Question

From the Book (MANAGERIAL ECONOMICS 12 EDITIONS). Discuss the relationship between production and cost. Use specific examples to illustrate your discussion.​

Answer 1

The relationship between production and cost in any manufacturing process varies based on volume produced and whether any part of the manufacturing process is outsourced or performed by subcontractors. Additionally, production and cost ratios vary based on the amount of automation involved in production and the amount of human oversight and involvement required.

Production processes can be studied empirically in terms of either production functions or cost functions. Estimates of the parameters of these functions provide valuable insights into the technology of firms and industries. The central questions relating to technology are (1) whether production processes display decreasing, constant, or increasing returns to scale; (2) how technological progress affects the parameters of production processes; and (3) at what rate technological progress has occurred. Estimation and interpretation of the estimates is complicated by the fact that observations on inputs, outputs, and costs reflect not only the state of technology but also the economic decisions made by producers and factor suppliers. Assumptions regarding economic behavior and competition in input and output markets often play a crucial role in the statistical analyses, and it is not always easy to determine whether the results reveal the nature of technology or serve instead to test the validity of the economic assumptions.

In the short run we are interested not just in costs, but in average costs of production (AC) and shape of AC curve, which depends on the shape of AVC curve (note: AFC always diminishes). However, dynamics of AVC depends on the relationship between average and marginal products of labor (variable factor).

So, we should consider three cases:

Constant return to variable factor: MPL = APL, then AVC stays constant, hence AC decreases as Q increases. We have negative dependence between production and average costs.
Decreasing return to variable factor: MPL < APL, then AVC increases, hence AC decreases at small Q and increases at large Q. We have undefined dependence.
Increasing return to variable factor: MPL > APL, then AVC decreases, hence AC decreases as Q increases. We have negative dependence.