CH 8 Production and Cost Functions

Pilot Publishing Company Ltd.
2005
Chapter 8
Production Function
&
Cost Function
Pilot Publishing Company Ltd. 2005
Short Run and Long Run
Production Function
Cost Accounting of Factor I nputs
Cost Function
Short Run Cost Curves
Long Run Cost Curves
Theory of Production Cost by A. Alchian
Advanced Material 8.1: Costs Related to an
Owned Durable Equipment
Contents:
Short Run & Long Run
Reasons for the existence of different production runs:
Whenever a market situation changes a firm has to
make a new decision so as to maximize wealth.
The firm is uncertain if the change in the market situation
is temporary or permanent.
It will make only the minimal and necessary change
in factors to minimize cost.
At the beginning
Even if the change is certain to be permanent,
the adjustment in factors should still be slow and
gradual because hasty change involves a larger cost.
Afterwards
Since adjustment is gradual, according to the completeness
in the adjustment in factors, three different production runs
are classified.
Classification of production runs
Very short run (VSR)
all factors are fixed (remains unchanged).
Short run (SR)
some factors are varied but some are fixed.
Long run (LR)
all factors are variable and
all required variations have been made.
Variable factors versus fixed factors
Variable factors: are factors of which the
employment varies with output.
Fixed factors: are factors of which the
employment does not vary with output.

Q8.1 Fill in the table.
VSR SR LR
Any change in
factor
employment?
Any change in
output level?
Reasons
No
No
Some factors are
varied but some
are fixed
Yes
All factors are
variable and all
required changes are
made
Yes
No adjustment
Time is needed
to recognize the
change, make
decision &
implement
adjustment
Temporary adjust.
Time is needed
to identify if the
change is permanent
& to make gradual
adjustment to
minimize cost
Final adjustment
Time is long enough
for the final adjust.
to be determined &
implemented.
Q8.2:
Some economists define the very long run as
the period over which the technology changes.
Comment..
Production Function
Production function () describes
the relationship between inputs () and
output ().
Output
I nputs
Variable
factor
Assumptions:
only two factors are involved capital & labour
Production function in the short run
Capital
Fixed
Factor
____________________: is the whole amount of output
produced by all the factors employed.
TP = Q
____________________: is the output per unit of the
variable factor employed.
L
Q
L
TP
AP
Three variables are defined to measure the output:
____________________: the change in output resulting
from employing an additional unit of the variable factor.
1 1

L L
L
Q
L
TP
MP
Total product (TP)
Average product (AP)
Marginal product (MP)
Law of diminishing marginal productivity ()
[or the law of diminishing returns ()
or the law of variable proportions ()]
The law of diminishing marginal productivity
states that if a _________ factor is added continuously to a
given amount of _________ factors, the marginal product
(and the average product) of the _________ factor must
finally decrease, ceteris paribus.
variable
fixed
variable
With a given amount of fixed factors, when one worker is
employed, he can use only some of the fixed factors each
time.
When more workers are employed, they can specialize
and raise the productivity. (Both MP & AP ).
However, after all the fixed factors have been efficiently
used, additional workers can help the preceding workers
only. Hence MP which will finally drag down AP (and
even TP).
Derivation of the law:
Once the MP curve
passes through the AP
curve and lies below it,
the AP curve will also
be dragged down. Why?
MP
Fixed factor Variable factors
MP
AP
AP
Graphical
illustration:
When AP rises, MP must lie above AP.
How can MP lying
above AP become lying
below it? (I f MP curve is
continuous, it must pass
through the maximum
point of AP curve.)
When AP falls, MP must lie below AP.
Features:
The slope of TP
curve is MP.
The slope of the
line joining the
origin and a point
on TP is AP.
Notice the points
where MP = maxi.;
MP=AP &
MP = 0.
I mplications of the law (if the law is violated)
By adding units of fertilizer or worker continuously to a
given plot of land, no matter how small its size is, TP can be
increased continuously. Enough food can be produced to
feed all the people in the world.
An infinitesimal piece of land is adequate to supply the
amount of food required. Hence the supply of land is no
longer scarce. Land price would drop to zero.
MP of workers cultivating superior land does not fall and is
always larger than MP of workers cultivating inferior land.
No inferior land would be cultivated.
If the amount of land is fixed, TP cannot be
increased significantly ( MP & AP ) to feed all
the people in the world.
Hence to raise production, more land is needed.
However, as the supply of land is limited and scarce,
under competition, land price must be positive.
Once MP of superior land falls below MP of inferior
land, inferior land will also be cultivated.
I mplications of the law (if the law holds)
Production Function in the long run
Returns to scale ()
refers to the change in output when all
factors are increased by the same proportion.
Production Function in the long run
I ncreasing returns to scale
There are three kinds of returns to scale:
Constant returns to scale
Decreasing returns to scale
I ncreasing returns to scale ()
when all factors are increased by the same proportion,
the total product increases more than proportionately.
Constant returns to scale ()
when the production scale increases,
the total product increases proportionately.
when the production scale increases,
the total product increases less than proportionately.
Decreasing return to scale ()
Assumptions (in the LR):
At the end
the production function has decreasing returns to scale
At the beginning
the production function has increasing returns to scale
Cost Accounting
of
Factor Inputs
For factors hired or employed by a firm:
The costs are (the value of) the highest-
valued alternative use of the money spent in
hiring them.
They are called explicit costs (),
as they involve a transfer of money.
For factors owned by a firm:
The costs of using these factors are (the value
of) the highest-valued alternative uses of the
factors.
They are called implicit costs ()
or imputed costs (),
as they do not involve
a transfer of money.
Q8.4:
What is the cost to a firm of using an owned
property as an office for a year,
if the premise can be leased at $20 000 a month
or sold at $5 million, given a market interest rate
of 4% per annum?
Classification of costs of different factor inputs
Sunk cost (historical cost)
The cost of a past act.
As past options are not available at present, sunk cost
cannot be avoided now. Sunk cost is not a (present or
future) cost.
Bygone is bygone. It should have no effect on
any present or future decisions.
Fixed cost
The cost of employing fixed factors.
It does not change with output.
It is a present cost paid for the use of fixed factors
and hence it affects the net receipt.
It has no effect on MC & no effect on the determination
of the wealth-maximizing output level.
Variable cost
The cost of employing variable factors.
It changes with output.
It is a present cost paid for the use of variable factors
& hence it affects the net receipt.
It affects marginal cost & hence it affects the wealth-
maximizing output.
Q8.6:
A restaurant is making a short run decision for its production
next month. I dentify if the following costs are sunk costs (SC),
fixed costs (FC) or variable costs (VC).
(a) Rent of the restaurant under a 2-year contract ( )
(b) Wage payments ( )
(c) Expenditure on meat and vegetables ( )
(d) Water charges ( )
(e) Electricity charges ( )
(f) Acquisition cost of machines ( )
(g) Continuing possession cost of machines ( )
(h) Operating cost of machines ( )
Cost Function
Cost function () describes the
relationship between output and cost.
Output
= ???
Short-run Cost Curves
Measure of costs
Output changes Cost changes
Total cost (TC)
Change in cost can be expressed in three ways:
Marginal cost (MC)
Average cost (AC)
Total cost
is the whole amount of payments to all factors used
in producing a given amount of output (Q), composed of:
Total fixed cost (TFC): is the whole amount of
payments to fixed factors.
Total variable cost (TVC): is the whole amount of
payments to variable factors.
TVC = w x L
total variable cost:
Formula:
TC = TFC +TVC Total Cost:
Assume two factors only:
Capital (fixed factor) and labour (variable factor)
L units of labour are employed at a wage rate of w.
a constant independent of output total fixed cost:
Average cost/average total cost (ATC)
is the cost per unit of output, composed of :
average fixed cost (AFC):
the fixed cost per unit of output.
average variable cost (AVC):
the variable cost per unit of output.
Formula:
AVC AFC
Q
TVC TFC
Q
TC
ATC

Average Total Cost:
Q
TFC
AFC
average fixed cost:
AP
w
L
Q
w
L
Q
L
L w
Q
L w
Q
TVC
AVC

average variable cost:
ATC curve and AVC curve will come closer and closer as
the amount of output increases (ATC = AFC + AVC and
AFC drops continuously).
AVC curve is U-
shaped. ( AVC =
w/AP and AP is
inverted-U shaped.)
AFC curve drops
continuously. (AFC
= TFC/Q)
Features:
The turning point of ATC curve (b) occurs at a larger
output than the turning point of AVC curve (a). Why?
(b) (a)
At (a), the fall in AFC is > the rise in AVC initially
but at (b), the fall in AFC is < the rise in AVC eventually
Marginal Cost
is the change in total cost for producing an additional
unit of output, composed of :
marginal fixed cost (MFC): is the change in fixed cost
for producing an additional unit of output
marginal variable cost (MVC): is the change in variable cost
for producing an additional unit of output.
Formula:
0
Q
TFC
MFC marginal fixed cost:
MVC MFC
Q
TVC TFC
Q
TC
MC
Marginal cost:
marginal variable cost:
MP
w
L
Q
w
L
Q
L
L w
Q
L w
Q
TVC
MVC

MC curve passes through the minimum points of AVC curve
and ATC curve.
MC or MVC
curve is
U-shaped
As TFC is a constant, MFC = 0. So MC = MVC.
MC = MVC = w/MP. As MP curve is inverted-U shaped, MC
or MVC curve is U-shaped.
MC curve (= MVC
curve) = Slope of TC
curve & TVC curve.
Derivation of total cost
curves:
Notice the points
where MC = mini.;
MC = AVC and MC
= ATC.
Q8.7: The following table is composed of product items and cost
items of a firm. Suppose the unit cost of capital and labour are
$10 and $20 respectively. Fill in the missing columns..
Units
of
capital
Units
of
labour
TP AP MP TFC TVC TC ATC
4
4
4
4
4
4
1
2
3
4
5
6
2
5
10
14
14
12
Q8.8
(a) When output increases, if AP of a variable factor rises,
what will happen to AVC and ATC?
(b) When output increases, if AP of a variable factor falls,
what will happen to AVC and ATC?
Long-run Cost Curves
The firm enjoys economies of
scale at the beginning
LRAC & LRMC
As the scale of production
further, the firm suffers
diseconomies of scale
LRAC & LRMC
The production scale (combination of factors) with
the lowest LRAC.
Optimum scale
LRAC curve with
a horizontal region
U-shaped LRAC curve
Optimum scale
LRMC = slope of LRTC
Slope
=LRMC
=LRAC
Derivation of total
cost curves:
Notice the points
where LRMC = mini.
and LRMC = LRAC.
Theory of Production Cost
by A. Alchian
Volume = Rate x Time Duration
Rate effect: To produce the same volume of output,
the faster the rate, the higher the average cost. Why?
Volume effect: At the same rate of production,
the larger the volume, the lower the average cost. Why?
Proportionate increase in both the rate and volume:
If both the rate and the volume are increased
proportionately, the average cost may fall at the beginning
but it must rise eventually. Why?
Advanced Material 8.1
Cost related to an owned durable equipment
1. Present value and future value
PV

= $X / (1+r)
t
Computing the present value
(PV) of a future sum ($X) is
called discounting ().
Present value
FV
t
= $Y (1+r)
t
Computing the future value
(FV) of a present sum ($Y) is
called compounding ().
Future value
2. Classification of costs related to an owned durable
equipment
Acquisition cost () is the amount forgone in
acquiring the ownership of an asset.
Continuing possession cost () is the
amount forgone in keeping an asset without using it.
Operating cost () is the amount forgone in
using an asset.
-Purchase price of machine A = $10 000
-Immediate resale value = $9 600
-Resale value if machine A has been laid idle for a year = $8 000
-Resale value if machine A has been operated for a year = $4 000
-Additional expense for operating machine A (e.g., labour cost) = $1 000
-Market interest rate = 10%
(a) Acquisition cost = ?
(b) Continuing possession cost = ?
(c) Operating cost = ?
Worked example:
Correcting Misconceptions:
1. I n the long run, all factors are variable and
are varied gradually so as to minimize cost.
2. The law of diminishing returns states that
when all inputs increase, output will increase
at a decreasing rate eventually.
3. I f the law of diminishing marginal productivity
does not hold, scarcity no longer exists and
production involves zero cost.
4. The cost of using a factor is equal to zero if
no explicit payment is involved.
5. The cost of using an owned asset is equal to
the purchase price of the asset.
6. Fixed cost is the same as sunk cost.
Correcting Misconceptions:
7. When output increases, if AP of the variable
factor falls, the AC rises.
Survival Kit in Exam
Question 8.1:
I n a recession, an employer can earn enough revenue to
cover the rent, labour cost, water and electricity charges
and the maintenance cost of machines. However, the
remaining revenue cannot cover their repayment to
bank loans for buying machines. Suppose the machines
have zero resale value. I s it irrational for the employer

(a) to continue the running of the firm, and
(b) to buy the machines?

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