Cambridge Judge Business School

Session 3
• PRODUCTION PROCESS
• TECHNOLOGY AND COSTS

Dr. Juliana Kozak Rogo

Outline for Today
I. Production
• Total Product, Marginal Product, Average Product
• Isoquants
II. Cost
• Choice in the Short-run
• Cost Minimization in the Long-run
• Types of costs
• Economies of scale, scope, cost complementarities,
learning curve
• Burger King Case
• Building the Boeing 787 Case
PRODUCTION
Production Function
• Firm is an entity that transforms inputs into outputs.
• The production function relates inputs to outputs.
• But it is a special level of output; namely, the maximum output for
the given inputs, usually Labor (L) and Capital (K).
• Every firm will strive to be as efficient as possible, and therefore
operate in a manner represented by the production function.
• General form: Q =F(K,L,...,other inputs.)
Short x Long Run
• Economists define the short run production function as one
in which the level of one or more inputs is fixed.
• Usually in the short run, capital is fixed. This is because a
firm can often change its level of labor (number of workers,
or even the hours it requires its workers to work) with more
ease than it can change its capital (the number of machines
or buildings it uses).
• The long run is amount of time needed to make all relevant
production inputs variable.
• No inputs are fixed in the long run.
Measures of Productivity
• Total Product (TP) is the maximum level of output that can
be produced with a given amount of inputs.
• Average Product (AP) of an input is total product divided by
the quantity used of the input.
APL = Q/L (average product of labour)
APK = Q/K (average product of capital)
• Marginal Product (MP) of an input is the change in total
output attributable to the last unit of an input or the
approximate change in product when input increases by 1
unit. This is also the slope of the production function.
∆𝑸
MPL = (marginal product of labour)
∆𝑳
∆𝑸
MPK = (marginal product of capital)
∆𝐊
Productivity Measures in the Short Run
Production in the Short Run - Stages
Stages of Production in the Short Run Intuitively
• Imagine the production function on the last slide was that of a local crepe
company. It has the trailer, crepe maker machines, blenders, phones–
fixed capital; and has crepe ingredients and workers.
• Initially, as the firm adds workers, production rises dramatically.
• Early on, workers specialize in different activities, such as taking
orders, preparing the toppings, and making the crepe.
• Marginal productivity is very high initially, which raises the average
product of all workers (by definition).
• However, as more workers are added, the
additional impact will be less.
• As the marginal productivity continues to fall
it will begin to reduce the average product of
labor.
• Eventually, as more workers are added
output might even fall, because the marginal
product of the additional worker is negative.
Short-Run Production
• Law of Diminishing Marginal Returns
• Principle that as the use of an input increases with other
inputs and technology fixed, the resulting additions to output
will eventually diminish.
• This law comes from realizing most observed production
functions have this property.
• This law determines the shape of the marginal product of
labor curves: if only one input is increased, the marginal
product of that input will diminish eventually.
• It is a well-known constraint in managerial
economics. It teaches managers to remain in
balance.
Choice in the Short Run
• What should be the manager’s role?
1. Ensure the firm operates on the production function
Offer an incentive structure that induces the worker to put
the desired level of effort.
2. Ensure the firm operates at the right point on the
production level.
Marginal Benefit of hiring Marginal Cost of hiring an
an additional worker additional worker

VMPL = P x MPL w

In the previous example: if the firm sells output for £3 and cost
of additional unit of labor is £400. How many workers the firm
should hire?
Choice in the Short Run
Long-Run Production
• In the long run firm is able to vary all inputs of production.
I.e. both capital and labor can change.
• With both factors variable, a firm can produce a given level
of output using a more capital intensive or more labor
intensive allocation.
• An isoquant is a function that represents the efficient
combinations of inputs (K, L) that yield the producer the
same level of output.
Marginal Rate of Technical Substitution (MRTS)
• The rate at which labor and
capital can substitute for each
other while holding output
constant is called the Marginal
Rate of Technical
Substitution (MRTS)
𝑀𝑃 𝑜𝑓 𝐼𝑛𝑝𝑢𝑡 1
• MRTS =-
𝑀𝑃 𝑜𝑓 𝐼𝑛𝑝𝑢𝑡 2

• For the Cobb-Douglas

production Function:
• Cobb-Douglas (imperfect
• Q(K,L) = Ka Lb , a, b constants.
substitution) production exhibits
diminishing marginal rate of • MPL = b Ka Lb-1
technical substitution (MRTS). • MPK = a Ka-1 Lb
b Ka Lb−1 bK
• MRTS =- = =-
a Ka−1 Lb aL
Cobb-Douglas Isoquants – Imperfect Substitutes

K Q3 • Isoquants here illustrate imperfect

Increasing substitution of inputs.
Q2
Q1 Output

• Most companies' production process will likely exhibit this

behavior.
• Note that, in reality, capital might not just be physical machines,
but also the technology embodied in them. As the amount of labor
is reduced, we might not need more machines, but we will surely
need more sophisticated machines to replace the labor.
Isoquants
Isoquants can also be straight lines (perfect substitutes), L-
shaped (perfect complements).

K Q3
K
Q2
Increasing
Q1 Increasing
Output
Output

Q1 Q2 Q3
L L
Q(K,L) = K+L (perfect Q(K,L) = Min {K, L}
substitutes) (perfect complements)
Isocost
• The cost of producing a given level of output depends on the
cost of a unit of labour (w) and the cost of a unit of capital (r).
C = rK + wL

or K = C/r – (w/r) L
• Isocost functions show the various combinations of capital and
labor that result in the same total input costs.
• For given input prices, isocost lines K
farther from the origin are associated Increasing
with higher costs.
Costs
• Unlike isoquants, Isocost functions
are always linear.

C1 C2 C3
L
Slope of the Isocost Line
K

• Keeping in mind that r is the

cost of capital and w is the
cost of labor.
New isocost line for • If w rises, the intercept of the
an increase in the x-axis becomes smaller, as
wage (price of labor). shown in the diagram.

• The slope of the isocost function changes with changes in the

prices of inputs. That is the case, because the slope of the
isocost function is given by –w/r.
Optimal Choice in the Long Run
• The objective of our firm is profit maximization.
• Well, the firm cannot maximize profits unless it is
minimizing its costs.
• That is, it should not waste inputs and it shouldn’t use
either too much capital relative to labor, or vice versa.
• What this means is that the firm should not be able to
lower its costs by reducing the amount of labor it uses
and substituting capital to still produce the same output.
• If the firm was able to do this, then it certainly wouldn’t
have been profit maximizing.
Optimal Choice in the Long Run
K
C1/r
• At the cost minimizing
input mix, the slope of the
C2/r A
Isocost function is equal to
the slope of the Isoquant
(MRTS).

𝑴𝑷𝑳 𝒘 𝑴𝑷𝑳 𝑴𝑷𝑲

= or =
B 𝑴𝑷𝑲 𝒓 𝒘 𝒓
Q=100

C2 C1
C2/w C1/w L
Optimal Choice in the Long Run

• When the price of an input

rises, the firm should use less
of that input and more of
other inputs to minimize the
cost of producing a given
level of output.
COSTS
Short-Run Costs
• Variable Costs VC(Q): costs
that vary with output changes.
$ • For Cambridge Crepes the
TC(Q) = VC + FC variable costs are the cost of
labor, dough, toppings.
VC(Q)

• Fixed Costs (FC): costs that

do not vary with output
FC changes.
• Thinking of the crepe example
Q again, fixed costs are the cost of
the griddles, the social media
ads, rent.
• Total Cost TC(Q): minimum total cost of producing alternative
levels of output:
TC(Q) = VC + FC
Short-Run Average and Marginal Costs

MC ATC Average Fixed Cost

$
AFC = FC/Q
AVC
Average Variable Cost
AVC = VC(Q)/Q
Min of
ATC
Average Total Cost (ATC)
Min of
AVC
ATC = TC(Q)/Q
AFC ATC = AVC + AFC
Marginal Cost:
Q
MC = ∆C(Q)/∆Q

• Note the relationship between the average and marginal costs.

– The marginal cost curve cuts the average cost curves at the
minimum point.
Short-Run: Fixed x Sunk Costs
• Fixed costs (FC) do not change as output changes.
• Sunk cost are the portion of fixed costs that cannot be
recovered.
• Examples of sunk costs using the crepe example:
• Advertising is a sunk cost.
• The cost of the griddle is NOT a sunk cost if it could be sold to
another crepe maker.
• If the price of a used griddle is only 70% of the cost of a new one,
then we say that 30% of the cost of a new griddle is sunk.
• Sunk costs are irrelevant for decision making, even though
they affect profits.
Measuring Cost: Which Costs Matter?
• A fundamental principle of managerial decision making is that managers
should focus on opportunity cost.
• Opportunity cost - cost associated with opportunities that are forgone
when a firm’s resources are not put to their best alternative use.
• Example: A person was making £50,000 in a previous job before
considering joining an MBA program that charges £60,000/year tuition.
What is the cost of attending the MBA?
Case 1: Pricing the Double Cheeseburger
Burger King Corporation (BKC) x National Franchise Association (NFA)

Please read the hand-out and discuss with

the person sitting next to you the pricing
strategy of the dollar-menu proposed by
Burger King Corporation.
Points for discussion:
1. What factors need to be considered in the

BKC decision to offer the promotion?

2. What are the relevant costs to a franchise

of selling a double cheeseburger?

3. What seems to be the conflict between the

two parties? How would you resolve it?

Graphical Illustration of Fixed Costs

Q0(ATC-AVC)
MC
$ = Q0 AFC ATC
= Q0(FC/ Q0) AVC
= FC

ATC
AFC Fixed Cost
AVC

Q0 Q
Graphical Illustration of Variable Costs

Q0AVC MC
$
ATC
= Q0[VC(Q0)/ Q0]
AVC
= VC(Q0)

AVC
Variable Cost

Q0 Q
Graphical Illustration of Total Costs
Q0ATC
MC
$
= Q0[C(Q0)/ Q0] ATC

= C(Q0) AVC

ATC

Total Cost

Q0 Q
Short-Run x Long-Run

When a firm operates in the short

run, its cost of production may not
be minimized because of
inflexibility in the use of capital
inputs.
Output is initially at level q1.
In the short run, output q2 can be
produced only by increasing labor
from L1 to L3 because capital is
fixed at K1.
In the long run, the same output
can be produced more cheaply by
increasing labor from L1 to L2 and
capital from K1 to K2.
Long-Run Costs
Long-Run Average Cost
$ • Long run AC curve is U
shaped.
LRAC
• A production process
exhibits economies of
scale if average costs fall
with output.
Economies Diseconomies • And diseconomies of
scale if average costs rise
of Scale of Scale with output.
Q* Output
Economies/Diseconomies of Scale

Economies of Scale Diseconomies of Scale

• If the firm operates on a larger scale, • Managing a larger firm may become
workers can specialize in the activities more complex and inefficient as
at which they are most productive. the number of tasks increases.
• Scale can provide flexibility. By varying Difficulties in coordinating,
the combination of inputs utilized to managing and integrating activities
produce the firm’s output, managers can a large firm.
organize the production process more • The advantages of buying in bulk
effectively. may have disappeared once
• The firm may be able to acquire some certain quantities are reached. At
production inputs at lower cost because some point, available supplies of
it is buying them in large quantities and key inputs may be limited, pushing
can therefore negotiate better prices. their costs up.
The mix of inputs might change with the
scale of the firm’s operation if managers
take advantage of lower-cost inputs.
Economies of Scope
• Economies of scope exist when the total cost of producing Q1 and Q2
together is less than the total cost of producing Q1 and Q2 separately,
that is: C(Q1,Q2)< C(Q1)+C(Q2).
• The degree of economies of scope is given by:

𝐶 𝑄1 + 𝐶 𝑄2 − 𝐶 𝑄1 , 𝑄2
𝑆𝐶 =
𝐶 𝑄1 , 𝑄2

●
• If SC> 0 then there are economies of scope. If SC< 0 there are
diseconomies of scope

• Example: compute SC if the cost of producing product 1 is 12 million,

the cost of producing product 2 is 6 million and the cost of producing
both products together is 15 million.
Economies of Scope
Cost Complementarity
• Cost Complementarities exist in a multiproduct cost
function when the marginal cost of producing one product is
reduced when the output of another product is increased.
• Let C(Q1, Q2) be the cost function for a multiproduct firm and
let MC1(Q1,Q2) be the marginal cost of producing product 1.
• The cost function exhibits cost complementarity if

𝑑𝑀𝐶1 𝑄1 , 𝑄2
<0
𝑑𝑄2
Dynamic Changes in Costs – Learning Curve

Economies of Scale versus

Learning

A firm’s average cost of

production can decline over
time because of growth of
sales when increasing
returns are present (a move
from A to B on curve AC1),
or it can decline because
there is a learning curve (a
move from A on curve AC1
to C on curve AC2).
Case 2: Outsourcing
Important Takeaways
• Production functions show the maximum level of output that can be attained with a
given combination of inputs.
• Marginal and average product are measures of productivity.
• Firms face the law of diminishing marginal returns in the short-run. In the short-run
one or more inputs are fixed and the manager maximizes profit by choosing the
amount of variable factor such that VMP=cost of input in the range of diminishing
marginal product.
• In the long-run, firm is able to vary all inputs and minimize costs when the marginal
product per dollar spent is equal for all inputs.
• We have extended production analysis to include cost functions. Opportunity cost is
the relevant economic cost concept.
• We defined total, variable, fixed, average, and marginal cost, as well as fixed x sunk
costs.
• We have discussed the shape of cost curves and graphical representation in the
short and long-run.
• We introduced the concepts of economies of scale, economies of scope and
learning curve.
Next…

Market Structure and Simple Pricing Strategies