Business Economics (ECO 341) Spring: 2012 Semester

Business Economics (ECO 341)Lecture 6Fall: 2012 Semester

Khurrum S. Mughal

111Cost Theory & AnalysisShort-Run Cost FunctionLink Between Production and CostLeast Cost RuleEconomic Concept of CostEconomies of ScaleDiseconomies of ScaleRevenue Analysis

Theme of the Lecture

2A period of time so short that the firm cannot alter the quantity of some of its inputs

Typically plant and equipment are fixed inputs in the short runFixed inputs determine the scale of the firms operationShort-Run3Total Cost = TC = f(Q)Total Fixed Cost = TFCTotal Variable Cost = TVCTC = TFC + TVCShort-Run Cost Functions4QTFCTVCTC060060160208026030903604510546080140560135195Short-Run Cost Functions5

TFCShort-Run Cost Functions6Average Total Cost = ATC = TC/QAverage Fixed Cost = AFC = TFC/QAverage Variable Cost = AVC = TVC/QATC = AFC + AVCMarginal Cost = TC/Q = TVC/QShort-Run Cost Functions7QTFCTVCTCAFCAVCATCMC060060----1602080????2603090????36045105????46080140????560135195????Short-Run Cost Functions8QTFCTVCTCAFCAVCATCMC060060----1602080602080202603090301545103604510520153515460801401520353556013519512273955Short-Run Cost Functions9

Short-Run Cost Functions10

11Cost Theory & AnalysisShort-Run Cost FunctionLink Between Production and CostLeast Cost RuleEconomic Concept of CostEconomies of ScaleDiseconomies of ScaleRevenue Analysis

Theme of the Lecture

12The cost curves are derived from the Prices of factors of production (Inputs)Production Function

What are diminishing returns to factors?

The cost curves are U-Shaped. Why?The Link Between Production and Cost1314

Cost Theory & AnalysisShort-Run Cost FunctionLink Between Production and CostLeast Cost RuleEconomic Concept of CostEconomies of ScaleDiseconomies of ScaleRevenue Analysis

Theme of the Lecture

15Marginal Product and the least-cost rule

Marginal Product of a factor divided by the factor price

Marginal product per dollar of input

Substitution Rule:when price of a factor changesChoice of Inputs by the Firm16MPL = MPK .. w rCost Theory & AnalysisShort-Run Cost FunctionLink Between Production and CostLeast Cost RuleEconomic Concept of CostEconomies of ScaleDiseconomies of ScaleRevenue Analysis

Theme of the Lecture

17Opportunity costs are the value of the other products that the resources used in production could have produced at their next best alternative

Economic Concept of Cost18Cost Theory & AnalysisShort-Run Cost FunctionLink Between Production and CostLeast Cost RuleEconomic Concept of CostEconomies of ScaleDiseconomies of ScaleRevenue AnalysisTheme of the Lecture

19Economies of scale refers to the phenomena of decreased per unit cost as the number of units of production increase.

The initial investment in capital is diffused with reduction in marginal cost of producing

Economies of scale means a reduction in the per unit costs of a product as a firm's production increases. Economies of ScaleTend to occur in industries with high capital costs

Types of economies of scale:Internal Economies of scaleExternal Economies of scale

Economies of ScaleResult of mass production. As the firm produces more and more goods, the average cost begin to fall because of:

Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, intensively.

Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc.

Financial economies made by borrowing money at lower rates of interest than smaller firms. Internal Economies of ScaleMarketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output.

Commercial economies made when buying supplies in bulk and therefore gaining a larger discount.

Research and development economies made when developing new and better products. Internal Economies of ScaleThese are economies made outside the firm as a result of its location, and occur when:

A local skilled labour force is available.

Specialist, and local back-up firms can supply parts or services.

An area has a good transportation network.

An area has an excellent reputation for producing a particular good. For example.External Economies of ScaleUnit CostOutputScale AScale BLRAC82p54pEconomies of Scale25Cost Theory & AnalysisShort-Run Cost FunctionLink Between Production and CostLeast Cost RuleEconomic Concept of CostEconomies of ScaleDiseconomies of ScaleRevenue Analysis

Theme of the Lecture

26As with all things, as industries get bigger so does the infrastructure and the problems associated with economies of scale.

This can result in:Internal Diseconomies of ScaleExternal Diseconomies of ScaleThe other sideAs the firm increases production, after some point average costs begin to rise because:

The disadvantages of the division of labour take effect- too many people doing different jobs add to costs.

Management becomes out of touch with the shop floor and some machinery becomes over-manned- costs increase.

Decisions are not taken quickly and there is too much formalities.

Lack of communication in a large firm means that management tasks sometimes get done twice.

Poor labour relations may develop in large companies. Internal Diseconomies of ScaleThese occur when too many firms have located in one area. Unit costs begin to rise because:

Local labour becomes scarce and firms now have to offer higher wages to attract new workers.

Land and factories become scarce and rents begin to rise.

Local roads become congested and so transportation costs begin to rise. External Diseconomies of ScaleCost Theory & AnalysisShort-Run Cost FunctionLink Between Production and CostLeast Cost RuleEconomic Concept of CostEconomies of ScaleDiseconomies of ScaleRevenue Analysis

Theme of the Lecture

30Revenue(or turnover) is the income generated from the sale of output in product markets. There are two main revenue concepts to grasp at this stage:Average Revenue(AR) = Price per unit = total revenue / outputMarginal Revenue(MR) = the change in revenue from selling one extra unit of outputRevenue AnalysisRevenue AnalysisPrice per unit(average revenue)Quantity Demanded(Qd)Total Revenue(TR)Marginal Revenue(MR)sunitsss4002208800037034012580031534046015640025531058017980019528070019600013525082020500075220940206800151901060201400-45Revenue Analysis