Business Economics (ECO 341) Lecture 6 Fall: 2012 Semester Khurrum S. Mughal 1 1

Theme of the Lecture Cost Theory & Analysis Revenue 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

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

Total Variable Cost = TVC Short-Run Cost Functions Total Cost = TC = f(Q) Total Fixed Cost = TFC Total Variable Cost = TVC TC = TFC + TVC

Short-Run Cost Functions Q TFC TVC TC 60 1 20 80 2 30 90 3 45 105 4 140 5 135 195

Short-Run Cost Functions TFC

Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q 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

Short-Run Cost Functions Q TFC TVC TC AFC AVC ATC MC 60 - 1 20 80 ? 2 30 90 3 45 105 4 140 5 135 195

Short-Run Cost Functions Q TFC TVC TC AFC AVC ATC MC 60 - 1 20 80 2 30 90 15 45 10 3 105 35 4 140 5 135 195 12 27 39 55

Short-Run Cost Functions

Theme of the Lecture Cost Theory & Analysis Revenue 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

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?

Theme of the Lecture Cost Theory & Analysis Revenue 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

Choice of Inputs by the Firm Marginal 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 changes MPL = MPK ………….. w r

Theme of the Lecture Cost Theory & Analysis Revenue 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

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

Theme of the Lecture Cost Theory & Analysis Revenue 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

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 Revenue 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

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 Revenue 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

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

Price per unit (average revenue) Quantity Demanded (Qd) Revenue Analysis Price per unit (average revenue) Quantity Demanded  (Qd) Total Revenue  (TR) Marginal Revenue  (MR) £s units 400 220 88000   370 340 125800 315 460 156400 255 310 580 179800 195 280 700 196000 135 250 820 205000 75 940 206800 15 190 1060 201400 -45

Revenue Analysis