Unit 4.

PRODUCTION FUNCTION AND COST FUNCTION

Cost theory is similar to production theory; they are often used together. This module will give
you insights on how managers deal and manage the costs of production and how businesses optimize
their profit or returns. The pricing decisions as well as the output determination of firms under the
four types of market structures, i.e, perfect competition, monopoly, monopolistic competition, and
oligopoly will also be discussed separately. This is to provide understanding on how firms make
production decisions as it competes towards achieving high returns or maximize profit. (3G E-
Learning LLC,USA.2017)

Unit Learning Objective:

At the end of this unit, the student
should be able to:

 Determine the profit

maximization point of a firm
in a graph showing the
dynamics of the Production
and Cost Functions

4.1 Production Function

4.1.1 What is a production function?

 It is a mathematical function that relates the maximum amount of output that can be obtained
from a given number of inputs – generally capital and labor.
 It relates physical output of a production process to physical inputs or factors of production.
But we can also consider other input to production like land.
 Its aim is to add value to product or service which will create a strong and long lasting
customer relationship or association.

4.1.2 What is the importance of production function to managers?

 Production functions are used in managerial economics to determine the most efficient
combination of inputted resources needed to produce a desired amount of products.
They are not exact replications of real circumstances and are not intended to be.
 They are abstract models intended to focus on the problem of the efficient usage of
resources available to the business.

Mathematically, such a basic relationship between inputs and outputs can be expressed as:

Q= f(L, K, N), Where; Q = quantity of output; L = Labor; K = Capital; N = Land

Hence, the level of output (Q) depends on the quantities of different inputs (L,K,N) available to the
firm. In the simplest case, where there are only two inputs, labor (L) and Capital (K) and one output
(Q), the production function becomes: Q = f (L,K)

4.1.3 The Law of Diminishing Marginal Returns (LDMR)

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 The law of diminishing marginal returns is a theory in economics that predicts that after some
optimal level of capacity is reached, adding an additional factor of production will actually result in
smaller increases in output. For example, a factory employs workers to manufacture its products, and,
at some point, the company operates at an optimal level. With other production factors constant,
adding additional workers beyond this optimal level will result in less efficient operations.

4.1.4 Short-run Period versus Long-Run Period

The short run is the period of time during which at least some factors of production are fixed.
For example, if the business rents or leases a space for their business, say Coffee Matters, the coffee
shop is operating in the short run, because it is limited to using the current building—the owner of
the coffee shop cannot choose a larger or smaller building.

4.1.4a What is a short-run production function?

The short-run production function assumes there is at least one fixed factor input, say,
land is the fixed input while other production inputs are variable. The Law of Diminishing
Returns explains such a production function.

4.1.4b There are three (3) stages of short-run production:

1. STAGE 1. Increasing Average Product – As more of the variable input is added to the fixed
input, the marginal product of the variable input increases. Most importantly, marginal
product is greater than average product which causes average product to increase.
2. STAGE 2. Decreasing Marginal Returns (Law of Diminishing Marginal Returns)-
characterized by decreasing yet positive marginal returns. As more of the variable input is
added to the fixed input, the marginal product of the variable input decreases. Most
important of all, Stage 2 is driven by the law of diminishing marginal returns.
3. STAGE 3. Negative Marginal Returns – The law of diminishing marginal returns causes
marginal product to decrease so much that it becomes negative.

From the three (3) stages, Stage 2 provides a range of production that is suitable to
most every firm. Although marginal product declines, additional employment of the
variable input does not add total production. Even though production cost rises with
additional employment, there are benefits to be gained from extra production. The trick is
to balance the extra cost with the extra production. Stage 2 tends to be the choice of firms
for short-run production. It is often referred to as the “economic region”. Firms can
comfortably, and profitably produce forever as they wish in Stage 2.

On the other hand, the long run is the period of time during which all factors are variable. Once
the lease expires for the coffee shop, the shop owner can move to a larger or smaller place. There is
no fixed cost in this period because the long-run is a sufficient period of time for all short-run fixed
inputs to become variable.

4.1.4c Returns to Scale

Since in the long-run all factors of production are variable, the scale of production can
be changed by changing the quantity of all factors of production. Returns to scale refers to the changes
in output as all factors change by the same proportion.

4.1.4d Three types of Returns to Scale

 Increasing Returns to Scale (or diminishing cost) refers to a situation when all factors of
production are increased, output increases at a higher rate. It means if all inputs are doubled,

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 output will also increase at the faster rate than double. Hence, it is said to be increasing returns
to scale.
 Constant Returns to Scale (or constant cost) refers to the production situation in which
output increases exactly in the same proportion in which factors of production are increased.
This situation arises when after reaching a certain level of production, economies of scale are
balanced by diseconomies of scale. This is known as homogenous production function.

 Diminishing Returns to Scale (or increasing costs) refer to a situation where if all the
factors of production are increased in a given proportion, output increases in a smaller
proportion. It means if inputs are doubled, output will be less than doubled. If 20 percent
increase in labor and capital is followed by 10 percent increase in output, then it is an instance
of diminishing returns to scale.

4.2 Cost Function

Now, let us look into the other side of this unit discussion – the Cost side.

4.2.1 What is a cost function?

A cost function is

 a function of input prices and output quantity whose value is the cost of making that
output given those input prices, often applied through the use of the cost curve by
companies to minimize cost and maximize production efficiency.
 it is a mathematical formula used to chart how production expenses will change at
different output levels. In other words, it estimates the total cost of production given a
specific quantity produced.

The cost function equation is expressed as:

C(x)= FC + V(x), where C equals total production cost;

FC is total fixed costs; V is variable cost; and x is the number of units produced or output

4.2.2 Importance of Cost function to managers

 Management uses this model to run different production scenarios and help predict
what the total cost would be to produce a product at different levels of output.
 Understanding a firm’s cost function is helpful in the budgeting process because it helps
management understand the cost behavior of a product. This is vital to anticipate costs
that will be incurred in the next operating period at the planned activity level.
 This allows management to evaluate how efficiently the production process was at the
end of the operating period.

4.2.3 Types of cost:

1. Fixed costs are costs that do not vary with different levels of production and fixed costs
exist even if the output is zero. Example: rent or salaries.
2. Average Fixed Cost = Fixed Costs/Quantity. When the quantity produced is low, the
average fixed cost is very high and this cost lowers as the quantity produced increases.

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 For example, if the Fixed Cost is $100 and initially you produce two units, then the
average fixed cost is $50. If you start creating 20 units, then the average fixed cost falls
to $5.
3. Variable Costs are costs that vary with the level of output. Ex: electricity. The variable
cost curve starts from zero. It means when output is zero, the variable cost is zero, but
as production increases the variable cost increases. It keeps rising to the point that
economies of scale cannot lower the per unit cost anymore hence the steep incline.
4. Marginal cost is the increase in cost caused by producing one more unit of the good.
When a firm increases its output, total costs, as well as variable costs, start to increase
at a diminishing rate. At this stage, due to economies of scale and the Law of
Diminishing Returns, marginal cost falls till it becomes minimum. Then as output rises,
the marginal cost increases. Formula: MC = change in Total Cost/change in
Quantity/Output.
5. Total Cost = Fixed Cost + Variable Cost
6. Average Total Cost = Total Cost/Quantity. (Total Cost = Fixed Cost + Variable Cost)

4.2.4 What is the profit maximization point of a firm?

The profit maximization rule states that if a firm chooses to maximize its profits, it must
choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR) and
the Marginal Cost curve is rising. In other words, it must produce at a level where MC = MR.

4.2.5 When can managers decide to shut down the firm?

 Managers can decide to shut down the firm if the price does not cover average variable
costs. In other words, if the total revenue (total sale proceeds) does not include total
variable costs, the business must shut down. Otherwise, its total loss will be higher than
the fixed costs. It will produce something only when the price covers the average
variable cost and part of the average fixed costs. The output at which marginal cost is
equal to marginal revenue keeps losses minimum.

4.2.6 When does a business experience Break-Even Point?

 It is in an output at which total revenue (TR) becomes equal to total cost (TC). At times
the firm may not make any profit. It just pays to produce a given output. Total revenue
is only equal to the total cost. The company has crossed the losses zone and is about to
enter the zero profit zone.

To determine at what output level the firm will maximize its profit, let us take a look at the
Cost-Output Schedule under Short-run presented below:

Assuming that the product is sold at P55.00 per unit, where Total Revenue is equivalent to
Sales (Price x Quantity sold/Output)

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 Total Total Total Average Average Average Marginal Total Marginal
Fixed Variable Cost Fixed Cost Variable Total Cost Cost (MC) Revenue Revenue
Output Cost Cost (TC) (AFC) Cost (ATC) (TR) (MR)
(TFC) (TVC) (AVC)

0 50 0 50 - - - - - -

1 50 25 75 50 25 75 25.00 55.00 55.00

2 50 55 105 25 27.5 52.5 30.00 110.00 55.00

3 50 60 110 16.6 20 36.6 5.00 165.00 55.00

4 50 75 125 12.5 18.7 31.2 15.00 220.00 55.00

5 50 90 140 10 18 28 15.00 275.00 55.00

6 50 145 195 8.3 24.1 32.4 55.00 330.00 55.00

7 50 225 275 7.1 32.1 39.2 80.00 385.00 55.00

8 50 355 405 6.2 44.1 50.5 130.00 440.00 55.00

9 50 555 605 5.5 61.6 67.1 200.00 495.00 55.00

Cost-Output Relation under Short-run with Profit

Maximization

Total Fixed Cost (TFC) Total Variable Cost (TVC)

800 Total Cost (TC) Average Fixed Cost (AFC)

Average Variable Cost (AVC) Average Total Cost (ATC)
600 Marginal Cost (MC) Total Revenue (TR)
Marginal Revenue (MR)
400

200

0
OUTPUT 0 1 2 3 4 5 6 7 8 9

The firm was able to maximize its profit at output 6 where the Marginal Cost (55) and Marginal
Revenue (55) is equal. The profit maximization point is where MR=MC.

4.2.7 Economies of Scale

 It refers to a cost advantage experienced by a firm when it increases its level of output.
The advantage arises due to the inverse relationship between per unit fixed cost and
the quantity produced.
 This exists when long run average costs decline as output expands.

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  Labor productivity can be higher in large firms, where individuals are hired to perform
specific tasks. This can reduce unit costs for large-scale operations. Technical factors
like highly specialized equipment can also lead to economies of scale.

4.2.8 Diseconomies of Scale

 It is condition when a company or business grows so large that the cost per unit
increase
 It takes place when economies of scale no longer function
 Costs keeps on increasing as output increase
 This condition can arise from technical issues of production or organizational issues
within the structure of a firm or industry.

4.3 Pricing and Output Determination under the Four Types of Market Structure

When a company is examining its overall profitability, pricing decisions are not limited to for-
profit organizations. Not-for-profit organizations, such as charity foundations, abd educational
institutions also set prices, though not obvious. For instance, charities seeking to raise money may set
different target levels for donations that reward donors with increases in status, gifts, or popularity.
These donations are equivalent to price.

Price and output decisions of firms that want to maximize profits always depend on costs.
Profits are always maximized at the point where marginal revenue is equal to marginal cost.

4.3.1 Types of Market Structure and their pricing and output decisions

4.3.1a. Perfect Competition – This is a type of market structure where there is a large
number of buyers and sellers of an essentially identical or homogenous product. Each
members of the market, whether buyer or seller, is so small in relation to the total
industry volume that is unable to influence the price of the product
Characteristics:
 Individual buyers and sellers are essentially price takers. At the ruling price a firm can
sell any quantity.
 There is free entry and free exit in the market, therefore, no firm can earn excessive
profits in the long-run. A perfectly competitive firm produces the quantity of output
that maximizes economic profit – the difference between total revenue and total cost.
 Profit is maximized at an output level where total revenue minus total cost.
 Its demand curve is horizontal or perfectly elastic.

4.3.1b. Monopoly – A type of market structure where there is only one producer of a
product with no close substitute.

Characteristics:
 The firm has substantial control over the price. If the product is differentiated, and if
there are no threats of new firms entering the same business, a monopolist can manage
to earn excessive profits over a long period.
 A monopolist can sell more of his output only at a lower price and can reduce the sale
at a high price.

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 It can maximize its profit at an output level where marginal revenue is equated with
marginal cost.
 Its demand curve slopes downward from left to the right
 The firm’s demand curve is the market demand curve
 Profit is maximized at an output where marginal revenue is equals marginal cost.

4.3.1c. Monopolistic Competition – A type of market structure with a large number of

firms selling differentiated products.

Characteristics:
 Firms have control over the price
 Unable to earn excessive profits in the long-run due to competition is based on product
innovation and advertising

4.3.1d. Oligopoly – A type of market structure where a small number of firms account
for the whole industry’s output. The product may be homogenous or differentiated.

Characteristics:
 Product or service may be homogenous or differentiated
 Price is set above marginal cost
 Demand curve is kinked
 Maximizes its profit through forming a cartel

Oligopolists face a kinked demand curve. A kinked demand curve model seeks to
explain the reason of price rigidity under oligopolistic market situations. A kinked demand
curve represents the behavior pattern of oligopolistic organizations in which rival
organizations lower down the prices to secure their market share, but restrict an increase
in the prices. It occurs when the demand curve is not a straight line but has a different
elasticity for higher and lower prices. This model of oligopoly suggests that prices are rigid
and that firms will face different effects for both increasing price and decreasing price.

A kinked demand curve