This chapter discusses key concepts related to production processes and costs. It introduces the production function and how managers can influence productivity. It also covers calculating costs from production functions, including fixed, variable, and marginal costs. Input combinations are shown using isoquants and isocost lines, and how firms minimize costs by finding the optimal input mix where the isoquant is tangent to the lowest isocost line. The chapter concludes with economies and diseconomies of scale and their impact on long-run average costs.

1. CHAPTER 5
The Production Process and Costs

2. INTRODUCTION

3. Learning Objectives
2-3
After studying this chapter, you will be able to:
 Explain how to measure productivity of inputs and managers
role in the production process.
 Calculate input demand function and explain how input
substitution can minimize production costs.
 Calculate a cost function from production function and explain
the difference between economic costs and accounting costs.
 Explain the relationship between fixed cost, variable cost,
marginal costs and its importance in economics.
• Understand the impact of various costs on long run and short
run production decision

4. The Production Function
2-4
• Production function: the relationship that describes how
inputs like capital and labor are transformed into output.
• Firms produce maximum amount of output with a given
set of inputs
Q=F(K, L)
Where, Q is the level of output,
-- K is the quantity of capital input
--L is the quantity of labour input

5. Use of Inputs in Short-Run and Long-Run
5-5
• Short-run: the period during which at least one factor input
is fixed while other inputs are variable. The manager can
not adjust the inputs to change production in the short
run.
• Long-run: the period during which all factors of production
(inputs) are variable. The manager can adjust the inputs
to alter production in the long run.

6. Increasing, decreasing andnegative marginal
returns
Total product
Average product
Marginal product
Total product (TP)
Increasing
marginal
returns to labor
Decreasing
marginal
returns to labor
Negative
marginal
returns to labor
APL decreasing
Labor input
(holding capital constant)
0
LMarginal product (MP )
APL maximized
Average product (APL)

7. Marginal Returns
• As more of the variable input is used, marginal product
initially increases (increasing marginal returns), then
starts to decline (decreasing marginal returns) then
becomes negative.
• How to determine the optimal use of the variable input
2-7

8. Manager’s role inproduction
2-8
 Maximum amount of output that can be produced with
given inputs
- Managers can provide incentives to the workers that
induces them to work hard
 Right mix of inputs to maximize profit:
- Value marginal product of labour, VMPL = P x MPL
-Value marginal product of capital, VMPK = P x MPK

9. CHAPTER 5
The Production Process and Costs

10. PRODUCTION COST

11. Isoquant and Marginal Rate of
TechnicalSubstitution
• An isoquant is a curve that shows various input
combinations that yield the same total quantity of output
• The slope of the isoquant = the ratio of the marginal
product of labor to the marginal product of
capital. MPL/MPK
• Marginal rate of technical substitution: measures the amount
of K the firm could give up in exchange for an additional L, in
order to be able to produce the same output as before.
MRTSL,K
2-

12. A
Isoquants and Marginal Rateof
Technical Substitution
Capital Input
Labor Input0
B
5-

13. Diminishing MRTS
Capital Input
D
Labor Input0
C
B
A

14. Isocost Line
• It is the different combinations of inputs that will cost the
firm the same amount comprise an isocost line.
• the slope of the isocost line is given by the ratio of the
input prices, PL/PK.
• Changes in isocost: slope of the isocost line change due
to change in input prices
2-

15. Isocost Line
Capital Input
Labor Input0

16. Changes in the IsocostLine
Capital Input
More expensive input
bundles
Labor Input0
Less expensive input
bundles
5-

17. Changes in the IsocostLine
Capital Input
Labor Input0
5-

18. CHAPTER 5
The Production Process and Costs

19. COST MINIMIZATION

20. Cost Minimization
2-
• the condition for optimality is that the isoquant is
tangential to the lowest isocost curve.
• Producers are interested in cost minimization
• For more information on “Cost Curve”
• https://www.youtube.com/watch?v=ucJBO9UTmwo
• https://www.youtube.com/watch?v=qYKJdooEnwU

21. Input Substitution
New cost-minimizing
point due to higher wage
Capital Input
I
Labor Input0
B
Initial point of cost minimization
A
H
5-
F
J
G

22. The Cost Function
Total costs
Variable costs
Fixed costs
Output0
5-

23. Average and MarginalCosts
•
5-

24. Average and Marginal Costs
ATC, AVC, AFC
and MC ($)
Minimum of ATC
Output0
Minimum of AVC
5-

25. Fixed and SunkCosts
5-
• Fixed costs
• Cost that does not change with output.
• Sunk cost
• Cost that is forever lost after it has been paid.
• Principle of Irrelevance of Sunk Costs
• A decision maker should ignore sunk costs to maximize profitsor
minimize loses.

26. Long-Run Costs
• In the long run, all costs are variable since a manager is
free to adjust levels of all inputs.
• Long-run average cost curve
• A curve that defines the minimum average cost of producing
alternative levels of output allowing for optimal selection of both
fixed and variable factors of production.
5-

27. Long-Run Average Total Costsin
Action
LRAC ($)
Output0
5-

28. CHAPTER 5
The Production Process and Costs

29. ECONOMIES OF SCALE

30. Economies of Scale
• Economies of scale
• Declining portion of the long-run average cost curve as output
increase.
• Diseconomies of scale
• Rising portion of the long-run average cost curve as output
increases.
• Constant returns to scale
• Portion of the long-run average cost curve that remains constantas
output increases.
• For more information on “Economies of Scale”
• https://www.youtube.com/watch?v=JdCgu1sOPDo
5-

31. Economies andDiseconomies
of Scale inAction
LRAC ($)
Output0
Economies of scale
5-
Diseconomies of scale

32. Constant Returns to Scale in Action
LRAC ($)
Output0
5-

33. CHAPTER 5
The Production Process and Costs

34. 2-39
RECAP
On Key Terms and Concepts

35. Key terms andconcepts
• Average Fixed Cost
• Average Product
• Average Variable Cost
• Cobb – Douglas production function
• Constant returns to scale
• Cost minimization
• Diminishing marginal returns
• Marginal rate of technical substitution
• Economies of scale
• Increasing marginal returns
• Isoquant
• Isocost
• Value marginal product
• Sunk cost
• Short run cost function
• Optimal input substitution
• Multiproduct cost function
2-