Maryland International College

Managerial Economics

Chapter Six

Production and Cost Functions

1
 Chapter Six
Production Function and Economics of a Firm
• Concept of production function
• Law of diminishing returns to a factor
• Optimization in the case of a single input, multiple inputs
• Iso-quants and iso-costs
• Optimal combination of inputs
• Expansion path and returns to scale
• Concept of Costs of production - Explicit and Implicit Costs, Opportunity cost, Private costs
and Social Costs, Accounting Costs and Economic costs,
• Short run and Long Run costs.
• Economies of scale.
• Cost estimation, Methods of cost estimation and cost forecasting
2
Production Process -

The production function depends upon

the following factors:
 The quantities of inputs to be used.
 The state of technical knowledge.
 The possible processes of
production.
 The size of the firm.
 The prices of inputs.

If these factors change the production

function automatically changes.

3
Production Function
• In economics, a production function gives the technological relation between
• Quantities of physical inputs and quantities of output of goods.
Production is the transformation of inputs into outputs
Production is not the creation of matter but it is the creation of value.
Production is also defined as producing goods which satisfy some human want.
Production function refers Maximum amount of output that can be produced from
any specified set of inputs, given existing technology
• Production function is one of the key concepts of mainstream Neoclassical theories,
that can be used to address
• allocative efficiency in the use of factor inputs in production - (input
combinations to produce mix of different outputs)
• technical efficiency - Achieved when maximum amount of output is produced
with a given combination of inputs
• Economic efficiency - Achieved when firm is producing a given output at the
lowest possible total cost 4
 Production Function
• Production Function: defines the relationship between inputs and the maximum
amount that can be produced within a given period of time with a given level of
technology
Q=f(X1, X2, ..., Xk); Q = Level of Output; X1, X2, ...,Xk= inputs used in production
• The inputs are what the firm buys, namely productive resources, and outputs are
what it sells.
• Inputs are considered variable or fixed depending on how readily their usage can be
changed
Variable input - An input for which the level of usage may be changed quite readily
Fixed input - An input for which the level of usage cannot readily be changed and
which must be paid even if no output is produced
• Short run - At least one input is fixed and all changes in output achieved by changing
usage of variable inputs
• In the short run, capital is fixed and only changes in the variable labor input can
change the level of output - Q = f (L, K) = f (L)
• Long run - All inputs are variable and output changed by varying usage of all inputs
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Production Function – Short Run Production
• Production function must be specified with reference to a particular period of time
• Production function of a firm is determined by the state of technology when
technology advances smaller input can produce much out put
• Total Product - is the number of units of the good or service produced by different
numbers of workers.
• Marginal product - is the additional output that will be forthcoming from an
additional worker, other inputs remaining constant (MP = ΔQ/ΔL)
• Average product - is calculated by dividing total output by the number of workers
who produced it (AP = Q/L)

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 Production Function – Short Run Production
• Quantity of some input varied and that of the other remains constant.
• This kind of input out put relationship forms subject matter of the law of
variable proportions.
• when one input increased while other inputs are kept constant, the resulting
out put as well 1st increases at an increasing rate, then at constant rate and
finally at decreasing rate, then decrease thoroughly.
• From this we deduce the following 3 laws
• Law of increasing return- when the %age change in out put is greater than
the %age change in input.
• Law Constant return - when %age change in input is equal to the %age
change in out put.
• Law of decreasing return – when the %age change in out put is less than the
%age change in input.

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 Production Function – Short Run Production
Number Total Marginal Average • The units of labor are assumed to
of Product/Outpu Product Product be of equal quality
Workers t
• Technology is fixed over the
0 0 - -
production time
1 4 4 4
• the graph shows that the total
2 10 6 5 output the firm (TP) increases as the
3 17 7 5.7 amount labor hired increases, until
4 23 6 5.8 the addition of a marginal labor
5 28 5 5.6 causes total output too decrease.
6 31 3 5.2 • As the figure suggests;
7 32 1 4.6
• total product will 1st increase at
an increasing rate,
8 32 0 4
• then at decreasing rate until it
9 30 2 3.3
reaches an absolute maximum
10 25 5 2.5 and then decrease.

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 Production Function – Short Run Production
Law of diminishing marginal productivity – as more and more of a variable input is
added to an existing fixed input, after some point the additional output one gets
from the additional input will fall.
Negative
Diminishing Diminishing Diminishing
32 returns
30 7
marginal marginal absolute
28
returns 6 returns returns
26
24
22 TP 5

Output per worker

20 Increasing
Output

18 4
16 marginal
14 3
12 returns
10
8 2 Increasing
6
AP
4 1 marginal
2 returns
0 0
1 2 3 4 5 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

Diminishing returns always apply in the short run, and in the short run every firm will face diminishing returns. This
means that every firm finds it progressively more difficult to increase its output as it approaches capacity production.
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 Production Function – Short Run Production Stage I – starts from the
origin and ends at the
32 point where MP equals
30
28 7 I II to AP
26 III
24 6 Stage II- starts from where
TP
22
20 stage I ends and ends at
5
18 the point where TP
16
Output

14 4 reaches its max and MP

12
equals zero

Output per
10 3

worker
8
6 2 Stage III – starts at the
4
2 1
AP point where TP is at its
0 max and ends where
0
1 2 3 4 5 6 7 8 9 10 production totally
1 2 3 4 5 6 7
(a) Total product Number of workers
8 9 10 Number of workers MP exhausts.
(b) Marginal and average product
i.e. the fixed resource will
In which stage can the firm maximize its return? exhaust and the total
• 2nd stage where MPL< APL and positive product will become
• Stage I - unused fixed resource that can increase out put zero.
• Stage III - no fixed input to operate with variable input. 10
 Example 1. How many workers a firm should hire?
Number Total Margin Total Total Profit
2. Where should you stop hiring additional
of Product al Revenue Cost labor?
Workers /Output Product 3. How much level of output should it
0 0 - - produce?
1 4 4 40 25 15  TR = PQ
2 10 6 100 50 50  TC = wL
3 17 7 170 75 95  The Value of MP = P*MP
4 23 6 230 100 130  Cost of an additional worker is the w (MC)
5 28 5 280 125 155
 So, does hiring an additional worker
worthwhile?
6 31 3 310 150 160
 Check the profit from hiring an extra worker
7 32 1 320 175 145  At 1 L – P*MPL = 40 and its cost is w = 25
8 32 0 320 200 120  At 6 L – P*MPL = 30 and its cost is w = 25
 At 7 L – P*MPL = 10 and its cost is w = 25
9 30 2 300 225 75
 Keep hiring workers till - P*MPL > w
10 25 5 250 250 0
 Stop hiring workers at - P*MPL = w
 i.e MPL=w/P
Price = 10 and Wage for Labor = 25
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Production functions with multiple inputs – Long run
• Additional capital increases the productivity of
labor.
• capital and labor are complementary inputs.
• Under the long run production function there is
enough time to vary all inputs. So all inputs are
variable.
• This forms the subject matter of the law of returns
to scale the relationship b/n all inputs and out puts.
• Unlike in the case of short run - the law of variable
proportion b/c of only one variable input,
• In Long run - all inputs are variable - the law of
returns to scale.
• Size of the producing plant (industry, firm) in the
case of returns to scale the production is
homogenous 12
Production functions with multiple inputs – Long run
• In the long run, it is possible for a firm to change all to change all inputs up
or down in accordance with its scale.
• This is known as returns to scale.
• The returns to scale are constant when output increases in the same proportion
as the increase in the quantities of inputs.
• The returns to scale are increasing when the increased in output is more than
proportional to the increase in inputs.
• They are decreasing if the increase in output is less than proportional to the
increase in inputs.
Q = (L, M, N, K T2)
• Given , if the quantities of all inputs L,M,N,K are increased n-fold the output Q
also increases n-fold. Then the production function becomes
• nQ = f(nL, nM, nN, nK )

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Production functions with multiple inputs – Long run
• This is known as linear an homogeneous production function, or a homogeneous
function of the first degree. If the homogeneous function is of the kth degree, the
production function is nkQ = f(nL, nM, nN, nK)
• If k is equal to 1, it is a case of constant returns to scale; if it is greater than 1, it is a
case of increasing returns of scale; and if it is less than 1, it is a case of decreasing
returns to scale
• Thus a production function is of two types: (i) Linear homogeneous of the first
degree in which the output would change in exactly the same proportion as the
change in inputs. Doubling the inputs would exactly double the output, and vice
versa. Such a production function expresses constant returns to scale. (ii) Non
homogeneous production functions of a degree greater or less than one. The
former relates to increasing returns to scale and the latter to decreasing returns to
scale.

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Production functions– Long run – Isoquant
• Isoquants are used to study production decisions in the Long run
• An Isoquant Curve shows all the possible combinations of input factors
that yield the same quantity of production.
• The isoquant curve is also known as Iso-Product Curve.
• The term “Iso” means "same" and “quant” or “product” means
"quantity" produced.
• It is a geometric representation of the production function, wherein
different combinations of labor and capital are employed to have the
same level of output.
• Isoquants are downward sloping - if greater amounts of labor are used,
less capital is required to produce a given output
• Isoquant Map: An isoquant map shows the different isoquant curves
representing the different combinations of factors of production,
yielding the different levels of output. 15
Production functions– Long run – Isoquant
•Suppose there are two input factors:-
Labor and Capital.
•The different combinations of these
factors are used to have the same level
of output
Combin Labor Capital Output
ations (unit) (Unit) (Number)
The higher the isoquant
A 1 10 100 curve, the higher is the
level of output.
B 2 9 100

C 3 8 100

D 4 7 100
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Production functions– Long run – Isoquant
 The slope of an iso-quant curve is called the rate of technical substitution
 which means how much capital are to be substituted for the labor to
give the same quantity of production if the labor is reduced by 1 unit.
 Thus, the input factors can be substituted for one another to have
an unchanged level of output.
 Taking Labor and Capital into the consideration, these factors can
be substituted for each other
 Mathematically, the data that an isoquant projects is expressed by the
equation
f (K,L) = Q

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Production functions– Long run – MRTS
 The Marginal Rate of Technical
Substitution (MRTS) equals the
absolute value of the slope. - MRTS
tells us how much of one input a
firm can sacrifice while still
maintaining a certain output level.
 The MRTS is also equal to the ratio
of Marginal Productivity of Labor
(MPL): Marginal Productivity of
Capital (MPK).
 The mathematical form of how
Labor (L) can be substituted for
Capital (K) in production is given
by: TS (L for K)= dK/dL = MPL/MPK
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Production functions– Properties of isoquant curves
I. The slope of isoquant is negative w/c shows the substitutability of
the two inputs. The slope is marginal rate of technical substitution
(MRTS) MRTSLK= - ∆K/ ∆L .
II. Isoquant need not parallel to each other.
III. isoquant never cross each other.
IV. Isoquants are convex to the origin- due to the diminishing MRTS
V. MRTS b/n capital and labor defined as the quantity of capital w/c
can be given up in exchange for an additional unit of labor.
VI. No isoquant can touch either axis if touch that means the production
is only using one input and it is impossible in the real world

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Production functions– Iso-cost curves
• An iso-cost line (equal-cost line) is a Total Cost of production
line that recognizes all combinations of two resources that a
firm can use, given the Total Cost (TC).
• It is a graph that shows all the combinations of capital and
labor available for a given total cost.
• For the two production inputs labor and capital, with fixed unit
costs of the inputs, the equation of the iso-cost line is
rK+ wL =C
• where w represents the wage rate of labor, r represents the
rental rate of capital, K is the amount of capital used, L is the
amount of labor used, and C is the total cost of acquiring those
quantities of the two inputs.

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Production functions– Iso-cost curves

• Each line segment is an

isocost line
representing one
particular level of Total
Input Costs, denoted
TC in the graph and C
is Total Cost .
• PL is the Unit Price Of
Labor and
• PK is the Unit Price Of
Physical Capital .
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Iso-quant and Iso-cost

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Iso-quant and Iso-cost

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Iso-quant and Iso-cost
Finding the least-cost technology with isoquants and isocosts
• The firm will choose the
combination of inputs that is least
costly.
• The least costly way to produce
any given level of output is
indicated by the point of
tangency between an isocost line
and the isoquant corresponding
to that level of output.

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Iso-quant and Iso-cost – Expansion Path
Finding the least-cost technology with Expansion path - Optimal input combinations as
the scale of production expands
isoquants and isocosts

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Iso-quant and Iso-cost
The cost-minimizing equilibrium condition
At the point where a line is just tangent to a curve, the two have the
same slope. At each point of tangency, the following must be true:
MPL PL
slope of isoquant    slope of isocost  
MPK PK
MPL PL
Thus, 
MPK PK

Dividing both sides by PL and multiplying both sides by MPK, we get

MPL MPK How do you choose the combination of
 two or more inputs?
PL PK 26
Returns to Scale
• Returns to scale describes the relationship between outputs and scale of inputs in
the long run when all the inputs are increased in the same proportion.
• Returns to scale refer to the relationship between changes in output and
proportionate changes in all factors of productions.
• To meet a long run change in demand, the firm increases its scale of production by
using more space, more machines and laborers in the factory.
• This law assumes that
i. All factors (inputs) are variable but enterprise is fixed.
ii. A worker works with given tools and implements.
iii. Technological changes are absent.
Suggested Reading –
iv. There is perfect competition. Nick Wilkinson (2005) Managerial
v. The product is measured in quantities. Economics –A Problem Solving
Approach. PP 195
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Returns to Scale
Causes of Increasing Returns to Scale
Increasing Returns to scale - because the increase in total output is more than
proportional to the increase in all inputs.
i. Indivisibility of Factors - machines, management, labour, finance, etc. cannot be
available in very small size. When a business unit expands, the returns to scale
increase because the indivisible factors are employed to their maximum capacity.
ii. Specialization and Division Labour : When the scale of the firm is expanded
there is wide scope of specialization and division of labour. specialized equipment
can be installed. Thus, efficiency increases and increasing returns to scale follow.
iii. Internal Economics: As the firm expands, it enjoys internal economies of production.
It may be able to install better machines, sell its products more easily, borrow
money cheaply, procure the services of more efficient manager and workers, etc.
iv. External Economies: When the industry itself expands to meet the increased
long run demand for its product, external economies appear which are shared
by all the firms in the industry. When a large number of firms are concentrated
at one place, skilled labour, credit and transport facilities are easily available. 28
Returns to Scale
Causes of Constant Returns to Scale
Constant Returns to Scale - as the increase in total output is in exact proportion to the
increase in Inputs.
i. Internal Economies and Diseconomies - But increasing returns to scale do
not continue indefinitely. As the firm expands further, internal economies
are counterbalanced by internal diseconomies. Returns increase in the same
proportion so that there are constant returns to scale over a large range of
output.
ii. External Economies and Diseconomies -The returns to scale are constant when
external diseconomies and economies are neutralized and output increases in
the same proportion.
iii. Divisible Factors - When factors of production are perfectly divisible,
substitutable, and homogeneous with perfectly elastic supplies at given prices,
returns to scale are constant.
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Returns to Scale
Causes of Diminishing Returns to Scale
Diminishing Returns to Scale - Returns to scale diminish the increase in output is less
than proportional to the increase in inputs.
i. Constant returns to scale is only a passing phase, for ultimately returns to scale start
diminishing indivisible factors may become inefficient and less productive.
ii. Business may become heavy and produce problems of supervision and
coordination.
iii. Large management creates difficulties of control and rigidities.
iv. Internal diseconomies are added to external diseconomies of scale.
 These arise from higher factor prices or from diminishing productivities of the factors.
As the industry continues to expand, the demand for skilled labour, land, capital,
etc. rises.
v. Transport and marketing difficulties emerge.
vi. All these factors tend to raise costs and the expansion of the firms leads to diminishing
returns to scale so that doubling the scale would not lead to doubling the output 30
Economies of Scale
• Economies of scale refers to the cost advantages that a business obtains due to
expansion. There are factors that cause a producer's average cost per unit to
fall as the scale of output is increased.
• It is a long run concept and refers to reductions in unit cost as the size of a facility and
the usage levels of other inputs increase. Diseconomies of scale are the opposite.
• The common sources of economies of scale are
• purchasing (bulk buying of materials through long-term contracts),
• managerial (increasing the specialization of managers),
• financial (obtaining lower-interest charges when borrowing from banks and
having access to a greater range of financial instruments),
• marketing (spreading the cost of advertising over a greater range of output in
media markets), and technological (taking advantage of returns to scale in the
production function).

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Economies of Scale
• The common sources of economies of scale are
• Each of these factors reduces the long run average costs (LRAC) of production by
shifting the short-run average total cost (SRATC) curve down and to the right.
• Economies of scale are also derived partially from learning by doing.
• Economies of scale is a practical concept that is important for explaining real world
phenomena such as patterns of international trade, the number of firms in a market,
and how firms get "too big to fail".
• The exploitation of economies of scale helps explain why companies grow large in
some industries.
• Economies of scale also play a role in a "natural monopoly.“
• An economy of scale exists when larger output is associated with lower per unit cost.

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Economies of Scale
• Economies of scale have been classified by Marshall into Internal Economies and
External Economies.
• Internal Economies are internal to firm when it expands its size or increases its
output.
• They are open to single factory or a single firm independently of the action of
other firms.
• They result from an increase in the scale of output of the firm, and cannot be
achieved unless output increases.
• They are not the result of invention of any kind, but are due to the use of
known methods of production which a small firm does not find worthwhile.
• External Economies are external to a firm which is available to it when the output of
the whole industry expands.
• They are shared by a number of firms or industries when the scale of production
in any industry or group of industries increases.
• They are not monopolized by a single firm when it grows in size, but are conferred
on it when some other firms grow large 33
The bases of firms decisions making
 The bases of decision making:

1. The market price of output

2. The techniques of production that are available
3. The prices of inputs

 Output price determines potential revenues.

 The techniques available tell - how much of each input is need, and
 input prices tell - how much they will cost.
 Together, the available production techniques and the prices of inputs determine
costs.
Firms Optimal Method of production decision

Price of output Production techniques Input prices

Determines Determine total cost and optimal

total revenue method of production

Total revenue
-Total cost with optimal method
= Total profit

Optimal method of production - the production method that minimizes cost.

Concepts of Costs of Production
• Explicit Vs Implicit Costs and Economic vs Accounting Costs

• Explicit Costs /Accounting Costs

• arise from transactions in which the firm purchases inputs or the services of inputs
from other parties
• Expenses or out-of-pocket costs (rent, raw materials, fuel, wages)
• they are normally recorded in a firm’s accounts
• Implicit costs /Economic Costs - opportunity costs
• Economic cost looks at the gains and losses of one course of action versus another.
• It does this in terms of time, money, as well as resources. The term also includes
determining the gains and losses that might have occurred by taking another course
of action
• costs associated with the use of the firm’s own resources and reflect the fact that
these resources could be employed elsewhere
Concepts of Costs of Production
• Sunk and incremental costs
• Sunk costs - are costs that do not vary according to different decisions.
• is a cost that an entity has incurred, and which it can no longer recover.
• these costs refer to outlays that have already occurred at the time of decision
making, like the cost of market research conducted before deciding whether to
launch a new product.
• Sunk costs should not be considered when making the decision to continue
investing in an on-going project,
• Incremental costs - refer to changes in costs caused by a particular decision.
• are the relevant costs for decision-making
Concepts of Costs of Production
• Private costs Vs Social Cost
• Private costs - refer to costs that accrue directly to the individuals performing a
particular activity (internal costs)
• For private firms these are the only costs that are relevant, unless there are
ethical considerations
• Social costs - include external costs that are passed on to other parties, are often
difficult to value.
• For example, firms that cause pollution and congestion
• the total cost to society of using a resource
• Social costs are relevant for public policy decision making.
Concepts of Costs of Production
• Historical Vs current costs
• Historical costs - represent actual cash outlay and this is what accountants record
and measure.
• i.e measuring costs in historical terms, at the time they were incurred.
• relevant for tax purposes it may not reflect the current costs.
• Current costs - refer to the amount that would be paid for an item under present
market conditions.
• Often current costs exceed historical costs, particularly with inflation.
• the item being costed may no longer be available, and the appropriate cost is the
replacement cost.
• Replacement cost is the relevant cost for decision-making.
Short run Costs
•Managers want to know the nature of the cost functions of their firm
•To make pricing decisions, to determine the appropriate levels of factors, to forecast
and plan for the costs and input levels for a given level of output.
• Fixed costs - related to the fixed factors and do not vary with output in the short
run
• Examples - rent, insurance, interest payments,
• may vary in the short run, but not because of a change in output.
• Fixed costs have to be paid even if output is zero for any period
•Variable costs - related to the variable factors and vary directly with output.
•Examples of variable costs are raw materials, wages, some fuel costs etc
•In practice a clear distinction between fixed and variable costs is not always possible;
some costs, like fuel, may have fixed and variable elements.
•costs, like administrative salaries, may be fixed over a certain output range, but if
output exceeds the range an increase in staff may be required
Short run Costs
•Types of costs in Short run
•Total fixed cost (TFC) – the cost incurred by the firm that does not depend on how
much output it produces
•Total variable cost (TVC) – the cost incurred by the firm that depends on how much
output it produces
•Total Cost (TC) – the sum of total fixed and total variable cost at each output
•Marginal Cost (MC) – the change in total cost that results from a one-unit change in
output
MC = TC/Q = TVC/Q
•Average Fixed Cost (AFC) – total fixed cost divided by the amount of output
AFC = TFC/Q
•Average Variable Cost (AVC) – total variable cost divided by the amount of output
AVC = TVC/Q
•Average Total Cost (ATC) – total cost divided by the output - ATC = TC/Q , ATC =
AFC + AVC
Short run Costs
total fixed costs (TFC) or overhead The total of all costs that do not change with
output, even if output is zero.

Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm

(1) (2) (3)

Q TFC AFC (TFC/Q)

0 $1,000 $ -
1 $1,000 1,000
2 $1,000 500
3 $1,000 333
4 $1,000 250
5 $1,000 200

Firms have no control over fixed costs in the short run. For this reason, fixed costs
are sometimes called sunk costs.
Short run Costs

spreading overhead The process of dividing total fixed costs by more units of output.
Average fixed cost declines as quantity rises.
Short run Costs
total variable cost (TVC) The total of all costs that vary with output in the short run.
total variable cost curve A graph that shows the relationship between total variable
cost and the level of a firm’s output

Derivation of Total Variable Cost Schedule from Technology and Factor Prices
UNITS OF INPUT REQUIRED
(PRODUCTION FUNCTION) TOTAL VARIABLE COST ASSUMING PK =
USING K L $2, PL = $1
PRODUCE TECHNIQUE TVC = (K x PK) + (L x PL)

1 Unit of A 4 4 (4 x $2) + (4 x $1) = $12

output B 2 6 (2 x $2) + (6 x $1) = $10
2 Units of A 7 6 (7 x $2) + (6 x $1) = $20
output B 4 10 (4 x $2) + (10 x $1) = $18
3 Units of A 9 6 (9 x $2) + (6 x $1) = $24
output B 6 14 (6 x $2) + (14 x $1) = $26
Short run Costs

 The total variable cost curve

embodies information about
both factor, or input, prices and
technology.
 It shows the cost of production
using the best available
technique at each output level
given current factor prices.
Short run Costs
 Marginal cost (MC) - The increase in total cost
that results from producing one more unit of
output.
 when a firm increases its output level, it hires
or demands more inputs.
 Short run marginal cost (SMC) measures rate of
change in total cost (TC) as output varies
 In the short run, every firm is constrained by
some fixed input that leads
-to diminishing returns to variable inputs
-limits its capacity to produce.
 As a firm approaches that capacity, it
becomes increasingly costly to produce
successively higher levels of output.
Marginal costs ultimately increase with
output in the short run.
Short run Costs
Short-Run Costs of a Hypothetical Firm
(3) (4) (6) (7) (8)
(1) (2) MC AVC (5) TC AFC ATC
q TVC (D TVC) (TVC/q) TFC (TVC + TFC) (TFC/q) (TC/q or AFC + AVC)

0 $ 0 $ - $ - $ 1,000 $ 1,000 $ - $ -
1 10 10 10 1,000 1,010 1,000 1,010
2 18 8 9 1,000 1,018 500 509
3 24 6 8 1,000 1,024 333 341
4 32 8 8 1,000 1,032 250 258
5 42 10 8.4 1,000 1,042 200 208.4
- - - - - - - -
- - - - - - - -
- - - - - - - -
500 8,000 20 16 1,000 9,000 2 18
Short run Costs and production relations
Marginal Cost
• The MC curve is U-shaped. MC falls to begin with as output rises, because of
increasing returns, and then, after reaching outputQ1, it begins to rise because of
diminishing returns.

• Where ΔC/ Δ L is the additional cost of hiring one more worker, in other words the
price of labour, PL, and Δ Q/ Δ L is the marginal product of labour - MPL.
• Assuming that each additional worker is paid the same wage, PL is constant.
• This means that MC is inversely related to marginal product.
• when there are increasing returns and MPL is rising, it follows that MC must be
falling; after output Q1 there are diminishing returns and MPL is falling, so MC
must be rising
• MC curve intersects both the AVC and ATC curves at their minimum points.
Short run Costs and production relations
Average variable cost
• The AVC curve is also U-shaped - for
similar reasons as for the MC curve.

• Thus average variable cost is inversely

proportional to average product;
• When AP is rising, AVC must be falling
and vice versa.
• The range of output when AP is rising,
and thus AVC falling (up to Q2), is the
range of operation of stage I.
• Increasing and diminishing returns are
responsible for this behaviour.
LONG-RUN COSTS AND OUTPUT DECISIONS
 In the Long-run production – all inputs are variable
 If all inputs of a firm change - the scale of the firm changes
 Firms increase size of the firm or scale of production by changing the fixed inputs
of short run production – in order to increase output
 Long-run cost behavior of a firm is derived from – short run costs of separate
production plants

 In order to discuss about long run We look at firms in three short-run

circumstances:
i. firms earning economic profits,
ii. firms suffering economic losses but continuing to operate to reduce or minimize
those losses, and
iii. firms that decide to shut down and bear losses just equal to fixed costs.
LONG-RUN COSTS AND OUTPUT DECISIONS
Short-run Conditions and Long-run Directions

ABC Car Wash Weekly Costs

TOTAL VARIABLE COSTS TOTAL COSTS

TOTAL FIXED COSTS (TFC) (TVC) (800 WASHES) (TC = TFC + TVC) $ 3,600

1. Normal return to investors $ 1,000 1. Labor $ 1,000 Total revenue (TR)

2. Materials 600 at P = $5 (800 x $5) $ 4,000

2. Other fixed costs $ 1,600 Profit (TR - TC) $ 400

(maintenance contract,
insurance, etc.) 1,000

$ 2,000
Short-run Conditions and Long-run Directions
Producing at a Loss to offset Fixed Costs: The ABC Car wash
A firm will operate if total revenue covers total variable cost

CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3

Total Revenue (q = 0) $ 0 Total Revenue ($3 x 800) $ 2,400

Fixed costs $ 2,000 Fixed costs $ 2,000
Variable costs + 0 Variable costs + 1,600
Total costs $ 2,000 Total costs $ 3,600

Profit/loss (TR - TC) - $ 2,000 Operating profit/loss (TR - TVC) $ 800

Total profit/loss (TR - TC) -$ 1,200

 If revenues exceed variable costs, operating profit is positive and can be used to
offset fixed costs and reduce losses, and it will pay the firm to keep operating.
 If revenues are smaller than variable costs, the firm suffers operating losses that
push total losses above fixed costs. In this case, the firm can minimize its losses by
shutting down.
Short-run Conditions and Long-run Directions
Shutting Down to Minimize Loss
A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost
CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50

Total Revenue (q = 0) $ 0 Total revenue ($1.50 x 800) $ 1,200

Fixed costs $ 2,000 Fixed costs $ 2,000
Variable costs + 0 Variable costs + 1,600
Total costs $ 2,000 Total costs $ 3,600

Profit/loss (TR - TC): - $ 2,000 Operating profit/loss (TR - TVC) -$ 400

Total profit/loss (TR - TC) -$ 2,400

 Any time that price (average revenue) is below the minimum point on the average variable cost curve, total
revenue will be less than total variable cost, and operating profit will be negative—that is, there will be a loss on
operation.
 In other words, when price is below all points on the average variable cost curve, the firm will suffer operating
losses at any possible output level the firm could choose.
 When this is the case, the firm will stop producing and bear losses equal to fixed costs. This is why the bottom of
the average variable cost curve is called the shut-down point.
 At all prices above it, the marginal cost curve shows the profit-maximizing level of output. At all prices below it,
optimal short-run output is zero.
Short-run Conditions and Long-run Directions
 As long as price (which is equal to average revenue per unit) is sufficient to cover
average variable costs, the firm stands to gain by operating instead of shutting down.

 Shut-down point The lowest point on

the average variable cost curve.
 When price falls below the minimum
point on AVC, total revenue is
insufficient to cover variable costs and
the firm will shut down and bear losses
equal to fixed costs.

 The short-run supply curve of a competitive firm is that portion of its marginal cost
curve that lies above its average variable cost curve
Short-run Conditions and Long-run Directions
short-run industry supply curve The sum of the marginal cost curves (above
AVC) of all the firms in an industry.

 The Industry Supply Curve in the Short Run Is the Horizontal Sum of the
Marginal Cost Curves (above AVC) of All the Firms in an Industry
LONG-RUN DIRECTIONS

Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run
SHORT-RUN SHORT-RUN LONG-RUN
CONDITION DECISION DECISION

Profits TR > TC P = MC: operate Expand: new firms enter

Losses 1. With operating profit P = MC: operate Contract: firms exit

(TR  TVC) (losses < fixed costs)

2. With operating losses Shut down: Contract: firms exit
(TR < TVC) losses = fixed costs
LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE

 increasing returns to scale, or economies of scale - an increase in a firm’s scale

of production leads to lower costs per unit produced.
 constant returns to scale An increase in a firm’s scale of production has no
effect on costs per unit produced.
 decreasing returns to scale, or diseconomies of scale An increase in a firm’s
scale of production leads to higher costs per unit produced.

 long-run average cost curve (LRAC) A graph that shows the different scales on
which a firm can choose to operate in the long run.
 LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
1. INCREASING RETURNS TO SCALE - A Firm Exhibiting Economies of Scale

 Most of the economies of scale that immediately come to mind are technological in
nature. Some economies of scale result not from technology but from absolute size.
LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
2. DECREASING RETURNS TO SCALE - A Firm Exhibiting Economies and
Diseconomies of Scale

 All short-run average cost curves are U-shaped, because we assume a fixed scale of plant that
constrains production and drives marginal cost upward as a result of diminishing returns.
 In the long run, we make no such assumption; instead, we assume that scale of plant can be
changed.
LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE

3. CONSTANT RETURNS TO SCALE

 Technically, the term constant returns means that the quantitative relationship
between input and output stays constant, or the same, when output is
increased.
 Constant returns to scale mean that the firm’s long-run average cost curve
remains flat.

 It is important to note that economic efficiency requires taking advantage of

economies of scale (if they exist) and avoiding diseconomies of scale.

 optimal scale of plant - The scale of plant that minimizes average cost
LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE

SHORT-RUN PROFITS: EXPANSION TO EQUILIBRIUM

Firms expand in the long run when increasing returns to scale are available
 LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE

 Firms will continue to expand as long as there are economies of scale to be

realized, and new firms will continue to enter as long as positive profits are
being earned.
 In the long run, equilibrium price (P*) is equal to long-run average cost, short-
run marginal cost, and short-run average cost. Profits are driven to zero:
P* = SRMC = SRAC = LRAC

 No other price is an equilibrium price. Any price above P* means that there
are profits to be made in the industry, and new firms will continue to enter.
 Any price below P* means that firms are suffering losses, and firms will exit the
industry.
 Only at P* will profits be just equal to zero, and only at P* will the industry be
in equilibrium.
LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
SHORT-RUN LOSSES: CONTRACTION TO EQUILIBRIUM
 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses
LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
 As long as losses are being sustained in an industry, firms will shut down and leave
the industry, thus reducing supply—shifting the supply curve to the left.
 As this happens, price rises –this gradual price rise reduces losses for firms
remaining in the industry until those losses are ultimately eliminated.
 Whether we begin with an industry in which firms are earning profits or suffering
losses, the final long-run competitive equilibrium condition is the same: and
profits are zero
P* = SRMC = SRAC = LRAC
 At this point, individual firms are operating at the most efficient scale of plant—
that is, at the minimum point on their LRAC curve.
External Economies and Diseconomies

 When long-run average costs decrease as a result of industry growth, we say

that there are external economies.
 When average costs increase as a result of industry growth, we say that there
are external diseconomies.
 Break Even Analysis – (Cost–volume–profit(CVP) analysis )
• examines relationships between costs, revenues and profit on the one hand
and volume of output on the other.
• It is applied mainly to short-run situations.
• helps to identify the level of output and sales volume at which the firm
‘breaks even’.
• It means the revenues are sufficient to cover all costs of production.
• finding out the volume of sales where the firm’s costs and revenues will
be equal.
• There is no profit and no loss.
• The total revenue is equal to the total cost of production.
• Various managerial decisions of firms are taken by the managers based on
the break- even point.
Break Even Analysis • The total revenue curve (TR) and total cost
curve (TC) is given.
• When they produce 50 units the total cost and
total revenue are equal that is $ 150’000 which
is at the intersecting point of the curves.
• Break even point always denotes the quantity
produced or sold to equalize the revenue and
cost.
• When the firm produces less than 50 units the
revenue earned is less than the cost of
production (TR<TC) therefore in the initial
period the firm incurs loss which is shown in
the graph.
• Through selling more than 50 units the revenue
increases more than the cost of production
therefore the difference increases and provides
profit to the organization (TR>TC).
Break Even Analysis

•Break-even output
• can be derived mathematically, using linear cost and revenue functions.
• The revenue function - R=PQ,
• the cost function – C = a + bQ, and
• we then solve for Q at BEQ
PQ = a + bQ, Q(P – b) = a
BEQ out put Q = a/(P – b)
• Where, a = fixed cost, b = average variable cost, P = price.
• (P - b), is referred to as the profit contribution.
Break even Quantity (BEQ) = TFC/(Selling Price – AVC)
Break Even Analysis
Managerial Uses of Break-Even Analysis
• Product planning - helps the firm in planning its new product development
• Activity planning - the firm decides the expansion of production capacity.
• Profit planning - this helps the firm to plan about their profit well in advance and at the same time it
helps to identify the quantity to be sold to achieve the targeted profit.
• Target capacity - the targeted sales quantity helps to decide the purchase, inventory and
management
• Price and cost decision - Decision regarding how much the price of the commodity should be
reduced or increased to cover their cost of production
• Safety margin - it helps to understand the extent to which the firm can withstand their fall in sales.
• Price decision - the selling price can be fixed based on its expected revenue or profit.
• Promotional decision - the firm can decide the kind of promotion required and how much amount
could be spent.
• Distribution decision - helps to improve the distribution system and for business expansion.
• Dividend decision - firm can decide the dividend to be fixed for their shareholders.
• Make or buy decision - helps to decide on whether to make or buy the product - outsourcing or in
house production.
Operating Leverage
• The degree of operating leverage(DOL) refers to the percentage change in
profit resulting from a 1 per cent change in units sold. Mathematically -
DOI = = =
• It can be interpreted as - elasticity of profits with respect to output and
can be measured in similar way to the demand elasticity.
• Example - if the firm is producing 1,500 units per month, DOL will be:
C = 10000 + 12Q
R = 20Q
∏ = 20Q – (10000 + 12Q) = 8Q – 10000; ∏ = 2000 ETB at output of
1500 units
DOL= 8 X (1500 /2000) = 6
• The interpretation of this result is that a 1 per cent increase in output will
increase profit by 6 per cent.
Cost Estimation
• Managers cannot apply their knowledge of the firm’s cost functions unless these
have been estimated in the first place.
• Therefore, cost estimation is important for the same reasons as an understanding of
cost theory
• To determine the pricing of the firm’s products.
• To determine the other components of the marketing mix
• To determine the optimal output of the firm in the short run and the relevant
input mix.
• To determine the optimal scale of operation of the firm in the long run.
• To determine whether to accept or refuse an order from a potential customer at
a particular price.
• To determine the impact of potential mergers and acquisitions on unit costs.
Cost estimation methodologies
• Like demand estimation, there are different methods of cost estimation that can be used.
• However, statistical analysis tends to be the preferred method, with its advantages being
essentially the same as for demand analysis.
• The other two alternative methods of estimation are - engineering analysis and the survivor
method.
• Engineering analysis - is mainly concerned with estimating physical relationships between
inputs and outputs in order to estimate a production function.
• It can be used to obtain the cost function of the firm, once we know the prices of the
inputs, and assuming that the firm produces with economic efficiency.
• Survivor method - it was originally developed by Stigler and only applies to long-run cost
estimation.
• The method does not rely on the use of accounting data
• It simply involves categorizing the firms in an industry according to size, observing the
industry over a relatively long time period, and recording the growth or decline of the
different size categories.
Cost estimation methodologies
• Statistical analysis - often used to estimate cost functions. These overcome some of the
problems, but are not
• The procedure for statistical cost estimation is essentially the same as for demand estimation. The same
seven steps are involved:
1. Statement of a hypothesis. Eg. – ‘a firm’s short-run total cost function is linear’
2. Model specification - determining what variables should be included in the cost function and
what mathematical form should take - on the basis of economic theory and empirical studies
3. Data collection - after the cost function specified - for which variables we have to collect data
4. Estimation of parameters - computing the values of the coefficients of the variables in the
model - measured in terms of the marginal effects and elasticity
5. Selecting the best model - once several alternative models have been estimated examine how
well each model fits the data and which model fits best
6. Testing a hypothesis - determined by comparing the goodness of fit
7. Forecasting - once the appropriate cost function has been estimated cost forecasts for
different outputs can be computed.