ABSTRACT
This chapter explores how technology, production choices, and input combinations determine a firm’s cost structure. We begin with the concept of the production function, illustrating how inputs such as labor and capital translate into output, and introducing core ideas like marginal product, isoquants, and input substitutability. Through examples ranging from bakeries to garment factories, we analyze how firms minimize costs by selecting optimal combinations of inputs given relative prices. We derive the cost function, and differentiate between short-run and long-run costs, fixed and variable costs, marginal cost, and average cost. Real-world productivity changes—such as those in agriculture since the Malthusian era—demonstrate how shifts in the production function affect economic outcomes. Finally, we examine economies of scale and returns to scale, which explain why some industries are dominated by many small firms while others by a few large producers.
