Managerial Economics

T h e P r o d u c ti o n P r o c e s s & C o s t
Oleh Kelompok 3 :
Amal Fitra Iriansah
Citra Mustika Putri
Giffar Masabih
S.Cistra Noor Aisyah
Learning Objectives
• Explain alternative ways of measuring the productivity of inputs and the rule of the
manager in production process
• Calculate input demand and the cost minimizing combination of input and use
isoquant analysis to illustrate optimal input substitution
• Calculate a cost function from a production function and explain how economic
costs differ from accounting costs
• Explain the differences between and the economics relevant of fixed costs, sunk
cost, variable cost, and marginal cost
• Calulate average and marginal cost from algebraic or tabular cost data and
illustrate the relationship between average and marginal costs
• Distinguished between shortrun and longrun production decision and illustrate
that impact on cost and economies of scales
• Conclude whethera multiple output production process exhibits economies of
scopes or cost complementarities and explain their significancefor managerials
decision
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Headline
After nearly eight weeks, Boeing and its IAM reached an agreement that ended a strike
involving 27,000 workers. The strike followed severaldays of “last minute,” around-the-clock
talks that beganwhen management and union negotiators failed toreach an agreement over
compensation and job pro-tection issues.
As a result of the agreement, IAM workers won benefits in areas that include healthcare,
pensions, wages and job security for 2,900 workers in inventory management and delivery
categories. Boeing also agreed to retrain workers who are laid off or displaced. Despite these
concessions, a spokesman for Boeing was quoted as saying that the agreement “gives us the
flexibility we need to run the company.’’ The four-year agreement allows Boeing to retain
critical subcontract-ing provisions it won in past struggles with the union.
Commenting on all this, one analysis concluded that “the union probably won the battle and
Boeing probably wins the war. ” Can you explain what this analyst means?

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 Overview
I . P r o d u c ti o n A n a l y s i s
Total Product, Marginal Product, Average Product
Isoquants
Isocosts
Cost Minimization
II. Cost Analysis
Total Cost, Variable Cost, Fixed Costs
Cubic Cost Function
Cost Relations
I I I . M u l ti - P r o d u c t C o s t F u n c ti o n s

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Production Analysis
P r o d u c ti o n F u n c ti o n
Q = F(K,L)
The maximum amount of output that can be
produced with K units of capital and L units of
labor.
Short-Run vs. Long-Run Decisions
Short run : the time frame in which there are fixed factors of production
Long run : The horizon over over which the manager can adjust all
factors of production
F i xe d v s . Va r i a b l e I n p u t s
Fixed factors : The inputs a manager cant adjust in the short run
Variable factors : The inputs a manager can adjust to alter production

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Total Product
Cobb-Douglas Production Function
Example: Q = F(K,L) = K.5 L.5
K is fixed at 16 units.
Short run production function:
Q = (16).5 L.5 = 4 L.5
Production when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units

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Marginal Productivity Measures
Marginal Product of Labor: MPL = DQ/DL
• Measures the output produced by the last worker.
• Slope of the short-run production function (with respect to
labor).
Marginal Product of Capital: MPK = DQ/DK
• Measures the output produced by the last unit of capital
• When capital is allowed to vary in the short run, MPK is the
slope of the production function (with respect to capital).

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Average Productivity Measures

Average Product of Labor
APL = Q/L.
Measures the output of an “average” worker.
Example: Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 16, then the average product of
labor is APL = [(16) 0.5(16)0.5]/16 = 1.
Average Product of Capital
APK = Q/K.
Measures the output of an “average” unit of capital.
Example: Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 16, then the average product of
labor is APL = [(16)0.5(16)0.5]/16 = 1.

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Increasing, Diminishing and
Negative Marginal Returns
Increasing Diminishing Negative Increasing Marginal Returns
Q Marginal Marginal Marginal Range of input usage over which marginal
Returns Returns Returns product increase

Decreasing (Diminishing) Marginal

Returns
Range of input usage over which marginal
Q=F(K,L) product declines

Negative Marginal Returns

Range of input usage over which marginal
AP product is negative

L
MP
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Guiding the Production Process

Producing on the production function
Aligning incentives to induce maximum worker effort. Profit-Maximizing Input Usage
To maximize profits, a manager
Employing the right level of inputs should use inputs at levels at
which the marginal benefit
When labor or capital vary in the short run, to maximize equals the marginal cost. More
profit a manager will hire specifically, when cost of each
labor until the value of marginal product of labor additional unit of labor is w, the
manager should continue to
equals the wage: VMPL = w, where VMPL = P x MPL. employ labor up to the point
capital until the value of marginal product of capital where VMPL = w in the range of
K = r, where VMPK = P x
*) Value Marginal
equalsProduct : The value
the rental rate:of VMP
the output produced by last unit of an diminishing marginal product
input
MPK .

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Isoquant
The combinations of inputs (K, L) that yield the producer the
same level of output.
The shape of an isoquant reflects the ease with which a
producer can substitute among inputs while maintaining the
same level of output.

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Marginal Rate of Technical Substitution (MRTS)

The rate at which two inputs are substituted while

maintaining the same output level.

MPL
MRTS KL 
MPK

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Linear Isoquants
Capital and labor are K
perfect substitutes Increasing
Q = aK + bL Output
MRTSKL = b/a
Linear isoquants imply that
inputs are substituted at a
constant rate, independent of
the input levels employed.

Q1 Q2 Q3
L

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Leontief Isoquants
Capital and labor are perfect Q3
K
complements. Q2
Q1 Increasing
Capital and labor are used in
Output
fixed-proportions.
Q = min {bK, cL}
Since capital and labor are
consumed in fixed proportions
there is no input substitution
along isoquants (hence, no
MRTSKL).

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Cobb-Douglas Isoquants
Inputs are not perfectly K
substitutable. Q3
Increasing
Diminishing marginal rate of Q2
Output
technical substitution. Q1
As less of one input is used in the
production process, increasingly
more of the other input must be
employed to produce the same
output level.
Q = K a Lb
MRTSKL = MPL/MPK
L

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 Isocost FR
The combinations of inputs that K New Isocost Line
produce a given level of output at associated with higher
the same cost: C1/r costs (C0 < C1).
wL + rK = C C0/r
Rearranging,
C0 C1
K= (1/r)C - (w/r)L L
C0/w C1/w
For given input prices, isocosts K
farther from the origin are New Isocost Line for
associated with higher costs. C/r a decrease in the
wage (price of labor:
Changes in input prices change w0 > w1).
the slope of the isocost line.

L
C/w0 C/w1
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Cost Minimization
Marginal product per dollar spent should be equal for all
inputs:
MPL MPK MPL w
  
w r MPK r

But, this is just

w
MRTS KL 
r

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Cost Minimization
K

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

L
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Optimal Input Substitution
• A firm initially produces Q0 by K
employing the combination of
inputs represented by point A
at a cost of C0.
• Suppose w0 falls to w1.
• The isocost curve rotates A
counterclockwise; which
K0
represents the same cost level
prior to the wage change.
B
• To produce the same level of K1
output, Q0, the firm will produce
on a lower isocost line (C1) at a
point B. Q0
• The slope of the new isocost line
represents the lower wage
relative to the rental rate of
capital. 0 L0 L1 C0/w0 C1/w1 C0/w1 L
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Cost Analysis

• Types of Costs
• Fixed costs (FC)
• Variable costs (VC)
• Total costs (TC)
• Sunk costs
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Total and Variable Costs
C(Q): Minimum total cost $
of producing alternative C(Q) = VC + FC
levels of output:
VC(Q)

C(Q) = VC(Q) + FC

VC(Q): Costs that vary with

output. FC

FC: Costs that do not vary 0 Q

with output.
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Fixed and Sunk Costs
FC: Costs that do not $
change as output C(Q) = VC + FC

changes.
VC(Q)

Sunk Cost: A cost that is

forever lost after it has
been paid.
FC

Q
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Some Definitions
Average Total Cost
ATC = AVC + AFC $
MC ATC
ATC = C(Q)/Q AVC

Average Variable Cost

AVC = VC(Q)/Q
MR
Average Fixed Cost
AFC = FC/Q

Marginal Cost AFC

MC = DC/DQ
Q
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Fixed Cost
Q0(ATC-AVC)
MC
$ = Q0 AFC ATC
= Q0(FC/ Q0) AVC

= FC
ATC
AFC Fixed Cost
AVC

Q0 Q
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Variable Cost
Q0AVC MC
$
ATC
= Q0[VC(Q0)/ Q0]
AVC
= VC(Q0)

AVC
Variable Cost

Q0 Q
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Total Cost
Q0ATC
MC
$
= Q0[C(Q0)/ Q0] ATC

= C(Q0)
AVC

ATC

Total Cost

Q0 Q
 e
M ori
FR
m :
ze

C
Cubic
( Q ) Cost Function
M a+
= Q+
2b Q2 lc
3c • Ca lus
u
:

/dQ
dC a +
= Q+
2b Q2
3c
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An Example
• Total Cost: C(Q) = 10 + Q + Q2
• Variable cost function:
VC(Q) = Q + Q2
• Variable cost of producing 2 units:
VC(2) = 2 + (2)2 = 6
• Fixed costs:
FC = 10
• Marginal cost function:
MC(Q) = 1 + 2Q
• Marginal cost of producing 2 units:
MC(2) = 1 + 2(2) = 5
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Economies of Scale
$

LRAC

Economies Diseconomies
of Scale of Scale
Q
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rod wo
p t t Multi-Product Cost Function
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s. e ra
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• Gl tio :
c
fun form
n

C  Q1 , Q2   f  aQ1Q2  bQ  cQ
1
2 2
2
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Economies of Scope
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Cost
( Complementarity
C1
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Q1 )
2 <
/D 0.
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Quadratic Multi-Product Cost Function
• C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
• MC1(Q1, Q2) = aQ2 + 2Q1
• MC2(Q1, Q2) = aQ1 + 2Q2
• Cost complementarity: a<0
• Economies of scope: f > aQ1Q2
C(Q1 ,0) + C(0, Q2 ) = f + (Q1 )2 + f + (Q2)2
C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
f > aQ1Q2: Joint production is cheaper
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A Numerical Example:

• C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 + (Q2 )2

• Cost Complementarity?
Yes, since a = -2 < 0
MC1(Q1, Q2) = -2Q2 + 2Q1
• Economies of Scope?
Yes, since 90 > -2Q1Q2
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Answering the Headlines

• The union wins the battle means refers to the

short run implications of the agreement between
benefited union workers in Boeing & IAM.
• While Boeing wins the war means refer to the
agreement’s long run implications, that also
increased Boeing’s long term value by flexibility to
substitute away from more costly union inputs.
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Conclusion
• To maximize profits (minimize costs) managers
must use inputs such that the value of marginal of
each input reflects price the firm must pay to
employ the input.
• The optimal mix of inputs is achieved when the
MRTSKL = (w/r).
• Cost functions are the foundation for helping to
determine profit-maximizing behavior in future
chapters.
Thank You