Business Economics (ECO 341)
Lecture 6
Fall: 2012 Semester
Khurrum S. Mughal
1
Theme of the Lecture
 Cost Theory & Analysis
 Short-Run Cost Function
 Link Between Production and Cost
 Least Cost Rule
 Economic Concept of Cost
 Economies of Scale
 Diseconomies of Scale
 Revenue Analysis
2
Short-Run
A 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 run
 Fixed inputs determine the scale of the firm’s operation
3
Short-Run Cost Functions
Total Cost = TC = f(Q)
Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC
4
Short-Run Cost Functions
Q
TFC
TVC
TC
0
60
0
60
1
60
20
80
2
60
30
90
3
60
45
105
4
60
80
140
5
60
135
195
5
Short-Run Cost Functions
TFC
6
Short-Run Cost Functions
Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q
7
Short-Run Cost Functions
Q
TFC
TVC
TC
AFC
AVC
ATC
MC
0
60
0
60
-
-
-
-
1
60
20
80
?
?
?
?
2
60
30
90
?
?
?
?
3
60
45
105
?
?
?
?
4
60
80
140
?
?
?
?
5
60
135
195
?
?
?
?
8
Short-Run Cost Functions
Q
TFC
TVC
TC
AFC
AVC
ATC
MC
0
60
0
60
-
-
-
-
1
60
20
80
60
20
80
20
2
60
30
90
30
15
45
10
3
60
45
105
20
15
35
15
4
60
80
140
15
20
35
35
5
60
135
195
12
27
39
55
9
Short-Run Cost Functions
10
11
Theme of the Lecture
 Cost Theory & Analysis
 Short-Run Cost Function
 Link Between Production and Cost
 Least Cost Rule
 Economic Concept of Cost
 Economies of Scale
 Diseconomies of Scale
 Revenue Analysis
12
The Link Between Production and Cost
 The 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?
13
14
Theme of the Lecture
 Cost Theory & Analysis
 Short-Run Cost Function
 Link Between Production and Cost
 Least Cost Rule
 Economic Concept of Cost
 Economies of Scale
 Diseconomies of Scale
 Revenue Analysis
15
Choice of Inputs by the Firm
 Marginal Product and the least-cost rule
 Marginal Product of a factor divided by the factor price
MPL = MPK …………..
w
r
 Marginal product per dollar of input
 Substitution Rule:
when price of a factor changes
16
Theme of the Lecture
 Cost Theory & Analysis
 Short-Run Cost Function
 Link Between Production and Cost
 Least Cost Rule
 Economic Concept of Cost
 Economies of Scale
 Diseconomies of Scale
 Revenue Analysis
17
Economic Concept of Cost
 Opportunity costs are the value of the other products
that the resources used in production could have
produced at their next best alternative
18
Theme of the Lecture
 Cost Theory & Analysis
 Short-Run Cost Function
 Link Between Production and Cost
 Least Cost Rule
 Economic Concept of Cost
 Economies of Scale
 Diseconomies of Scale
 Revenue Analysis
19
Economies of Scale
 Economies 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 Scale
 Tend to occur in industries with high capital costs
 Types of economies of scale:
 Internal Economies of scale
 External Economies of scale
Internal Economies of Scale
 Result 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 Scale
 Marketing 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.
External Economies of Scale
 These 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………….
Economies of Scale
Unit Cost
Scale A
82p
Scale B
54p
LRAC
Output
Theme of the Lecture
 Cost Theory & Analysis
 Short-Run Cost Function
 Link Between Production and Cost
 Least Cost Rule
 Economic Concept of Cost
 Economies of Scale
 Diseconomies of Scale
 Revenue Analysis
26
The other side
 As 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 Scale
 External Diseconomies of Scale
Internal Diseconomies of Scale
 As 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.
External Diseconomies of Scale
 These 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.
Theme of the Lecture
 Cost Theory & Analysis
 Short-Run Cost Function
 Link Between Production and Cost
 Least Cost Rule
 Economic Concept of Cost
 Economies of Scale
 Diseconomies of Scale
 Revenue Analysis
30
Revenue Analysis
 Revenue (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 / output
 Marginal Revenue (MR) = the change in revenue
from selling one extra unit of output
Revenue Analysis
Price per unit
(average
revenue)
£s
Quantity Demanded
(Qd)
Total Revenue
(TR)
Marginal Revenue
(MR)
units
£s
£s
400
220
88000
370
340
125800
315
340
460
156400
255
310
580
179800
195
280
700
196000
135
250
820
205000
75
220
940
206800
15
190
1060
201400
-45
Revenue Analysis