CHAPTER 7
PRODUCTION, INPUTS, AND COST: BUILDING
BLOCKS FOR SUPPLY ANALYSIS
Chapter 7 introduces students to the various concepts of cost used in analyzing the behavior of
firms. The chapter is divided into two principal sections: first, the case of one variable input, and
second, the case of many variable inputs, including returns to scale. The appendix covers
production indifference curves.
CHAPTER OUTLINE
SHORT-RUN VS. LONG-RUN COSTS: WHAT MAKES AN INPUT
VARIABLE?
Costs differ in the short and long runs because in the long run, more adjustments can be
made.
Fixed Costs and Variable Costs
Costs are divided into fixed and variable costs. The total fixed cost curve is horizontal, while
the average fixed cost curve declines, getting closer and closer to, but never touching, the
PRODUCTION, INPUT CHOICE, AND COST WITH ONE VARIABLE
INPUT
The Total, Average, and Marginal Physical Products of an Input
Total, average, and marginal physical products are defined and illustrated in a case in which
Marginal Physical Product and the “Law” of Diminishing Marginal Returns
When one input is increased, holding all other inputs constant, the amount of added output
The Optimal Quantity of an Input and Diminishing Returns
For a profit-maximizing firm, the optimal quantity of an input is that at which its marginal
revenue product equals its price.
MULTIPLE INPUT DECISIONS: THE CHOICE OF OPTIMAL INPUT
COMBINATIONS
Substitutability: The Choice of Input Proportions
Firms usually have a variety of technological options and can substitute one input for
another. The least-cost choice depends upon the relative prices of the inputs.
The Marginal Rule for Optimal Input Proportions
The rule for optimal input proportions is that the ratio of MPP to Price be the same for all
Changes in Input Prices and Optimal Input Proportions
If an input price rises, the ratio of MPP to P falls, and the firm should switch away from that
COST AND ITS DEPENDENCE ON OUPUT
Input Quantities and Total, Average, and Marginal Cost Curves
Total cost, average cost, and marginal cost are derived from the optimal input decisions.
The Law of Diminishing Productivity and the U-Shaped Average Cost Curve
A typical average cost curve declines at first (because declining average fixed costs
The Average Cost Curve in the Short and Long Run
The average cost curve differs between the long run and the short run because of the variable
ECONOMIES OF SCALE
Economies of scale (or increasing returns to scale) exist when output rises faster than the
The “Law” of Diminishing Returns and Returns to Scale
The law of diminishing returns holds in the case of the expansion of a single input, holding
other inputs constant. Returns to scale are relevant when all inputs increase at the same rate.
Historical Costs versus Analytical Cost Curves
All points on the cost curve used in economic analysis refer to the same period of time. A
Resolving the Economies of Scale Puzzle
To determine if a single large firm can produce a good more cheaply than a number of
smaller firms, we must compute the costs of both large-scale and small-scale production in
the current year as opposed to using historical information.
COST MINIMIZATION IN THEORY AND PRACTICE
Real business situations are more complex than those outlined in this chapter, and the quality
APPENDIX: PRODUCTION INDIFFERENCE CURVES
Characteristics of the Production Indifference Curves, or Isoquants
Each production indifference curve shows all combinations of input quantities capable of
The Choice of Input Combinations
The least costly way to produce any given level of output is indicated by the point of
Cost Minimization, Expansion Path, and Cost Curves
The expansion path shows the firm’s cost-minimizing input combination for each relevant
output level.
MARGIN DEFINITIONS
Short Run: a period of time over which some of the firm’s cost commitments are fixed.
Long Run: a period of time long enough for all of the firm’s commitments to come to an end.
Economies of Scale (Increasing Returns to Scale): an increase in inputs yields a
proportionately greater increase in output.
Production Indifference Curve (Isoquant): curve showing all the different quantities of two
inputs that are just sufficient to produce a given quantity of output.
MAJOR IDEAS
1. A profit-maximizing firm hires an input to the point where its marginal revenue product
is equal to its price.
2. A profit-maximizing firm will substitute inputs as their prices change, to arrive at the
least-cost combination for a given output.
ON TEACHING THE CHAPTER
The material in this chapter is challenging to students, not so much because any particular
concept is difficult, but because there are so many concepts. A single reading through the chapter
can leave students in a daze—with diminishing returns, MPP, MRP, TC, AC, MC, fixed costs,
variable costs, long-run costs, short-run costs, increasing and decreasing returns to scale, equality
of price and MRP, ratio of MPP to price, and historical and analytical curves. They all relate to
costs somehow, and the challenge is not only to learn what they mean, but also to figure out
when each is appropriate. The text is clear, but instructors will need to concentrate on clarity
also.
One approach to take is this: In the real world, managers make many production decisions
simultaneously. But the economist, seeking to understand those decisions, analyzes them—that is
to say, breaks them up to look at them piece by piece. In analyzing production decisions, it turns
out that different perspectives can yield insights that are different—not in the sense of being
contradictory but in the sense of showing different features. The various perspectives include:
a) Varying one input while holding all others constant, to show the relationship between that
input and total output.
b) Varying the proportion of inputs, while holding output constant, in order to minimize
costs.
c) Varying output, while holding the proportion of inputs constant, to study returns to scale.
d) Varying output while identifying costs, in order to derive average and marginal costs.
