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1.
2.
3.
4.
5.
6.
Firm chooses
Level of output and
fixed the price
Output
Revenue
Total cost
curves,
short-run
and long
run
Marginal
cost curves,
short-run
and long
run
Average cost
curves, shortrun and long
run
Modeling
Firm
chooses
level of
output
Marginal
revenue
curve
Checks: Whether
to produce at all
in short-run:
whether to close
down in long run
Demand curve
facing the firm
(prices at
which the firm
can sell each
level of output)
Production
The term production refers to more than the physical
transformation of resources. Production involves all the
activities associated with providing goods and services.
Thus the hiring of workers (from unskilled labor to top
management), personnel training, and the organizational
structure used to maximize productivity are all part of the
production process.
Input: any good or service used to produce output.
A technique: a particular method of combining inputs to
make outputs.
Technology: is the list of all known techniques
Technical progress: production of a given output with less
inputs than before or shift in production possibility curve.
FOPs
Outputs
Firm
Black Box
2. Returns to a factor
The relation between output and variation in only one of the
inputs employed.
The terms factor productivity and returns to a factor are
used to denote this relation between the quantity of an
individual input (or factor of production) employed and the
output produced.
Factor productivity provides the basis for efficient resource
employment in a production system.
Total Product
of the Input
(Q)
15
31
48
59
68
72
73
72
70
67
Marginal Prod:
of Input X
(MPx= A Q/ A X)
15
16
17
11
9
4
1
-1
-2
-3
Average Prod:
of Input X
(Apx = Q/X)
15
15.5
16
14.8
13.6
12
10.4
9
7.8
6.7
Output Q
TPx
Input x
10
20
Output Q
15
10
APx
5
0
-5
Input X
10
MPx
Cost Analysis
Cost Analysis plays a central role in managerial economics because
virtually every managerial decision requires a comparison between costs
and benefits.
There are number of other cost concepts.
Relevant cost and Opportunity cost
Accounting cost and economic cost
Explicit vs implicit costs
Marginal cost or Incremental Cost
Sunk cost (while leaving industry you can not recover this costs) and
fixed cost
Short and long-run costs
Short-run Costs
Short-run Total Costs
Total Cost: TC (fixed and variable costs in production)
Total Fixed Cost: TFC (Cost which does not change with
output and it is the overhead or capital costs. The curve is a hori
zontal or flatter)
Total Variable Cost: TVC (Cost which change with output: labor
and raw materials). This curve is the inverse shape of TP
curve.First it increases at decreasing rate (additional unit of labo
ur add more value to production) and then increases at increasi
ng rate (additional unit of labour add more to cost rather to prod
uction).
TC = TFC + TVC, TFC = TC - TVC, TVC = TC - TFC
TC
120
138
151
162
175
190
210
234
263
300
TFC
100
100
100
100
100
100
100
100
100
100
TVC
20
38
51
62
75
90
110
134
163
163
200
ATC
120
69
50.3
40.5
35
31.7
30
29.3
29.2
30
AFC
100
50
33.3
25
20
16.7
14.3
12.5
11.1
10
AVC MC
20
20
19
18
17
13
15.5 11
15
13
15
15
15.7 20
16.8 24
18.1 29
20
37
Increasing
productivity
of variable
factors
Decreasing
productivity
of variable
factors
Total cost
F
Total
Variable
cost
Fixed
cost
O
Q2 Q3
Q1
Output per time period (units)
Total Costs
Fixed
cost = OF
Variable
cost
Cost
MC
ATC
AVC
Q1
Q2
Q3
AFC
Output
Cost ()
ATC
AVC
TFC
AFC
0
q1
Cost ()
ATC and MC
MC
ATC
q*
Short-run Optimality
Full or optimum capacity = firm produces at minimum level of
short-run average cost curve and at this point all the inputs are
employed to their optimum efficiency.
If the firm faces long U shape (Saucer) cost curve, the range of
the minimum points are called load factor or normal capacity
utilization.
If firm producing a point right to this then its average costs is
rising.
If firm is producing left to this point then firm has a reserve
capacity; firm is not fully utilizing its factors of production.
Newspaper business
Jewellery retailing
Electronic components manufacture
Electricity generation
Software development
Cellular telecommunications
Hotel management
LR Average Costs
cost ()
LRMC
SRAC1
c1
SRAC5
SRAC4
SRAC2
c2
SRAC3
c*
q1
q2
q*
q4
q5
Cost ()
Returns to Scale
Increasing
returns to
scale
Constant
returns to
scale
Decreasing
returns to
scale
LRMC
LRAC
LRAC
LRMC
q1
Minimum efficient
scale (MES)
Average
(i.e. per
unit) cost of
production
Increasing
returns to
scale
Decreasing
returns to
scale
Constant returns to
scale
Decreasing
cost
production
Increasing
cost
production
Constant cost
production
q1
q2
Output expansion
over the long run
Economies of Scope
This exist where several different outputs draw on a common
resources and it is a diversification in a same or different
production and marketing lines. This diversification leads to
cost savings. Generally economies of scale and scope reinforce
each other to minimize cost.
The Degree of Economies of Scope (DES)
DES = {[TC(An) + TC(Bn)] TC (An + Bn)}/[TC (An+Bn)]
TC(An) = Total cost of producing An units of product A separately
TC(Bn) = Total cost of producing Bn units of product B separately
TC (An+Bn) = Total cost of producing A and B jointly
DES < 0 Negative ES. It is better to produce separately
DES >0 Positive ES. More economical to produce jointly.
Generally economies of scale and economies of scope are reinforcing
each other to reduce costs.
Real Economies
Production
Labour
Capital
Inventory
Selling/
Marketing
Managerial
Other
Specialisation/team-working
Decentralisation
Mechanisation
Advertising
Large-scale promotion
Exclusive dealers
Transport
Storage
R & D efficiencies
By-product production
Experience curves
X-inefficiency
The situation of wastage of firms resources and its costs
higher than necessary level. This can happen due to
managerial or technological or any other factor. This firm
can not exist market in long-run. Most of the public sector
institutions have this problem. But generally in the long-ru
n in competitive markets, firms can not survive if they hav
e X-inefficiency problem: full efficient firms only survive.
We can measure it as actual cost point - MES = (q1a-q1b)
=ab
C
a
LRAC
Profits Maximization
Total Revenue - Total Costs = Profits
TR - TC = Profits
d(TR)/dQ - d(TC)/dQ = Marginal profits
MR = MC, Profits maximizing condition or rule
Marginal revenue = Marginal cost
Profits maximising output decision:
MR > MC Q should goes up
MR = MC Q profit maximising output
MR < MC Q should goes down
Profits maximising output and revenue maximising output are
two different concepts (see next table).
PQd
(TR)
0
TC
(TFC+ TVC)
10
(TR-TC)
-10
21
21
25
-4
20
40
36
19
57
44
13
18
72
51
21
17
85
59
26
16
96
69
27
15
105
81
24
14
112
95
17
13
117
111
12
10
120
129
-9
P
(per unit)
-
Qd
MC
Perfect Competition
Other Markets
MR/D/P
0
MR
AR =DQ
MC
ATC
AVC
AFC
O
MR > MCQ1
Q2
Q3
MC <
MRMR
MC 1
MC
MR
MC 2
MR
0
Q
Q1
Q2
MR
MR1
0
Q1
Q2
MR2
MR
Q
Figure a
Figure b
Normal Profits
At a breakeven point firm makes zero profits. But economists
name it as a normal profits based on the opportunity cost conce
pt.
Abnormal Profits (Super normal profits)
Surplus above the normal profits. Between Q1 and Q4
Shut-Down Price
Below the normal profits firm does not get full cost recovery.
Therefore, they will decide to shut-down the business.
SRM
C
Abnormal profits
P5
Normal profits
D5 = MR5
D4 = MR4
P4
P3
D3 = MR3
Shut-down price P2
D2 =MR2
P1
SRAC
SRAV
C
D1 =MR1
Q1
Q2
Q3
Q4 Q5
Output
Exercise
Usage of profits maximizing model to loss making firm - Baldwins
fashion Ltd
This firm make profits till very recent but now in loss and
considering closing down. Your advice to regain the profits and to
remain in the industry.
Solutions:
1) Decreasing variable costs
2) Decreasing fixed costs
3) Increasing the level of demand
4) Combinations of all these