Managerial Economics and Business Strategy:

Ch. 5 - The Production Process and Costs

Rayhan Gunaningrat, SE., MM.
Department of Management
Faculty of Law and Business
Universitas Duta Bangsa
headLINE:
Boeing Loses the Battle but Wins the War

Boeing and its International Association of Machinists and Aerospace Workers

Union (IAM) reached an agreement that ended a strike involving 27,000
workers. The strike began when management and union negotiators failed to
reach an agreement over compensation and job protection issues.

As a result of the agreement, IAM workers won benefits in areas that include
health care, pensions, wages, and job security for 2,900 workers in inventory
management and delivery categories. Boeing also agreed to retrain workers
who are laid off or displaced.
headLINE:
Boeing Loses the Battle but Wins the War (2)

Despite these concessions, a spokesman for Boeing was quoted as saying that
the agreement “gives us the flexibility we need to run the company.” The
four-year agreement allows Boeing to retain critical subcontracting provisions it
won in past struggles with the union.

Commenting on all this, one analysis concluded that “the union probably won
the battle and Boeing probably wins the war.” Can you explain what this analyst
means?
Outline

INTRODUCTION

THE PRODUCTION FUNCTION

THE COST FUNCTION

MULTIPLE-OUTPUT COST FUNCTIONS

INTRODUCTION

Companies as well as nonprofit organizations are in the business of producing

goods or providing services, and their successful operation requires managers
to optimally choose the quantity and types of inputs to use in the production
process.

This chapter provides the economic foundations needed to succeed in

managerial positions such as production and pricing management.
Production Analysis
THE PRODUCTION FUNCTION

Q is quantity of output produced.

K is capital input.
L is labor input.
F is a functional form relating the inputs to output.
Production function is the maximum amount of output that can be produced
with K units of capital and L units of labor.
Short-Run vs Long-Run Decisions

The short run is the time frame in which there are fixed factors of production.
The short-run production function is essentially only a function of labor since
capital is fixed rather than variable.

The long run is the horizon over which the manager can adjust all factors of
production. If it takes a company three years to acquire additional capital
machines, the long run for its management is three years, and the short run is
less than three years.
Production Function Algebraic Forms

Linear production function: inputs are perfect substitutes.

Leontief production function: inputs are used in fixed proportions.

Cobb-Douglas production function: inputs have a degree of substitutability.

For more details: https://xplaind.com/400834/production-functions

 Total Product
Measures of Average Product

Productivity Marginal Product

Productivity Measures: Total Product

Total product (TP) is the maximum output produced with given amounts of
inputs. For example:
Short run Cobb-Douglas Production Function:
Q = F(K,L) = K.5 L.5
K is fixed at 16 units.
Q = (16).5 L.5 = 4 L.5
Total Product when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units
Productivity Measures: Average Product
Average product (AP) of an input is a measure of output produced per unit of
input.
➔ Average Product of Labor: APL = Q/L.
◆ Measures the output of an “average” worker.
◆ Example: Q = F(K,L) = K.5 L.5
● If the inputs are K = 16 and L = 25, then the average product of labor is APL
= [(16) 0.5(25)0.5]/25 = 0.8.
➔ Average Product of Capital: APK = Q/K.
◆ Measures the output of an “average” unit of capital.
◆ Example: Q = F(K,L) = K.5 L.5
● If the inputs are K = 16 and L = 25, then the average product of capital is
APK = [(16)0.5(25)0.5]/16 = 1.25.
Productivity Measures: Marginal Product

Marginal product (MP) of an input is the change in total output attributable to

the last unit of an input.
➔ Marginal Product of Labor: MPL = ΔQ/ΔL.
◆ Measures the output produced by the last worker.
◆ Slope of the short-run production function (with respect to labor).
➔ Marginal Product of Capital: MPK = ΔQ/ΔK.
◆ Measures the output produced by the last unit of capital.
◆ When capital is allowed to vary in the short run, MPK is the slope of the production
function (with respect to capital).
Increasing, Decreasing, and Negative Marginal Returns
Increasing, Decreasing, and Negative Marginal Returns
The Role of the Manager in the Production Process

(1) To ensure that the firm operates on the production function.

Aligning incentives to induce maximum worker effort.
(2) To ensure that the firm uses the correct level of inputs.
➔ When labor or capital vary in the short run, to maximize profit a manager will hire
◆ labor until the value of marginal product of labor equals the wage: VMPL = w, where
VMPL = P x MPL.
◆ capital until the value of marginal product of capital equals the rental rate: VMPK = r,
where VMPK = P x MPK.
Isoquants

An isoquant defines the combinations of inputs

(K,L) that yield the producer the same level of
output.

The shape of an isoquant reflects the ease with

which a producer can substitute among inputs
while maintaining the same level of output.

Input mix A implies a more capital-intensive

plant than does input mix B.
Marginal Rate of Technical Substitution (MRTS)

Marginal rate of technical substitution (MRTS) is the rate at which a producer

can substitute between two inputs and maintain the same level of output.

The MRTS of capital and labor is the absolute value of the slope of the isoquant
and is the ratio of the marginal products:
Linear Isoquants

➔ Capital and labor are perfect

substitutes
◆ Q = aK + bL
◆ MRTSKL = b/a
◆ Linear isoquants imply that
inputs are substituted at a
constant rate, independent of
the input levels employed.
Leontief Isoquants

➔ Capital and labor are perfect

complements.
➔ Capital and labor are used in
fixed-proportions.
➔ Q = min{aK, bL}
➔ Since capital and labor are consumed
in fixed proportions there is no input
substitution along isoquants (hence, no
MRTSKL).
Cobb-Douglas Isoquants

➔ Inputs are not perfectly substitutable.

➔ Diminishing marginal rate of technical
substitution.
◆ As less of one input is used in the
production process, increasingly more
of the other input must be employed to
produce the same output level.
➔ Q = K a Lb
➔ MRTSKL = MPL/MPK
Isocosts

➔ The combinations of inputs that produce a given level of

output at the same cost:

wL + rK = C

➔ Rearranging,

K= (1/r)C - (w/r)L

➔ For given input prices, isocosts farther from the origin are
associated with higher costs.
➔ Changes in input prices change the slope of the isocost line.
Cost Minimization
“Producing output at the lowest possible cost.”

Marginal product per dollar spent should be

equal for all inputs:

But, this is just:

Optimal Input Substitution
“To minimize the cost of producing a given level of output, the firm should use less
of an input and more of other inputs when that input’s price rises.”

➔ A firm initially produces Q0 by employing the

combination of inputs represented by point A at a
cost of C0.
➔ Suppose w0 falls to w1.
◆ The isocost curve rotates counterclockwise; which
represents the same cost level prior to the wage
change.
◆ To produce the same level of output, Q0, the firm will
produce on a lower isocost line (C1) at a point B.
◆ The slope of the new isocost line represents the
lower wage relative to the rental rate of capital.
Cost Analysis
Types of Costs

➔ Short-Run ➔ Long-Run
◆ Fixed costs (FC) ◆ All costs are variable
◆ Sunk costs ◆ No fixed costs
◆ Short-run variable costs
(VC)
◆ Short-run total costs (TC)
Total, Fixed, and Variable Costs

TC: Minimum total cost of producing

alternative levels of output:

TC = VC(Q) + FC

VC(Q): Costs that vary with output.

FC: Costs that do not vary with output.

For more details:

https://www.youtube.com/watch?v=b3VuNkFl1c8
Fixed and Sunk Costs

FC: Costs that do not change as output

changes.

Sunk Cost: A cost that is forever lost after

it has been paid.

Decision makers should ignore sunk costs

to maximize profit or minimize losses
Some Definitions

➔ Average Total Cost

◆ ATC = AVC + AFC
◆ ATC = TC/Q
➔ Average Variable Cost
◆ AVC = VC(Q)/Q
➔ Average Fixed Cost
◆ AFC = FC/Q
➔ Marginal Cost
◆ MC = ΔTC/ΔQ
Cubic Cost Function

where a, b, c, and f are coefficient. Note that f represents fixed costs “constant”.

Marginal Cost?
MC(Q) = a + 2bQ + 3cQ2

Calculus:
dC/dQ = a + 2bQ + 3cQ2
An Example
Long-Run Costs

Economies of scale exist whenever

long-run average costs decline as
output increases.

Diseconomies of scale exist

whenever long-run average costs
increase as output increases.
Economies Diseconomies
of scale of scale
MULTIPLE-OUTPUT
Economies of Scope
COST FUNCTIONS
Cost Complementarity
A function that defines the cost of
producing given levels of two or more
types of outputs assuming all inputs
are used efficiently.
Economies of Scope

➔ C(Q1, 0) + C(0, Q2) > C(Q1, Q2).

◆ It is cheaper to produce the two outputs jointly instead of separately.
➔ Example:
◆ It is cheaper for Mie Gacoan to produce Mie Pangsit and Nasi Kulit
jointly than separately.
Cost Complementarity

The marginal cost of producing good A declines as more of good B is

produced:

ΔMC1(QA,QB) /ΔQB < 0.

Example:
Producing tables and chairs.
Conclusion

➔ To maximize profits (minimize costs) managers must use inputs such

that the value of marginal of each input reflects price the firm must pay
to employ the input.
➔ The optimal mix of inputs is achieved when the MRTSKL = (w/r).
➔ Cost functions are the foundation for helping to determine
profit-maximizing behavior in future chapters.
ANSWERING THE headLINE

The phrase “wins the battle” refers to the short-run implications of the
agreement between Boeing and the IAM, while “wins the war” refers to the
agreement’s long-run implications.

The analyst recognizes that the agreement benefited union workers in the short
run, but the agreement also increased Boeing’s long-term value by giving it the
flexibility to substitute away from more costly unionized inputs.