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Review:
1. What is a production function?
700 Eu • 2. What is the marginal product of some
input?
3. What is the MRTS?
400 Eu • 4. What are decreasing returns to scale?
Total costs are determined by the production function and the costs of inputs
But there are many different combinations of inputs that can produce q units.
The firm’s problem is to choose the combination of inputs that minimizes costs.
The Cost Function
Example 2: A firm needs 2 workers and 1 machine to produce a single unit. The wage is w = 5
and rent is r = 10. What is the cost of producing 10 units? What is the cost function?
Example 3: A firm can produce 1 unit of output with either 2 workers or with 1 machine.
If the wage is w=5 and rent is r = 5. What is the cost of producing 10 units? Derive the
cost function TC(Q)?
The Cost Function
When the firm hires L workers and K units of capital the total cost is:
w = wage rate
L = Quantity of Labor
r = price per unit of capital services
K = Quantity of Capital
TC wL rK
The Cost Function
If are many different combinations of inputs that can produce Q units. The firm’s problem is
to choose the best combination of inputs (that minimizes costs).
Definition:
The iso-cost line is the set of combinations of labor and capital that
yield the same total cost for the firm.
Example: The wage is w = $10 per hour and the rent is r = $20 per hour.
The iso-cost line for TC = $1,000 is all the combination L and K such that:
TC2
TC1/r
TC0/r TC1
TC0
TC1/r
Q
TC0/w TC1/w TC2/w
L
Deriving The Cost Function
Example: Suppose a firm needs 10 workers and 1 machine to produce a single unit. What is
the production function? The wage is w = 5 and rent is r = 100. What is the cost of
producing 50 units? What is the cost function?
Solution:
The production function F(L,K)= Min[0.1L,K].
To produce 50 units we need 50 machines and 500 workers, and the total cost will be
500*5+50*100=7,500
The Cost Function
Example: Suppose F(K,L)=L + 2K, the wage is w = 1 and rent is r = 1. What is the cost of
producing 1000 units? Derive the cost function TC(Q)?
Solution:
If MPL/w > MPK /r the productivity of a dollar spent on labor is larger than the
productivity of a dollar spent on capital.
If MPL/w < MPK /r the productivity of a dollar spent on labor is smaller than the
productivity of a dollar spent on capital.
Deriving The Cost Function
To get the cost of 1,000 units we need to ficure out how many workers and machines to use:
1. Optimality condition: MPL/MPK = w/r or K/L = 5/20
2. Use the production constriant: 50L1/2K1/2=1,000
K = 10; L = 40; And the total cost is 5*40+20*10=400
The Cost Function
Example:
Question:
How does the total cost curve shift if the price of all inputs rises by the same
amount?
Total Fixed Costs – the cost of fixed inputs; does not vary with output
•Fixed costs but not sunk: become zero if no production takes place Q=0
• Fixed and sunk: positive even if Q=0
Fixed and Variable Inputs
Definition
For given input prices:
The average cost function is the long run total cost function divided by output, Q.
ATC(Q) = TC(Q)/Q
The marginal cost function is the rate of change of total cost as output varies
MC(Q) = TC(Q)/Q
Long Run Total Cost
Key points:
Definitions
We say that a cost function exhibits economies of scale, if the average cost
decreases as output rises, all else equal.
We say that a cost function exhibits diseconomies of scale, if the average cost
increases as output rises, all else equal.
The smallest quantity at which the long run average cost curve attains its
minimum point is called the minimum efficient scale.
Economies Of Scale
AC ($/yr) AC(Q)
Q (units/yr)
0 Q* = MES
Economies Of Scale
- Adding software engineers increases communication costs: If there are n engineers, there
are ½n*(n – 1) pairs, so that communication costs rise at the square of the project size
- “The Peter Principle”: Workers move up until they become incompetent
- System slack: it is easier to hide inefficiencies in a large organization than in a small one
Economies Of Scale
24
- When the production function exhibits decreasing returns to scale, the long
run average cost function exhibits diseconomies of scale.
- When the production function exhibits increasing returns to scale, the long
run average cost function exhibits economies of scale.
- When the production function exhibits constant returns to scale, the long
run average cost function is flat: it neither increases nor decreases with
output.