ENGINEERING ECONOMICS

LECTURE 5

HUMA FAWAD
HITEC , TAXILA
FALL 2018

1
ECONOMIC DECISION MAKERS
 1. Household
 (Demand Goods/Services, Resources Supply)

 2. Firm/Businessess
 Entity(Types of Firms – Sole Proprietorship, Partnership,

Corporations)
 Competition (Monopoly- One firm, Oligopoly – Few Firms, Many

Firms a. Monopolistic Competition – Differentiated Products,

Perfect Competition – Identical Products)
 3. Government
 (Size, Growth, Source of Revenue, Tax, etc)

 4. Global
 (Exchange rate, Trade Restriction, International Trade)
CIRCULAR FLOW MODEL
FIRM/BUSSINESS ENTITIES

 Sole Proprietorship

 Partnership

 Corporation
 Sole Proprietorship
 Business owned by an  Advantages
individual – Ease of formation
– Subject to few
 Owner maintains title to regulations
assets and profits – No corporate income
 Termination occurs on taxes
owner’s death or by  Disadvantages
– Difficult to raise
owner’s choice
capital
– Unlimited liability
– Limited life
 Partnerships
 Two or more owners Advantages

 General Partnership
 Each partner is fully
responsible for
liabilities
–Ease of formation
–Subject to few
regulations
–No corporate income
taxes
–Easy to raise capital

 Limited Partnerships
Disadvantages

–Unlimited liability
–Limited life
 Partnerships
 Limited Partnership and Limited Liability
Company
 Allows one or more partners limited liability
based on amount of capital invested
 Must have one general partner with unlimited
liability
 Names of limited partners may not appear in
name of firm
 Limited partners may not participate in
management decisions.
 Corporation
 Legally functions separate and apart from its owners
 Can sue, be sued, purchase, sell, and own
property
 Owners who dictate direction and policies
 Elect a board of directors
 Investors liability is restricted to amount of investment in
company
Unlimited life.Life continues with transfer of ownership
 Taxed separately
 Comparison of Organizational
Forms
 Large growing firms choose the corporate
form

 Ease in raising capital

 Limited liability

 Transfer of ownership is simple

 Comparison of Organizational
Forms
 Sole Proprietorship and General Partnership
 Unlimited liabilities
 Not as easy to raise capital
 Limited Partnership
 Limited liability for partners
 Practical number of partners restricted
 Restricted marketability of interest in
partnership
COST OF FIRMS DECISION

MICROECONOMICS
Firm’s Choice: Firm’s Costs and
Production Decision
 A firm chooses:
 What quantity of the good to produce,
 The price of the good (sometimes...).
 Firm’s decision depends on:
 Costs of production.
 The degree of competition in the market (if there
are more sellers, more competitive).
Firm’s Choice: Firm’s Costs and
Production Decision
 Firm’s Objective
 The goal of a firm is to maximize profits.
Total Revenue, Total Cost, and Profit

 Profit is the firm’s total revenue minus its total

cost.

Profit = Total Revenue - Total Cost

Total Revenue, Total Cost, and Profit

 Total Revenue
 The amount a firm receives for the sale of its
output. For a competitive firm, TR = P x Q
 Total Cost
 The market value of the inputs a firm uses in
production.
Economic Profit versus Accounting
Profit
 Economic profit is not the same as
accounting profit. When calculating economic
profit, we include all opportunity costs
including hidden (implicit) costs.
 Accounting profit (as it appears on balance
sheets) refers to the firm’s total revenue
minus only the firm’s open (explicit) costs.
Costs as Opportunity Costs

 Example: Costs of Your Textile Factory

 Worker’s wages, electricity, cost of machines, rent
are open (explicit) costs.
 Instead of starting the textile factory, you could
work as an engineer for Rs. 25,000/month. Then
the hidden (implicit) cost of running the textile
factory is Rs.25,000/month.
Economic Profit versus Accounting
Profit
 A firm earns positive economic profit only if
total revenue exceeds both open and hidden
opportunity costs.
 Economic profit is always less than or equal
to accounting profit: A firm could be making
positive accounting profit but at the same
time zero or negative economic profit.
PRODUCTION AND COSTS

 The Production Function

 The production function shows the relationship
between quantity of inputs (Ex: number of
workers) used to make a good and the quantity of
output of that good.
Table : Production Function and Total Cost: Cookie Factory

Fixed Variable

1 20
Copyright©2004 South-Western
Figure : Production Function

Quantity of
Output
(cookies
per hour)
150 Production function
140
130
120
110
100
90
80
70
60
50
40
30
20
10

0 1 2 3 4 5
Number of Workers Hired
Copyright © 2004 South-Western
The Production Function

 Marginal Product
 The marginal product of labor (any input) is the
change in output produced by an additional
worker (additional input).

Output
MPL 
Number of workers
The Production Function

 Diminishing Marginal Product

 Diminishing marginal product: Keeping all other
inputs fixed, marginal product of one of the inputs
declines as the quantity of that input increases.
 Ex: As more and more workers are hired at a firm, each
additional worker contributes less and less to output
because the firm has a fixed amount of machines &
equipment & capacity.
 Another example: a farm with fixed area, machines,
technology, labor. Try planting 100 gr. seeds or 200 gr.
or 300 gr. seeds.
The Production Function

 Diminishing Marginal Product

 The slope of the production function measures the
marginal product of labor.
 When the marginal product of labor declines, the
production function becomes flatter.
Figure 2 Production Function

Quantity of
Output
(cookies
per hour)
150 Production function
140
130
120
110
100
90
80
70
60
50
40
30
20
10

0 1 2 3 4 5
Number of Workers Hired
Copyright © 2004 South-Western
Production Function and Total Cost: Cookie Factory

Fixed Variable

Copyright©2004 South-Western
The Various Measures Of Cost

 Costs of production may be separated into fixed

costs and variable costs.
 Fixed costs are those costs that do not change with
the quantity of output produced. Ex: Rent,
accountant’s wage, some taxes..
 Variable costs are those costs that do change with
the quantity of output produced. Ex: Labor,
Electricity, Transportation,...
Fixed and Variable Costs

 Total Costs
 Total Fixed Costs (TFC)

 Total Variable Costs (TVC)

 Total Costs (TC)

 TC = TFC + TVC
Table : Various Measures of Cost: Osman’s Lemonade Stand

Copyright©2004 South-Western
Fixed and Variable Costs

 Average Costs
 Average costs can be determined by dividing the
firm’s costs by the quantity of output it produces.
 Average cost answers the following question: How
much does it cost to produce one unit of a good
on average?
Fixed and Variable Costs

 Average Costs
 Average Fixed Cost (AFC) =Total Fixed Cost /
Qty
 Average Variable Cost (AVC) =Total Variable
Cost / Qty
 Average Total Costs (ATC) = Total Cost / Qty

 ATC = AFC + AVC

Table :The Various Measures of Cost: Osman’s
Lemonade Stand

Copyright©2004 South-Western
Marginal Cost

 Marginal Cost
 Marginal cost (MC) is the additional cost of
producing the last unit.
 Marginal cost helps answer the following question:
 How much does it cost to produce an additional unit of
output?
Marginal Cost
Osman’s Lemonade Stand

Quantity Total Marginal Quantity Total Marginal

Cost Cost Cost Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
5 6.50 1.10 10 15.00 2.10
Marginal Cost

(change in total cost) TC

MC  
(change in quantity) Q
Figure 4 Osman’s Total-Cost Curves

Total Cost
$15.00 Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Figure 5 Osman’s Marginal-Cost Curve

Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Cost Curves and Their Shapes

 Marginal cost increases as we produce more

and more
 This is due to the property of diminishing marginal
product. See example.
Figure 6 Osman’s Average-Cost and Marginal-
Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Table 2 The Various Measures of Cost: Osman’s
Lemonade Stand

Copyright©2004 South-Western
Cost Curves and Their Shapes

 The average total-cost (ATC) curve is U-shaped.

 At very low levels of output, ATC is high because fixed
cost is spread over only a few units.
 ATC declines as output increases because fixed cost
is spread over more units.
 As output increases further, ATC starts rising because
average variable cost rises faster than the decline in
AFC.
Cost Curves and Their Shapes

 The quantity where the firm achieves the

lowest average cost is at the minimum point
of the U-shaped ATC curve. This quantity is
called the efficient scale of the firm.
Figure 7 Osman’s Average-Cost and Marginal-
Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50 ATC

1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Cost Curves and Their Shapes

 Relationship between Marginal Cost and

Average Total Cost
 Whenever MC is smaller than ATC, ATC is falling.
 Whenever MC is greater than ATC, ATC is rising.
 ATC is like your cumulative GPA and MC is like
your last semester’s grade average.
 As a result, MC crosses ATC at the minimum of
ATC.
Figure 5 Osman’s Average-Cost and Marginal-
Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Cost Curves and Their Shapes

 Summarize Three Important Properties of

Cost Curves
 Marginal cost eventually rises as the quantity of
output increases.
 The ATC curve is U-shaped.
 The MC curve crosses the ATC curve at the
minimum point of ATC.
Costs In The Short Run And In The
Long Run
 For many firms, the division of total costs
between fixed and variable costs depends on
the time horizon being considered.
 In the short-run, some costs are fixed (Ex: rent of
building and machines), some are variable (labor,
energy, raw materials).
 In the long-run, fixed costs become variable costs
(Ex: renting decisions can change, can buy/rent
new machines and equipment). All costs are
variable in the long-run.
Costs In The Short Run And In The
Long Run
 Because many costs are fixed in the short-
run but variable in the long-run, a firm’s long-
run cost curves are different from its short-run
cost curves.
 Figure 7 Average Total Cost in the Short and Long Run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory

$12,000

ATC in long run

0 1,200 Quantity of
Cars per Day
Copyright © 2004 South-Western
 Figure 7 Average Total Cost in the Short and Long
Run
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
Copyright © 2004 South-Western
Costs versus Size of the Firm

 If long-run ATC falls as the quantity of output

increases, the firm has Increasing Returns to Scale
(=Economies of Scale).
 If long-run ATC rises as the quantity of output
increases, the firm has Decreasing Returns to Scale
(=Diseconomies of Scale).
 If long-run ATC stays constant as the quantity of
output increases, the firm has Constant Returns to
Scale.
 Economies and Diseconomies of Scale

 The shape of LRATC depends on the type of

industry.
 Some industries exhibit economies of scale (also
called increasing returns to scale) like cable TV,
GSM providers, electricity, oil extraction, high-tech
goods, etc. Such industries are characterized by
high fixed costs.
 Some industries show decreasing returns to scale
because firms are too big. Coordination problems &
bureaucracy. IBM and General Motors are
examples.
 Short Run & Long Run

© Pilot Publishing Company Ltd.

2005
Reasons for the existence of different
production runs:
Whenever a market situation changes a firm has
to make a new decision  so as to maximize wealth.
At the beginning
 The firm is uncertain if the change in the market
situation is temporary or permanent.
 It will make only the minimal and necessary
change in factors to minimize cost.

© Pilot Publishing Company Ltd.

2005
Reasons for the existence of different
production runs:
Afterwards

Even if the change is certain to be permanent,

 the adjustment in factors should still be slow
and gradual because hasty change involves a
larger cost.

© Pilot Publishing Company Ltd.

2005
Reasons for the existence of different production
runs:

Since adjustment is gradual, according to the

completeness in the adjustment in factors, three
different production runs are classified.

© Pilot Publishing Company Ltd.

2005