Managerial Economics &

Business Strategy
Chapter 5
The Production Process and Costs

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Overview
I. Production Analysis
Q Total Product, Marginal Product, Average Product
Q Isoquants
Q Isocosts
Q Cost Minimization
II. Cost Analysis
Q Total Cost, Variable Cost, Fixed Costs
Q Cubic Cost Function
Q Cost Relations
III. Multi-Product Cost Functions
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Production Analysis
• Production Function
Q Q = F(K,L)
Q 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
• Fixed vs. Variable Inputs

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Total Product
• Cobb-Douglas Production Function
• Example: Q = F(K,L) = K.5 L.5
Q K is fixed at 16 units.
Q Short run production function:
Q = (16).5 L.5 = 4 L.5
Q Production when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Marginal Productivity Measures
• Marginal Product of Labor: MPL = ∆Q/∆L
Q Measures the output produced by the last worker.
Q Slope of the short-run production function (with respect
to labor).
• Marginal Product of Capital: MPK = ∆Q/∆K
Q Measures the output produced by the last unit of
capital.
Q When capital is allowed to vary in the short run, MPK is
the slope of the production function (with respect to
capital).

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Average Productivity Measures
• Average Product of Labor
Q APL = Q/L.
Q Measures the output of an “average” worker.
Q 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
Q APK = Q/K.
Q Measures the output of an “average” unit of capital.
Q 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Increasing, Diminishing and
Negative Marginal Returns

Increasing Diminishing Negative

Q Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Guiding the Production Process
• Producing on the production function
Q Aligning incentives to induce maximum worker effort.
• Employing the right level of inputs
Q When labor or capital vary in the short run, to
maximize profit a manager will hire
• labor until the value of marginal product of labor equals
the wage: VMPL = w, where VMPL = P x MPL.
• capital until the value of marginal product of capital
equals the rental rate: VMPK = r, where VMPK = P x
MPK .

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Marginal Rate of Technical
Substitution (MRTS)
• The rate at which two inputs are substituted
while maintaining the same output level.

MPL
MRTS KL =
MPK

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Linear Isoquants
• Capital and labor are K
perfect substitutes Increasing
Q Q = aK + bL Output
Q MRTSKL = b/a
Q Linear isoquants imply that
inputs are substituted at a
constant rate, independent
of the input levels
employed.
Q1 Q2 Q3
L

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Leontief Isoquants
Q3
• Capital and labor are perfect K
Q2
complements.
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). L

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Cobb-Douglas Isoquants
• Inputs are not perfectly K
Q3
substitutable. Increasing
Q2
• Diminishing marginal rate Output
Q1
of technical substitution.
Q 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 = KaLb
• MRTSKL = MPL/MPK
L

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Isocost
• The combinations of inputs that K New Isocost Line
produce a given level of output associated with higher
C1/r costs (C0 < C1).
at the same cost:
wL + rK = C C0/r
• Rearranging,
C0 C1
K= (1/r)C - (w/r)L C0/w C1/w L
• For given input prices, isocosts K
farther from the origin are New Isocost Line for
C/r a decrease in the
associated with higher costs. wage (price of labor:
• Changes in input prices change w0 > w1).
the slope of the isocost line.

L
C/w0 C/w1

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Cost Minimization
K

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Optimal Input Substitution
• A firm initially produces Q0 K
by employing the
combination of inputs
represented by point A at a
cost of C0.
• Suppose w0 falls to w1.
A
Q The isocost curve rotates K0
counterclockwise; which
represents the same cost level
prior to the wage change. B
Q To produce the same level of K1
output, Q0, the firm will
produce on a lower isocost line
(C1) at a point B. Q0
Q The slope of the new isocost
line represents the lower wage
relative to the rental rate of
L1 C0/w0 C1/w1 C0/w1 L
capital. 0 L0

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Cost Analysis

• Types of Costs
Q Fixed costs (FC)
Q Variable costs (VC)
Q Total costs (TC)
Q Sunk costs

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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 = ∆C/∆Q
Q
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Fixed Cost
Q0×(ATC-AVC)
MC
$ = Q0× AFC ATC
= Q0×(FC/ Q0) AVC
= FC

ATC
AFC Fixed Cost
AVC

Q0 Q

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Variable Cost
Q0×AVC MC
$
ATC
= Q0×[VC(Q0)/ Q0]
AVC
= VC(Q0)

AVC
Variable Cost

Q0 Q

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Total Cost
Q0×ATC
MC
$
= Q0×[C(Q0)/ Q0] ATC

= C(Q0) AVC

ATC

Total Cost

Q0 Q

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Cubic Cost Function
• C(Q) = f + a Q + b Q2 + cQ3
• Marginal Cost?
Q Memorize:
MC(Q) = a + 2bQ + 3cQ2
Q Calculus:
dC/dQ = a + 2bQ + 3cQ2

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 An Example
Q Total Cost: C(Q) = 10 + Q + Q2
Q Variable cost function:
VC(Q) = Q + Q2
Q Variable cost of producing 2 units:
VC(2) = 2 + (2)2 = 6
Q Fixed costs:
FC = 10
Q Marginal cost function:
MC(Q) = 1 + 2Q
Q Marginal cost of producing 2 units:
MC(2) = 1 + 2(2) = 5

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Economies of Scale
$

LRAC

Economies Diseconomies
of Scale of Scale
Q

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Multi-Product Cost Function
• C(Q1, Q2): Cost of jointly producing two
outputs.
• General function form:

C (Q1 , Q2 ) = f + aQ1Q2 + bQ + cQ 1
2 2
2

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Economies of Scope
• C(Q1, 0) + C(0, Q2) > C(Q1, Q2).
Q It is cheaper to produce the two outputs jointly instead
of separately.
• Example:
Q It is cheaper for Time-Warner to produce Internet
connections and Instant Messaging services jointly than
separately.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Cost Complementarity
• The marginal cost of producing good 1
declines as more of good two is produced:

∆MC1(Q1,Q2) /∆Q2 < 0.

• Example:
Q Cow hides and steaks.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006