me slides session 3

8/6/2019 Me Slides Session 3

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1

PAN African eNetwork

Project Masters of Finance and Control

Managerial EconomicsSemester - I

Ms. Sonia Singh



Costs and Production



The Production Process• We now turn to consider the other side of the market:

the Producer side• What will we do with this?• We examine the production process, which will allow

us to understand the costs faced by a firm, which in

turn, provides us with an understanding of supplyrelationships• Thus we consider, in sequence:

– Production Theory

– Cost Theory



Central Actor: The Firm• What are firms?

– A way of organizing resources to provide goods and servicesto a market

– An organization specializing in the production of some good or service

• What do firms do? – They engage in production

– Production is a transformation process in which inputs aretransformed into outputs

• Why do they do it?

– For profit



• The Firm’s Objective – The economic goal of the firm is to maximize

profits.



Total Revenue, Total Cost, and Profit

• Total Revenue – The amount a firm receives for the sale of its

output.• Total Cost

– The market value of the inputs a firm uses inproduction.



Total Revenue, Total Cost, and Profit

• Profit is the firm’s total revenue minus itstotal cost.

Profit = Total revenue - Total costProfit = Total revenue - Total cost



Costs as Opportunity Costs

• A firm’s cost of production includes all theopportunity costs of making its output of goods and services.

• Explicit and Implicit Costs – A firm’s cost of production include explicit costs

and implicit costs.

• Explicit costs are input costs that require a directoutlay of money by the firm.• Implicit costs are input costs that do not require an

outlay of money by the firm.



Economic Profit versus Accounting Profit

• Economists measure a firm’s economic profit as total revenue minus total cost,including both explicit and implicit costs.

• Accountants measure the accounting profit as the firm’s total revenue minusonly the firm’s explicit costs.



Economic Profit versus Accounting Profit

• When total revenue exceeds both explicitand implicit costs, the firm earns economic profit. – Economic profit is smaller than accounting

profit.



Economic Profit vs.Accounting Profit

• If we calculate Profit = Revenue - ExplicitCost we have Accounting Profit

• If we calculate Profit = Revenue - ExplicitCosts - Implicit Costs we haveEconomic Profit



Figure 1 Economic versus Accountants

Copyright © 2004 South-Western

Revenue

Total

opportunitycosts

How an Economist

Views a Firm

How an Accountant

Views a Firm

Revenue

Economicprofit

Implicitcosts

Explicitcosts

Explicitcosts

Accountingprofit



The difference between implicit and explicit is important when we compute theprofit.

When computing the profit accountants only consider the explicit cost andeconomist consider both implicit and explicit cost.

Imagine a firm with the following costs and revenue:

Implicit Cost = 50

Explicit Cost = 30Revenue = 100

Accountant Profit = Revenue – Explicit Cost = 100 – 30 = $70

Economic Profit = Revenue – Explicit Cost – Implicit Cost = 100- 50 -30 = $20

The difference is quite big between accountant and economic profit. For thisclass, whenever we talk about profit we are referring to the economic profit.



Profit= Total Revenue – TotalCost

Costs depend on thetechnology or production

Study production or technologyto understand cost

Revenue depends on themarket structure

We will study marketstructures in the next slide



The Firm

• What kinds of firms are there? – Sole proprietorships – Partnerships – Corporations

• Why do firms exist? – Cheaper

• Specialization arguments (firms, employees)• Lower Transactions Costs• Risk Reduction



Production• How do firms organize resources?• The Production Process• Dependent on the Technology available

• Can be translated into more precise terms:• The Production Function--For a given

production technology, the production

function tells us how much output you canget from a particular combination of inputs



Production

• An entrepreneur must put together resources -- land, labour, capital -- andproduce a product people will bewilling and able to purchase



PRODUCTION FUNCTION

• THE RELATIONSHIP BETWEEN THEAMOUNT OF INPUT REQUIRED AND

THE AMOUNT OF OUTPUT THATCAN BE OBTAINED IS CALLED THEPRODUCTION FUNCTION



What can you say aboutMarginal Product ?

• As the quantity of a variable input(labour, in the example) increases while

all other inputs are fixed, output rises.Initially, output will rise more and morerapidly, but eventually it will slow downand perhaps even decline.

• This is called the LAW OF DIMINISHINGMARGINAL RETURNS



LAW OF DIMINISHING RETURNS

IT HOLDS THAT WE WILL GET LESS &

LESS EXTRA OUTPUT WHEN WE ADDADDITIONAL DOSES OF AN INPUTWHILE HOLDING OTHER INPUTS FIXED.IT IS ALSO KNOWN AS LAW OFVARIABLE PROPORTIONS.



COMBINING RESOURCES

• THERE ARE MANY COMBINATIONS OFRESOURCES THAT COULD BE USED

• CONSIDER THE FOLLOWING TABLESHOWING DIFFERENT NUMBER OFMECHANICS AND AMOUNT OF CAPITALTHAT THE HYPOTHETICAL FIRM, INDIAINC., MIGHT USE



Number CAPITAL

of

Mechanics 5 10 15 20 25 30 35 40

0 0 0 0 0 0 0 0 0

1 30 100 250 340 410 400 400 390

2 60 250 360 450 520 530 520 500

3 10 0 3 60 4 80 57 0 610 6 20 62 0 61 0

4 13 0 4 40 5 80 64 0 690 7 00 70 0 69 0

5 13 0 5 00 6 50 71 0 760 7 70 78 0 77 0

6 11 0 5 40 7 00 76 0 800 8 20 83 0 84 0

7 10 0 5 50 7 20 79 0 820 8 50 87 0 89 0

ALTERNATIVE QUANTITIES OF OUTPUT THAT CAN BEPRODUCED BY DIFFERENT COMBINATIONS OF RESOURCES



PRODUCTION IN THE SHORT

RUN• THE SHORT RUN IS A PERIOD JUST SHORT

ENOUGH THAT AT LEAST ONE RESOURCE(INPUT-INDUSTRIAL PLANT,MACHINES)CANNOT BE CHANGED -- IS FIXED ORINELASTIC. THUS IN THE SHORT RUNPROUDCTION OF A COMMODITY CAN BEINCREASED BY INCREASING THE USE OFONLY VARIABLE INPUTS LIKE LABOUR ANDRAW MATERIALS.



Number CAPITAL

of

Mechanics 5 10 15 20 25 30 35 40

0 0 0 0 0 0 0 0 0

1 30 100 250 340 410 400 400 390

2 60 250 360 450 520 530 520 5003 100 360 480 570 610 620 620 610

4 130 440 580 640 690 700 700 690

5 130 500 650 710 760 770 780 770

6 110 540 700 760 800 820 830 840

7 100 550 720 790 820 850 870 890

Quantities of Output that Can BeProduced When One Resource is Fixed



LONG RUN

• THE LONG RUN IS A PERIODSUFFIECIENTLY LONG THAT ALLFACTORS INCLUDING CAPITAL CAN BE

ADJUSTED OR ARE VARIABLE.

• THIS MEANS THAT THE FIRM CAN

CHOOSE ANY COMBINATION ON THEMANUFACTURING TABLE -- NOT JUSTTHOSE ALONG COLUMN LABELLED “10”



THREE STAGES OF PRODUCTIONNo. of workers (N) Total product – TP L

(tonnes)Marginal Product

(MPL)Average Product

(APL)Stage of production

(1) (2) (3) (4) (5)1 24 24 24

IINCREASING AND

CONSTANTRETURNS

2 72 48 36

3 138 66 46

4 216 78 54

5 300 84 60

6 384 84 64

7 462 78 66II

DIMINISHINGRETURNS

8 528 66 669 576 48 64

10 600 24 60

11 594 -6 54 III

-VE RETURNS12 552 -42 46

BEHAVIOUR OF TPP MPP AND



BEHAVIOUR OF TPP,MPP ANDAPP DURING THE THREE STAGES

OF PRODUCTIONTOTAL PHYSICALPRODUCT

MARGINAL PHYSICAL PRODUCT AVERAGEPHYSICALPRODUCT

STAGE I

INCREASES AT ANINCREASING RATE

INCREASES, REACHES ITSMAXIMUM & THEN DECLINES TILLMR = AP

INCREASES &REACHES ITSMAXIMUM

STAGE IIINCREASES AT A

DIMINISHING RATETILL IT REACHESMAXIMUM

IS DIMINISHING AND BECOMESEQUAL TO ZERO

STARTSDIMINISHING

STAGE IIISTARTS DECLINING BECOMES NEGATIVE CONTINUES TO

DECLINE



FROM THE ABOVE TABLE ONLY STAGE II ISRATIONAL WHICH MEANS RELEVANT RANGEFOR A RATIONAL FIRM TO OPERATE.

IN STAGE I IT IS PROFITABLE FOR THE FIRM TOKEEP ON INCREASING THE USE OF LABOUR.

IN STAGE III, MP IS NEGATIVE AND HENCE IT IS

INADVISABLE TO USE ADDITIONAL LABOUR.i.e ONLY STAGE I AND III ARE IRRATIONAL



Law of Variable Proportions

a/k/a Law of DiminishingReturns• When total output (production) of a

commodity is increased by adding units of variable input (labor, capital use, etc.) whilequantities of other inputs are held constant,the increases in total production become,after some point, smaller and smaller.

• Total production increases but the size of theincreases diminish.



Total Product

Units of Labor

TP

As more units of the variable resource, labor, are used;the total product continues to increase. After a certain

point, however, total product still increases but at adecreasing rate. Finally, total product actually beginsto decrease.



• The law of diminishing returns assumesall units of variable inputs, workers in thiscase, are of equal quality.

• As each additional worker is added, up topoint C, TP continues to increase. After point C, TP declines.

• Total product goes through 3 phases: Itrises initially at an increasing rate; then itincreases but at a decreasing rate; finallyit reaches a maximum and declines



Total Product

Units of Labor

TP

Product per unit

Units of Labor Marginal Product

A B C

Marginal Product is theadditional output added

per additional unit of input

2 31



• Marginal Product is geometrically the slopeof the total product curve.

• Marginal product measures the changes intotal product associated with eachadditional input, in this case workers.

• The three phases of total product are alsoreflected in marginal product.

• Where total product is increasing at an

increasing rate, marginal product is alsorising. Workers added are adding larger and larger amounts to total product.



Total Product

Units of Labor

TP

Product per unit


A B C

2 31

1 23

MP is 0



•Where total product is increasing but at adecreasing rate, marginal product is positive butfalling. Each additional worker adds less to total

product than did preceding workers.

•When total product is at a maximum, marginal product is zero.

•When total product declines, marginal product

becomes negative. Each additional unit of inputadded actually takes away from total product.



Let’s Plot the MPP Schedule

We’ll place it on top of the APPschedule so we can compare the

two



150

125

100

75

50

25

0

1 2 3 4 5 6 7 8

Average andMarginalProduct

Number of Mechanics

APP

Marginal and Average

MPP

MPP>APP|----------|

|-----------------------------|MPP<APP

MPP=APP



Total Product

Units of Labor

TP

Product per unit


A B C

MP is 0

IncreasingReturns

DiminishingReturns

Negative Returns

IncreasingReturns

DiminishingReturns

Negative Returns



ISOQUANT

AN ISOQUANT OR ISO PRODUCT CURVE OR EQUALPRODUCT CURVE OR A PRODUCTION INDIFFERENCECURVE SHOW THE VARIOUS COMBINATIONS OF

TWO VARIABLE INPUTS RESULTING IN THE SAMELEVEL OF OUTPUT.

IT IS DEFINED AS A CURVE PASSING THROUGH THEPLOTTED POINTS REPRESENTING ALL THECOMBINATIONS OF THE TWO FACTORS OFPRODUCTION WHICH WILL PRODUCE A GIVENOUTPUT.



Isoquants

An isoquant is a curve or line that

has various combinations of inputs that yield the same amountof output.



• For example from the following table we can see that differentpairs of labour and capital result in the same output.

Labour (Units)

Capital(Units)

Output(Units)

1 5 10

2 3 10

3 2 104 1 10

5 0 10



43

An Isoquant

0 1 2 3 4 5 6 7 8 9 10

Capital, K(m

achinesrented)

2

4

68

10

Labor, L (worker-hours employed)

i

j

Quantity of Soybeans = 1 (kg./hour)

Each point on a givenisoquant represents differentrecipes for producing the

same level of output.12



FOR EACH LEVEL OF OUTPUT THERE WILL BE ADIFFERENT ISOQUANT. WHEN THE WHOLE ARRAY OFISOQUANTS ARE REPRESENTED ON A GRAPH, IT ISCALLED AN ISOQUANT MAP.

IMPORTANT ASSUMPTIONS

THE TWO INPUTS CAN BE SUBSTITUTED FOR EACHOTHER. FOR EXAMPLE IF LABOUR IS REDUCED IN ACOMPANY IT WOULD HAVE TO BE COMPENSATED BYADDITIONAL MACHINERY TO GET THE SAME OUTPUT.



45

k

An Isoquant Map

0 1 2 3 4 5 6 7 8 9 10

Capital, K(m

achinesrented)


j



0

1

2

3

4

5

6

7

8

9 1

0

m

Different isoquantsrepresents different levels of output.



SLOPE OF ISOQUANT

THE SLOPE OF AN ISOQUANT HAS ATECHNICAL NAME CALLED THE

MARGINAL RATE OF TECHNICALSUBSTITUTION (MRTS) OR THEMARGINAL RATE OF SUBSTITUTION IN

PRODUCTION. THUS IN TERMS OFCAPITAL SERVICES K AND LABOUR LMRTS = Dk/DL



Marginal Rate of SubstitutionCapital

Labor

Change in K Change in L

On the next slide Iwill refer to a changewith the use of atriangle.

slope =



MRS

The slope of the curve at a point is

K/ L

Now, if the marginal product of an input is defined as thechange in output divided by the change in the input, the slopecan be manipulated to be:

K Q and since K = 1

L Q Q MP K

So the slope is MP L/MP K and is called the MRS (in absolutevalue) and it is a measure of the rate at which inputs can be

substituted and output remains the same.



TYPES OF ISOQUANTS

1. LINEAR ISOQUANT

2. RIGHT-ANGLE ISOQUANT3. CONVEX ISOQUANT



RIGHT ANGLE ISOQUANT



RIGHT-ANGLE ISOQUANTIN RIGHT-ANGLE ISOQUANTS THERE IS

COMPLETE NON-SUBSTIUTABILTYBETWEEN INPUTS.

FOR EXAMPLE TWO WHEELS AND AFRAME ARE REQUIRED TO PRODUCE ABYCYCLE THESE CANNOT BEINTERCHANGED.

THIS IS ALSO KNOWN AS LEONTIEFISOQUANT OR INPUT-OUTPUT ISOQUANT.

CONVEX ISOQUANT



CONVEX ISOQUANTIN CONVEX ISOQUANTS THERE IS SUBSTIUTABILTY

BETWEEN INPUTS BUT IT IS NOT PERFECT.

FOR EXAMPLE

(1) A SHIRT CAN BE MADE WITH LARGE AMOUNT OFLABOUR AND A SMALL AMOUNT MACHINERY.

(2) THE SAME SHIRT CAN BE WITH LESS LABOURERS, BY

INCREASING MACHINERY.(3) THE SAME SHIRT CAN BE MADE WITH STILL LESS

LABOURERS BUT WITH A LARGER INCREASE INMACHINERY.



WHILE A RELATIVELY SMALL ADDITION OF MACHINERYFROM M1(MANUAL EMBROIDERY) TO M2(TAILORINGMACHINE EMBROIDERY) ALLOWS THE INPUT OFLABOURERS TO BE REDUCED FROM L1 TO L2. A VERYLARGE INCREASE IN MACHINERY TO M3(COMPUTERISED EMBROIDERY) IS REQUIRED TOFURTHER DECREASE LABOUR FROM L2 TO L3.

THUS SUBSTIUTABILITY OF LABOURERS FORMACHINERY DIMINISHES FROM M1 TO M2 TO M3.



PROPERTIES OF ISOQUANTS

1. AN ISOQUANT IS DOWNWARD SLOPINGTO THE RIGHT. i.e NEGATIVELYINCLINED. THIS IMPLIES THAT FOR THE

SAME LEVEL OF OUTPUT, THEQUANTITY OF ONE VARIABLE WILLHAVE TO BE REDUCED IN ORDER TO

INCREASE THE QUANTITY OF OTHERVARIABLE.





2. A HIGHER ISOQUANT REPRESENTSLARGER OUTPUT. THAT IS WITH THESAME QUANTITY OF 0NE INPUT ANDLARGER QUANTITY OF THE OTHERINPUT, LARGER OUTPUT WILL BEPRODUCED.




4. ISOQUANT IS CONVEX TO THE ORIGIN.THIS MEANS THAT THE SLOPEDECLINES FROM LEFT TO RIGHTALONG THE CURVE. THAT IS WHEN WE

GO ON INCREASING THE QUANTITY OFONE INPUT SAY LABOUR BY REDUCINGTHE QUANTITY OF OTHER INPUT SAYCAPITAL, WE SEE LESS UNITS OFCAPITAL ARE SACRIFICED FOR THEADDITIONAL UNITS OF LABOUR.



58

• Assume that there are two resources, Labor (L)and Capital (K).

• The money payments to these resources areWages (W) and Rent (R). An isocost line is similar to the budget line. It’s a set of points with thesame cost, C. Let’s plot K on the y axis and L onthe x axis.

WL + RK = C ; solve for K by first subtracting WL from bothsides.RK = C - WL; next divide both sides by R.K = C/R – ( W/R)L; note that C/R is the y intercept and W/R isthe slope.

A Cost Function: Two Resources

A i li



59

C/R

C/W

Absolute value of slope equalsThe relative price of Labor, W/R.

K (machines rented)

Labor hours used inproduction

An isocost line



60

Bundles of: Labor Machine rental with C = $30 ($6 per labor hour) ($3 per machine hour)

a 0 10

b 1 8c 2 6

d 3 4e 4 2

f 5 0

A Numerical Example

Points a through f lie on the isocost line for C = $30/hour.



61

The Isocost Line

0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10


Capital, K(m

achinesrented)

a

b

c

d

e

f



62

The Isocost Line

0 1 2 3 4 5 6 7 8 9 10Labor, L (worker-hours employed)

Capital, K(m

achinesrented)

Cost = $30R = $3/machineW = $6/hour

2

4

6

8

10a

b

c

d

e

f

Ch th i h th



63

Cost Minimization

0 1 2 3 4 5 6 7 8 9 10

Capital, K(m

achinesrented)

2

4

6

8

10


a

equ.W = $6; R = $3;C = $30

Choose the recipe where thedesired isoquant is tangent tothe lowest isocost.

C = $18

12

C = $36



From the Production Function to the

Total-Cost Curve• The relationship between the quantity afirm can produce and its costs determines

pricing decisions.• The total-cost curve shows thisrelationship graphically.

Table 1 A Production Function and TotalC l ’ C ki



Cost: Hungry Helen’s Cookie Factory

Copyright©2004 South-Western

Figure 3 Hungry Helen’s Total-Cost Curve



g g y


TotalCost

$80

70

60

50

40

30

20

10

Quantityof Output

(cookies per hour)

0 10 20 30 15013011090705040 1401201008060

Total-costcurve



THE VARIOUS MEASURES OF

COST• Costs of production may be divided intofixed costs and variable costs .



Fixed and Variable Costs

• Fixed costsFixed costs are those costs that do not vary with the quantity of output produced.

• Variable costsVariable costs are those costs that dovary with the quantity of output produced.




• Total Costs – Total Fixed Costs ( TFC ) – Total Variable Costs ( TVC ) – Total Costs ( TC ) – TC = TFC + TVC




• Average Costs – Average costs can be determined by dividing

the firm’s costs by the quantity of output it

produces. – The average cost is the cost of each typical

unit of product.




• Average Costs – Average Fixed Costs ( AFC ) – Average Variable Costs ( AVC ) – Average Total Costs ( ATC ) – ATC = AFC + AVC



Average Costs

A F C F CQ

= =F i x e d c o s tQ u a n t i t y

A V CV C

Q= =V a r i a b l e co s t

Q u a n t i t y

A T CT C

Q= =T o t a l c o s t

Q u a n t i t y

Table 2 The Various Measures of Cost:h h l d d



Thirsty Thelma’s Lemonade Stand

Copyright©2004 South-Western




• Marginal Cost – Marginal cost (MC ) measures the increase in

total cost that arises from an extra unit of

production. – Marginal cost helps answer the following

question:• How much does it cost to produce an additional

unit of output?



Marginal Cost

M CT C

Q= =( c h a n g e i nt o t a l c o s)

( c h a n g e i nq u a n t i t y

∆

∆

Marginal Cost



gThirsty Thelma’s Lemonade

Stand

Quantity

Figure 4 Thirsty Thelma’s Total-Cost Curves




Total Cost

$15.00

14.00

13.00

12.00

11.00

10.00

9.008.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

Quantityof Output

(glasses of lemonade per hour)

0 1 432 765 98 10

Total-cost curve



Cost Curves and Their Shapes

• Marginal cost rises with the amount of output produced. – This reflects the property of diminishing

marginal product .




• The average total-costaverage total-cost curve is U-shaped .• At very low levels of output average total

cost is high because fixed cost is spreadover only a few units.

• Average total cost declines as outputincreases.

• Average total cost starts rising becauseaverage variable cost rises substantially.




• The bottom of the U-shaped ATC curveoccurs at the quantity that minimizesaverage total cost . This quantity is

sometimes called the efficient scale of thefirm.

Figure 5 Thirsty Thelma’s Average-Cost andMarginal-Cost Curves



Marginal Cost Curves


Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantityof Output

(glasses of lemonade per hour)

0 1 432 765 98 10

ATC




• Relationship between Marginal Cost andAverage Total Cost – Whenever marginal cost is less than average

total cost, average total cost is falling. – Whenever marginal cost is greater than

average total cost, average total cost is rising.




• Relationship Between Marginal Cost andAverage Total Cost – The marginal-cost curve crosses the average-

total-cost curve at the efficient scaleefficient scale.• Efficient scale is the quantity that minimizes

average total cost.



Typical Cost Curves

It is now time to examine therelationships that exist between the

different measures of cost.

b



Big Bob’s Cost Curves

Figure 6 Big Bob’s Cost Curves




(a) Total-Cost Curve

$18.00

16.00

14.00

12.00

10.00

8.00

6.00

4.00

Quantity of Output (bagels per hour)

TC

42 6 8 141210

2.00

TotalCost

0

Figure 6 Big Bob’s Cost Curves




(b) Marginal- and Average-Cost Curves

Quantity of Output (bagels per hour)

Costs

$3.00

2.50

2.00

1.50

1.00

0.50

0 42 6 8 141210

MC

ATC AVC

AFC

l



Typical Cost Curves

• Three Important Properties of Cost Curves – Marginal cost eventually rises with the

quantity of output.

– The average-total-cost curve is U-shaped. – The marginal-cost curve crosses the average-

total-cost curve at the minimum of averagetotal cost.



COSTS IN THE SHORT RUN

AND IN THE LONG RUN• Because many costs are fixed in the shortrun but variable in the long run, a firm’s

long-run cost curves differ from its short-run cost curves.

Figure 7 Average Total Cost in the Short and LongRun




Quantity of Cars per Day

0

Average

TotalCost

1,200

$12,000

ATC in shortrun withsmall factory

ATC in shortrun withmedium factory

ATC in shortrun withlarge factory

ATC in long run

E i d Di i f S l



Economies and Diseconomies of Scale

• Economies of scale refer to the property wherebylong-run average total cost falls as the quantity of output increases.

• Diseconomies of scale refer to the propertywhereby long-run average total cost rises as thequantity of output increases.

• Constant returns to scale refers to the propertywhereby long-run average total cost stays thesame as the quantity of output increases

Figure 7 Average Total Cost in the Short and LongRun




Quantity of Cars per Day

0

Average

TotalCost

1,200

$12,000

1,000

10,000

Economies

of scale

ATC in shortrun withsmall factory

ATC in shortrun withmedium factory

ATC in shortrun withlarge factory ATC in long run

Diseconomiesof

scale

Constantreturns to

scale

S



Summary

• The goal of firms is to maximize profit,which equals total revenue minus totalcost.

• When analyzing a firm’s behavior, it isimportant to include all the opportunitycosts of production.

• Some opportunity costs are explicit whileother opportunity costs are implicit.

S



Summary

• A firm’s costs reflect its production process.• A typical firm’s production function gets flatter as the

quantity of input increases, displaying the property of diminishing marginal product.

• A firm’s total costs are divided between fixed and variablecosts. Fixed costs do not change when the firm alters thequantity of output produced; variable costs do change asthe firm alters quantity of output produced.

S



Summary

• Average total cost is total cost divided by thequantity of output.

• Marginal cost is the amount by which total

cost would rise if output were increased byone unit.

• The marginal cost always rises with the

quantity of output.• Average cost first falls as output increasesand then rises.

S



Summary

• The average-total-cost curve is U-shaped.• The marginal-cost curve always crosses

the average-total-cost curve at theminimum of ATC.

• A firm’s costs often depend on the timehorizon being considered.

• In particular, many costs are fixed in theshort run but variable in the long run.



Text & References:

Text:Gupta, G.S. 2006, Managerial Economics, 2nd Edition,Tata McGraw Hill

Peterson, H.C and Lewis, W.C. 2005, Managerial Economics, 4 th Edition,Prentice Hall of India References:

R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business EconomicsMacmillan.

Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co. Koutsoyiannis,A. Modern Economics, Third Edition. Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and

Review, 6 th Edition, Tata McGraw Hill. Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking. Salvatore,D, International Economics, 9 th Edition, John Wiley & Sons. Salvatore, D, Managerial Economics, 5 the edition, Thomson-South

In this section of the semester we will focus our attention to the



In this section of the semester, we will focus our attention to thebehavior of the firm. That is, we want to know how firms behave andhow firms determine how much to produce.

We first start by defining what is the firm’s only goal.

The firm is in business to make the largest possible profit. In other words, the firm is in business to maximize profits.

Since the firm is in business to maximize profits we need to have adefinition of profits:

Profit = Revenue - Costs

Profits are composed of revenue and costs. The revenue is how muchthe firm receives from the sale of its good. The cost is how much thefirm has to pay to produce the good.

Since, revenue and costs determine profit we need to understand themto know how the firm behaves.



1) Revenue

The firm’s revenue can be written as:

Revenue = Price x Quantity

That is, the revenue is the price charged for the good times the number of goodssold by the firm. Notice that the price is a price per unit. For example is theprice for shirts is $4 and a firm sold 9 units of them, then the firm’srevenue is 4 x 9 = $36.

Now lets set: Price = P and Quantity = Q

We can now re-write the revenue as:

Revenue = P x Q

The revenue will behave in different ways depending of the type of market that thefirms operates. There are four types of markets: competitive, oligopoly,monopoly and monopolistic competition. Since we have not covered thismarkets yet we will leave the discussion of the revenue to when we cover each particular market.

We now move to the other part of the profit: costs.



2) Costs

All firms want to keep low costs because that increases their profit. However,we first need to define what we mean by costs.

In general, there are two types of costs: explicit and implicit.

Explicit Cost: costs that require a monetary payment from the firm (there is anoutlay of money). The firm in this case is actually paying someone.

Implicit Cost: costs that DO NOT require a monetary payment from the firm.The firm in this case is not paying money for a good or service.

Costs = Explicit + Implicit

From now whenever we talk about cost we are consider both implicit andexplicit cost.



The difference between implicit and explicit is important when we compute theprofit.

When computing the profit accountants only consider the explicit cost andeconomist consider both implicit and explicit cost.

Imagine a firm with the following costs and revenue:

Implicit Cost = 50

Explicit Cost = 30Revenue = 100

Accountant Profit = Revenue – Explicit Cost = 100 – 30 = $70

Economic Profit = Revenue – Explicit Cost – Implicit Cost = 100- 50 -30 = $20

The difference is quite big between accountant and economic profit. For thisclass, whenever we talk about profit we are referring to the economic profit.



Before we continue with more definitions of costs we will talk about thetechnology of the firms.

Why?

Because the technology of the firm determines the way costs behave .

For example, cars used to be very expensive at the beginning of the 1900’s,this is because the technology they used. Back then only a handful of peoplecould afford to buy cars. Nowadays, firms use a different type of technology socars are cheaper.

To summarize:

We will study the firm and firms only concern is to maximize profits. Profits arecomposed of revenue and costs. The revenue = P x Q and it depends on the

type of market the firms operates. The costs of the firm depend on thetechnology of the firm, so we will first cover technology and then move on tocosts.



Profit= Total Revenue – TotalCost

Costs depend on thetechnology or production

Study production or technologyto understand cost

Revenue depends on themarket structure

We will study marketstructures in the next slide



3) Technology

The technology of the firm is how the firms uses “inputs” to produce and “output”.

Inputs are defined as the resources that the firm uses to produce something else.

Examples of inputs are: labor, electricity, raw materials, buildings and so on.

Output is what the firm is actually producing (the final product).

Examples of outputs are: cars, computers, watches, and so on.

For example a firm uses the inputs cotton, labor and sewing machines to produce theoutput t-shirts.

Economists divide inputs into three big categories: capital (K), labor (L) and naturalresources (NR)

Capital (K) = refers to physical machines, building and equipment used in production.

Capital DOES NOT refer to the amount of money the firm has .Labor (L) = refers to the amount of workers.

Natural Resources (NR) = refers to the raw material used in production such as oil,electricity, cotton, etc.



Firms use inputs to produce and output. The relationship between these two is called theproduction function.

Production Function: the relationship between the inputs and output.

That is, the production function tell us how many tons of cotton, labor, sewing machinesand workers are necessary to produce certain amount of t-shirts. Thus, the productionfunction represents the technology of production.

The production function is usually written as follows:

Q = f(K,L,NR)

f(K,L,NR) can be read as “depends on K,L,NR”. Therefore, Q=f(K,L,NR) is read as “theoutput (Q) depends on K, L and NR”. Notice that f(K,L,NR) is NOT a multiplication or addition or anything like that, it just says that Q depends on L, K, and NR.

In order to simplify things we are going to forget about NR, this is just to make our lifeeasier. Therefore, we are going to re-write the production function as:

Q=f(L,K)

That is, output depends on labor and capital.

Production and Time Horizon



In the case of production the time horizon matters. Firms usually have moreconstraints in the long-run than in the short run.In fact, we can say that in long-run everything is possible for the firm while in theshort-run only few things can happen.

For example, imagine that you produce donuts and you get a huge order of donutsfor next week (3 million donuts). Most likely you will not be able to do it.Why?Because you need more machinery more supplies and more workers. You canprobably hire more people relatively easy, say in a couple of days. But bringing newmachinery and equipment and having a bigger shop will take months if not years.

Thus, we usually say that in the short-run some input are variable. This means thatin the short-run this inputs some can be increased or reduced easily (Labor for example) while others (Capital) cannot be changed in the short-run.

However, in the long-run (that is in the distant future) everything is possible. In thatfuture you can hire more workers but you can also build a bigger factory with moreequipment and machinery to make donuts.

Production and Time Horizon



This take us to the main distinction between short and long run:

In the short-run at least one input (usually capital) is fixed (that is one inputdoes not change).

In the long-run ALL inputs are variable (all inputs can be increased or decreased).

From now on, we are going to talk about production in the short-run unlessotherwise is explicitly noted.

N th t d t d th d ti f ti i t l k t i l



Now, that we understand the production function we are going to look at one numericalexample and then we will expand it later to include costs.

Example:

Consider a firm that produces cars (Q) using capital (K) and Labor (L). Because it is theshort-run we are going to have capital fixed. The following table show the differentamount of labor and capital that yield the corresponding output.

K L Q1 0 0

Notice that when the firm has no Labor it producesnothing but still has one unit of capital because capital is

fixed.

When the firm has one unit of labor and one unit of capital the firm produces 1 unit of output (1 car).

When the firm has two units of labor and one unit of capital the firm produces 3 units of output (3 cars) and soon.

I dditi ti th t t t i f t 22 d th d



In addition, notice that output increases from zero to 22 and then decreases as weincrease the number of workers.

MPL is the marginal product of labor. MPL is the amount of output that an extra

unit of labor will produce . The formula for the MPL is the following

K L Q1 0 0

MPL tells the firm how much an extra worker willproduce and therefore it is important information. If youare a firm owner and you are thinking about hiringsomeone you have to consider the MPL of that worker and compare it to how much you will pay the worker tosee if it is worth it (we will talk about this in the topic, but

you can see now how MPL is important).

MPL increases reaches a high point and thendecreases.

Change in OutputMPL

Change in Labor =



Why does MPL first increases and then decreases?

This happens because of specialization. Consider the following example.

You have a lemonade stand and you have all you equipment and a single table whereyou must prepare the lemonade.

When you hire your first worker, he has to do everything: cut the lemons, squeeze them,pour the water, the sugar, stir, put ice, serve the individual cups and attend customers.Obviously having one worker is better than having no worker.

If you hire a second worker the two workers can specialize a litle bit. One person will takecare of cutting the lemons and squeeze them while other one will pour the water and thesugar and attend customers. This specialization makes the second worker moreproductive. In our previous example, the second worker produces 2 more units of outputwhile the first worker produces only one unit.

As you keep increasing the number of workers the specialize more and more so thateach worker produces more than the previous worker and MPL keeps increasing.



However, at some point specialization reaches a limit. The limit is reached when youhave a lot of people working in the same table. As you can tell when you have more and

more workers working all in the same table and sharing the same equipment they will bein each other’s way and therefore they will not be as productive.

When this happens the advantage of specialization start to decrease and MPLdecreases. If you adding worker you will actually reach a point when adding an extraworker reduce output. This is a worker that makes everyone slow down and productiondecreases when you hire him. In our previous example, this will be the tenth worker and

no rational firm will hire him.Why specialization reaches a limit?

The reason is that capital is fixed. That is, you can only use one table to producelemonade and only one set of equipment and machinery. However, if you cold have moretables and equipment MPL will never decrease.

Therefore MPL will increase and later decrease in the short-run because in the short-runcapital is fixed.

Finally,the last column of the previous example shows APL which is the average productof labor. The a



Finally, the last column of the previous example shows APL.

APL is the average product of labor.

APL tells us what is typical amount that a worker will produce.

The formula for APL is the followingQ

APL L

=

APL also increases and then decreases.

Costs



Now, that we understand the production process of the firm we can study thefirm’s costs.

We will resume with the previous example we mentioned before. In order to getthe costs of the firm we need to know the price of the inputs. In this case, weneed to know the price of labor and capital.

We will assume that the price of labor is $50 and the price of capital is $20.

Now we need to obtain some definitions of costs:

1) Fixed Cost (FC)= costs that do not vary with the quantity produced.

Examples of fixed costs are buildings, expensive or heavy equipment, bookkeeping and so on.

2) Variable Cost (VC)= costs that vary with the quantity produced.

Examples of variable costs are labor, raw materials, electricity, and so on

4) Total Cost (TC) = Fixed Cost + Variable Cost

5) Average Fixed Cost (AFC) = Fixed Cost / Output

Costs



5) Average Fixed Cost (AFC) = Fixed Cost / Output

AFC is the typical fixed cost of one unit of output.

6) Average Variable Cost (AVC) = Variable Cost / OutputAVC is the typical fixed cost of one unit of output.

7) Average Total Cost (ATC) = Total Cost / Output

ATC is the typical fixed cost of one unit of output.

Because the TC = VC + FV then ATC= AVC + AFC8) Marginal Cost (MC) = the change in the total cost from producing oneextra unit:

Using all these different definitions of costs and the price of labor and capitalwe obtain the table in the following slide

Change in Total CostMC=

Change in Output

CostsPrice of Labor = $50 Price of Capital = $20



K L Q1 0 01 1 1The previous table can be divided into three parts. The production section, the

total cost section and the per unit section.As it turns out all the relevant information can be obtained by looking at the per unit costs. Hence, we will graph the per unit cost and get a summary of theimportant results.

Production Total Costs Per unit costs

The graph of the per unit costs is the following



Q

$MC

ATC

AVC

AFC



The previous table has a lot of information. Lets have a summary of the mainpoints:

1)AFC is always decreasing.

2)AVC decreases reaches a low point and then increases again.

3)ATC decreases reaches a low point and then increases again.4)MC decreases reaches a low point and then increases again.

5)When MC > ATC then ATC is increasing

When MC < ATC then ATC is decreasing

6) MC crosses ATC and AVC at their lowest point

Costs

An activity



An activity

• Using only one or two sentences, describethe relationship between inputs, marginalproduct and total product.

What you need to do



What you need to do.• Explain the difference between fixed

and variable costs.• Describe the difference between the

short-run and long-run.• Compute the average and marginal

physical product for a single inputgiven data on total output at differentinput levels.

• Explain the “Law of diminishingmarginal returns”• Explain how total product, average

product, and marginal product canbe computed.

• Explain the relationship betweentotal product, average product andmarginal product curves.

• Explain the theory of production• Describe the Three stages of

production.

• Theory of production• Law of variable proportions• Short-run• Long-run• Production function• Total product• Marginal product

• Stages of production• Diminishing returns



Thank You

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