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Managerial Economics & Overview

Business Strategy I. Production Analysis
I Total Product, Marginal Product, Average Product
Chapter 5 I Isoquants
Isocosts
The Production Process and Costs I

I Cost Minimization
II. Cost Analysis
I Total Cost, Variable Cost, Fixed Costs
I Cubic Cost Function
I Cost Relations

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Production Analysis Total Product

Production Function Cobb-Douglas Production Function
I Q = F(K,L) Example: Q = F(K,L) = K.5 L.5
I The maximum amount of output that can be I K is fixed at 16 units
units.
produced with K units of capital and L units of I Short run production function:
labor. Q = (16).5 L.5 = 4 L.5
Short-Run vs. Long-Run Decisions I Production when 100 units of labor are used?

Fixed vs. Variable Inputs Q = 4 (100).5 = 4(10) = 40 units

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Marginal Product of Labor Average Product of Labor

MPL = Q/L APL = Q/L
Measures the output produced by the last Measures the output of an average
worker
worker. worker
worker.
Slope of the production function Q = 4L.5 so APL = Q/L = 4L-.5
Q= 4 L.5 so MPL = dQ/dL = 2 L-.5 If L= 100, AP(100) = 4/L.5 = 4/10 = .4
If L = 100, MP(100) = 2/L.5 = 2/10 = .2

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

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Isoquant Linear Isoquants

The combinations of inputs (K, L) that Capital and labor are
yield the producer the same level of output. perfect substitutes
K
The shape of an isoquant reflects the ease Increasing
O
Output
with which a producer can substitute
among inputs while maintaining the same
level of output.
Q1 Q2 Q3
L

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Leontief Isoquants Cobb-Douglas Isoquants

Q3 K
Capital and labor are K Inputs are not Q3
Q2
perfect complements Q1 Increasing
perfectly substitutable Q2
Increasing
Output
Capital and labor are Output Diminishing marginal Q1
used in fixed-proportions rate of technical
substitution
Most production
processes have
isoquants of this shape
L

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Isocost
The combinations of K
Cost Minimization
inputs that cost the
producer the same amount Marginal product per dollar spent should be
of money equal for all inputs:
For given input prices, C0 C1
L MPL MPK
isocosts farther from the =
K w r
origin are associated with New Isocost Line for
higher costs. a decrease in the Expressed differently
wage (price of
Changes in input prices labor).
w
change the slope of the MRTS KL =
r
isocost line L

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

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Total and Variable Costs

Cost Minimization C(Q): Minimum total cost $
of producing alternative C(Q) = VC + FC
K
levels of output:
Point of Cost VC(Q)
Minimization
Slope of Isocost C(Q) = VC + FC
=
Slope of Isoquant
VC(Q): Costs that vary
Q
with output FC

FC: Costs that do not vary

with output Q
L

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Some Definitions Fixed Cost

Average Total Cost
Q0(ATC-AVC)
ATC = AVC + AFC
MC
ATC = C(Q)/Q $ $ = Q0 AFC
MC ATC
ATC
= Q0(FC/ Q0) AVC
Average Variable Cost AVC

AVC = VC(Q)/Q = FC

ATC
Average Fixed Cost AFC Fixed Cost
AFC = FC/Q AVC

Marginal Cost AFC

Q
Q0
MC = C/Q
Q
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Variable Cost Total Cost

Q0ATC
Q0AVC MC MC
$ $
ATC = Q0[C(Q0)/ Q0] ATC
= Q0[VC(Q0)/ Q0]
AVC = C(Q0) AVC
= VC(Q0)

ATC

AVC Total Cost

Variable Cost

Q0 Q Q0 Q

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

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Economies of Scale Cubic Cost Function

$
C(Q) = f + a Q + b Q2 + cQ3
Marginal Cost?
LRAC
I Memorize:
MC(Q) = a + 2bQ + 3cQ2
I Calculus:
Economies Diseconomies dC/dQ = a + 2bQ + 3cQ2
of Scale of Scale
Output

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

An Example
Long vs. Short-Run Example
I Total Cost: C(Q) = 10 + Q + Q2
I Variable cost function:
VC(Q) = Q + Q2
Suppose we have a production process that
I Average cost function: has fixed input requirements like those in
C(Q)/Q = 10/Q +1 + Q slide 9 of this chapter.
p In fact lets assume
I Fixed costs: labor and capital have to be used in the ratio
FC = 10 of 2 (labor) to 1 (capital) and the isoquants
I Marginal cost function: show in slide 9 are for 1, 3 and 5 units of
MC(Q) = 1 + 2Q output respectively.
I Marginal cost of producing 2 units:
MC(2) = 1 + 2(2) = 5
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Long vs. Short-Run Example Long vs. Short-Run Example

a. What is the minimum about of labor that b. If capital costs $2000 per unit and labor
can be used to produce 1 unit of output, 3 costs $1000, what does the long-run
units of output, 5 units? How about average curve look like.
capital?
i l?
Q KL Q PLL PKK TC AC
1 1 2 1 2000 2000 4k 4000
3 3 6 3 6000 6000 12k 4000
5 5 10 5 10,000 10,000 20k 4000
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

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Long vs. Short-Run Example

c. If we fix capital at 5 units, then what does
the short-run total and average cost curve
look like?
Q PLL PKK STC SAC
1 2000 10,000 12k 12000
3 6000 10,000 16k 5333
5 10,000 10,000 20k 4000

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002