OHT 0.

Principles of
Business Economics

Joseph G. Nellis
Professor of International Management Economics
Cranfield School of Management
Cranfield University

David Parker
Professor of Business Economics and Strategy
Aston Business School
Aston University

© Pearson Education Limited 2002

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 0.2
Contents

1 Business economics: an overview

2 The analysis of consumer demand
3 The analysis of production costs
4 Analysis of the firm’s supply decision
5 Demand, supply and price determination
6 Analysis of perfectly competitive markets
7 Analysis of monopoly markets
8 Analysis of monopolistically competitive markets
9 Oligopoly
10 Managerial objectives and the firm
11 Understanding competitive strategy
12 Understanding pricing strategies
13 Understanding the market for labour
14 Understanding the market for capital
15 Understanding the market for natural resources
16 Government and business
17 Business and economic forecasting
18 Business economics - a checklist for managers

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.1

CHAPTER 1
Business economics: an overview
• Microeconomic Environment
– deals with the operation of the firm in its immediate market
– involves determination of prices, revenues, costs,
employment, etc

• Macroeconomic Environment
– deals with the general economic conditions of the larger
economy of which each firm forms a part.
– involves the impact of political, legal and economic
decisions, both nationally and internationally.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.2

Figure 1.1 The business environment

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Learning outcomes OHT 1.3A

This chapter will help you to:

• Understand the core terms and concepts used in

business economics.

• Appreciate the nature of a firm’s production

decisions with respect to what to produce, how
to produce and for whom to produce.

• Employ economic reasoning when making

choices in the use of resources and to recognise
the importance of diminishing returns.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.3B

• Comprehend the nature of marginal analysis in

the context of business and consumer
decisions.

• Recognise the different objectives which

different firms may pursue and the consequent
impact on price and output decisions.

• Distinguish between the short run and long run

in business economics.

• Understand the nature of different competitive

structures in market economies ranging from
perfectly competitive to monopoly situations.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.3C

• Analyse the external environment and internal

capabilities of a firm using core techniques in
business economics and thereby understand the
forces shaping the firm’s competitive
environment.

• Appreciate the choice of generic strategies

facing firms in terms of cost leadership,
differentiation and focus options.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.4A

Basic concepts in business economics

There are a number of basic concepts which lie at the heart

of business economics and managerial decision-making.The
most important of these are the following:

• Resource allocation.

• Opportunity cost.

• Diminishing marginal returns.

• Marginal analysis.

• Business objectives.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.4B

Basic concepts in business economics

• Time dimension.

• Economic efficiency and equity.

• Risk and uncertainty.

• Externalities.

• Discounting.

• Property rights.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.5
Resource allocation

Economics is concerned with the efficient allocation of scarce

resources. When purchasing raw materials,employing labour
and undertaking investment decisions,the manager is involved
in resource allocation.Decisions need to be made at three
levels, namely:

• What goods and services to produce with the available

resources,

• How to combine the available resources to produce

different types of goods and services;and

• For whom the different goods and services are to be

supplied.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.6

Figure 1.2 The production decision

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.7

The opportunity cost of any activity is what we give up

when we make a choice.In other words,it is the loss of the
opportunity to pursue the most attractive alternative given
the same time and resources.

A production possibility curve shows the maximum output

of two goods or services that can be produced given the
current level of resources available and assuming
maximum efficiency in production.

The concept of diminishing marginal returns refers to the

situation whereby as we apply more of one input
(e.g.labour) to another input (e.g.capital or land),then after
some point the resulting increase in output becomes
smaller and smaller.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.8

Figure 1.3 Production possibility curve

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.9

Marginal Analysis

• Marginal utility is the amount by which consumer well-being

or total utility changes when the consumption of a good or
service changes by one unit.

• Marginal product is the amount by which total product

changes due to a one unit change in the amount of input
used.

• Marginal revenue is the change in total revenue which

results from increasing the quantity sold by one unit.

• Marginal cost is the change in total cost which results from

increasing the quantity produced by one unit.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.10
Business Objectives

• Profit maximisation

• The achievement of personal goals,involving personal

security and reward,status, degree of discretionary
power,etc.

• Growth targets for the company in terms of scale of

output,market share,geographical market,annual
extension of physical capacity,size of departments or
size of the labour force,etc.

• Maximisation of sales revenue.

• Pursuit of the interests of all stakeholders including

employees,customers,suppliers, etc.as well as
shareholders.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.11

Time dimension

The short run represents the operating period of

the business in which at least one factor of
production is fixed in supply.

The long run represents the planning horizon for

the business in which all factors of production may
be varied.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.12
Discounting

The concept of discounting is concerned with the fact that

costs and benefits arising in future years are worth less to us
than costs and benefits arising today.

Discounting formula
St
NPV =  1  r  t

where NPV is the net present value of the cash flow over the
life of the project, S is the future sum, r is the rate of interest
or discount rate, and t the number of years elapsing before
the future sum is received.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.13

The competitive environment & market

structure

• Perfectly competitive markets.

• Monopolistically competitive markets.

• Oligopolistic competition.

• Monopoly.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.14

Defining the nature of the market

• The number and size distribution of the buyers

and sellers in the market.

• The degree of product differentiation that

exists.

• The severity of the barriers to entry and exit

that face potential new entrants to the market.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.15

Figure 1.4 Characteristics of markets

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.16

Porter 痴 Five Forces Model

• The bargaining power of buyers 防 how much leverage

buyers have in determining the price.

• The bargaining power of (input) suppliers 釦 the competition

among suppliers which determines the price of inputs to the
firm.

• The threat from potential new entrants into the market 釦 the
degree of ‘market contestability 弛 or the extent to which firms
are able to enter the market and contest for consumers.

• The threat from substitute products or services 貌 e.g. mobile

telephones for fixed-line services.

• The degree of competition (rivalry)in the market.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.17

Figure 1.5 Forces shaping the competitive environment

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.18

Cost positioning of the firm

• Cost leadership.

• Differentiation.

• Focus.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.19

Figure 1.6 Strategy and the competitive environment - an overview

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.20A

Key learning points

• Microeconomics deals with the operation of the firm in

its immediate market, involving the determination of its
prices, revenues,costs and input employment levels.

• Macroeconomics is concerned with the interactions in

the economy as a whole of which each firm forms a part.

• Resource allocation is concerned with decisions

regarding what, how , and for whom to produce.In a
market economy the price mechanism is the major
determinant of these decisions.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.20B
Key learning points

• The opportunity cost of any activity is the loss of the

opportunity to pursue the most attractive alternative
given the same resources.

• A production possibility curve shows the maximum

output that can be produced given the current level of
resources available and assuming maximum
efficiency in production.

• Diminishing marginal returns refers to the situation

whereby,as we apply more of one input to a fixed
amount of another input,then after some point the
resulting increase in output becomes smaller and
smaller.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.20C

Key learning points

• Marginal analysis reminds us that most choices involve relatively

small (incremental)increases or decreases in production (or
consumption).

• The short run represents the operating period of the business in

which at least one factor of production is fixed in supply.

• The long run represents the planning horizon of the business in

which all factors of production may be varied in order to alter the
scale of production.

• Externalities represent wider outcomes of the market mechanism

and arise when some of the benefits or costs of consuming a good
or service spill over to others.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.20D
Key learning points
• The concept of discounting is concerned with the fact that costs
and benefits arising in future years are worth less to us than costs
and benefits arising today.

• Property rights are the rights to own,benefit from and transfer

assets (tangible or intangible)in market economies

• Perfectly competitive markets are made up of numerous small

sellers each offering identical products with complete freedom of
entry and exit. Each firm is a price-taker rather than a price-
maker

• In monopolistically competitive markets there are many sellers

but there is also some degree of product differentiation.This form
of market structure is also sometimes referred to as imperfectly
competitive.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.20E
Key learning points
• Oligopolistic competition arises where there exists a small
number of relatively large firms which are constantly aware of
each other’s actions and reactions regarding price and non-price
competition.

• A monopoly exists where the market is supplied by one firm

producing a product for which there is no close substitute. A
monopolist, therefore, tends to be a price-maker, in that the firm
is able to set a price in the face of little or no competition. In
practice, the term monopoly is often applied also to markets that
are dominated by one firm.

• Porter 痴 Five Forces Model describes the competitive

environment as being determined by the power of buyers, the
power of suppliers, the threat from potential new entrants, the
threat from substitutes and the degree of rivalry in the market.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 1.20F

Key learning points

• The external environment of business is determined by

changes in political, economic, social and technological
factors, i.e.PEST influences.

• A SWOT analysis involves consideration of a firm’s internal

strengths and weaknesses in the context of the opportunities
and threats which it faces.

• Generic strategies refer to the choice between pursuing a

market strategy based on cost leadership, differentiation or
focus .

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.1

CHAPTER 2.
The analysis of consumer demand
• The market demand curve.
• Utility and the demand curve.
• Consumer surplus.
• The determinants of demand.
• The classification of goods.
• Concepts of elasticity.
• The relationship between price elasticity and
sales revenue.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.2A
Learning outcomes

This chapter will help you to:

• Understand why changes in price affect consumer demand and, in
particular, why demand curves are normally downward sloping, i.e.
the law of demand.

• Understand why demand curves may shift in response to changes

in various factors, other than price, which impact upon demand
(known as the conditions of demand).

• Analyse the nature of the relationship between marginal utility and

the demand curve for any product or service.

• Appreciate the meaning and importance of consumer surplus in the

context of pricing strategies.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.2B
Learning outcomes
• Interpret the relative importance of income and
substitution effects on demand when the price of a
good or service changes.

• Classify goods and services according to how

demand responds to changes in price and income,
giving rise to the terms normal, inferior, Giffen and
Veblen goods or services.

• Calculate price, cross-price and income elasticities of

demand and interpret the significance of the results.

• Appreciate the relationship between price elasticity,

marginal revenue and total revenue arising from the
sale of goods or services.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.3
The market demand curve

A consumer’s demand curve relates the amount

the consumer is willing to buy to each conceivable
price for the product.

The market demand curve for a good or service is

derived by summing the individual demand curves
of consumers horizontally for any given price.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.4

Figure 2.1 Derivation of the market demand curve

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.5
The law of demand

In general there is a central law of demand, which

states that there is an inverse relationship
between the price of a good and the quantity
demanded assuming all other factors that might
influence demand are held constant .

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.6

Figure 2.2 Linear and non-linear demand relationships

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.7
Utility and the demand curve
The term utility describes the pleasure, satisfaction or
benefit derived by a person from the consumption of goods
or services.

Marginal utility is the addition to total utility as a consumer

purchases each extra unit of a good or service.

Consumer equilibrium

MU a MU b MU z
 ... 
Pa Pb Pz
where
MU =marginal utility
P =price
a ,b ,...,z =various goods and services consumed
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Consumer surplus OHT 2.8
Consumer surplus is the excess of the price which a person would
be willing to pay rather than go without the good, over that which he
or she actually does pay.

Marginal utility and water shortages

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.9A

Determinants of demand
• The ‘own price 弛 of the good itself (P0 ).

• The price of substitute goods (Ps ).

• The price of complementary goods (Pc ).

• The level of advertising expenditure on the

product in question, a , as well as on
complementary and substitute products, b,...,
z (denoted Aa,b,…..z).

• The level and distribution of consumers

disposable incomes (Yd ),i.e.income after
state
J. Nellis and D. Parker, direct
Principles of Business taxes
Economics. ©and benefits.
Pearson Education Limited 2002.
 OHT 2.9B
Determinants of demand
• Wealth effects (W )caused by, for example, stock
market booms, rising house prices, windfall gains,etc.

• Changes in consumers 稚 tastes and preferences (T ).

• The cost and availability of credit (C ).

• Consumers 弾 expectations concerning future price

rises and availability of the product (E ).

• Changes in population (POP),if we are examining the

total market demand.

Demand function

Qd  f  P0 , Ps , Pc , Aa ,b...z , Yd ,W , T , C , E , POP 
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.10

Figure 2.3 Shift in the demand curve

When the own price of a product changes, the outcome is a movement along the
demand curve and when any other determinants of demand change, there will
be a shift of the demand curve (either to the left, showing a fall in the quantity
demanded, or to the right, showing a rise) depending on the nature of the
change.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.11

Figure 2.4 Examples of changes in the conditions of demand (demand curves

DD refer to the good in question)
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.12
Classification of products

• Normal products.

• Inferior products.

• Giffen products.

• Veblen products.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.13
Classification of products
Normal products
Goods and services may be classified as ‘ normal products 段 if the quantity
demanded rises as incomes rise and falls as incomes fall.

Inferior products
Certain products are classified as ‘inferior’ because the demand for them falls as
incomes rise (and vice versa).

Giffen products
A special case of the inferior product arises when,as price rises ,more of the
good in question is bought 睦 resulting seemingly in an upward sloping demand
curve,contrary to the normal law of demand.

Veblen products
It has been suggested that ‘ luxury type 恥 products also display perverse price
謀 demand relationships,though for different reasons to that of the Giffen
products case.These are sometimes referred to as Veblen products,

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.14
Concepts of elasticity
• Price elasticity of demand.This measures the responsiveness of
quantity demanded of a product to changes in its ‘ own price. For
example,if the price of alcohol increases,what happens to the quantity of
alcohol demanded?

• Cross-price elasticity of demand.This measures the responsiveness of

quantity demanded to changes in the prices of other goods (both
complements and substitutes).For example,if the price of one brand of
coffee rises,what happens to the demand for another coffee brand?Or,if
the price of petrol falls,what happens to the demand for cars?

• Income elasticity of demand.This measures the responsiveness of

demand to a change in the income of consumers.For example,if incomes
are rising,on average, by $50 per month,what will happen to the demand
for housing?

Coefficient of elasticity = Percentage change in quantity demanded

Percentage change in the relevant variable

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.15

Price elasticity of demand

E d = Percentage change in quantity demanded

Percentage change in the price of the product

Two different types of price elasticity (E d )can be

calculated,as follows:

• Arc elasticity of demand.

• Point elasticity of demand.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Arc elasticity of demand
OHT 2.12
 Q2  Q1  / 1  Q2  Q1 
2
Arc Ed =
 P2  P1  / 1  P2  P1 
2


 Q2  Q1  x
 P2  P1 
 P2  P1   Q2  Q1 

Figure 2.5 Arc elasticity of demand

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.17

Point elasticity of demand

Ed 
 Q2  Q1  / Q1

 Q2  Q1  P1
x
Point
 P2  P1  / P1  P2  P1  Q1

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.18

Degrees of elasticity
• Products with a price elasticity of demand
of less than 1 are said to have a relatively
inelastic demand with respect to price 釦
they are said to be price inelastic .

• Products with a price elasticity of demand

greater than 1 are said to have a relatively
elastic demand 釦 they are said to be price
elastic .

• Products with a price elasticity of demand

exactly equal to 1 are said to have a unit
(or unitary)elasticity of demand.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.19

Figure 2.6 Degrees of elasticity of demand

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.20

Cross-price elasticity of demand

Cross-price Ed = Percentage change in the demand for A

Percentage change in the price of B

The terminology regarding the degree of cross-price

elasticity (ignoring the sign)is the same as for price
elasticity,namely:

• 1 =unit cross-price elasticity.

• Less than 1 =inelastic cross-price elasticity.
• Greater than 1 =elastic cross-price elasticity.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.21A
Income elasticity of demand
Income Ed = Percentage change in demand
Percentage change in real income

Inferior goods
These are goods of which consumers buy less when real
incomes rise.The value of income elasticity is,
therefore,negative.Examples might be potatoes,
unbranded clothing,cheap package holidays,etc.

Normal goods
These are the most common goods with demand
generally rising as real income rises. They can
themselves be further subdivided into two categories:
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.21B

Necessities .These are goods and services which

exhibit a positive income elasticity of demand,though the
value will tend to be less than 1. Articles such as basic
foodstuffs and ordinary day-to-day clothing fall into this
category.Consumers will purchase a certain amount of
these goods at very low levels of income,but they will
tend for any given percentage increase in real income to
increase their spending on the goods by a smaller
proportion.

Luxuries . At very low income levels,nothing will be

spent on these but,once a certain threshold income level
is reached,the proportionate rise in demand for luxury
goods is greater than the proportionate rise in real
income,e.g.foreign holidays,dining out and DVD players.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 The relationship between price elasticity OHT 2.22
and sales revenue
Total revenue = price x quantity sold
TR = P x Q

Figure 2.7 Demand and total revenue

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.23
Price elasticity and total revenue

• With a price inelastic demand:

(a)an increase in price causes a reduction in
quantity demanded,but total revenue increases;

(b)a fall in price causes an increase in quantity

demanded,but total revenue earned declines.
• With a price elastic demand:
(a)an increase in price causes such a large fall in
quantity demanded that total revenue falls;

(b)a reduction in price causes such a large increase

in the quantity demanded that the total revenue
rises.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.24

Marginal revenue
Marginal revenue (MR) is defined as the change in ()
total revenue (TR) as a firm sells one more or one less
unit of its output (Q ).

TR
MR =
Q
Average revenue (AR)is the total revenue (TR) divided by
output (Q )or the revenue earned on average for each
unit sold.

AR =
TR
Q
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.25

Figure 2.8 Elasticity, marginal revenue and total revenue

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.26A

Elasticity, marginal revenue and total revenue - key

relationships
• Marginal revenue falls as output rises. Since the demand curve
slopes downwards, the addition to total revenue from producing
and selling extra units declines.

• Average revenue exceeds marginal revenue. When the

demand curve is downward sloping,the marginal revenue from
selling one more unit falls faster than the average revenue from
selling the total output.

• The marginal revenue curve declines at twice the rate of the

demand (average revenue)curve. Hence, the marginal revenue
curve cuts the horizontal axis at a point midway between the origin
and point C in Figure 2.8.A proof of this mathematical relationship
is given in Appendix 2.2 at the end of the chapter.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.26B

Elasticity, marginal revenue and total revenue -

key relationships
• When total revenue is increasing,marginal revenue is
positive. This results from the fact that demand is elastic
between points A and B on the demand curve DD in Figure
2.8.

• When total revenue is falling,marginal revenue is

negative.A negative marginal revenue results from demand
being inelastic between points B and C in Figure 2.8.

• Total revenue is maximised when marginal revenue is

zero which occurs when the price elasticity is
unitary.Therefore,further attempts to increase total revenue
by lowering price below P *will fail because the sales
volume will not increase sufficiently to compensate for the
price fall.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27A
Key learning points

• A demand curve relates the amount that consumers are

willing to buy to each conceivable price for the product.

• In general, the law of demand states that there is an

inverse relationship between the price of a good and the
quantity demanded,assuming all other factors that might
influence demand are held constant (i.e.ceteris paribus ).

• Utility theory helps explain why consumers buy more of

something the lower its price.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27B
Key learning points
• Marginal utility is the addition to total utility as a consumer
purchases each extra unit of a good or service.

• The law of diminishing marginal utility is concerned with

the tendency for marginal utility to fall as more units of a
good or service are consumed at any given time.

• Consumer equilibrium describes how consumers

maximise their total utility by distributing expenditure so
that the ratio of marginal utilities for all the goods and
services they consume,at any given time, is equal to their
relative prices.

• Consumer surplus is reflected by the excess of the price

which a person would be willing to pay rather than go
without the good,over that which he or she actually
does pay.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27C

• When the own price of a good changes,the outcome is a

movement along the demand curve and when any other
determinant or condition of demand changes, there will be a shift
of the demand curve .

• The impact of a change in price on quantity demanded is made

up of two distinct effects:an income effect and a substitution
effect. The income effect arises from the fact that as the own
price of a good falls,consumers are in effect better off and hence
able to buy more of the good.The substitution effect reflects the
fact that as the price falls, the product becomes relatively cheaper
than alternatives and hence there will be a tendency for
consumers to substitute more of it for other goods.

• Goods and services are classified as normal products if the

quantity demanded rises as (real)incomes and falls as incomes
fall.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27D

• In contrast, goods and services are classified as inferior

products if the quantity demanded falls (rises)as incomes
rise (fall).

• A Giffen product is a special case of an inferior product and

has what appears to be an upward sloping demand
curve,contrary to the normal law of demand,because the
income effect outweighs the substitution effect.

• A Veblen product also has seemingly an upward sloping

demand curve because of ‘snob’ effects, i.e.it is demanded
because it is expensive and therefore exclusive. Many luxury
products fit into this category.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27E

The (own) price elasticity of demand for a product may be

defined in general terms as:

Ed = Percentage change in quantity demanded

Percentage change in the price of the product

The value of Ed may be calculated on the basis of a

movement along a section of the demand curve,giving rise
to a value of the arc elasticity .This is expressed on the
basis of the average quantity and average price,as follows:

Arc Ed
 Q2  Q1  x  P2  P1 
 P2  P1   Q2  Q1 
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27F

• For very small price changes,elasticity may be calculated with

reference to a single point on the demand curve,giving rise to a
value of the point elasticity ,as follows:

Point Ed =
 Q2  Q1  x P1
 P2  P1  Q1
• Products with a price elasticity of demand of less than 1 (in
absolute terms)are said to have a relatively inelastic demand
with respect to price 釦 hey are said to be price inelastic .In
this case,total sales revenue will tend to rise (fall)as price rises
(falls).

• Products with a price elasticity of demand greater than 1 (in

absolute terms)are said to have a relatively elastic demand 釦
they are said to be price elastic. In this case,total sales
revenue will tend to fall (rise)as price rises (falls).

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27G
• Products with a price elasticity of demand equal to 1 (in
absolute terms)are said to have a unit or unitary elasticity of
demand. In this case, total sales revenue will remain
unchanged as price rises or falls.

• The value of price elasticity of demand can range from infinity

(in absolute terms)to 0. A product with a perfectly inelastic
demand will have a value of Ed equal to 0 at every price,while
a product with a perfectly elastic demand will have a value of
Ed equal to infinity at a particular price.

• Cross-price elasticity of demand indicates the

responsiveness of the demand for one product to changes in
the prices of other goods and services and may be calculated
as:

Cross-price Ed = Percentage change in the demand for A

Percentage change in the price of B
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27H

• Substitutes will tend to have a positive value for cross-price

Ed ,while complements will tend to have a negative value.

• Income elasticity of demand measures the responsiveness

of quantity demanded with respect to (real) income variations
as follows:

Income Ed = Percentage change in quantity demanded

Percentage change in real income
Necessities exhibit a positive income elasticity of demand
though the value will tend to be less than 1. In contrast,
luxuries will tend to have an income elasticity of demand
greater than 1.

• Marginal revenue is defined as the incremental change in

total revenue and is usually measured as a firm sells one
more or one less unit of its output.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27I

• The marginal revenue curve declines at twice the rate of the

demand (average revenue)curve.

• When total revenue is increasing (decreasing),marginal

revenue is positive (negative)such that total revenue is
maximised when marginal revenue is zero .This occurs
when the price elasticity of demand is equal to 1.

• An indifference curve shows all combinations of two goods or

services that yield the same level of utility or satisfaction so that
the consumer is indifferent between each combination.

• The slope of the budget line is determined by the relative

prices of the two goods or services and the position of the line
by the consumer 痴 income.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.27J

• Together, the indifference curve mapping and the

budget line determine the combination of the goods or
services that the consumer will choose to buy.
• Indifference curve analysis can be used to show the
income and substitution effects of a price change.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Appendix 2.1 Indifference curve analysis OHT A2.28
The meaning of indifference curves
An indifference curve details all combinations of two goods or
services that yield the same level of utility or satisfaction.

Figure A2.1 A typical indifference curve

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT A2.29

Figure A2.2 An indifference curve map

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
The budget constraint OHT A2.30
Budget constraint
PxQx + PyQym

The slope of the budget line is determined by the relative prices of the two goods
and the position of the line by the consumer’s income.

Figure A2.3 The budget constraint

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT A2.31

Figure A2.4 Illustrating the effects of price and income changes

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT A2.32

Figure A2.5 Utility maximisation with a budget constraint

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT A2.33

Figure A2.6 Substitution and income effects of a price change for a normal good
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT A2.34

Figure A2.7 Income and substitution effects for an inferior good

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.35A

Appendix 2.2 Marginal revenue and the demand

curve

Proof that the marginal revenue curve declines at twice the rate of
the demand curve

The equation of a linear demand relationship is:

P = a - bQ (2.1)

Total revenue (TR) = P x Q

Total revenue (TR) = (a - bQ) x Q (substituting for P = a - bQ)

Total revenue (TR) = aQ - bQ2

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 2.35B

Appendix 2.2 Marginal revenue and the demand curve

Marginal revenue (MR) is defined as the change in total revenue with

respect to a unit change in sales. In terms of differential calculus:

TR TR
MR  
Q Q

=   aQ  bQ 2
 (substituting for TR = aQ - bQ2)
Q

= a - 2bQ 2.2)

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.1

CHAPTER 3.
The Analysis of production costs
3.1
• The production function.
• Variable costs versus fixed costs.
• Production decisions in the short run and long run.
• Diminishing returns in production.
• The relationship between production and costs.
• Maximising profit and the production decision.
• Economies and diseconomies of scale.
• Economies of scope.
• Organising production.
• The experience curve.
• Product and process innovation.
• The relationship between short-run and long-run costs.
• Optimal scale and X-inefficiency.
• The importance of information and knowledge.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.2A
Learning outcomes
This chapter will help you to:
• Understand the relationship between the firm’s factor inputs,
its outputs and its costs of production in the short-run and
long-run.
• Differentiate between total, average and marginal costs of
production and how these costs affect output decisions and
profitablity.
• Determine the level of output which maximises profit for any
given cost structure and demand conditions.
• Distinguish between variable and fixed costs of production and
their role in determining when a firm should shut down
production.
• Appreciate the meaning of diminishing returns in the context of
short-run production decisions.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.2B

Learning outcomes
• Understand the nature of external and internal economies of
scale as the size of a business alters.
• Appreciate the significance of innovation in sustaining a
firm’s competitive advantage over the long run.
• Distinguish between scale inefficiencies in production and
inefficiencies that result from the poor management of
resources (i.e. X-inefficiency).
• Realise the growing importance of information and
knowledge in business decision-making as factors of
production in their own right.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.3

Production function

The production function is a mathematical expression which

relates the quantity of all inputs to the quantity of outputs,
assuming that managers employ all inputs efficiently. In general
terms the production function for any firm may be expressed as
follows:
Q = F (I1, I2, I3,…,In)
Cost function
C = F(Q,p1,p2,p3,…,pn)
where the cost, C, is expressed as a function of the quantity of
output, Q, and the prices p1, p2, p3,…,pn of the corresponding
inputs I1,I2,I3,…,In.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.4A
Variable costs versus fixed costs
• Total fixed costs (TFC)are fixed at all levels of output.

• Total variable costs (TVC)and,therefore,total costs (TC)rise as

output increases.

• Average fixed costs (AFC)decline continuously as the fixed costs

are distributed across more and more output,until at very large output
levels they may be negligible.The AFC curve is a rectangular
hyperbola,i.e.the area under the curve remains constant as output
changes.

• Average variable costs (AVC)may fall initially but after a certain

level of output they begin to rise.This occurs because of what
economists term the law of diminishing returns ,mentioned in Chapter
1 and discussed more fully below.It is, of course,possible for average
variable costs to rise continuously as output expands, while in some
businesses there may be a large output range over which they are
constant.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.4B
Variable costs versus fixed costs
• Average total costs (ATC),being the combination
of AFC and AVC, tend to decline initially and then
rise after a certain level of output (Q )is reached.
Average total cost is often referred to by
accountants as the unit cost .It is also often simply
referred to as the average cost .

• Summary
TC TFC TVC
AVC TVC/Q
AFC TFC/Q
ATC AFC AVC TC/Q

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.5

Figure 3.1 Total and average costs of production

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.6

Production decisions in the short run and long run

• The short run is the time period during which

the amount of at least one input is fixed in
supply (e.g.the amount of capital equipment
installed or in some organisations the number
of personnel employed) but the other inputs
can be altered.

• The long run represents a sufficient length of

time for management to be able to vary all
inputs into the production process.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.7
Diminishing returns in production

The law of diminishing (marginal)returns

In the short run,when one or more factors of

production are held fixed, there will come a point
beyond which the additional output from using extra
units of the variable input(s)will diminish.

• TPP is the total output when labour is applied to

capital.
• APP is the total output or physical product divided by
the number of units of labour employed.
• MPP is the addition to total physical product as each
extra unit of labour is employed.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Table 3.1 Example of the law of diminishing returns
OHT 3.8
(1) (2) (3) (4) (5)
Units of Units of Total Average physical Marginal physical
capital input labour input physical product product of labour product of labour
(n) (TPP) (APP) = (3)  (2) (MPP)

10 1 8 8 8 (8-0)
10 2 20 10 12 (20-8)
10 3 35 11.7 15 (35-20)
10 4 40 10 5 (40-35)
10 5 42 8.4 2 (42-40)
10 6 43 7.2 1 (43-42)

Figure 3.2 Diminishing returns

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.9
The relationship between production and
costs

Marginal cost
The change in total costs of production as output is changed
incrementally is referred to as the marginal cost .Given a total cost
function,it is technically the ‘first derivative’ that is, the slope of the
total cost curve at each level of output (insert equation) ).Where the
total cost curve is linear,the marginal cost is a constant,and it is
easier to refer to the marginal cost of output.

Incremental cost
The incremental cost per unit is the total change in costs caused by
the output increment (this is equal to the sum of the marginal costs
over the increment in output), divided by the change in output.In
other words,incremental cost equals the ‘average 知 marginal cost
over the range of outputs.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.10

Table 3.2 Deriving cost data from product data

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

Cost of capital Cost of labour Total cost Average cost
Total
employed employed =(1)+(2) per unit = (3)  (4)
output
$ $ $ $

100 10 110 8 13.7

100 20 120 20 6.0
100 30 130 35 3.7
100 40 140 40 3.5
100 50 150 42 3.6
100 60 160 43 3.7

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.11

Figure 3.3 Marginal cost and output

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.12

Figure 3.4 Constant marginal costs

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Table 3.3 Cost of production: a worked example OHT 3.13

Quantity Variable Fixed Total Marginal Average Average Average

of output cost cost cost cost variable cost fixed cost total cost
(units) ($) ($) ($) ($) ($) ($) ($)
Q VC FC TC MC AVC AVC ATC (8) = (4)/(1)
(1) (2) (3) (4) = (2) + (3) (5) (6) = (2)/(3) (7) = (3)/(1) = (6) + (7)

0 0 48 48 20 - - -
1 20 48 68 10 20 48 68
2 30 48 78 6 15 24 39
3 36 48 84 4 12 16 28
4 40 48 88 8 10 12 22
5 48 48 96 12 9.6 9.6 19.2
6 60 48 108 20 10 8 18
7 80 48 128 32 11.4 6.9 18.3
8 112 48 160 44 14 6 20
9 156 48 204 17.3 5.3 22.6

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.14

Figure 3.5 Worked example of short-run cost curves

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.15

The profit maximisation rule

Profits are maximised where marginal cost (MC)equals

marginal revenue (MR). It is possible that over the
firm’s full potential range of outputs there are two points
where MC =MR (in Figure 3.6 the two points are shown
at X and at output q *). Producing at point X would not
profit maximise because outputs up to X are produced
where MC > MR. Technically,profits are maximised
where MC =MR and the MC curve is rising (not
falling),as at q *output in Figure 3.6.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.16

Figure 3.6 Profit-maximising output

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.17

• Normal profit is the minimum profit which must be earned to ensure

that a firm will continue to supply the existing good or service. In
incorporated firms it is equivalent to the ‘cost of capital’, namely the
interest charges on loan capital plus the return to equity investors
that must be paid if creditors and investors are to put their capital
into the firm. In non-corporate enterprises (sole traders and
partnerships)this is the profit that ensures that a sufficient number
of people are prepared to invest, organise production and
undertake risks in an industry (including the return to risky
‘entrepreneurship’). The normal profit will differ from industry to
industry,according to the degree of risk involved. Costs of
production, in an economic as opposed to an accounting sense,
include an allowance for normal profit.

• Supernormal profit is any profit earned above normal profit and is a

form of economic rent (see pp.143 and 308).

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.18

Figure 3.7 The production decision

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.19
Economies and diseconomies of scale

• Constant returns to scale.This arises when

the volume of output increases in the same
proportion to the volume of inputs.

• Increasing returns to scale.This arises

where the volume of output rises more
quickly than the volume of inputs.

• Decreasing returns to scale.This arises

where the volume of output rises less quickly
than the volume of inputs.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.20
Internal economies of scale

• Labour.
• Investment.
• Procurement.
• Research and development.
• Capital.
• Diversification.
• Product promotion.
• Transport and distribution.
• By-products.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.21

External economies of scale

• Labour force.

• Suppliers.

• Social infrastructure.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.22
Internal diseconomies of scale

Management

Labour

Other inputs

External diseconomies of scale

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Long-run average costs OHT 3.23

Figure 3.8 The long-run average cost curve

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.24

E-commerce and costs of production

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.25

Economies of scope

• Sharing common inputs over a range of its

activities.

• Jointly promoting its range of products and

services;or

• Jointly distributing its range of products and

services.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.26
Organising production

Figure 3.9 Organisational structures

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.27

Figure 3.10 The impact of improved technology on long-run production costs

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 The experience curve OHT 3.28

Figure 3.11 The experience curve

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.29

Figure 3.12 The ‘virtuous circle’

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.30

Figure 3.13 Benefits from increasing the scale of production

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 The relationship between short-run and long- OHT 3.31
run costs

Figure 3.14 Long-run average total cost curve

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.32

Figure 3.15 The ‘L-shaped’ long-run average total cost curve

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Optimal scale and x-inefficiency OHT 3.33

Figure 3.16 The ‘production cost’ gap

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Large goods vehicles: an example of economies of OHT 3.34
scale

Economies of scale of large goods vehicles

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.35A
Key learning points
• The production function is a mathematical
expression which relates the quantity of all inputs
to the quantity of outputs.
• Total physical product (TPP)is the total output
from the factors of production employed.
• Average physical product (APP)is the TPP
divided by the number of units of the variable
factor of production employed.
• Marginal physical product (MPP)is the change in
TPP when an additional unit of the variable factor
of production is employed.
• Fixed costs are costs of production which do not
vary as output changes.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Key learning points OHT 3.35B

• Variable costs are costs of production which do vary

with output.

• Average total cost (ATC) is total cost divided by output

(TC/Q ) and is made up of average fixed cost (AFC) plus
average variable cost (AVC),where AFC =TFC/Q and
AVC =TVC/Q .TFC is total fixed cost;TVC is total
variable cost;and Q is output.

• The law of diminishing (marginal)returns states

that,in the short run,when one or more factors of
production are held fixed,there will come a point beyond
which the additional output from using extra units of the
variable input(s)will diminish.

• The output at which average costs are at their lowest is

known as the technically optimum output .
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.35C
Key learning points
• Marginal costs (MC),defined as the additional costs
incurred when producing a very small increment or one
more unit of output,will only depend on changes in variable
costs in the short run because fixed costs are unaltered as
output changes. In the long run, however, marginal costs
reflect changes in the total costs of production since all
inputs are variable.

• The marginal cost curve will always be below (above)the

average cost curve when average costs are falling (rising).

• Profits are maximised at the level of output where marginal

cost equals marginal revenue and when marginal costs are
rising.

• Economists include a normal profit in costs.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.35D
Key learning points
Normal profit is defined as the minimum profit which must be
earned in order to ensure that a firm will continue to supply the
existing good or service.

Normal profit is earned when price is set equal to average total

cost.

Supernormal profit is earned when price is set above average

total cost.

The shut-down point in the short-run exists when price has fallen
below average variable costs.In the long run a profit-maximising
firm must cover its average total costs if it is to remain in business.

Constant returns to scale arise when the volume of output

increases in the same proportion to the volume of inputs.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT3.35E

Key learning points

• Increasing and decreasing returns to scale arise when the
volume of output rises more quickly or less quickly,
respectively,than the volume of inputs.
• The existence of increasing and decreasing returns to scale is
explained by the presence of both internal and external
economies and diseconomies of scale ,which relate to the
behaviour of long-run production as the scale of output changes.
• Decreasing ,constant and increasing cost production relate
to what happens to the costs of production as the scale of
production is changed.
• The minimum efficient scale (MES)represents the technical
optimum scale of production for the firm,corresponding to
minimum unit costs over the long run.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.35F
Key learning points
• Economies of scope exist where a range of goods use
joint inputs,promotion or distribution resulting in a
reduction in the long-run average costs of production.
• Static cost reductions tend to occur in the short run and
are associated with improving existing production
methods.
• Dynamic efficiency gains are more clearly associated
with new developments in product and production
processes over time.
• The experience (learning)curve relates to declining unit
costs of production over time as the cumulative volume of
output rises.
• Innovation occurs within firms in the form of both
products and processes. Product innovation involves the
introduction of new goods and services;while process
innovation is concerned with improving the existing
methods by which outputs are produced so as to lower the
costs of production.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Key learning points OHT 3.36G

• X-inefficiency indicates the extent to which the costs of

production are above the minimum average cost due to
waste and organisational slack given the existing scale of
production.
• The envelope curve shows how total costs of production
change as output continues to rise over the long run.This
represents the envelope of all possible short-run average
total cost curves relating to different scales of production
and is appropriate where there are no significant
‘indivisibilities 段 in the capital stock.
• Information and knowledge are of growing importance as
factors of production in their own right in the new
information-led or ‘weightless economy’.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.35H

Key Learning Points

Appendix 3.1 (see p. 95)

• An isoquant curve shows in graphical form different

combinations of factor inputs that can be used to
produce a given quantity of a product.

• An isoquant map is a collection of ranked isoquant

curves that shows in graphical form a firm’s increasing
output when moving outward from the origin using
larger quantities of factor inputs.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.35I
Key Learning Points

• The marginal rate of technical substitution

(MRTS)is the ratio of the marginal physical product of
two inputs in the production process;i.e.the amount
by which it is possible to reduce one factor input and
maintain a given level of output by substituting one
extra unit of the other factor input. In notation form:

MPL
MRTS kforL   
MPK
• An isocost line shows the combination of two inputs
which can be purchased for the same total money
outlay.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT 3.35J

Key Learning Points

• An optimal combination of inputs in the production
process takes place when the ratio of the marginal
products of the factor inputs is equal to the ratio of the
input prices; i.e.

MPL PL
    
MPK PK

Or, alternatively
MPL MPK

PL PK

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Appendix 3.1 Isoquants, isocosts and the OHT 3.36
optimal combination of inputs
The key task facing the firm is to determine the specific
combination of capital and labour which should be
selected in order:

• either to maximise output for a given production cost;

• or to minimise production cost subject to a given output.

The task of determining the optimal combination of inputs

introduces a number of important concepts including:

• Isoquant curves and isoquant maps.

• The marginal rate of technical substitution.
• Isocost lines.

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Isoquant curves and isoquant maps OHT A3.37
An isoquant curve shows in graphical form the different combinations of factor
inputs (such as capital and labour) that can be used to produce a given quantity of
a product per time period with a given state of technology

Figure A3.1 Isoquant curve for a given level of production

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 An isoquant map is a collection of ranked isoquant curves that shows OHT 3.38
in graphical form a firm’s increasing output per time period when
moving outward from the origin using larger quantities of two factor
inputs (such as capital and labour).

Figure A3.2 Isoquant map for different levels of production

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT3.39

The marginal rate of technical substitution

The marginal rate of technical substitution (MRTS )is the

ratio of the marginal physical products (MP)of two inputs
in the production process;i.e.the amount by which it is
possible to reduce one factor input (e.g.capital)and
maintain a given level of output by substituting an extra
unit of the other factor input (e.g.labour).

MPLabour
MRTSCapitalforLabour   
MPCapital

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Isocost lines OHT A3.40
The isocost line shows the combination of the two inputs
(capital and labour) which can be purchased for the same total
money outlay.
C = PKK+PLL

Figure A3.3 Isocost line

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 Optimal combination of inputs OHT 3.41

Maximising output for a given production cost

Principle : to maximise output subject to a given total cost of

production and given input prices for capital and labour, the firm
must purchase inputs in quantities such that the marginal rate of
technical substitution of capital for labour (MRTSK for L ) is equal to
the ratio of the price of labour to the price of capital (P L /P K ).

MPLPL
MRTS KforL      
MPK PK
The optimality condition can be reorganised as:

MPL MPK

PL PK
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT A3.42

Figure A3.4 Maximising output for a given cost

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT A3.43

Optimal combination of inputs

Minimising cost subject to a given output

MPL PL
MRTS KforL      
MPK PK

Or, alternatively

MPL MPK

PL PK
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
 OHT A3.44

Figure A3.5 Minimising cost for a given output

J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.