Managerial Economics & Business Strategy

Chapter 5The Production Process and Costs

Switching to the Long Run• Now…K and L are both variable• Can plot out optimal choices for K and L

Called firm expansion path Best possible input choices when can vary all inputs

In SR constrained by capacity…

• Why?? Can’t change firm size LR can decrease costs to a greater extent because can change all

factors of production

Short Run vs. Long Run

• Short Run assumes FIXED plant size• Each plant size has a unique ATC curve associated

with it SRATC

• LRATC combines all the SRATC curves• Which points of the SRATC???• Minimum points

Why minimum?

• LRATC shows the lowest average cost at which a firm can produce any given level of output

• LRATC is the lower ENVELOPE of the SRATC curves

• Called envelope curve

Economies of Scale

LRAC

$

Q

Economiesof Scale

Diseconomiesof Scale

Multi-Product Cost Function

• Most firms do not only produce one good• C(Q1, Q2): Cost of jointly producing two outputs.• General function form:

22

212121, cQbQQaQfQQC

Economies of Scope

• C(Q1, 0) + C(0, Q2) > C(Q1, Q2). When it is cheaper to produce the two outputs jointly instead of

separately.

• Example: It is cheaper for Time-Warner to produce Internet connections and

Instant Messaging services jointly than separately. Cheaper to sell fish and chicken in one restaurant rather than have

two restaurants specializing in each

Cost Complementarity

• The marginal cost of producing good 1 declines as more of good two is produced:

MC1Q1,Q2) /Q2 < 0.

• Examples: Cow hides and steaks. Doughnut holes and doughnuts

Quadratic Multi-Product Cost Function

• C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2 • What are the MC functions?

MC1(Q1, Q2) = aQ2 + 2Q1 MC2(Q1, Q2) = aQ1 + 2Q2

• Cost complementarity: a < 0• Economies of scope: f > aQ1Q2

C(Q1 ,0) + C(0, Q2 ) = f + (Q1 )2 + f + (Q2)2 C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2 f > aQ1Q2: Joint production is cheaper

A Numerical Example:

• C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 + (Q2 )2 • Cost Complementarity?

Yes, since a = -2 < 0MC1(Q1, Q2) = -2Q2 + 2Q1

• Economies of Scope?Yes, since 90 > -2Q1Q2

Chapter 5 homework

Numbers: 4, 5, 6, 13 and, 17

Managerial Economics & Business Strategy

Chapter 6The Organization of the Firm

Manager’s Role• Procure inputs in the least

cost manner, like point B.• Provide incentives for

workers to put forth effort.• Failure to accomplish this

results in a point like A. Higher costs

• Achieving points like B managers must

Use all inputs efficiently. Get inputs cheap

$100 80

100Q

Costs

A

B

C(Q)

Methods of Procuring Inputs• Spot Exchange

When the buyer and seller of an input meet, exchange, and then go their separate ways.

• Contracts A legal document that creates an extended relationship

between a buyer and a seller.

• Vertical Integration When a firm shuns other suppliers and chooses to

produce an input internally.