Chapter 5

Production and
Cost Analysis
in the Short
Run
ESMA 794
Economics for Managers
Spring 2024
Ahmad Mayyas
Khalifa University
Department of Management Science & Engineering
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 chapter 5
Production and Cost Analysis in the Short Run

Objectives

• To learn the fundamental building blocks on

the supply side of the market
• To learn the differences between short-run
versus long-run production and costs
• To be able to construct and analyze a model of
a short-run production function

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 chapter 5
Production and Cost Analysis in the Short Run

The Production Function

EQUATION 5.1 The Production Function

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Production and Cost Analysis in the Short Run

The Production Function

• different types of labor and capital inputs, which
we could denote by LA, LB, LC and KA, KB, and KC,
respectively.
• In the production function, capital (K) refers to
physical capital, such as machines and buildings,
not financial capital
• A production function can apply to large scale
production processes or to small firms
comprising only a few employees.
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Production and Cost Analysis in the Short Run

Fixed Inputs Versus Variable Inputs

• Fixed input: An input whose quantity a manager

cannot change during a given period of time

• Variable input: An input whose quantity a

manager can change during a given period of
time.

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Production and Cost Analysis in the Short Run

Short-Run Versus Long-Run Production Functions

• Short-run production function: A production
process that uses at least one fixed input.
– Production cost is highly influenced by the change
in the fixed cost (facility cost, machinery, etc.)

• Long-run production function: A production

process in which all inputs are variable.
– Production cost is governed by the change in the
variable cost (materials, labor, energy, etc.)
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Production and Cost Analysis in the Short Run

Short-Run Versus Long-Run Production Functions

• The calendar lengths of the short run and the long
run depend on the particular production process,
contractual agreements, and the time needed for
input adjustment.
• Managers always operate in the short run, but they
must also have a long-run planning horizon.
– Managers need to be aware that the current amount of
fixed inputs, such as the size of a factory or amount of
office space, may not be appropriate as market conditions
change.
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Production and Cost Analysis in the Short Run

Model of a Short-Run Production Function

Total product: The total quantity of output produced with given
quantities of fixed and variable inputs.

EQUATION 5.2 Model of a Short-Run Production Function

In this production function, the amount of output (Q) or total product (TP) is
directly related to the amount of the variable input (L), while holding constant the
level of the fixed input (K) and the technology embodied in the production function.

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Production and Cost Analysis in the Short Run

Average Product and Marginal Product

Average product: The amount of output per unit of variable input

EQUATION 5.3 Average Product

and Marginal Product

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Average Product and Marginal Product

Marginal product: The additional output produced with an additional unit of
variable input.

EQUATION 5.4 Average

Product and Marginal Product

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Production and Cost Analysis in the Short Run

Relationships Among Total, Average,

and Marginal Product

e.g., disguised Adding more labor/workers (L)

unemployment
will ensure that your TP will
increase to a certain extent, but
does not ensure the same trend
happens for Average Product (AP)
Region-2 and Marginal Product (MP)
Region-1

Region-3
FIGURE 5.1 The Short-Run Production Function

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Production and Cost Analysis in the Short Run

Economic Explanation of the Short-Run

Production Function
1. Increasing marginal returns: The results in that region of the
marginal product curve where the curve is positive and
increasing, so that total product increases at an increasing rate.
2. Law of diminishing marginal returns or law of the diminishing
marginal product: The phenomenon illustrated by that region of
the marginal product curve where the curve is positive, but
decreasing, so that total product is increasing at a decreasing
rate.
3. Negative marginal returns: The results in that region of the
marginal product curve where the curve is negative and
decreasing, so that total product is decreasing.
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Production and Cost Analysis in the Short Run

TABLE 5.2 Relationships Among Total Product (TP), Average Product (AP),and Marginal Product (MP)
in Figures 5.1a and 5.1b

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Production and Cost Analysis in the Short Run

Real-World Firm and Industry

Productivity Issues
• Online retailers, which face increased demand during
the holidays, have to decide whether it is more
efficient to hire additional workers to fill the orders
or to change technology by using robots.
• Amazon usually hires more workers who walk 18 to
20 miles per day down aisles lined with shelves to
load carts with orders and bring them back to
packing stations.
– The company holds weekly brainstorming sessions to
prevent diminishing returns and increase productivity.
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Production and Cost Analysis in the Short Run

Real-World Firm and Industry

Productivity Issues
• The number of vehicles per worker had ranged between 8 and 15 for both
domestic and foreign producers in 1960. Although productivity for
General Motors, Ford, and Chrysler remained in that range in 1983, the
number of vehicles per worker increased to 42 for Nissan and 58 for
Honda in that year.
• The Japanese productivity advantage in the early 1980s did not result
primarily from differences in technology or labor. Approximately two-
thirds of the cost advantage resulted from changes in management
focusing on inventory systems, relations with suppliers, and plant layout.
Japanese production was organized around a lean and coordinated
system, with inventories delivered from nearby suppliers every few hours
(Just In-Time). Workers could stop the assembly line as soon as problems
arose, which improved quality and eliminated the need for repair stations.
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Production and Cost Analysis in the Short Run

Model of Short-Run Cost Functions

Measuring Opportunity Cost: Explicit vs. Implicit Costs
• Cost function: A mathematical or graphic expression
that shows the relationship between the cost of
production and the level of output, all other factors
held constant.
• Opportunity cost: The economic measure of cost that
reflects the use of resources in one activity, such as a
production process by one firm, in terms of the
opportunities forgone in undertaking the next best
alternative activity
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Production and Cost Analysis in the Short Run

Model of Short-Run Cost Functions

Measuring Opportunity Cost: Explicit vs. Implicit Costs
• Explicit cost: A cost that is reflected in a payment to
another individual, such as a wage paid to a worker,
that is recorded in a firm’s bookkeeping or accounting
system.
• Implicit cost: A cost that represents the value of using
a resource that is not explicitly paid out and is often
difficult to measure because it is typically not
recorded in a firm’s accounting system.

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Production and Cost Analysis in the Short Run

Fixed Costs Versus Variable Costs

• Total fixed cost: The total cost of using the fixed input, which
remains constant regardless of the amount of output produced.
• Total variable cost: The total cost of using the variable input,
which increases as more output is produced.
• Total cost = TFC+VC
• Average fixed cost: The total fixed cost per unit of output.
• Average variable cost: The total variable cost per unit of output.
• Average total cost: The total cost per unit of output, which also
equals average fixed cost plus average variable cost ATC = AFC + AVC

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Fixed Costs Versus Variable Costs

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Example
TABLE 5.4 Short-Run Cost Functions (Based on the production function from Table 5.1 and input prices
PK = $50 and PL = $100)

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Production and Cost Analysis in the Short Run

FIGURE 5.2 Short-Run Cost Functions

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Relationship Between Short-Run Production

and Cost

Marginal cost: The additional cost of producing an additional unit of output,

which equals the change in total cost or the change in total variable cost as
output changes.
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Production and Cost Analysis in the Short Run

FIGURE 5.3 The Relationship Between Short-Run Production and Cost

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Production and Cost Analysis in the Short Run

Other Short-Run Production and Cost Functions

• Linear total product curve that

results in the constant marginal
product curve in

• Because marginal cost is

constant, average variable
cost is also constant and
equal to marginal cost.
• Marginal cost must be less
than average total cost
because average total cost is
decreasing

FIGURE 5.4 Alternative Short-Run

© 2014 Pearson Education, Inc. Production and Cost Functions
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Production and Cost Analysis in the Short Run

Other Short-Run Production and Cost Functions

• If marginal product is constant over this range of output, marginal
cost must also be constant.
– There are no diminishing returns in the production function that would
cause the marginal cost of further production to increase.
• Because marginal cost is constant, average variable cost is also
constant and equal to marginal cost.
• Average total cost decreases throughout because it is being
pulled down by the declining average fixed cost. Marginal cost
must be less than average total cost because average total cost is
decreasing.
• Because marginal cost is constant, the total cost and total variable
cost functions must be linear, with the difference between the
two curves equal to total fixed cost.
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Production and Cost Analysis in the Short Run

Problem (EoC 5.1)

The following table shows data for a simple production function.

a. From the information in the table, calculate marginal and average products.
b. Graph the three functions (put total product on one graph and marginal and average products
on another).
c. For what range of output does this function have diminishing marginal returns?
d. At what output is average product maximized?

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Solution

a. b. See shapes of graphs in Figure 5.1.

c. After the fifth worker (or output of 75),
there are diminishing marginal returns.
d. Average product is maximized at an
output level of 75 (5 workers).

FIGURE 5.1 The Short-

Run Production Function

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Production and Cost Analysis in the Short Run

Problem EoC 5.5

The following table shows data for the simple production function used in Question 1. Capital costs
this firm $20 per unit, and labor costs $10 per worker

a. From the information in the table, calculate total fixed cost (TFC), total variable cost (TVC), total
cost (TC), average fixed cost (AFC), average variable cost (AVC), average total cost (ATC), and
marginal cost (MC).
b. Graph your results, putting TFC, TVC, and TC on one graph and AFC, AVC, ATC, and MC on
another.
c. At what point is average total cost minimized? At what point is average variable cost minimized?

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Solution

$200
a.

b. See Figure 5.2.

c. Average total cost is minimized at an output level of 90.
Average variable cost is minimized at an output level of 75. FIGURE 5.2 Short-Run Cost Functions

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Problem EoC 5.9

Suppose that a firm’s only variable input is labor. When 50 workers are used,
the average product of labor is 50, and the marginal product of the 50th worker
is 75. The wage rate is $80, and the total cost of the fixed input is $500.

a. What is average variable cost? Show your calculations.

b. What is marginal cost? Show your calculations.
c. What is average total cost? Show your calculations.
d. Is each of the following statements true or false? Explain your answer.
– 1. Marginal cost is increasing.
– 2. Average variable cost is increasing.
– 3. Average total cost is decreasing.

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Solution
Given: L = 50; APL = 50; MPL = 75; PL = $80; TFC = $500.
a. AP = Q/L  50 = Q/50  Q = 2,500

AVC = TVC/Q = (80)(50)/2,500 = 4,000/2,500 = $1.60

b. MC = PL/MPL = 80/75 = $1.07

c. ATC = TC/Q = [TVC + TFC]/Q = [4,000 + 500]/2,500 = 4,500/2,500 = $1.80

d.
– (1) We don't know if marginal cost is increasing or decreasing, as we have only one data point
– (2) Average variable cost must be decreasing, as marginal cost is less than AVC.
– (3) Average total cost must be decreasing for the same reason.

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Conclusions
• For production functions, all eventually incur diminishing
returns when increased units of the variable inputs are used
relative to the amount of the fixed inputs and the additional
amount of output produced begins to decline.
• Diminishing returns are fundamental to all short-run
production processes.
• The U-shaped cost curves of economic theory show the full
range of outcomes in a production process, but that real-world
cost curves may have different shapes.
• All of these issues are fundamental to the discussion of pricing
and other competitive strategies.

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