Managerial Economics

ninth edition

Thomas Maurice

Chapter 10
Production & Cost Estimation
McGraw-Hill/Irwin McGraw-Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e
Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

Managerial Economics

Empirical Production Function

Cubic empirical specification for a short-run production function is derived from a long-run cubic production function Cubic form of the long-run production function is expressed as

Q aK L bK L
3 3 2

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Managerial Economics

Properties of a Short-Run Cubic Production Function

Q AL BL
3

Holding capital constant, short-run cubic production function is derived as follows:

Q aK L bK L 3 2 AL BL
3 3 2

Where A aK 3 and B bK 2
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Managerial Economics

Properties of a Short-Run Cubic Production Function

Q AL BL
3

The average & marginal products of labor are, respectively:

AP Q L AL BL
2

MP Q L 3 AL 2BL
2

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Managerial Economics

Properties of a Short-Run Cubic Production Function 3 2 Q AL BL

Marginal product of labor begins to diminish beyond Lm units of labor Average product of labor begins to diminish beyond La units of labor

B B Lm and La 3A 2A
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Managerial Economics

MP & AP Curves for the Short-Run Cubic Production Function (Figure 10.1)
Q = AL3 + BL2

10-6

Managerial Economics

Properties of a Short-Run Cubic Production Function 3 2 Q AL BL

To have necessary properties of a production function, parameters must satisfy the following restrictions:

A 0 and B 0

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Managerial Economics

Estimation of a Short-Run Production Function

To use linear regression analysis, the cubic equation must be transformed into linear form
Q = AX + BW Where X = L3 and W = L2

Estimated regression line must pass through the origin

Specify in computer routine
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Managerial Economics

Estimation of a Short-Run Cost Function

Estimate using data for which the level of usage of one or more inputs is fixed
Usually time series data are used

Data collection may be complicated by the fact that accounting data do not include firms opportunity costs
Capital costs should reflect not only acquisition cost but any foregone rental income, depreciation, & capital gains/losses

Must eliminate effects of inflation

Divide by appropriate price index
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Managerial Economics

Properties of a Short-Run Cubic Cost Function

TVC aQ bQ cQ
2 3

Average variable cost & marginal cost functions are, respectively:

AVC a bQ cQ 2 SMC a 2bQ 3cQ
2

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Managerial Economics

Properties of a Short-Run Cubic Cost Function

TVC aQ bQ cQ
2 3

Average variable cost reaches its minimum value at: Qm b 2c To conform to theoretical properties, parameters must satisfy the following restrictions:
a 0 , b 0 , and c 0
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Managerial Economics

Properties of a Short-Run Cost Function

Cubic specification produces S-shaped TVC curve & U-shaped AVC & SMC curves All three cost curves employ the same parameters
Only necessary to estimate one of these functions to obtain estimates of all three

In the short-run cubic specification, input prices are assumed constant

Not explicitly included in cost equation
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Managerial Economics

Summary of Short-Run Empirical Production Functions

Short-run cubic production equations
Total product

Q AL BL
3

Average product of labor

Marginal product of labor Diminishing marginal returns Restrictions on parameters
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AP AL BL
2

MP 3 AL2 2BL
B begin at Lm 3A

A 0 and B 0

Managerial Economics

Summary of Short-Run Empirical Cost Functions

Short-run cubic cost equations
Total variable cost

TVC aQ bQ 2 cQ 3
AVC a bQ cQ 2
SMC a 2bQ 3cQ 2

Average variable cost

Marginal cost Average variable cost reaches minimum at Restrictions on parameters
10-14

b Qm 2c

a 0, b 0, c 0