cost function has the form C = 25 + 20q
- 6q2 + q3. MC = dC/dq. Average cost, AC = C/q.
A. MC = 20 – 12q + 3q2.
B. AC = 20 – 6q + q2.
C. If q = 0, MC = AC.
D. This cost function has economies of scale for all
levels of q.
E. All of the above.