Managerial Economics
eighth edition
Thomas Maurice
Chapter 7
Production & Cost Estimation
McGraw-Hill/Irwin
Managerial Economics
Empirical Production Function
Cubic empirical specification for a short-run production function is derived from a long-run cubic production function Cubic form of the long-run production function is expressed as
Q aK L bK L
3 3 2
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Managerial Economics
Properties of a Short-Run Cubic Production Function
Q AL BL
3
Holding capital constant, short-run cubic production function is derived as follows:
Q aK L bK L 3 2 AL BL
3 3 2
Where A aK 3 and B bK 2
3
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Managerial Economics
Properties of a Short-Run Cubic Production Function
Q AL BL
3
The average & marginal products of labor are, respectively:
AP Q L AL BL
2
MP Q L 3 AL 2BL
2
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Managerial Economics
Properties of a Short-Run Cubic Production Function 3 2 Q AL BL
Marginal product of labor begins to diminish beyond Lm units of labor Average product of labor begins to diminish beyond La units of labor
B B Lm and La 3A 2A
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Managerial Economics
MP & AP Curves for the Short-Run Cubic Production Function (Figure 10.1)
Q = AL3 + BL2
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Managerial Economics
Properties of a Short-Run Cubic Production Function 3 2 Q AL BL
To have necessary properties of a production function, parameters must satisfy the following restrictions:
A 0 and B 0
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Managerial Economics
Estimation of a Short-Run Production Function
To use linear regression analysis, the cubic equation must be transformed into linear form
Q = AX + BW Where X = L3 and W = L2
Estimated regression line must pass through the origin
Specify in computer routine
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Managerial Economics
Estimation of a Short-Run Cost Function
Estimate using data for which the level of usage of one or more inputs is fixed
Usually time series data are used
Data collection may be complicated by the fact that accounting data do not include firms opportunity costs
Capital costs should reflect not only acquisition cost but any foregone rental income, depreciation, & capital gains/losses
Must eliminate effects of inflation
Divide by appropriate price index
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10
Managerial Economics
Properties of a Short-Run Cubic Cost Function
TVC aQ bQ cQ
2 3
Average variable cost & marginal cost functions are, respectively:
AVC a bQ cQ 2 SMC a 2bQ 3cQ
2
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11
Managerial Economics
Properties of a Short-Run Cubic Cost Function
TVC aQ bQ cQ
2 3
Average variable cost reaches its minimum value at: Qm b 2c
To conform to theoretical properties, parameters must satisfy the following restrictions:
a 0 , b 0 , and c 0
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Managerial Economics
Properties of a Short-Run Cost Function
Cubic specification produces S-shaped TVC curve & -shaped AVC & SMC curves All three cost curves employ the same parameters
Only necessary to estimate one of these functions to obtain estimates of all three
In the short-run cubic specification, input prices are assumed constant
Not explicitly included in cost equation
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Managerial Economics
Summary of Short-Run Empirical Production Functions
Short-run cubic production equations
Total product
Average product of labor
Q AL BL
3
AP AL BL
2
Marginal product of labor
Diminishing marginal returns Restrictions on parameters
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MP 3 AL2 2BL
B begin at Lm 3A
A 0 and B 0
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Managerial Economics
Summary of Short-Run Empirical Cost Functions
Short-run cubic cost equations
Total variable cost Average variable cost Marginal cost Average variable cost reaches minimum at Restrictions on parameters
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TVC aQ bQ 2 cQ 3
AVC a bQ cQ 2
SMC a 2bQ 3cQ 2
b Qm 2c
a 0, b 0, c 0
