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  • 1. Managerial Economics & Business Strategy Chapter 5 goes with unit 5 The Production Process and Costs (pp. 168-187 but place most emphasis on costs which start at the bottom of page 177)
  • 2. Overview
    • Cost Analysis
      • Total Cost, Variable Cost, Fixed Costs
      • Cubic Cost Function
      • Cost Relations
  • 3. Production Analysis
    • Production Function
      • Q = F(K,L)
      • 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
    • Fixed vs. Variable Inputs
  • 4. Marginal Productivity Measures
    • Marginal Product of Labor: MP L = Q/ L
      • Measures the output produced by the last worker.
    • Marginal Product of Capital: MP K = Q/ K
      • Measures the output produced by the last unit of capital.
  • 5. Average Productivity Measures
    • Average Product of Labor
      • AP L = Q/L.
      • Measures the output of an average worker.
    • Average Product of Capital
      • AP K = Q/K.
      • Measures the output of an average unit of capital.
  • 6. Isoquant
    • 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.
  • 7. Marginal Rate of Technical Substitution (MRTS)
    • The rate at which two inputs are substituted while maintaining the same output level.
  • 8. Linear Isoquants
    • Capital and labor are perfect substitutes
      • Q = aK + bL
      • Linear isoquants imply that inputs are substituted at a constant rate, independent of the input levels employed.
    Q 3 Q 2 Q 1 Increasing Output L K
  • 9. Leontief Isoquants
    • Capital and labor are perfect complements.
    • Capital and labor are used in fixed-proportions.
    • Since capital and labor are consumed in fixed proportions there is no input substitution along isoquants
    L Q 3 Q 2 Q 1 K Increasing Output
  • 10. 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 1 Q 2 Q 3 K L Increasing Output
  • 11. Isocost
    • 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.
    K L C 1 L K C 1 / r C 1 / w C / w 0 C / r New Isocost Line for a decrease in the wage (price of labor: w 0 > w 1 ). C 0 C 0 / w C 0 / r C / w 1 New Isocost Line associated with higher costs (C 0 < C 1 ).
  • 12. Cost Minimization Q L K Point of Cost Minimization Slope of Isocost = Slope of Isoquant
  • 13. Cost Analysis
    • Types of Costs
      • Fixed costs (FC)
      • Variable costs (VC)
      • Total costs (TC)
      • Sunk costs
  • 14. Total and Variable Costs
    • C(Q): Minimum total cost of producing alternative levels of output:
      • C(Q) = VC(Q) + FC
    • VC(Q): Costs that vary with output.
    • FC: Costs that do not vary with output.
    0 $ Q C(Q) = VC + FC VC(Q) FC
  • 15. 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. $ Q FC C(Q) = VC + FC VC(Q)
  • 16. Some Definitions
    • Average Total Cost
      • ATC = AVC + AFC
      • ATC = C(Q)/Q
    • Average Variable Cost
      • AVC = VC(Q)/Q
    • Average Fixed Cost
      • AFC = FC/Q
    • Marginal Cost
      • MC = C/ Q
    MR $ Q ATC AVC AFC MC
  • 17. Fixed Cost ATC AVC Q 0 AFC Fixed Cost Q 0 (ATC-AVC) = Q 0 AFC = Q 0 (FC/ Q 0 ) = FC $ Q ATC AVC MC
  • 18. Variable Cost AVC Variable Cost Q 0 Q 0 AVC = Q 0 [VC(Q 0 )/ Q 0 ] = VC(Q 0 ) $ Q ATC AVC MC
  • 19. ATC Total Cost Q 0 Q 0 ATC = Q 0 [C(Q 0 )/ Q 0 ] = C(Q 0 ) Total Cost $ Q ATC AVC MC
  • 20. Conclusion
    • Cost functions are the foundation for helping to determine profit-maximizing behavior in future chapters.