Production and Cost

Analysis
Overview
I. Production Analysis
Total Product, Marginal Product, Average
Product
Production Function with one variable
Production Function with two variables

II. Cost Analysis

Total Cost, Variable Cost, Fixed Costs
Cost Relations
Introduction

 In the supply process, people first offer their factors of

production to the market.
 Then the factors are transformed by firms into goods that
consumers want.
 Production - Transformation of factors into goods.
 The firm is an economic institution that transforms factors
of production into consumer goods – it:
 Organizes factors of production.
 Produces goods and services.
 Sells produced goods and services.
The Production Process: The Long Run
and the Short Run
The production process can be divided into the
long run and the short run.
A long-run decision is a decision in which the
firm can choose among all possible production
techniques (In the long run, all inputs are
variable).
A short-run decision is one in which the firm is
constrained in regard to what production
decision it can make (In the short run, some
inputs are fixed).
 Analysis of Production Function:
Short Run
 In the short run at least one factor fixed in supply
but all other factors capable of being changed
 Reflects ways in which firms respond to changes in
output (demand)
 Can increase or decrease output using more or less
of some factors but some likely to be easier to
change than others
 Increase in total capacity only possible in the long
run
 Analysing the Production
Function: Long Run
 The long run is defined as the period of time
taken to vary all factors of production
By doing this, the firm is able to increase its
total capacity – not just short term capacity
Associated with a change in the scale of
production
The period of time varies according to the firm
and the industry
In electricity supply, the time taken to build
new capacity could be many years; for a
market stall holder, the ‘long run’ could be as
little as a few weeks or months!
Production Function
 Production Function
 States the relationship between inputs and outputs
 Function showing the highest output that a firm can produce
for every specified combination of inputs.
 Inputs – the factors of production classified as:
 Land
 Price paid to acquire land = Rent
 Labour
 Price paid to labour = Wages
 Capital – buildings, machinery and equipment
not used for its own sake but for the contribution
it makes to production
 Price paid for capital = Interest
Q = f (K, L, La)
Production
The theory of the firm describes how a firm makes cost-
minimizing production decisions and how the firm’s cost varies
with its output.

 The Production Decisions of a Firm

The production decisions of firms are analogous to the
purchasing decisions of consumers, and can likewise be
understood in three steps:
1. Production Technology
2. Cost Constraints
3. Input Choices
 Production Tables and Production
Functions
 A production table shows the output resulting from various
combinations of factors of production or inputs.
 Total Product: is the aggregate amount of output produced
from all inputs
 Marginal product is the additional output that will be
forthcoming from an additional worker, other inputs
remaining constant.
 Average product is calculated by dividing total output by
the quantity of the inputs.
Marginal and Average Product

MPL = Q/L
 Measures the output produced by the last unit used. Slope of the
production function

APL = Q/L
A Production Table

Number of Total output Marginal Average

workers product product

0 0 4 —
1 4 6 4
2 10 5
3 7
17 6 5.7
4 23 5.8
5
5 28 3 5.6
6 31 1 5.2
7 32 0 4.6
8 32 -2 4.0
9 30 -5 3.3
10 25 2.5
Production with
One Variable Input (Labor)
Output
per
Month D
112

Total Product

60

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

 Production Function and The Law of
Diminishing Marginal Productivity
Diminishing Diminishing
b Diminishing Diminishing
32 marginal absolute
7 marginal absolute
30 returns returns
returns returns
28
26 6 c
24
22 TP 5
20 Increasing

Output per worker

Output

18 4
16 marginal
14 returns
3
12
10
8 2
AP
6
4 1
2
d
0 0
1 2 3 54 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Number of workers Number of workers MP
(a) Total product (b) Marginal and average product
The Law of Diminishing Marginal
Productivity
 MP rises first: the slope of TP curve gets steeper
 MP reaches maximum, where slope of TP curve is steepest
 When diminishing returns set in (MP falls), TP becomes less steep

AP rises at first. It continues rising as long as the

addition to output from the last worker (MP) is
greater than the average output (AP).
The Law of Diminishing Marginal
Productivity
 This continues beyond upper most point of MP (b). Even
though MP is now falling, the AP goes on rising as long as the
MP is still above the AP. Thus, AP goes on rising until a point
and beyond that point (c).
 After c, MP is below AP. New workers add less to output than
the average. This pulls the average down: AP falls
 As long MP is greater than zero, TP will go on rising; new
workers add to total output
 At point d, (when MP touches zero), TP is at a maximum (its
slope is zero). An additional worker will add nothing to output.
 Beyond that TP fall and MP is negative
PRODUCTION WITH TWO VARIABLE INPUTS
 Production in the Long Run

 In the long run, all inputs are variable.

 Isoquants defines combinations of inputs that yield

the same level of product
 Isoquants
 Curves showing all possible combinations of inputs
that yield the same output. The combinations of
inputs (K, L) that yield the producer the same level
of output.

 The shape of an Isoquants reflects the ease with

which a producer can substitute among inputs
while maintaining the same level of output
 PRODUCTION WITH TWO VARIABLE
INPUTS
 IsoquantsProduction with Two Variable Inputs
LABOR INPUT
Capital
Input 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

● isoquant Curve showing

all possible combinations
of inputs that yield the
same output.
PRODUCTION WITH TWO VARIABLE
INPUTS
● isoquant map Graph combining a number of
isoquants, used to describe a production function.
A set of isoquants, or
isoquant map, describes
the firm’s production
function.
Output increases as we
move from isoquant q1 (at
which 55 units per year
are produced at points
such as A and D),
to isoquant q2 (75 units
per year at points such as
B) and
to isoquant q3 (90 units
per year at points such as
C and E).
PRODUCTION WITH TWO VARIABLE
INPUTS
 Diminishing Marginal Returns

Holding the amount of

capital fixed at a particular
level—say 3, we can see
that each additional unit of
labor generates less and
less additional output.
 PRODUCTION WITH TWO VARIABLE
INPUTS
● Marginal Rate of Technical Substitution (MRTS) Amount by
which the quantity of one input can be reduced when one extra
unit of another input is used, so that output remains constant.
MRTS = − Change in capital input/change in labor input
= − ΔK/ΔL (for a fixed level of q)

Like indifference curves,

isoquants are downward sloping
and convex. The slope of the
isoquant at any point measures
the marginal rate of technical
substitution—the ability of the
firm to replace capital with labor
while maintaining the same level
of output.
On isoquant q2, the MRTS falls
from 2 to 1 to 2/3 to 1/3.

(MP ) / (MP ) = −(K / L) = MRTS

L K
 Production in the Long Run
One way to measure returns to scale is
to use a coefficient of output elasticity:
Percentage change in Q
EQ =
Percentage change in all inputs
 If E>1 then IRTS
 If E=1 then CRTS
 If E<1 then DRTS
Optimum Combination of Inputs
A Numerical Example
Bundles of: Labor Machine rental
with C = Rs.30 (Rs.6 per labor hour) (Rs.3 per machine hour)

a 0 10
b 1 8
c 2 6
d 3 4
e 4 2
f 5 0

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

25
The Isocost Line

Capital, K (machines rented)

a
10
b
8
c
6
d
4
e
2
f
0 1 2 3 4 5 6 7 8 9 10
Labor, L (worker-hours employed)
26
Cost Minimization

Capital, K (machines rented)

12
10

8 C = Rs.36

6
W = Rs 6; R = Rs.3;C = Rs.30
4 equ.
2
C = Rs.18

0 1 2 3 4 5 6 7 8 9 10
Labor, L (worker-hours employed)
28
 Class test

For cost of INR 50, make the isocost

schedule and isocost curve in the graph
for labor and capital inputs

Labor cost INR 10 per hour

Captial cost INR 5 per hour
Costs Analysis
 Fixed costs – costs that are not related directly to
production – rent, rates, insurance costs, admin
costs. They can change but not in relation to
output Fixed costs are those that are spent and
cannot be changed in the period of time under
consideration.
 In the long run there are no fixed costs since all costs are variable.
 In the short run, a number of costs will be fixed.

 Variable Costs – costs directly related to variations

in output. Raw materials primarily
 Workers represent variable costs – those that change as output changes
 The Short Run Cost Function

 A firm’s short run cost function tells us the minimum

cost necessary to produce a particular output level.
 For simplicity the following assumptions are made:
 the firm employs two inputs, labor and capital
 labor is variable, capital is fixed
 the firm produces a single product
 technology is fixed
 the firm operates efficiently
 the firm operates in competitive input markets
 the law of diminishing returns holds
Costs

 Total Cost - the sum of all costs incurred in production

 TC = FC + VC
 Average Cost – the cost per unit
of output
 AC = TC/Output
 Marginal Cost – the cost of one more or one fewer units
of production
 MC = TCn – TCn-1 units
 MC = ΔTC/ ΔQ (Note that all marginal costs are variable,
since, by definition, there can be no extra fixed costs as
output rises)
The Short Run Cost Function
The Short Run Cost Function
 Graphically, these results are be depicted in the figure below.

AFC
The Short Run Cost Function

 Important Observations
 AFC declines steadily over the range of production.
 In general, AVC, AC, and MC are u-shaped.
 MC measures the rate of change of TC
 When MC<AVC, AVC is falling
When MC>AVC, AVC is rising
When MC=AVC, AVC is at its minimum
 The distance between AC and AVC represents AFC
Relationship Between Marginal and
Average Costs
 The position of the marginal cost relative to average total cost tells us
whether average total cost is rising or falling.
 To summarize:
If MC > ATC, then ATC is rising.
If MC = ATC, then ATC is at its low point.
If MC < ATC, then ATC is falling.
 Marginal cost curves always intersect average cost curves at the minimum
of the average cost curve.
Average and Marginal Cost Curves

 The average fixed cost curve looks like a child’s slide – it starts out with a
steep decline, then it becomes flatter and flatter.
 It tells us that as output increases, the same fixed cost can be spread out
over a wider range of output.
Market Structure
 Revenue

 Total revenue – the total amount received

from selling a given output
 TR = P x Q
 Average Revenue – the average amount
received from selling each unit
 AR = TR / Q
 Marginal revenue – the amount received
from selling one extra unit of output
 MR = TRn – TR n-1 units
Profit

 Profit = TR – TC
 The reward for enterprise
 Profits help in the process of directing resources to
alternative uses
 Price relating to costs helps a firm to assess profitability in
production
Profit
 Normal Profit – the minimum amount
required to keep a firm in its current line of
production
 Abnormal or Supernormal profit – profit
made over and above normal profit
 Abnormal profit may exist in situations where
firms have market power
 Abnormal profits may indicate the existence of
welfare losses
Profit

Sub-normal Profit – profit below normal profit

Firms may not exit the market even if sub-
normal profits made if they are able to
cover variable costs
Cost of exit may be high
Sub-normal profit may be temporary
Market Structure

 Price-takers
 Price-makers
Revenue Curves

A: Price-Takers (When prices are not affected by

firm output)
AR Curve: Horizontal
MR Curve: Same as AR as one more unit at a
constant price (AR) merely adds that amount
to TR
TR Cure: Straight line- As P is constant, TR will
rise at a constant rate as more is sold
Revenue Curves

 B: Price-makers (When prices are affected by firm output)

 AR Curve: It will be downward sloping curve; in order to sell
more, the firm must lower the price and AR equals price
 MR Curve: When a firm is facing a downward sloping curve, MR
will be less than average revenue and may be even negative
If demand is price elastic: MR is positive
If demand is price inelastic: MR is negative
How to find the profit maximization

1. Using Total Revenue and Total Cost

• Total Profit = TR-TC and the profit maximization will be at a point where the
difference (positive) between them will be the highest
2. Using Average and Marginal Curves
• Find Profit Maximization Output (MR=MC)- WHY
• How much profit at particular output (AR and AC)
Market Structure

 Market structure – identifies how a market is made up in terms of:

 The number of firms in the industry
 The nature of the product produced
 The degree of monopoly power each firm has
 The degree to which the firm can influence price
 Profit levels
 Firms’ behaviour – pricing strategies, non-price competition,
output levels
 The extent of barriers to entry
 Market Structure

Perfect Pure
Competition Monopoly

More competitive (fewer imperfections)

 Market Structure
Perfect Pure
Competition Monopoly

Less competitive
(greater degree of imperfection)
 Market Structure
Pure
Perfect
Monopoly
Competition

Monopolistic Competition Oligopoly Duopoly Monopoly

The further right on the scale, the greater the degree

of monopoly power exercised by the firm.
Market Structure

Importance:
Degree of competition affects the consumer –
will it benefit the consumer or not?
Impacts on the performance and behaviour of
the company/companies involved
 How to Characterize Market
Structure?
• Number of Sellers and Buyers
• Product differentiation and its degree
• Conditions of entry and exit
• Control over prices
 What are Different Market Models?
Market Model No. of Sellers Nature of Entry Degree of
Product Barriers Control
to Sellers Over Price.

1. Perfect Large, small, Homogeneous None None

competition independent

No close Insurmoun
2. Monopoly One Considerable
substitutes table

Many, small Differentiated,

3. Monopolistic
partially but very close None Some
Competition
independent substitutes

Few, Homogeneous
4. Oligopoly interdepende Or Substantial Some
nt Differentiated
Perfect Competition
Perfect Competition

 Characteristics:
Large number of firms
Products are homogenous (identical) – consumer has
no reason to express a preference for any firm
Freedom of entry and exit into and out
of the industry
Firms are price takers – have no control
over the price they charge for their product
Each producer supplies a very small proportion
of total industry output
Consumers and producers have perfect knowledge
about the market
Perfect Competition

 There are many sellers.

 There are so many firms that no firm is able to influence the
market price.
 Each firm is very small relative to the size of the market.
 The products sold by the firms in the industry are identical.
 There is nothing to differentiate the products sold by the firms.
Consumers are indifferent to which firm they buy the good from.
That is, the products of the firms are perfect substitutes for one
another.
Perfect Competition

 Entry into and exit from the market are easy, and there are
many potential entrants.
 There are no huge economies of scale to achieve to be
competitive.
 There are no legal obstacles to entry—no regulation or licensing
required.
 Other firms cannot prevent entry.
 Firms can stop producing and can sell or liquidate the businesses
easily.
 Buyers (consumers) and sellers (firms) have perfect information.
Price Taker

 A firm in a perfectly competitive market is said to be a price

taker because the price of the product is determined by market
supply and demand, and the individual firm can do nothing to
change that price.
 It cannot charge more than the market price, and
 It will not charge less. (Why take less for your product when you
can get more?)
 The result is that the individual firm perceives the demand curve
for its product as being perfectly horizontal.
 The Competitive Industry and Firm
1. The intersection of the market supply 3. The typical firm can sell all it
and the market demand curve… wants at the market price…

Price per Market Price per Firm

Ounce Ounce
S

Rs 400 Rs400
Demand
Curve Facing
D the Firm

Ounces of Gold per Day Ounces of Gold per Day

2. determine the equilibrium 4. so it faces a horizontal
market price demand curve
Back
Profit Maximization

 Profit is maximized when MR=MC.

 If the cost of producing one more unit is less than the revenue it
generates, then a profit is available for the firm that increases
production by one unit.
 If the cost of producing one more unit is more than the revenue
it generates, then increasing production reduces profit.
 Thus the firm will stop increasing production at the point at which
it stops being profitable to do so—when MR=MC.
 Graphically this occurs where the MC curve cross the MR curve
from below.
 At this output the firm

Perfect Competition
is making normal profit.
This is a long run
equilibrium position.

Diagrammatic representation Given

ThetheMC assumption
is the cost of of profit
maximisation,
producing additional
the firm produces
Cost/Revenue
MC at an
(marginal)
(Q1).
output where
falls
This
at first
units MC
output (due
of output.
level
= MR It
to the
is alaw of
fraction
diminishing
of the total
returns)
industry
then rises
supply.
as output rises.
AC

The average cost curve is the

standard ‘U’ – shaped curve.
MC cuts the AC curve at its P = MR = AR
lowest point because of the
mathematical relationship
between marginal and average The industry price is
values. determined by the demand
and supply of the industry
as a whole. The firm is a
very small supplier within
the industry and has no
Q1 Output/Sales control over price. They will
sell each extra unit for the
same price. Price therefore
= MR and AR
Monopoly
What is a Monopoly?

 A monopoly is a market structure in which there is a

single supplier of a product.
 The monopolist:
 May be small or large.
 Must be the ONLY supplier of the product.
 Sells a product for which there are NO close substitutes.
(The greater the number of close substitutes for a firm’s
products, the less likely it is that the firm can exercise
monopoly power.
The Creation of Monopolies

 Monopolies often arise as a result of barriers to entry.

 Barrier to entry: anything that impedes the ability of
firms to begin a new business in an industry in which
existing firms are earning positive economic profits.
There are three general classes of barriers to entry:
 Economies of scale and economies of scope
 Actions by firms to keep other firms out
 Government (legal) barriers
The Demand Curve
Facing a Monopoly Firm

 In any market, the industry demand curve is downward-sloping. This is the

result of the law of demand.
 The monopolist is the industry because it is the sole producer.
 Therefore the monopolist confronts a downward-sloping demand curve.
The industry demand curve is the firm’s demand curve.
Marginal Revenue

 Recall that the marginal revenue (MR) is:

TR
MR =
Q
 MR is less than price for a monopoly firm.
 The MR is less than price and declines as output
increases because the monopolist must lower the
price in order to sell more units (because the
demand curve slopes downward).
Average Revenue

 Whenever MR is greater than AR, AR rises.

 Whenever MR is less than AR, AR falls.
 Average revenue is:
P Q
AR = =P
Q
 Note that the AR is the same as price. In fact, the AR curve is
the demand curve.
 With a downward-sloping demand curve, prices fall as output
increases. This means that AR falls.
 MR must always be less than AR.
Profit Maximization

 The monopolist will not set the price arbitrarily high.

 For the monopolist, the profit-maximizing price still corresponds to the point
where MR=MC.
 The monopolist’s market power will allow the firm to achieve above-normal
profits.
 AR (D) curve for a monopolist

Monopoly likely to be relatively price

inelastic. Output assumed to
be at profit maximising output
(note caution here – not all
monopolists may aim
for profit maximisation!)
Costs / Revenue

MC
£7.00 This is both the short run and
long run equilibrium position
AC for a monopoly
Monopoly
Profit
£3.00 Given the barriers to entry,
the monopolist will be able to
exploit abnormal profits in the
long run as entry to the
market is restricted.

MR AR
Output / Sales
Q1
70 E-Content on Price determination

https://www.youtube.com/watch?v=_NiAyOsCoWs

3/5/2025
Monopolistic Competition
Monopolistic Competition

Relatively Large Number of Buyers and Sellers

Differentiated Products
Sellers have some element of control over price
Easy Entry and Exit
Small Market Shares
No Collusion
Independent Action
Don’t confuse monopolistic competition with monopoly
Main Attributes of Monopolistic
Competition
 Many Sellers
 Product differentiation
 Free Entry and Exit
 Examples of Monopolistic Competition

 Books
 Furniture
 Computer games
 Bottled water
 Plumbers/electricians/local builders
 Health clubs
 Estate agents
 Novels
 Movies
The firm produces
Monopolistic Competition
where MR = MC (profit
maximising output). At
If the firm produces Q1
this output level,
and sells each unit for
AR>AC and the firm
£1.00 on average with
makes abnormal profit
the cost (on average) for
(the grey shaded area).
each unit being 60p, the
firm will make 40p x Q1
in abnormal profit.
MC Marginal Cost and
Cost/Revenue
Average Cost will be
the same shape.
However, because
AC the products are
£1.00 differentiated in
some way, the firm
will only be able to
Abnormal Profit sell extra output by
lowering price.
£0.60
This is a short run
equilibrium position for a
firm in a monopolistic
market structure.

MR D (AR) Since the additional

revenue received from
Q1 each unit sold falls, the
The demand curve Output / SalesMR curve lies under
facing the firm will be
the AR curve.
downward sloping and
represents the AR
earned from sales.
Monopolistic Competition

 In the long-run,
➢ Profits in the short run may attract other competitors
➢ Increase in supply of product in the industry will reduce demand of firms’
output demand
➢ Due to higher price elasticity of demand, the output and price of out will
fall whereas that of industry output will rise
➢ There will be normal profit as price is equal to average cost
➢ But, price is greater than marginal cost: reflects some monopoly power
 Monopolistic Competition and Perfect
Competition

Perfect Competition Monopolistic Competition

Rs Rs

MC AC MC AC

P
PC
AR = MR

MR

Qpc Quantity QMC Quantity

Oligopoly
Oligopoly
 An oligopoly is a market structure characterized
by:
 Few firms
 Either standardized or differentiated products
 Difficult entry
 Some control over the price
 All the firms may be the same size, or a few large
firms may dominate the industry while coexisting
with several small firms.
 A key characteristic of oligopolies is that each
firm can affect the market, making each firm’s
choices dependent on the choices of the other
firms. They are interdependent.
Oligopoly

 The importance of interdependence is that it leads

to strategic behavior.
 Strategic behavior is the behavior that occurs when
what is best for A depends upon what B does, and
what is best for B depends upon what A does.
 The sellers have to consider the response of their
rivals while choosing price and output
Examples of Oligopolistic Competition

 Supermarkets
 Banking industry
 Steel
 Chemicals
 Oil
 Automobiles
 If the firm seeks to lower its price
to gain a competitive advantage,
The firm therefore, effectively its rivals will follow suit. Any

Oligopoly
faces gains it makes will quickly be lost
a ‘kinked demand curve’ forcing it and the % change in demand will
to maintain a stable or rigid be smaller than the % reduction
pricing structure. Oligopolistic in price – total revenue would
firms may overcome this by again fall as the firm now faces a
Price
engaging in non-price
competition.
relatively inelastic demand curve.
The kinked demand curve - an explanation for price stability?

The principle of the kinked

demand curve rests on the
principle that:
a. If a firm raises its price, its
rivals will not follow suit
b. If a firm lowers its price, its
£5 rivals will all do the same

Total D = elastic Assume the firm is charging a

Revenue B price of £5 and producing an
output of 100.
Total Revenue A Kinked D Curve
If it chose to raise price above £5,
its rivals would not follow suit and
Total Revenue B the firm effectively faces an
elastic demand curve for its
product (consumers would buy
from the cheaper rivals). The %
change in demand would be
100 greater than the % change in
Quantity
price and TR would fall.
D = Inelastic
Type of Oligopoly

 Pure or Perfect
 One of the types of oligopoly is the perfect oligopoly. This occurs when the product is
homogeneous in nature (e.g. Aluminum or milk industry).
 Differentiated or Imperfect
 Another of the types of oligopoly is an imperfect oligopoly. This occurs when product
differentiation exists (e.g. Talcum powder industry).

 Open and Closed

• Open – New firms can enter the market and compete with existing firms.
• Closed – Entry into the market is restricted.
Types of Oligopoly

 Collusive and Competitive

• Collusive – This occurs when few firms come to an understanding with respect to the price
and output of the products.
• Competitive – This occurs when there is a lack of understanding between the firms and
they invariable compete with each other.
 Partial or Full
• Partial – This occurs when one large firm dominates the industry. Also, this firm is the
price leader.
• Full – This occurs when there is no price leadership in the market.
85 Class Test

 Explain the difference in the price determination in monopolistic

competition and perfect market competion

3/5/2025