# ECONOMICS FOR MANAGERS

by Paul Farnham

y

Chapter 5:

Production and Cost Analysis

in the Short Run

© 2005 Prentice Hall, Inc.

5.1

Defining the

Production Function

P d ti

F

ti

The formula can be read as “quantity of

quantity

output is a function of the inputs

listed inside the parentheses”

Q = f (L, K, M…)

where

Q = quantity of output

L = quantity of labor input

K = quantity of capital input

y

M = quantity of materials input

© 2005 Prentice Hall, Inc.

5.2

Fixed Inputs Versus

Variable I

V i bl Inputs

t

Fixed input: quantity a manager

cannot change during a given

g

g g

time

Variable input: quantity a manager

can change during a given time

Amount of output would vary as

managers made decisions

regarding amounts of input

© 2005 Prentice Hall, Inc.

5.3

Short-run Versus

Long-run P d ti

L

Production

Not expressed in terms of

calendar time, but in terms of

,

fixed and variable inputs

Short run

Short-run production function:

involves at least one fixed input

Long-run

Long run production function:

production process in which all

inputs are variable

© 2005 Prentice Hall, Inc.

5.4

Managerial Rule of Thumb:

Short run

Short-run Production and

Long-run Planning

Managers operate in the short

run, but must have long-run

vision

i i

They need to be aware that the

current amount of fixed inputs

t

t f fi d i

t

may not be appropriate as market

conditions change

Managers make more long run

economic decisions

© 2005 Prentice Hall, Inc.

5.5

Model of the Short-run

Production Function

P d ti

F

ti

Total product: total quantity of output

produced with a given quantity of

fixed and variable inputs

TP or Q = f (L, K)

where

TP or Q = total product or quantity

p

q

y

of output

L = quantity of labor input

K = quantity of capital input

© 2005 Prentice Hall, Inc.

5.6

Average Product

Average product: amount of

A

d t

t f

output per unit of variable input

AP = TP / L or Q / L

where

AP = The average product of labor

© 2005 Prentice Hall, Inc.

5.7

Marginal Product

Marginal product: th additional

M

i l

d t the dditi

l

output produced with an

additional unit of variable input

MP = ΔTP / ΔL = ΔQ / ΔL

where

MP = The marginal product of labor

© 2005 Prentice Hall, Inc.

5.8

Total Product: Short-run

Production Function

Figure 5.1a

Law of diminishing

returns where marginal

product eventually

decreases

TP

0

© 2005 Prentice Hall, Inc.

L1

L2

L3

L

5.9

TP: Short-run

Production Function

P d ti

F

ti

TP increases rapidly up to level of

labor input L1 then increases at a

slower rate as labor input increases

TP curve becomes flatter and flatter

until it reaches maximum output

level at L3

Curve implies that marginal product

of labor first increases rapidly then

decreases, eventually becoming

zero or less

© 2005 Prentice Hall, Inc.

5.10

AP and MP: Short-run

Production Function

Figure 5.1b

MP

AP

0

© 2005 Prentice Hall, Inc.

L1

L2

L3

L

5.11

AP and MP: Short-run

Production Function

Between zero and L2, MP curve

lies above AP curve, causing AP

curve to increase

Below L2, MP curve is below AP

curve, causing AP curve to

decrease

Therefore, MP curve must

intersect AP curve at maximum

point of AP curve

i t f

© 2005 Prentice Hall, Inc.

5.12

Economic Explanation

Increasing marginal returns:

region where MP curve is positive

and increasing

di

i

Law of diminishing returns:

region where marginal product

i

h

i l

d t

curve is positive but decreasing

Negative marginal returns: region

N

ti

i l t

i

where product curve is negative

so that TP is decreasing

© 2005 Prentice Hall, Inc.

5.13

Law of Diminishing

Returns

R t

Additional output generated by

additional units of variable input

p

(MP) is decreasing

Occurs because capital input and

technologies are held constant

© 2005 Prentice Hall, Inc.

5.14...

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