Managerial Economics

ninth edition

Thoma
Mauric

Chapter 10
Production & Cost
Estimation
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial Economics,
Managerial Economics,

Copyright 2008 by the McGraw-Hill Companies, Inc. All

Managerial Economics

Empirical Production Function

Cubic empirical specification for a
short-run production function is
derived from a long-run cubic
production function
Cubic form of the long-run
production function is expressed as

Q aK L bK L
3

10-2

Managerial Economics

Properties of a Short-Run Cubic

Production Function
3
2

Q AL BL

Holding capital constant, short-run

cubic production function is
derived as follows:

Q aK L bK L
3
2
AL BL
3

Where A aK 3 and B bK 2
10-3

Managerial Economics

Properties of a Short-Run Cubic

Production Function
3
2

Q AL BL

The average & marginal products

of labor are, respectively:

AP Q L AL BL
2

MP Q L 3 AL 2BL
2

10-4

Managerial Economics

Properties of a Short-Run Cubic

Production Function
3
2

Q AL BL

Marginal product of labor begins to

diminish beyond Lm units of labor
Average product of labor begins to
diminish beyond La units of labor

B
Lm
3A
10-5

B
and La
2A

Managerial Economics

MP & AP Curves for the Short-Run

Cubic Production Function (Figure 10.1)
Q = AL3 +
BL2

10-6

Managerial Economics

Properties of a Short-Run Cubic

Production Function
3
2

Q AL BL

To have necessary properties of a

production function, parameters
must satisfy the following
restrictions:

A 0 and B 0
10-7

Managerial Economics

Estimation of a Short-Run
Production Function

To use linear regression analysis, the

cubic equation must be transformed
into linear form
Q = AX + BW
Where X = L3 and W = L2

Estimated regression line must pass

through the origin
Specify in computer routine
10-8

Managerial Economics

Estimation of a Short-Run Cost

Function

Estimate using data for which the level of

usage of one or more inputs is fixed
Usually time series data are used

Data collection may be complicated by the

fact that accounting data do not include
firms opportunity costs
Capital costs should reflect not only acquisition
cost but any foregone rental income,
depreciation, & capital gains/losses

Must eliminate effects of inflation

Divide by appropriate price index
10-9

Managerial Economics

Properties of a Short-Run Cubic

Cost Function
2
3
TVC aQ bQ cQ

Average variable cost & marginal

cost functions are, respectively:
AVC a bQ cQ 2
SMC a 2bQ 3cQ

10-

Managerial Economics

Properties of a Short-Run Cubic

Cost Function
2
3
TVC aQ bQ cQ

Average variable cost reaches its

minimum value at:

Qm b 2c
To conform to theoretical properties,
parameters must satisfy the following
restrictions:

a 0 , b 0 , and c 0
10-

Managerial Economics

Properties of a Short-Run Cost

Function

Cubic specification produces

S-shaped TVC curve & U-shaped AVC
& SMC curves
All three cost curves employ the same
parameters
Only necessary to estimate one of these
functions to obtain estimates of all three

In the short-run cubic specification,

input prices are assumed constant
10-

Not explicitly included in cost equation

Managerial Economics

Summary of Short-Run Empirical

Production Functions
Short-run cubic
production equations
Total product

10-

Q AL3 BL2

Average product of labor

AP AL BL

Marginal product of labor

MP 3 AL2 2 BL

Diminishing marginal
returns
Restrictions on
parameters

B
begin at Lm
3A

A 0 and B 0

Managerial Economics

Summary of Short-Run Empirical

Cost Functions
Short-run cubic
cost equations
Total variable cost
Average variable cost
Marginal cost
Average variable cost
reaches minimum at
Restrictions on
parameters
10-

TVC aQ bQ 2 cQ 3
AVC a bQ cQ 2
SMC a 2bQ 3cQ 2
b
Qm
2c

a 0, b 0, c 0