Topic on

Production and Cost

Functions and Their
Estimation
 Production function

A table, graph, or equation showing the maximum

output rate of the product that can be achieved
from any specified set of usage rates of inputs
 Production function
Thomas Machine Company
Amount of Labor Output of Parts AP Labor MP Labor
(annual # units) (hundreds/year)
1 12 12.0 1
2 27 13.5 15
3 42 14.0 15
4 56 14.0 14
5 68 13.6 12
6 76 12.7 8
7 76 10.9 0
8 74 9.3 -2
 Production function
Thomas Machine Company

80
60
Parts

40
20
0
0 2 4 6 8 10
Labor
 Production function
Thomas Machine Company

20
15
10 AP Labor
Parts

5 MP Labor
0
-5 0 5 10

Labor
 Law of diminishing marginal
returns
If equal increments of an input are added to a
production process, and the quantities of other
inputs are held constant, eventually the marginal
product of the input will diminish

Note: 1) This is an empirical generalization.

2) Technology remains fixed.
3) The quantity of at least one input is
held fixed.
 Marginal revenue product

The amount that an additional unit of the

variable input adds to the firm’s total revenue

MRPY = DTR/DY
 Marginal expenditure

The amount that an additional unit of the

variable input adds to the firm’s total costs.

MEY = DTC/DY
Optimal level of input use

MRPY = MEY
 Production functions with two
variable inputs

Number of Machine Tools

Amount of Labor 3 4 5 6
1 5 11 18 24
2 14 30 50 72
3 22 60 80 99
4 30 81 115 125
5 35 84 140 144
Q = f (labor, machine Tools)

150

100

50

0
Number of
1 2 3 4 5 Machine Tools
Labor
 Isoquant

A curve showing all possible (efficient)

combinations of inputs that are capable of
producing a certain quantity of output

Iso quant

same quantity
Capital

K2
300
K1 200
100
0
L2 L1 Labor
 Marginal rate of technical
substitution
Shows the rate at which one input can be
substituted for another input, if output remains
constant. (Slope of the isoquant.)

Given Q = f(X1, X2)

MRTS = -dX2 / dX1

= -MP1 / MP2
 Isocost curves

Various combinations of inputs that a firm can

buy with the same level of expenditure

PLL + PKK = M

where M is a given money outlay.

Capital

M/PK

Slope = -PK /PL

0 M/PL Labor
Maximization of output for given
cost
Capital

R
300
200
100
0
Labor
 MPL/PL = MPK/PK

Capital

R
300
200
100
0 Labor
 Optimal Lot Size

• To consider the size of inventory

• Find the relationship between size of lot
and total annual cost.
What Toyota Taught the World?
• Lower the cost per setup
• Reduce the optimal lot size
• Just-in-time production system
 Returns to scale
If the firm increases the amount of all inputs by
the same proportion:
• Increasing returns means that output
increases by a larger proportion
• Decreasing returns means that output
increases by a smaller proportion
• Constant returns means that output increases
by the same proportion
 Output elasticity
The percentage change in output resulting from 1
percent increase in all inputs.

 e > 1 ==> increasing returns

 e < 1 ==> decreasing returns
 e = 1 ==> constant returns
 Example: Xerox
Sending out teams of engineers and
technicians to visit other firms to obtain
information concerning best-practice
methods and procedures.
• Competitive Benchmarking
Measurement of Production
Functions

Three types of statistical analysis

• Time series data
• Cross section data
• Technical information
The Analysis of Costs
 Opportunity costs

The value of the other products that the resources

used in production could have produced at their
next best alternative
 Historical costs

The amount the firm actually paid for a particular

input
 Explicit vs. implicit costs

• Explicit costs include the ordinary items that an

accountant would include as the firms expenses

• Implicit costs include opportunity costs of

resources owned and used by the firm’s owner
 Short run
A period of time so short that the firm cannot alter
the quantity of some of its inputs

• Typically plant and equipment are fixed inputs

in the short run
• Fixed inputs determine the scale of the firm’s
operation
Three concepts of total costs

• Total fixed costs = FC

• Total variable costs = VC
• Total costs = FC + VC
Fixed, variable, and total costs
Media Corp.
OUTPUT FC VC TC
0 2000 0 2000
1 2000 100 2100
2 2000 180 2180
3 2000 280 2280
4 2000 392 2392
5 2000 510 2510
6 2000 650 2650
7 2000 800 2800
8 2000 960 2960
9 2000 1140 3140
10 2000 1340 3340
11 2000 1560 3560
12 2000 2160 4160
Fixed, Variable, and Total Costs
-- Media Corp.

5000
4000 FC
dollars

3000
VC
2000
1000 TC
0
0 10 20
Units of Output
 Average and marginal costs
Media Corp.
OUTPUT AFC AVC ATC MC
0
1 2000.0 100.0 2100.0 100
2 1000.0 90.0 1090.0 80
3 666.7 93.3 760.0 100
4 500.0 98.0 598.0 112
5 400.0 102.0 502.0 118
6 333.3 108.3 441.7 140
7 285.7 114.3 400.0 150
8 250.0 120.0 370.0 160
9 222.2 126.7 348.9 180
10 200.0 134.0 334.0 200
11 181.8 141.8 323.6 220
12 166.7 180.0 346.7 600
 Average and marginal costs
Media Corp.

2000
1500
$$$

1000 AFC
500 AVC
0 ATC
0 2 4 6 8 10 12 MC
Units of output
 Long-run cost functions
• Often considered to be the firm’s planning horizon
• Describes alternative scales of operation when all
inputs are variable

Average
cost

Quantity of output
 Long-run average cost function

Shows the minimum cost per unit of producing each output

level when any scale of operation is available

SR average cost
Average functions
cost
LR average cost

Quantity of output
 Key steps:
Cost estimation process
Definition of costs
 Correction for price level changes
 Relating cost to output
 Matching time periods
 Controlling product, technology, and plant
 Length of period and sample size
 Minimum efficient scale
The smallest output at which long-run average
cost is a minimum.
Average
cost

Quantity of output
Qmes
 The survivor technique
• Classify the firms in an industry by size and
compute the percentage of industry output
coming from each size class at various times
• If the share of one class diminishes over time,
it is assumed to be inefficient
• These firms are then operating below
minimum efficient scale
 Economies of scope

Exist when the cost of producing two (or more)

products jointly is less than the cost of
producing each one alone.

S = C(Q1) + C(Q2) - C(Q1+ Q2)

C(Q1+ Q2)
 Break-even analysis
Total Revenue
Dollars Total Cost

Profit

Loss

Quantity of output