Managerial Economics

ELEMENTS OF SUPPLY AND OUTPUTS

Outline
1.1 Sellers Goal
1.2 Existence of Firms

1.3 Inputs turned to Output

1.4 Run
1.5 Average vs. Marginal Product
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Goal of the Seller: Maximize Profit

How to make the product?

What is the cost of making the product?

How much can the seller get for the product in the
market?

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Why Do Firms Exist?

Firms offer a means of coordination that is extremely important and would be
sorely missing if workers operated independently.
Firms eliminate the need for every worker to negotiate every task that he or
she will perform, and bargain over the fees that will be paid for those tasks.
Firms can avoid this kind of bargaining by having managers that direct the
production of salaried workersthey tell workers what to do and when to do it,
and the workers (as well as the managers themselves) are simply paid a weekly
or monthly salary.

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Making the Goods: How Inputs are Turned into Outputs

How do you make a cake?
Factors of production Inputs
Labor inputs include skilled workers
(carpenters, engineers) and unskilled
workers (agricultural workers), as well as
the entrepreneurial efforts of the firms
managers.
Materials include steel, plastics,
electricity, water, and any other goods that
the firm buys and transforms into final
products.
Capital includes land, buildings,
machinery and other equipment, as well
as inventories.
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Time Period
Short run
Period of time when some of the firms inputs cannot be changed
Ex. In the short run, you cant buy another oven

Long run
Period of time when all of the firms inputs can be changed

Ex. In the long run, you can buy another oven, even build another kitchen

Variable factor of production

Input that can be changed in a certain period of time and that changes if
the level of output changes
Fixed factor of production
Input that cannot be changed in the short-run and that stays the same,
regardless of how much output is produced
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Production with One Variable Input (Labor)

PRODUCTION WITH ONE VARIABLE INPUT
AMOUNT OF LABOR (L)

AMOUNT OF CAPITAL (K)

TOTAL OUTPUT (q)

AVERAGE PRODUCT (q/L)

MARGINAL PRODUCT
(q/L)

10

10

10

10

10

10

30

15

20

10

60

20

30

10

80

20

20

10

95

19

15

10

108

18

13

10

112

16

10

112

14

10

108

12

-4

10

10

100

10

-8

Whats important about this production table?

Marginal product increases with the first workers = specialization
Workers are more efficient when they specialize in production and work together to produce a good.
Marginal product increases through Worker 3.
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Whats important about this production table?

Eventually, marginal product falls= law of diminishing returns
At some point, each additional worker contributes less output than the worker before.
Why?
Production can lead to bottlenecks because capital is fixedworkers are waiting for
machinery to become open, etc.

Marginal product (MP) can be negative

Why?
Capital is fixed in the short run. If more and more workers keep getting added, they will get in
each others way and actually cause output to fall.

MP becomes negative with the 9th worker.

Marginal Physical Product (MPP) is the change in output that results from
changing the variable input by one unit, holding all other inputs fixed.
MPP of labour = Q/L

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Slope of the Product Curve

The total product curve in (a) shows the output
produced for different amounts of labor input.
The average and marginal products in (b) can be
obtained (using the data in previous slide) the total
product curve.
To the left of point E in (b), the marginal product is
above the average product and the average is
increasing; to the right of E, the marginal product is
below the average product and the average is
decreasing.
As a result, E represents the point at which the average
and marginal products are equal, when the average
product reaches its maximum.
At D, when total output is maximized, the slope of the
tangent to the total product curve is 0, as is the
marginal product.
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Short-run Analysis of Total, Average, and Marginal Product

The Three Stages of Production in the short run:
Stage I: from zero units of the variable input to where AP is maximized (where MP=AP)
Stage II: from the maximum AP to where MP=0
Stage III: from where MP=0

In the short run, rational firms should be operating only in Stage II

Q: Why not Stage III? firm uses more variable inputs to produce less output
Q: Why not Stage I? underutilizing fixed capacity, so can increase output per unit by increasing
the amount of the variable input

What level of input usage within Stage II is best for the firm?
The answer depends upon:
how many units of output the firm can sell
the price of the product
the monetary costs of employing
the variable input
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The Cost of Doing Business: Introducing Cost Curves

What is the cost of making the product?
All firms use the same basic cost measures, and these should be based on inputs opportunity
costs.

Fixed
Cost

Variable
Cost

Total Cost

VC

C = F + VC

Fixed Cost (F) does not vary with the level of output; includes expenditures on land, office
space, production facilities, and other overhead expenses; are often sunk costs, but not
always.
Variable Cost(VC) changes as the quantity of output changes; refers to the costs of variable
inputs.
F and VC should be based on inputs opportunity costs.
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The relationship between averages and marginal

When marginal is below average, average
gets pulled down.
When marginal is above average, average
gets pulled up.
The only time marginal does not change
average is when they are equal (they
intersect).
CGPA is a good example.

The change in variable cost is the per-unit cost of the extra labor w times the amount of
extra labor needed to produce the extra output L. Because VC = wL, it follows that
MC = VC =
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One More Cost Concept: Sunk Cost

Suppose Anju buys a movie ticket, walks into the theater, and settles down to
watch the movie. Thirty minutes into the movie, she realizes that she hates it.
The money she paid for the ticket is a sunk cost. The cost was incurred in the
past, it cannot be changed, and it cannot be recovered. (Assuming that movie
theaters do not give your money back if you dislike the movie.)
I paid to watch this movie, but I really hate it. Should I get up and walk out or should I stay
and watch the movie? I think Ill stay and watch the movie because if I leave, Ill lose the
money I paid for the ticket. (Advice: ignore sunk costs)

Sunk cost is a cost incurred in the past that cannot be changed by current
decisions and therefore cannot be recovered.

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Sunk, Fixed, & Variable Costs: Computers, Software, & Pizzas

Personal computer industry: most costs are variable - because computers
are very similar, competition is intense, and profitability depends on the ability to
keep costs down. Most important are the cost of components and labor.
Computer software industry: most costs are sunk - a software firm spend a
large amount of money to develop a new application. The company can recoup
its investment by selling as many copies of the program as possible.

The Pizza business: most costs are fixed- sunk costs are fairly low because
equipment can be resold if the pizzeria goes out of business. Variable costs are
lowmainly the ingredients for pizza and perhaps wages for a workers to
produce and deliver pizzas.

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The Rewards of Doing Business: Introducing Revenue Curves

How much can the seller get for the product in the market?
Revenue
The amount of money the firm brings in from the sale of its product
Total revenue = Price x Quantity Sold

What does the firm have control over?

This demand curve is equal to
marginal revenue because it
represents the change in
revenues from selling one more
qty.

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Scale and Scope

Economies of Scale
Economies that exist when inputs are increased by some percentage and output increases by
a greater percentage, causing unit costs to fall.

Constant Returns to Scale

The condition when inputs are increased by some percentage and output increases by an
equal percentage, causing unit costs to remain constant.

Diseconomies of Scale
The condition when inputs are increased by some percentage and output increases by a
smaller percentage, causing unit costs to rise.

Economies of Scope
The Condition when the cost of producing a set of products jointly within one firm is less than
the cost of producing the products separately across independent firms.

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Economies of Scope
A production process exhibits economies of scope when the cost of producing
multiple goods is less than the aggregate cost of producing each item
separately.
=

(1 )+2 )(1 ,2 )
(1 )+2 )

Here, C(Q1, Q2) denotes the firms cost of jointly producing the goods in the
respective quantities; C(Q1) denotes the cost of producing good 1 alone and
similarly for C(Q2).
For instance, suppose producing the goods separately means incurring costs
of 12 million and 8 million, respectively. The total cost of jointly producing the
goods in the same quantities is 17 million.
Joint production implies a 15 percent cost saving vis--vis separate production.
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Learning Curve
A learning curve displays the relation
between average cost for a given output
period, Q*, and cumulative past
production.
In this example, there are significant
learning effects in the early stages of
production.
These effects become minimal as the
firm continues to produce the product.

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Economies of Scale vs Learning Effects

The average cost curves for a firm
when it has experienced high and
low cumulative volume.
In both cases, there are economies
of scale (average cost declines with
output).
The average cost for each level of
output, however, is lower where the
firm has experienced high cumulative
volume because of learning effects.

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Long run Average Cost (LAC)

Economies of Scale

Constant Returns to Scale

Diseconomies of Scale

The size at which a company should attempt to establish its operations depends on the extent of the scale
economies and the extent of the market.
Some firms can operate at minimum unit cost using a small scale.

Consider a street vendor of leather coats. Each additional sale entails variable costs for the coat, a few minutes of
direct labor effort to answer potential customers questions, and some small allocated cost associated with the
step-van or other vehicle where the inventory is stored and hauled from one street sale location to another.
99 % of the operating cost is the variable cost of an additional leather coat per additional sale. Long-run average
cost will be essentially flat, constant at approximately the wholesale cost of a leather coat. As a result, in street
vending, a small-scale operation will be just as efficient as a large-scale operation.
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Break-even Analysis
Many of the planning activities that take place within a firm are based on anticipated levels of
output.
The interrelationships among a firms sales, costs, and operating profit at various anticipated
output levels is known as break-even analysis.

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Break-even Analysis: Some Algebra

Total revenue is equal to the selling price per unit times the output quantity:
TR = P Q
Total (operating) cost is equal to fixed plus variable costs, where the variable
cost is the product of the variable cost per unit times the output quantity:
TC = F + (V Q)

Break-even:

TR = TC

PQb = F + VQb Qb = F/(P-V) = (Fixed Cost)/Contribution Margin

The difference between the selling price per unit and the variable cost per unit,
(P V), is referred to as the contribution margin.
It measures how much each unit of output contributes to meeting fixed costs
and operating profits.
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Break-Even Analysis: An Example

Assume that A manufactures one product, which it sells for 250 per unit (P).
Variable costs (V) are 150 per unit. The firms fixed costs (F) are 1 million.
Qb = 10,000 units
This analysis can be used to approve or reject a batch sale promotion.
Suppose that the 1 million is a trade rebate to elicit better shelf location for As
product. If the estimated effect of this promotion is additional sales of 9,000
units, which is less than the break-even output, the change in total contributions
will fall below the 1 million promotion cost (i.e., [250 150] 9,000 <
1,000,000). Therefore, the promotion plan should be rejected.

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