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

Principles of

Business Economics

Joseph G. Nellis

Professor of International Management EconomicsCranfield School of ManagementCranfield University

David Parker

Professor of Business Economics and Strategy Aston Business School Aston University

© Pearson Education Limited 2002

OHT 0.1

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1 Business economics: an overview

2 The analysis of consumer demand3 The analysis of production costs4 Analysis of the firm¶s supply decision5 Demand, supply and price determination6 Analysis of perfectly competitive markets7 Analysis of monopoly markets

8 Analysis of monopolistically competitive markets9 Oligopoly10 Managerial objectives and the firm11 Understanding competitive strategy12 Understanding pricing strategies13 Understanding the market for labour

14 Understanding the market for capital15 Understanding the market for natural resources16 Government and business17 Business and economic forecasting18 Business economics - a checklist for managers

OHT 0.2Contents

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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.

OHT 1.1

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OHT 1.2

Figure 1.1 The business environment

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Learning outcomes

This chapter will help you to:

Understand the core t erms and concept s used inbusiness economics.

Appreciate the nature of a firm¶s productiondecisions with respect to what to produce, how

to produce and for whom to produce.

Employ economic reasoning when makingchoices in the use of resources and to recognisethe importance of diminishing ret urns.

OHT 1.3A

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Comprehend the nature of marginal analysis in

the context of business and consumer decisions.

Recognise the different objec t ives whichdifferent firms may pursue and the consequent

impact on price and output decisions.

Distinguish between the shor t run and long run

in business economics.

Understand the nature of different competitivestructures in market economies ranging from

perfec t ly compet i t ive to monopoly situations.

OHT 1.3B

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Analyse the ex t ernal environment and int ernal capabili t ies of a firm using core techniques inbusiness economics and thereby understand theforces shaping the firm¶s competitiveenvironment.

Appreciate the choice of generic st rat egies

facing firms in terms of cost leadershi p,different iat ion and focus options.

OHT 1.3C

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Resource allocation.

Opportunity cost.

Diminishing marginal returns.

Marginal analysis.

Business objectives.

Basic concepts in business economics

There are a number of basic concepts which lie at the heartof business economics and managerial decision-making.Themost important of these are the following:

OHT 1.4A

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Time dimension.

Economic efficiency and equity.

Risk and uncertainty.

Externalities.

Discounting.

Property rights.

OHT 1.4B

Basic concepts in business economics

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Resource allocation

Economics is concerned with the efficient allocation of scarceresources. When purchasing raw materials,employing labour and undertaking investment decisions,the manager is involvedin resource allocat ion.Decisions need to be made at threelevels, namely:

What goods and services to produce with the availableresources,

How to combine the available resources to producedifferent types of goods and services;and

For whom the different goods and services are to besupplied.

OHT 1.5

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OHT 1.6

Figure 1.2 The production decision

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The oppor t uni t y cost of any activity is what we give up

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

A produc t ion possibili t y curve shows the maximum output

of two goods or services that can be produced given thecurrent level of resources available and assumingmaximum efficiency in production.

The concept of diminishing marginal ret urns refers to thesituation 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 becomessmaller and smaller.

OHT 1.7

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OHT 1.8

Figure 1.3 Production possibility curve

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Marginal utility is the amount by which consumer well-beingor total utility changes when the consumption of a good or service changes by one unit.

Marginal product is the amount by which total productchanges due to a one unit change in the amount of inputused.

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 fromincreasing the quantity produced by one unit.

OHT 1.9

Marginal Analysis

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Profit maximisation

The achievement of personal goals,involving personalsecurity and reward,status, degree of discretionarypower,etc.

Growth targets for the company in terms of scale of output,market share,geographical market,annualextension of physical capacity,size of departments or size of the labour force,etc.

Maximisation of sales revenue.

Pursuit of the interests of all st akeholders includingemployees,customers,suppliers, etc.as well asshareholders.

Business ObjectivesOHT 1.10

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The shor t 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 maybe varied.

Time dimension

OHT 1.11

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The concept of discount ing is concerned with the fact thatcosts and benefits arising in future years are worth less to usthan costs and benefits arising today.

Discount ing formula

NPV =

where NPV is the net present value of the cash flow over thelife of the project, S is the future sum, r is the rate of interestor discount rate, and t the number of years elapsing beforethe future sum is received.

Discounting

OHT 1.12

§

t

t

r

S

1

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The competitive environment & marketstructure

Perfectly competitive markets.

Monopolistically competitive markets.

Oligopolistic competition.

Monopoly.

OHT 1.13

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Defining the nature of the market

The number and size distribution of the buyersand sellers in the market.

The degree of product differentiation thatexists.

The severity of the barriers to entry and exit

that face potential new entrants to the market.

OHT 1.14

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OHT 1.15

Figure 1.4 Characteristics of markets

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Porter Five Forces Model

The bargaining power of buyershow much leverage buyershave in determining the price.

The bargaining power of (input) suppliersthe competitionamong suppliers which determines the price of inputs to the

firm.

The threat from potential new entrants into the marketthedegree of µmarket contestabilityor the extent to which firmsare able to enter the market and contest for consumers.

The threat from substitute products or services e.g. mobiletelephones for fixed-line services.

The degree of competition (rivalry)in the market.

OHT 1.16

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OHT 1.17

Figure 1.5 Forces shaping the competitive environment

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Cost positioning of the firm

Cost leadership.

Differentiation.

Focus.

OHT 1.18

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OHT 1.19

Figure 1.6 Strategy and the competitive environment - an overview

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Key learning points

Microeconomics deals with the operation of the firm inits immediate market, involving the determination of itsprices, revenues,costs and input employment levels.

Macroeconomics is concerned with the interactions inthe economy as a whole of which each firm forms a part.

Resource allocation is concerned with decisionsregarding what, how , and for whom to produce.In amarket economy the price mechanism is the major

determinant of these decisions.

OHT 1.20A

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The opportunity cost of any activity is the loss of theopportunity to pursue the most attractive alternativegiven the same resources.

A production possibility curve shows the maximumoutput that can be produced given the current level of resources available and assuming maximum efficiencyin production.

Diminishing marginal returns refers to the situation

whereby,as we apply more of one input to a fixedamount of another input,then after some point the

resulting increase in output becomes smaller andsmaller.

OHT 1.20B

Key learning points

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Marginal analysis reminds us that most choices involve relativelysmall (incremental)increases or decreases in production (or consumption).

The short run represents the operating period of the business inwhich at least one factor of production is fixed in supply.

The long run represents the planning horizon of the business inwhich all factors of production may be varied in order to alter thescale of production.

Externalities represent wider outcomes of the market mechanismand arise when some of the benefits or costs of consuming a goodor service spill over to others.

Key learning points

OHT 1.20C

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The concept of discounting is concerned with the fact that costsand benefits arising in future years are worth less to us than costsand 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 smallsellers 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 sellersbut there is also some degree of product differentiation.This formof market structure is also sometimes referred to as imperfectly

competitive.

Key learning points OHT 1.20D

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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-pricecompetition.

A monopoly exists where the market is supplied by one firmproducing a product for which there is no close substitute. A

monopolist, therefore, tends to be a price-maker , in that the firmis able to set a price in the face of little or no competition. Inpractice, the term monopoly is often applied also to markets thatare dominat ed by one firm.

Porter

Five Forces Model describes the competitiveenvironment as being determined by the power of buyers, the

power of suppliers, the threat from potential new entrants, thethreat from substitutes and the degree of rivalry in the market.

Key learning points OHT 1.20E

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The external environment of business is determined bychanges in political, economic, social and technological

factors, i.e.PEST influences.

A SWOT analysis involves consideration of a firm¶s internalstrengths and weaknesses in the context of the opportunitiesand threats which it faces.

Generic strategies refer to the choice between pursuing amarket strategy based on cost leadership, differentiation or focus .

Key learning points

OHT 1.20F

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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.

CHAPTER 2.

The analysis of consumer demand

OHT 2.1

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This chapter will help you to: Understand why changes in price affect consumer demand and, inparticular, 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 t he condi t ions of demand).

Analyse the nature of the relationship between marginal ut ili t y andthe demand curve for any product or service.

Appreciate the meaning and importance of consumer surplus in thecontext of pricing strategies.

Learning outcomes OHT 2.2A

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Interpret the relative importance of income andsubst i t ut ion effec t s on demand when the price of agood or service changes.

Classify goods and services according to how demandresponds to changes in price and income, giving rise

to the terms normal, inferior, Giffen and Veblen goodsor services.

Calculate pric e, cross-price and income elasticities of demand and interpret the significance of the results.

Appreciate the relationship between price elast ici t y,marginal revenue and t ot al revenue arising from thesale of goods or services.

OHT 2.2B

Learning outcomes

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A consumer¶s demand curve relates the amountthe consumer is willing to buy to each conceivableprice for the product.

The market demand curve for a good or service isderived by summing the individual demand curvesof consumers horizontally for any given price.

The market demand curveOHT 2.3

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OHT 2.4

Figure 2.1 Derivation of the market demand curve

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In general there is a central law of demand, whichstates that there is an inverse relationshipbetween the price of a good and the quantitydemanded assuming all ot her fac t ors t hat might

influence demand are held const ant .

The law of demandOHT 2.5

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OHT 2.6

Figure 2.2 Linear and non-linear demand relationships

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OHT 2.8

Marginal utility and water shortages

Consumer surplus

C onsumer surplus is the excess of the price which a person wouldbe willing to pay rather than go without the good, over that which heor she actually does pay.

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Determinants of demand

The µown priceof the good itself (P 0 ).

The price of substitute goods (P s ).

The price of complementary goods (P c ).

The level of advertising expenditure on theproduct in question, a , as well as oncomplementary and substitute products, b,...,z (denoted A

a,b,«..z

).

The level and distribution of consumersdisposable incomes (Y d ),i.e.income after state direct taxes and benefits.

OHT 2.9A

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Wealth effects (W )caused by, for example, stock

market booms, rising house prices, windfall gains,etc.

Changes in consumerstastes and preferences (T ).

The cost and availability of credit (C ).

Consumersexpectations concerning future pricerises and availability of the product (E ).

Changes in population (POP),if we are examining thetotal market demand.

Demand func t ion

OHT 2.9B

Determinants of demand

POP E C T W Y A P P P f Q d zbac sd ,,,,,,,,, ...,0!

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OHT 2.10

Figure 2.3 Shift in the demand curveWhen the own price of a product changes, the outcome is a movement along t he

demand curve and when any other determinants of demand change, there willbe a shif t of t he demand curve (either to the left, showing a fall in the quantitydemanded, or to the right, showing a rise) depending on the nature of thechange.

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OHT 2.11

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

DD refer to the good in question)

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Normal products.

Inferior products.

Giffen products.

Veblen products.

Classification of productsOHT 2.12

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Normal products

Goods and services may be classified as µ normal productsif the quantitydemanded rises as incomes rise and falls as incomes fall.

Inferior products

Certain products are classified as µinferior¶ because the demand for them falls asincomes rise (and vice versa).

Giffen products

A special case of the inferior product arises when,as price rises ,more of thegood in question is boughtresulting seemingly in an upward sloping demandcurve,contrary to the normal law of demand.

Veblen productsIt has been suggested that µ luxury typeproducts also display perverse pricedemand relationships,though for different reasons to that of the Giffenproducts case.These are sometimes referred to as Veblen products,

OHT 2.13

Classification of products

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P rice elasticity of demand.This measures the responsiveness of

quantity demanded of a product to changes in its µ 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).F

or 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 demandfor housing?

C oefficient of elast ici t y = Percentage change in quantity demandedPercentage change in the relevant variable

OHT 2.14Concepts of elasticity

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P rice 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 becalculated,as follows:

Arc elasticity of demand. Point elasticity of demand.

OHT 2.15

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OHT 2.12

Figure 2.5 Arc elasticity of demand

Arc elast ici t y of demand

1212

1212

2

1/

2

1/

P P P P

QQQQ

12

12

12

12

QQ

P P x

P P

QQ

!

Arc Ed =

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Point elast ici t y of demand

OHT 2.17

1

1

12

12

112

112

/

/

Q

P x P P

QQ

P P P

QQQ E d

!

!Point

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Products with a price elasticity of demand

of less than 1 are said to have a relativelyinelastic demand with respect to pricethey are said to be price inelastic .

Products with a price elasticity of demandgreater than 1 are said to have a relativelyelastic demandthey are said to be price

elastic .

Products with a price elasticity of demandexactly equal to 1 are said to have a unit

(or unitary)elasticity of demand.

OHT 2.18

Degrees of elasticity

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OHT 2.19

Figure 2.6 Degrees of elasticity of demand

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C ross-price elast ici t y of demand

Cross-price Ed = Percentage change in the demand for APercentage change in the price of B

The terminology regarding the degree of cross-priceelasticity (ignoring the sign)is the same as for priceelasticity,namely:

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

OHT 2.20

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Income elasticity of demand

Income Ed = Percentage change in demandPercentage change in real income

Inferior goods

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

N ormal goodsThese are the most common goods with demandgenerally rising as real income rises. They canthemselves be further subdivided into two categories:

OHT 2.21A

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Necessi t ies .These are goods and services which exhibit

a positive income elasticity of demand,though the valuewill tend to be less than 1. Articles such as basicfoodstuffs and ordinary day-to-day clothing fall into thiscategory.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 toincrease their spending on the goods by a smaller proportion.

Luxuries . At very low income levels,nothing will bespent on these but,once a certain threshold income level

is reached,the proportionate rise in demand for luxurygoods is greater than the proportionate rise in realincome,e.g.foreign holidays,dining out and DVD players.

OHT 2.21B

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OHT 2.22

Figure 2.7 Demand and total revenue

The relationship between price elasticity

and sales revenue

Total revenue = price x quantity sold

TR = P x Q

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P rice elasticity and total revenue

With a price inelastic demand:(a)an increase in price causes a reduction inquantity demanded,but total revenue increases;

(b)a fall in price causes an increase in quantitydemanded,but total revenue earned declines. With a price elastic demand:

(a)an increase in price causes such a large fall inquantity demanded that total revenue falls;

(b)a reduction in price causes such a large increasein the quantity demanded that the total revenuerises.

OHT 2.23

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M arginal revenue

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

MR =

Average revenue (AR)is the total revenue (TR) divided byoutput (Q )or the revenue earned on average for each unitsold.

AR =

OHT 2.24

Q

TR

(

(

QTR

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OHT 2.25

Figure 2.8 Elasticity, marginal revenue and total revenue

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Marginal revenue falls as output rises. Since the demand curveslopes downwards, the addition to total revenue from producingand selling extra units declines.

Average revenue exceeds marginal revenue. When the demandcurve is downward sloping,the marginal revenue from selling onemore unit falls faster than the average revenue from selling thetotal output.

The marginal revenue curve declines at twice the rate of the

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

OHT 2.26A

Elasticity, marginal revenue and total revenue - key

relationships

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When total revenue is increasing,marginal revenue is

positive. This results from the fact that demand is elasticbetween points A and B on the demand curve DD in Figure2.8.

When total revenue is falling,marginal revenue isnegative. A negative marginal revenue results from demandbeing 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 isunitary.Therefore,further attempts to increase total revenueby lowering price below P *will fail because the salesvolume will not increase sufficiently to compensate for theprice fall.

Elasticity, marginal revenue and total revenue -

key relationships

OHT 2.26B

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A demand curve relates the amount that consumers arewilling to buy to each conceivable price for the product.

In general, the law of demand states that there is aninverse relationship between the price of a good and the

quantity demanded,assuming all other factors that mightinfluence demand are held constant (i.e.cet eris paribus ).

Utility theory helps explain why consumers buy more of something the lower its price.

Key learning points OHT 2.27A

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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 withthe tendency for marginal utility to fall as more units of agood or service are consumed at any given time.

Consumer equilibrium describes how consumersmaximise their total utility by distributing expenditure sothat the ratio of marginal utilities for all the goods andservices they consume,at any given time, is equal to their relative prices.

Consumer surplus is reflected by the excess of the pricewhich a person would be willing to pay rather than gowithout the good,over that which he or she actuallydoes pay.

OHT 2.27BKey learning points

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When the own price of a good changes,the outcome is amovement 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 upof two distinct effects:an income effect and a substitution

effect. The income effect arises from the fact that as the ownprice of a good falls,consumers are in effect better off and henceable to buy more of the good.The substitution effect reflects thefact 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 thequantity demanded rises as (real)incomes and falls as incomes

fall.

OHT 2.27C

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In contrast, goods and services are classified as inferior products if the quantity demanded falls (rises)as incomesrise (fall).

A Giffen product is a special case of an inferior product andhas what appears to be an upward sloping demand

curve,contrary to the normal law of demand,because theincome effect outweighs the substitution effect.

A Veblen product also has seemingly an upward slopingdemand curve because of µsnob¶ effects, i.e.it is demanded

because it is expensive and therefore exclusive. Many luxuryproducts fit into this category.

OHT 2.27D

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The (own) price elasticity of demand for a product may bedefined in general terms as:

Ed = Percentage change in quantity demandedPercentage change in the price of the product

The value of Ed may be calculated on the basis of amovement along a section of the demand curve,giving riseto a value of the arc elasticity .This is expressed on thebasis of the average quantity and average price,as follows:

Arc Ed

OHT 2.27E

12

12

12

12

QQ P P x

P P QQ

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For very small price changes,elasticity may be calculated withreference to a single point on the demand curve,giving rise to avalue of the point elasticity ,as follows:

Point Ed =

Products with a price elasticity of demand of less than 1 (in

absolute terms)are said to have a relatively inelastic demandwith respect to pricehey are said to be price inelastic .In thiscase,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 demandthey are said to be price elastic. In this case,total salesrevenue will tend to fall (rise)as price rises (falls).

OHT 2.27F

1

1

12

12

Q

P x

P P

QQ

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Products with a price elasticity of demand equal to 1 (inabsolute terms)are said to have a unit or unitary elasticity of demand. In this case, total sales revenue will remainunchanged 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 theresponsiveness of the demand for one product to changes inthe prices of other goods and services and may be calculated

as:

Cross-price Ed = Percentage change in the demand for APercentage change in the price of B

OHT 2.27G

OHT 2 27H

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Substitutes will tend to have a positive value for cross-priceEd ,while complements will tend to have a negative value.

Income elasticity of demand measures the responsivenessof quantity demanded with respect to (real) income variationsas follows:

Income Ed = Percentage change in quantity demandedPercentage change in real incomeNecessities exhibit a positive income elasticity of demandthough the value will tend to be less than 1. In contrast,luxuries will tend to have an income elasticity of demandgreater than 1.

Marginal revenue is defined as the incremental change intotal revenue and is usually measured as a firm sells one moreor one less unit of its output.

OHT 2.27H

OHT 2 27I

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The marginal revenue curve declines at twice the rate of the

demand (average revenue)curve.

When total revenue is increasing (decreasing),marginal revenueis positive (negative)such that total revenue is maximised

when marginal revenue is zero .This occurs when the priceelasticity 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 thatthe consumer is indifferent between each combination.

The slope of the budget line is determined by the relativeprices of the two goods or services and the position of the lineby the consumer income.

OHT 2.27I

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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 theincome and substitution effects of a price change.

OHT 2.27J

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OHT A2.28

Figure A2.1 A typical indifference curve

Appendix 2.1 Indifference curve analysis

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.

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OHT A2.29

Figure A2.2 An indifference curve map

Th b d t t i t

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OHT A2.30

Figure A2.3 The budget constraint

The budget constraint

Budget constraint

PxQx + PyQyem

The slope of the budget line is determined by the relative prices of the two goodsand the posi t ion of the line by the consumer¶s income.

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OHT A2.31

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

O

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OHT A2.32

Figure A2.5 Utility maximisation with a budget constraint

OHT A2 33

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OHT A2.33

Figure A2.6 Substitution and income effects of a price change for a normal good

OHT A2 34

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OHT A2.34

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

OHT 2 35A

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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

OHT 2.35A

Appendix 2.2 Marginal revenue and the demand

curve

OHT 2 35B

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OHT 2.35B

Appendix 2.2 Marginal revenue and the demand curve

Q

bQaQ

H

H 2

Marginal revenue (MR) is defined as the change in total revenue withrespect to a unit change in sales. In terms of differential calculus:

Q

TR

Q

TR

MR H

H

!(

(

!

= a - 2bQ 2.2)

(substituting for TR = aQ - bQ2)=

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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 andlong-run.

Differentiate between total, average and marginal costs of production and how these costs affect output decisions andprofitablity.

Determine the level of output which maximises profit for anygiven cost structure and demand conditions.

Distinguish between variable and fixed costs of production and

their role in determining when a firm should shut downproduction.

Appreciate the meaning of diminishing returns in the context of short-run production decisions.

Learning outcomes OHT 3.2A

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Learning outcomes

Understand the nature of ex t ernal and int ernal economies of scale as the size of a business alters.

Appreciate the significance of innovat ion in sustaining afirm¶s competitive advantage over the long run.

Distinguish between scale inefficiencies in production andinefficiencies that result from the poor management of resources (i.e. X-inefficiency ).

Realise the growing importance of information andknowledge in business decision-making as factors of

production in their own right.

OHT 3.2B

OHT 3.3

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P roduction function

The production function is a mathematical expression whichrelates the quantity of all inputs to the quantity of outputs,assuming that managers employ all inputs efficiently. In generalterms the production function for any firm may be expressed asfollows:

Q = F (I1, I2, I3,«,In)

C ost func t ion

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 correspondinginputs I 1 ,I 2 ,I 3 ,«,I n.

OHT 3.4AVariable costs ers s fi ed costs

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Total fixed costs (TFC)are fixed at all levels of output.

Total variable costs (TVC)and,therefore,total costs (TC)rise asoutput increases.

Average fixed costs (AFC)decline continuously as the fixed costsare 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 outputchanges.

Average variable costs (AVC)may fall initially but after a certainlevel of output they begin to rise.This occurs because of what

economists term the law of diminishing ret urns ,mentioned in Chapter 1 and discussed more fully below.It is, of course,possible for averagevariable costs to rise continuously as output expands, while in somebusinesses there may be a large output range over which they areconstant.

Variable costs versus fixed costs

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Average total costs (ATC),being thecombination of AFC and AVC, tend to declineinitially and then rise after a certain level of output (Q )is reached. Average total cost isoften referred to by accountants as the uni t cost

.It is also often simply referred to as theaverage cost .

Summary

TC !TFC TVC

AVC !TVC/Q AFC !TFC/Q ATC ! AFC AVC !TC/Q

OHT 3.4B

Variable costs versus fixed costs

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OHT 3.5

Figure 3.1 Total and average costs of production

OHT 3 6

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The shor t run is the time period during whichthe amount of at least one input is fixed insupply (e.g.the amount of capital equipment

installed or in some organisations the number of personnel employed) but the other inputscan be altered.

The long run represents a sufficient length of

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

Production decisions in the short run and long run

OHT 3.6

OHT 3 7Di i i hi t i d ti

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T he law of diminishing (marginal)ret urns

In the short run,when one or more factors of production are held fixed, there will come a pointbeyond which the additional output from using extra

units of the variable input(s)will diminish.

T PP is the total output when labour is applied tocapital.

APP is the total output or physical product divided bythe number of units of labour employed.

MPP is the addition to total physical product as eachextra unit of labour is employed.

OHT 3.7Diminishing returns in production

OHT 3 8Table 3.1 Example of the law of diminishing returns

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OHT 3.8

Figure 3.2 Diminishing returns

p g

(1)Units of

capital input

(2)Units of

labour input

(n)

(3)Total

physical product

(TPP)

(4) Average physicalproduct of labour

(APP) = (3) z (2)

(5)Marginal physicalproduct of labour

(MPP)

1010101010

10

12345

6

820354042

43

81011.710

8.4

7.2

8 (8-0)12 (20-8)15 (35-20)5 (40-35)2 (42-40)

1 (43-42)

Th l ti hi b t d ti dOHT 3.9

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Marginal cost The change in total costs of production as output is changedincrementally is referred to as the marginal cost .Given a total costfunction,it is technically the µfirst derivative¶ that is, the slope of thetotal cost curve at each level of output (insert equation) ).Where the

total cost curve is linear,the marginal cost is a constant,and it iseasier to refer to t he marginal cost of output.

Increment al cost

The increment al cost per uni t is the total change in costs caused bythe output increment (this is equal to the sum of the marginal costs

over the increment in output), divided by the change in output.Inother words,incremental cost equals the µaveragemarginal costover the range of outputs.

The relationship between production and

costs

OHT 3.9

OHT 3 10

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Table 3.2 Deriving cost data from product data

(1)Cost of capital

employed$

(2)Cost of labour

employed$

(3)Total cost=(1)+(2)

$

(4)Total output

(5) Average cost

per unit = (3) z (4)$

100100100100100100

102030405060

110

120

130

140

150

160

8

2035404243

13.76.03.73.53.63.7

OHT 3.10

OHT 3 11

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OHT 3.11

Figure 3.3 Marginal cost and output

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Table 3.3 Cost of production: a worked example OHT 3.13

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Variablecost

($)VC(2)

Fixedcost

($)FC(3)

Totalcost

($)TC

(4) = (2) + (3)

Marginal

cost

($)MC(5)

Averagevariable cost

($) AVC

(6) = (2)/(3)

Averagefixed cost

($) AVC

(7) = (3)/(1)

Averagetotal cost

($) ATC (8) = (4)/(1)

= (6) + (7)

Quantityof output

(units)Q(1)

0

123456789

0

2030

36

40

48

60

80

112

156

48

484848484848484848

48

6878848896108128160204

20

10648

12203244

-

201512109.610

11.414

17.3

-

482416129.68

6.96

5.3

-

68392822

19.218

18.320

22.6

OHT 3.14

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Figure 3.5 Worked example of short-run cost curves

OHT 3.15

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T he profi t maximisat ion rule

Profits are maximised where marginal cost (MC)equalsmarginal revenue (MR). It is possible that over thefirm¶s full potential range of outputs there are two pointswhere MC =MR (in Figure 3.6 the two points are shown

at X and at output q *). Producing at point X would notprofit maximise because outputs up to X are producedwhere MC > MR. Technically,profits are maximisedwhere MC =MR and t he M C curve is rising (not

falling),as at q*

output inF

igure 3.6.

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OHT 3.16

Figure 3.6 Profit-maximising output

OHT 3.17

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Normal profi t is the minimum profit which must be earned to ensurethat a firm will continue to supply the existing good or service. In

incorporated firms it is equivalent to the µcost of capital¶, namely theinterest charges on loan capital plus the return to equity investorsthat must be paid if creditors and investors are to put their capitalinto the firm. In non-corporate enterprises (sole traders andpartnerships)this is the profit that ensures that a sufficient number

of people are prepared to invest, organise production andundertake risks in an industry (including the return to riskyµentrepreneurship¶). The normal profit will differ from industry toindustry,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 profi t is any profit earned above normal profit and is aform of economic rent (see pp.143 and 308).

OHT 3 18

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OHT 3.18

Figure 3.7 The production decision

OHT 3.19

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Constant returns to scale.This arises whenthe volume of output increases in t he same

propor t ion to the volume of inputs.

Increasing returns to scale.This arises

where the volume of output rises morequickly than the volume of inputs.

Decreasing returns to scale.This ariseswhere the volume of output rises less quickly

than the volume of inputs.

Economies and diseconomies of scale

OHT 3.20Internal economies of scale

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

Internal economies of scale

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Labour force.

Suppliers.

Social infrastructure.

External economies of scale

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Management

Labour

Other inputs

External diseconomies of scale

Internal diseconomies of scale

OHT 3.23Long-run average costs

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OHT 3.23

Figure 3.8 The long-run average cost curve

OHT 3.24

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E-commerce and costs of production

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Sharing common inputs over a range of itsactivities.

Jointly promoting its range of products andservices;or

Jointly distributing its range of products andservices.

Economies of scope

OHT 3.25

OHT 3.26Organising production

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Figure 3.9 Organisational structures

g g p

OHT 3.27

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

OHT 3.28The experience curve

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Figure 3.11 The experience curve

OHT 3.29

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Figure 3.12 The µvirtuous circle¶

OHT 3.30

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Figure 3.13 Benefits from increasing the scale of production

OHT 3.31The relationship between short-run and long-

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Figure 3.14 Long-run average total cost curve

run costs

OHT 3.32

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Figure 3.15 The µL-shaped¶ long-run average total cost curve

OHT 3.33Optimal scale and x-inefficiency

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Figure 3.16 The µproduction cost¶ gap

OHT 3.34Large goods vehicles: an example of economies of

scale

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Economies of scale of large goods vehicles

scale

OHT 3.35AKey learning points

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The production function is a mathematicalexpression which relates the quantity of all inputsto the quantity of outputs.

Total physical product (TPP)is the total outputfrom the factors of production employed.

Average physical product (APP)is the TPP

divided by the number of units of the variablefactor of production employed.

Marginal physical product (MPP)is the change inTPP 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.

OHT 3.35BKey learning points

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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) plusaverage variable cost (AVC),where AFC =TFC/Q and

AVC =TVC/Q .TFC is total fixed cost;TVC is totalvariable cost;and Q is output.

The law of diminishing (marginal)returns statesthat,in the short run,when one or more factors of production are held fixed,there will come a point beyondwhich the additional output from using extra units of the

variable input(s)will diminish.

The output at which average costs are at their lowest isknown as the technically optimum output .

OHT 3.35CKey learning points

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Marginal costs (MC),defined as the additional costsincurred when producing a very small increment or one moreunit of output,will only depend on changes in variable costsin the short run because fixed costs are unaltered as outputchanges. In the long run, however, marginal costs reflectchanges in the total costs of production since all inputs arevariable.

The marginal cost curve will always be below (above)theaverage cost curve when average costs are falling (rising).

Profits are maximised at the level of output where marginalcost equals marginal revenue and when marginal costs arerising.

Economists include a normal profit in costs.

N l fit i d fi d th i i fit hi h t b

OHT 3.35DKey learning points

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Normal profit is defined as the minimum profit which must beearned in order to ensure that a firm will continue to supply theexisting good or service.

Normal profit is earned when price is set equal to average totalcost.

Supernormal profit is earned when price is set above average

total cost.

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

Constant returns to scale arise when the volume of outputincreases in the same proportion to the volume of inputs.

OHT3.35E

K l i i t

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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 isexplained 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 technicaloptimum scale of production for the firm,corresponding to

minimum unit costs over the long run.

Key learning points

OHT 3.35FKey learning points

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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 exist ing productionmethods.

Dynamic efficiency gains are more clearly associatedwith new developments in product and production

processes over time. The experience (learning)curve relates to declining unit

costs of production over time as the cumulat ive volume of output rises.

Innovation occurs within firms in the form of both products

and processes. Produc t innovation involves theintroduction of new goods and services;while process

innovation is concerned with improving the existingmethods by which outputs are produced so as to lower thecosts of production.

OHT 3.36GKey learning points

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X-inefficiency indicates the extent to which the costs of

production are above the minimum average cost due towaste and organisational slack given the existing scale of production.

The envelope curve shows how total costs of productionchange as output continues to rise over the long run.Thisrepresents the envelope of all possible short-run averagetotal cost curves relating to different scales of productionand is appropriate where there are no significantµindivisibilitiesin the capital stock.

Information and knowledge are of growing importance asfactors of production in their own right in the new

information-led or µweightless economy¶.

OHT 3.35H

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Key Learning Points

Appendix 3.1 (see p. 95)

An isoquant curve shows in graphical form differentcombinations of factor inputs that can be used toproduce a given quantity of a product.

An isoquant map is a collection of ranked isoquantcurves that shows in graphical form a firm¶s increasingoutput when moving outward from the origin usinglarger quantities of factor inputs.

OHT 3.35IKey Learning Points

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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 bywhich it is possible to reduce one factor input andmaintain a given level of output by substituting oneextra unit of the other factor input. In notation form:

An isocost line shows the combination of two inputswhich can be purchased for the same total moneyoutlay.

Key Learning Points

K

L

k for LMP

MP MRT S !

OHT 3.35J

Key Learning Points

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An optimal combination of inputs in the production

process takes place when the ratio of the marginalproducts of the factor inputs is equal to the ratio of theinput prices; i.e.

Key Learning Points

K

L

K

L

P

P

MP

MP !

Or , alternatively

K

K

L

L

P MP

P MP !

Appendix 3.1 Isoquants, isocosts and the

optimal combination of inputsOHT 3.36

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The key task facing the firm is to determine the specific

combination of capital and labour which should beselected in order:

ei t her 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 inputsintroduces a number of important concepts including:

Isoquant curves and isoquant maps. The marginal rate of technical substitution. Isocost lines.

optimal combination of inputs

OHT A3.37Isoquant curves and isoquant maps

An isoquant curve shows in graphical form the different combinations of factor

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

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

OHT 3.38 An isoquant map is a collection of ranked isoquant curves that showsin graphical form a firm¶s increasing output per time period when

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Figure A3.2 Isoquant map for different levels of production

g p g p p pmoving outward from the origin using larger quantities of two factor inputs (such as capital and labour).


OHT3.39

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The marginal rat e of t echnical subst i t ut ion (MR T S )is theratio of the marginal physical products (MP)of two inputsin the production process;i.e.the amount by which it ispossible to reduce one factor input (e.g.capital)andmaintain a given level of output by substituting an extra

unit of the other factor input (e.g.labour).


Capit al

Labour Labour Capit alfor

MP

MP MRT S !

OHT A3.40Isocost lines

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Figure A3.3 Isocost line

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

OHT 3.41Optimal combination of inputs

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Maximising out put for a given produc t ion cost

Principle : to maximise output subject to a given total cost of production and given input prices for capital and labour, the firmmust 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 ).

p p

K

L

K

K for L P

P

MP

MP MRT S

L

!!

K

K

L

L

P

MP

P

MP !

The optimality condition can be reorganised as:

OHT A3.42

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Figure A3.4 Maximising output for a given cost

OHT A3.43

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Optimal combination of inputs

Minimising cost subject to a given output

K

L

K

L

K for L

P

P

MP

MP MRT S !!

Or , alternatively

K

K

L

L

P MP

P MP !

OHT A3.44

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Figure A3 5 Minimising cost for a given output

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