EC2204- Business Economics

4: Production and Cost

 Learning Outcomes

Upon completing this section, the student should be able to:

 Define and understand the theory of production.

 Describe and illustrate a production function.
 Appreciate the meaning and measurement of cost.
 Differentiate between the various measures of cost.
 Distinguish between technical and economic efficiency.
 Appreciate the concept of a Cobb-Douglas production function
 Describe and illustrate the three stages of production.
 4: Production and Cost
 In business economics we must decide not only what to produce for the market,
but also how to produce it in the most efficient or least cost manner.
 This section develops a widely accepted tool for judging whether or not the
production choices are least cost.
 A production function relates the most that can be produced from a given set of
inputs.
 This allows the manager to measure the marginal product of each input. In the
short-run, some inputs are fixed.
 The Law of Diminishing Marginal Returns applies to the short-run when some
inputs are fixed.
 The long-run production function deals with a period of time over which all
inputs can vary.
 Scale economies apply to the long-run case where all inputs can be varied.
 Also, this section discusses reasons for increasing or decreasing returns in the
long-run.
 Production Functions in the Short-run

1. Each good or service produced requires inputs of time, materials, and capital. These
resource inputs produce an output. If we listed the greatest output possible for any set of
inputs, we would have described a production schedule, table, or function.
2. A production function is a schedule of maximum output from any set of inputs, Xi. Q = f
(X1,X2,...,Xn)
3. Production is real. It is visible either in a large scale factory assembly line or in smaller scale
in an artist's workshop. Production can be measured in the number of cars assembled or
the number of paintings completed.
4. Yet even in something as real as production, it is vital to a manager to have methods to
measure efficiency and ways to think about improving the production process. Theory is
useful when it helps organize thought in constructive ways.

5. In economics, efficiency generally refers to the least cost way to do an activity.

6. A production function with two inputs: Q =f(K, L), where K is the amount of capital, and
L is the amount of labor is used to illustrate issues in production.

7. A Cobb-Douglas Production Function relies on a multiplicative production model:

β1 B 2……… Cobb-Douglas Production Function
Q = AK L
 Production Function, Q = f (L, K)
Law of Diminishing Returns
Output (Q)
Total Product Curve
Increases in one factor of production such as, holding one
12
or other factors fixed such as capital and
11 entrepreneurship, after some point, lead to diminishing
9 marginal increases in total product. i.e. the marginal
product diminishes.

This point, at Q = 5, is both technically

and economically efficient
(see Figure 7.2)
5

0 1 2 3 4 5 6 7 Units
 Economic Efficiency
Occurs at only one point – At the Level of output where MR = MC

Price MC

P = D = MR = AR = MC MR = MC

Economic efficiency
occurs at 5 units of
output only
0 1 2 3 4 5 6 7 8 Output Q
 Production Function, Q = f (L, K)
Law of Diminishing Returns
Output (Q)
Total Product Curve
Increases in one factor of production such as, holding one
12
or other factors fixed such as capital and
11 entrepreneurship, after some point, lead to diminishing
9 marginal increases in total product. i.e. the marginal
product diminishes.

This point, at Q = 5, is both technically

and economically efficient
(see Figure 7.2)
5

0 1 2 3 4 5 6 7 Units
 Cost Structure of a Firm (p60-61)
1 2 3 4 5 6 7 8
O utput FC VC TC A FC A VC A TC MC
(Q )
(2+ 3) (2/1) (3/1) (4/1) ΔTC
1 30 40 70 30.0 40.0 70.0 -
2 30 60 90 15.0 30.0 45.0 20
3 30 90 120 10.0 30.0 40.0 30
4 30 130 160 7.5 32.5 40.0 40
5 30 180 210 6.0 36.0 42.0 50
6 30 250 280 5.0 41.7 46.7 70
7 30 350 380 4.3 50.0 54.3 100
 Relationship between the Cost Curves
1. When the marginal cost is below the average cost (MC < AC), your average costs are falling.
2. When the marginal cost is equal to the average cost (MC = AC), your average cost stays the same.
3. When the marginal cost is above the average cost (MC > AC), your average costs are rising.
Note: MC curve always cut both the AVC and the ATC at their minimum points.

C
o
st MC
’s
/
u
n
it
ATC

AVC

0
Quantity (Q)
Short-Run Average Cost Curves
Cost’
s
/unit
AC
Fixed Costs are spread over a larger output – Law of Diminishing Returns set-in
Increasing returns to scale – Decreasing returns to scale
Better use of
specialisation

Average Costs are minimized at point A

0
Quantity (Q)
 Long-Run Average Cost Curves
Long-Run Average Cost Curves are downward
sloping due to:
1.Product-specific economies which include Long-Run Average Cost Curves
specialization and learning curve effects.
2.Plant-specific economies, such as economies in
overhead, required reserves, investment, or
interactions among products
3.Firm-specific economies which are economies in
distribution and transportation of a
geographically dispersed firm, or economies in
marketing, sales promotion, or R&D of multi-
product firms.
Economies of Scale: These include purchasing
economies – a large firm can benefit from bulk
purchases of inputs, construction economies
– building costs do not increase with the size of
the firm, economies – greater specialisation
and division of – greater productivity,
financial economies- better interest rate terms
and advertising economies – advertising costs
per unit of output are lower for a large firm.
 Long-Run Average Cost Curves
Envelope of Short-Run ATC Curves

Long-Run Average Cost Curves are upward

Long-Run Average Cost Curve: the flat sloping due to:
section is due to constant returns to scale. 1. Diseconomies of scale, examples include
transportation costs, imperfections in the
market, and problems of coordination and
control by management.
2. The minimum efficient scale (MES) is the smallest
scale at which minimum per unit costs are
attained.
3. Modern business management offers techniques to
avoid diseconomies of scale through profit
centers, transfer pricing, and tying incentives to
performance.
Diseconomies of Scale: These include managerial
diseconomies – the bigger the firm the more
difficult it is to manage, principal agent –
conflict of interest between management and
workers. (P/A problem), diseconomies – large
companies have a higher proportion of ‘non-
productive’ workers and infrastructure
diseconomies- as the firm gets bigger greater
demands are made on the infrastructure
 The Three Stages of Production
Stage 1: The average product
(AP) is rising where the AP is
total output divided by number
inputs (workers).

Stage 2: The average product

is declining (but the marginal
product (MP) is positive) where
MP is the additional output
generated from hiring one
additional worker

Stage 3: The marginal product

is negative, or total product
(TP) is declining.

Sample Exam Question: Describe and illustrate the three stages of production.
Relationship between Inputs and Output
Production Functions and Returns to Scale

1. Constant Returns to Scale (CRS) increasing all inputs by lambda (λ) percent,
increases output by lambda percent.

2. Increasing Returns to Scale (IRS)--increasing all inputs by lambda percent,

increases output by more than lambda percent.

3. Decreasing Returns to Scale (DRS)--increasing all inputs by lambda percent,

does not quite increase output by lambda percent.

4. A production function Q = f(x, y) is homogeneous of degree n, if:

f(λx, λy) = λn f (x, y) for λ ≠ 0.

5. A Cobb-Douglas production function: Q = A K α Lβ- can be IRS, CRS, or DRS.

This function is homogeneous of degree = α + β
Production Functions and Returns to Scale

5. A Cobb-Douglas production function: Q = A Kα Lβ- can be IRS,

CRS, or DRS. This function is homogeneous of degree = α + β.

a. If α + β = 1 then your production function is Constant Returns to Scale

(CRS).
b. If α + β > 1 then your production function is Increasing Returns to Scale
(IRS).
c. If α + β < 1 then your production function is Decreasing Returns to Scale
(DRS).
 A Cobb-Douglas production function: Q = A K 0.6 L0.4
 This function is Constant Returns to Scale (CRS) as α + β = 1 (0.6 + 0.4 = 1.0)
 A Cobb-Douglas production function: Q = A K 0.6 L0.5
 The function is Increasing Returns to Scale (IRS) as α + β > 1 (0.6 + 0.5 = 1.1)
 A Cobb-Douglas production function: Q = A K 0.4 L0.5
 The function is Decreasing Returns to Scale (DRS) as α + β < 1 (0.4 + 0.5 = 0.9)
 Cobb-Douglas Production Functions
 The generalized Cobb-Douglas production function Q = A Kα Lβ is
linear in logs

 Log Q = Log A + α Log K + β Log L

 Log Q = Log A + 0.6 Log K + 0.4 Log L – CRS

 Log Q = Log A + 0.6 Log K + 0.5 Log L – IRS
 Log Q = Log A + 0.4 Log K + 0.5 Log L – DRS

 where α is the capital elasticity of output, α = EK

 and β is the labour elasticity of output, β = EL
 Sample Question 1

 Let there be a cubic VC function: VC = 0.5Q 3 - 10Q2 + 150Q

1. Find AVC from VC function?

2. Find minimum average variable cost of output?
3. Find MC function from VC function?

∆AVC
 Minimum AVC, is where =0
∆Q
VC 0.5Q 3 − 10Q 2 + 150Q
1.where AVC = Q Q = 0.5Q 2 - 10Q + 150
∆AVC
2. = ∆Q Q -10 = 0, So Q = 10, AVC minimised at Q =10
∆TC
3. MC function = = 1.5Q 2 − 20Q + 150
∆Q
 Sample Question 2
Consider the following variable cost function: VC = 120Q - 9Q 2 + 0.25Q3.
Fixed costs = 180 and Q = output.
a. Determine the average variable cost (AVC) function?
AVC = VC = 120Q − 9Q 2 + 0.25Q 3 = 120Q – 9Q +0.25Q2
Q Q
b. Find the level of output Q that minimises average variable costs?
∆VC
AVC are minimised when =0 -9 + 0.5Q = 0, so Q = 4.5
∆Q

c. Determine the marginal cost (MC) function?

Recall TC = FC + VC, so TC = 180 + 120Q - 9Q2 + 0.25Q3.

∆TC
MC function = = 120 − 18Q + 0.75Q 2
∆Q
 Sample Question 3
Suppose: Q = 1.4 L0.70 K0.35

Q1. Is this function homogeneous? A. It’s homogeneous to degree 1.05

Q2. Is the production function constant returns to scale? A. No. it’s IRS as
increases in all inputs by λ, increase output by 1.05
Q3. What is the elasticity of output? A. Elasticity of output is 0.70
Q4. What is the capital elasticity of output? A. Capital elasticity of output is 0.35
Q5. What happens to Output (Q), if (L) increases by 3% and capital (K) is cut
10%? -
Ans.- %ΔQ = 0.70*3% + 0.35* -10% = 2.1% - 3.5% = -1.4%

Conclusion: Output (Q) drops by 1.4%

 Sample Question 4
Output (Q) Fixed Cost (€) Variable C ost (€)
0 50 0
5 50 20
10 50 35
15 50 55
20 50 80

Use the above table to answer the following questions

a. Calculate the average total cost (ATC) at output = 20
TC FC + VC 50 + 80
ATC =
Q =
Q
= = €6.50
20
b. At output = 10, what is the TC?
TC = FC + VC = 50 + 35 = 85
c. What is the Marginal Cost (MC) as output is increased from 5 to 10 units?
As output is increased from 5 to 10 units, ΔTC = [ΔFC= 0 + ΔVC=15] and ΔQ = 5
∆TC 15
So MC = = = €3
∆Q 5
 MCQ’s
You are given the following cost function: TC = 1,500 + 300Q + 25Q2. From this
cost we know:
a. Fixed cost is 300.
b. Average total cost is 1500/Q.
c. Total cost declines as Q rises,
d. Marginal cost is 300 + 50Q

4. If marginal costs are greater than average total costs, then:

a. average total cost curve is falling,
b. average total cost curve is flat,
c. average total cost curve is rising,
d. average total cost curve is a minimum.
 Recall our Learning Outcomes

You should now be able to:

 Define and understand the theory of production.

 Describe and illustrate a production function.
 Appreciate the meaning and measurement of cost.
 Differentiate between the various measures of cost.
 Distinguish between technical and economic efficiency.
 Appreciate the concept of a Cobb-Douglas production
function
 Describe and illustrate the three stages of production.