The Nature and Scope of

Managerial Economics
 Managerial Economics

• Managerial economics, meaning the

application of economic methods in the
managerial decision-making process,
and it is a fundamental part of any
business.
 This is happening for several
reasons
It is becoming more important for managers to make
good decisions and to justify them, as their
accountability either to management or to
shareholders increases.

Number and size of multinationals increases, the

costs and benefits at stake in the decision-making
process are also increasing.

In the age of plentiful data it is more imperative to

use quantitative and rationally based methods,
rather than ‘intuition’.
The pace of technological development is
increasing with the impact of the ‘new
economy’. There is an increased need for
economic analysis because of the greater
uncertainty and the need to evaluate it.

Improved technology has also made it

possible to develop more sophisticated
methods of data analysis involving
statistical techniques. Modern computers
are adept at ‘number-crunching’, and this
is a considerable aid to decision-making
that was not available to most firms until
recent years.
What is Managerial Economics???

It is the integration of economic principles

with business management practices

It is essentially applied economics in the

field of business management.
 Definitions: Managerial Economics

• Integration of Economic theory with business

practice for purpose of facilitating decision
making and forward planning by
management
- Spencer & Siegelman

• It is concerned with the application of

economic concepts and economics to the
problems of formulating rational decision
making
-Mansfield
Why do Managers need to know Economics?

• Economic theories contribute in building

analytical models, which help to recognize
the structure of managerial problems

• Economic theories do enhance analytical

capabilities of business analyst

• They offer clarity to various concepts used

in business analysis, which enables the
managers to avoid conceptual pitfalls
Decision Problems faced by firms

• What should be the price of the product?

• What should be the size of the plant to be
installed?
• How many workers should be employed?
• What is the optimal level of inventories of
finished products, raw material, spare
parts, etc.?
• What should be the cost structure?
Relationship between Economics & Management

Business Management
Economics theory
Decision Problems

Managerial Economics-
Application of Economics
to
solving business problems

Optimal Solutions to
Business problems
 Significance: Managerial Economics

• Reconciling traditional theoretical

concepts in relation to the actual
business behavior and conditions
• Estimating economic relationships
• Predicting relevant economic
quantities
• Formulating business policies and
plans
 Characteristics: Managerial Economics

• Microeconomic in character
• Is Normative rather than positive in
character
• It is prescriptive rather than descriptive
• Also uses Macroeconomics since it
provides an intelligent understanding of
environment
 Scope: Managerial Economics

• Incorporate micro and macroeconomics to deal with

business problems
 Microeconomics - micro means a small part
Concerned with analysis of behavior of
individual economic variables such as individual
consumer or a producer or price of a particular
commodity
 Macroeconomics - concerned with aggregate
behavior of the economy as a whole
The Firm Environment
 Chief Characteristics

• Micro economics in character.

• Uses eco. concepts like “Theory of
the Firm” and “Profit Theory”.
• Avoids abstract issues of eco. Theory
but involves complications.
• It is perspective than descriptive eg.
Law of demand states that as price increases demand goes
down but is it good or bad.
 Difference

Managerial Economics Economics

Involves application of economic Economics deals with the body of
principles to problems of the firm. the principles itself.

Scope is not wide Scope is wider

Micro in character Both micro and macro
Deals only with the firm and Deals with both
not with individual’s
economic problem
Modifies models and Simplifies models
enlarges them
More complex , introduces Simple , makes
certain feedbacks assumptions
 Subject matter of Managerial Economics

• Demand Analysis and Forecasting-

various factors influencing the demand for a firm’s product
• Cost Analysis- uncertain and uncontrollable
• Production and Supply Analysis- deals
with different production functions and their managerial use
- supply of commodities
• Pricing decisions, policies and
practices- price is the genesis of the revenue of the
firm
• Profit Management- profit is the chief measure
of success
• Capital Management - management-large sum
of money is involved- matter for top level decision
Management Eco. And other Subjects

Operation Statistics
Research

Managerial
Eco

Mathematics
Accounting
Managerial Economics
Is a Tool for Improving
Management Decision
Making
Value Maximization Is
a Complex Process
Microeconomics applied to (operational)
internal issues

• Demand Analysis
• Production and Supply analysis
• Cost analysis
• Analysis of market structure and Pricing Theory
• Profit Analysis
• Capital and Investment Decisions
Macroeconomics applied to external issues-
Economic Environment

• Type of Economic system of a country

• Study of Macro variables
• Study related to foreign trade
• Study of Government policies – Monetary, Fiscal
 Role of a Managerial Economist

• He is an economic advisor to a firm

• He not only studies the economic trends at
macro level but also interpret their relevance
to the particular industry
• Task of making specific decisions
• General task of managers to use readily
available information in outside environment
to make a decision that furthers the goals of
organization
Decisions to be taken by Managerial
economist
• Production scheduling
• Demand Estimation and Forecasting
• Analysis of market to determine nature and
extent of competition
• Pricing problems of industry
• Assist business planning process
• Advising on investment and capital budgeting
• Analyzing and forecasting environmental factors
Basic Economic Principles for Managerial
Decision making

• Opportunity Cost Principle

• Marginal Principle
• Incremental Principle
• Equi - Marginal Principle
• Time Perspective Principle
• Discounting Principle
 Opportunity Cost

• Related to alternative uses of scarce

resources
• Opportunity cost of availing an opportunity
is the expected income foregone from
second best alternative
• Difference between actual earning and its
opportunity cost is called economic gain.
 Marginal Principle

• Refers to change (increase or decrease)

in total of any quantity due to a unit
change in its determinant.
• MC= TCn - TCn-1

• MR = TRn-TRn-1

• Decision Rule FOR Profit Maximization:

MR=MC
Marginal value

The marginal value of a dependent

variable is the change in this dependent
variable associated with a 1-unit change in
a particular independent variable
 Limitations of Marginalism

• When used in cost analysis MC refers to

change in variable cost only

• Generally firms do not have knowledge of

MC & MR cos most firms produce in and
sell their products in bulk except cases
such as airplanes, ships, etc
 Incremental Principle

• Applied to business decisions which involve a

large change in total cost or total revenue

• Incremental cost can be defined as the change

in total cost due to a particular business
decision i.e change in level of output,
investment, etc.

• Includes both fixed & variable cost but does

not include cost already incurred i.e sunk cost
 Contd.. Incremental Principle
• Incremental revenue is a change in total
revenue resulting from a change in level of
output, price etc
• A business decision worthwhileness is always
determined on the basis of criterion that
incremental revenue should exceed
incremental cost
 Equi - Marginal Principle
• Deals with allocation of resources among
alternative activities

• According to this principle an input should be

employed in different activities in such
proportion that the value added by last unit is
the same in all activities or marginal products
from various activities are equalized.

• MPA=MPB=MPC=…MPN
 Time Perspective Principle
• Short run & Long run time periods play an
important role in Business decisions

• Short run mean that period within which some

of inputs cannot be altered (fixed inputs).
However in long run all inputs can be altered
so they are variable in long run

• Determination of time perspective is of great

significance where projections are involved
 Discounting Principle
• A rupee now is worth more than a rupee
earned a year after

• To take decision regarding investment which

will yield return over a period of time it is
necessary to find its present worth by using
discounting principle

• This principle helps to bring value of future

rupees to present rupees
• PV=1/1+i i=8%
• PV=100/1.08=92.59
 Variables and Functions
• By definition, any economic
quantity , value or rate that varies
on its own or due to a change in
its determinant(s) is an economic
variable.
 Functions
• A function is a mathematical technique of
stating the relationship between any two
variables having cause and effect relationship
– When a relation is established between
two or more variables, it is said that
they are functionally related
– When two variables are involved it is bi-
variate and more than two it is Multi-
variate
 Functions
• Of the two one is independent variable
which may change on its own
independently and other is dependent
which changes in relation to changes in
the assigned independent variable in a
given function
• In mathematical terms, Y= f (X)
 How Is Managerial Economics
Useful?
• Evaluating Choice Alternatives
– Identify ways to efficiently achieve goals.
– Specify pricing and production strategies.
– Spell out production and marketing rules to
maximize profits.
• Making the Best Decision
– Managerial economics helps meet
management objectives efficiently.
– Managerial economics shows the logic of
consumer, and government decisions.
 Managerial Decision
Problems
• Product Price and Output
• Make or Buy
• Production Technique
• Inventory Level
• Advertising Media and Intensity
• Labor Hiring and Training
• Investment and Financing
 The Managerial Decision-Making
Process
• Managerial Economics – applies
economic theory and methods to
business and administrative decision
making.
• Specifically managerial economics
– prescribes rules for improving
managerial decisions.
– indicates how one can achieve
organizational objectives efficiently
– allows one to recognize how
economic forces affect organizations
– describes the economic
consequences of managerial
Theory of the Firm
 Production Function

Inputs Process Output

Land
Product or
Labour service
generated
– value added
Capital
 Objectives of the firm
• Objectives are targets or goals that a business sets
itself
• The theory of the firm is based on the assumption
that all businesses will operate to make a profit
• Businesses face upward sloping total cost and
revenue curves – as more is produced costs
increase and as more is sold revenue increases
 Marginal costs and marginal benefits
• The point of profit maximisation is where the
difference between Total revenue and total costs is
greatest
 Additional Objectives
• There are additional objectives that a business
could pursue including:
– Growth
– Sales revenue maximisation
– Limit pricing to gain monopoly power
– Customer satisfaction
• The satisficing principal sets a minimum acceptable
level of achievement
 Divorce of Ownership and Control
• Divorce of ownership and control is where the
people that own the business (the shareholders)
are not the same as the people that control the
business (the board of directors)
• Where there is a divorce of ownership and control
businesses may not pursue profit maximisation as
the managers may have different objectives to the
owners
 Law of Diminishing Returns and Returns To
Scale

• The law of diminishing returns says that as we add

more units of a variable output to factors of
production then output will initially rise and then fall
• Diminishing returns occur when marginal revenue
starts to fall as each extra worker is adding less to
total revenue
 Diminishing returns and productivity
• Diminishing returns occur as the productivity of extra
workers decreases over time
• When output is low other factors of production tend to be
under utilised so each worker is able to use the other
factors more efficiently increasing productivity
• When production reaches a certain level the factors of
production are less plentiful and therefore each worker
adds less to productivity
 Law of diminishing returns and costs
• Law of diminishing returns can also be called the
law of increasing opportunity cost
• There is an inverse relationship between returns of
inputs and the cost of production
• Costs per unit of output will therefore start to rise at
a certain point
Productivity and factor prices + Production and
factor choices
• The productivity of different factors of production
will influence the businesses choice of factor inputs
• Factor prices will also influence the choice of inputs
– if some factors are more expensive than others it
is likely that the business will choose these over
more expensive factors
 Costs
• Costs – what a business pays out
• Fixed costs – these do not alter with output
• Variable costs – alter directly with the business’s
level of output
• Total costs – are fixed and variable costs added
together
• Semi variable – have a fixed and a variable element
 Fixed Costs
• Examples – rent, management salaries, rates
• Graphically fixed costs will always be illustrated by
a horizontal line
• As output changes fixed costs stay the same
 Variable costs
• Examples – fuel, raw materials
• Graphically variable costs will always be a diagonal
line from the origin
• As output changes variable alter directly
 Total Costs
• Managers use these figures to make decisions on
level of output and prices
 Average Costs
• Average costs are total costs divided by the
quantity produced
• ATC / AC = TC / quantity
• Average fixed costs fall when output increases as
the fixed costs are spread over more units
• AFC = FC / quantity
 Short run costs
• In the short run consider fixed and variable costs
• Average total cost line is U-shaped as when
diminishing returns start to kick in the average total
cost per unit increases
 Marginal costs
• Marginal costs relate to variable costs
• Marginal costs are the amount each additional unit
adds to costs
• Marginal costs per unit decrease as production
increases until they meet a critical level when they
start to increase
Short Run Costs
 Long Run Costs
• In the long run all factors of production can be
varied so fixed and variable costs can alter
 Economies of Scale
• These occur when mass producing a good results
in lower average cost.
• Average costs fall per unit – Average costs per unit
= total costs / quantity produced
• Economies of scale occur within an firm (internal) or
within an industry (external).
 Internal and External Economies
• Internal Economies of Scale
As a business grows in scale, its costs will fall due to
internal economies of scale. An ability to produce units
of output more cheaply.
• External Economies of Scale
Are those shared by a number of businesses in the
same industry in a particular area.
Types of internal economy Example
of scale

Production / Technical •Larger firms can use computers / technology to replace workers
Economies on a production line
•Mass production lowers cost per unit
•Large scale producers can employ techniques that are unable to
be used by a small scale producer.
•Able to transport bulk materials.

Purchasing / Marketing • Advertising costs can be spread across products

Economies •Large businesses can employ specialist staff
• Bulk buying – if you buy more unit cost falls

Financial Economies •Larger firms have better lending terms and lower rates of interest
•Easier for large firms to raise capital.
•Risk is spread over more products.
• Greater potential finance from retained profits.
• Administration costs can be divided amongst more products

Managerial Economies • More specialised management can be employed, this increases

the efficiency of the business decreasing the costs
Risk-bearing Economies • large firms are more likely to take risks with new products as they
have more products to spread the risk over
 External Economies of Scale
• These are advantages gained for the whole
industry, not just for individual businesses.
 Examples of External Economies
• As businesses grow within an area, specialist skills
begin to develop.
• Skilled labour in the area – local colleges may begin
to run specialist courses.
• Being close to other similar businesses who can
work together with each other.
• Having specialist supplies and support services
nearby.
• Reputation
 Diseconomies of Scale
• Occur when firms become too large or inefficient
• Average costs per unit start to rise
 Diseconomies of Scale
Types of diseconomy of Example
scale

Communication •When firms grow there can be problems with communication

•As the number of people in the firm increases it is hard to get the
messages to the right people at the right time
•In larger businesses it is often difficult for all staff to know what is
happening

Coordination and control •As a business grows control of activities gets harder
problems •As the firm gets bigger and new parts of the business are set up it is
increasingly likely people will be working in different ways and this
leads to problems with monitoring

Motivation •As businesses grow it is harder to make everyone feel as though

they belong
•Less contact between senior managers and employees so
employees can feel less involved
•Smaller businesses often have a better team environment which is
lost when they grow
 Economies of Scale and Monopolies
• Economies of scale can lead to the development of
monopolies as larger businesses are able to exploit
lower unit costs and therefore make more profits
 Economies of Scale
• Minimum efficient scale – where an increase in the
scale of production gives no benefits to a reduction
in unit costs
• Minimum efficient plant size – where an increase in
the scale of production of an individual plant within
the industry doesn’t result in any unit cost benefits
 Minimum Efficient Scale
• This is the point where production is sufficient for internal
economies of scale to be fully exploited
• Minimum efficient scale is seen as the lowest point on the
long run average cost curve
• The MES depends on a number of factors including:
– Ratio of fixed to variable costs
– If a natural monopoly exists
 Economies of Scale and Barriers to Entry
• Economies of scale can act as a barrier to entry for
firms into a market
• This is because economies of scale allow a firm to
have a lower cost structure and therefore can
decrease prices if a new firm enters the market
eventually driving them out
Technological Change, Costs and Supply in the
Long run
• Invention, innovation and technology can impact a
businesses by decreasing costs in the long run
• Innovation, invention and technology can also impact a
businesses method of production – for example causing the
firm to move from labour intensive to capital intensive
methods
• These factors may also result in an increase in efficiency
for the firm which can also result in cost savings
 Revenue
• Total Revenue = Quantity Sold x Average Selling Price
• Generally if it reduces its selling price you expect to sell
more
• A rise in price usually leads to a fall in quantity sold
• Average revenue = Total revenue / output
• Marginal revenue = the amount each unit adds to total
revenue
 Revenue Curves
• Marginal revenue slopes downwards – as more is
produced the increase in revenue gets smaller
• Because marginal revenue declines as production
increases average revenue per unit also declines
with increased production
 Profit
• Profit is the payment for enterprise – the risks that
are taken
• Normal profit – this is the amount of profit needed to
keep all factors of production in their current use in
the long run
• Normal profit is a minimum level that is needed for
an entrepreneur to stay in that business
• Supernormal / abnormal profit – is any profits that
exceed the normal amount
 Profit
• Profits are maximised where there is the largest
difference between MR and MC
• Profits have a number of roles in an economy:
– Supernormal or rising profits attract new entrants to
markets
– Retained profits provide finance for future investments
– Allocation of factors of production - scarce factors tend
to be more expensive and will therefore be used where
they are likely to be the most profitable
Basic Cost-Management
Concepts
 Basic Definitions
• A cost is incurred when a firm uses a resource
for some purpose

• Costs are assembled into meaningful groups

called cost pools (e.g., by type of cost or source)

• Any factor that has the effect of changing the

level of total cost is called a cost driver

• A cost object is any product, service, customer,

activity, or organizational unit to which costs are
assigned for some management purpose
 Cost Concepts: Overview

There are four main ways to classify

costs (“different costs for different
purposes”):
– For product and service costing (GAAP)
– For strategic decision-making (cost-driver
analysis)
– For planning and decision-making
– For control/feedback
 Product/Service Costing:
Cost Assignment
The process of assigning costs to cost
pools or from cost pools to cost objects
– Direct costs can be conveniently and
economically traced to a cost pool or a cost
object
– Indirect costs cannot be traced conveniently or
economically to a cost pool or a cost object
– Because indirect costs cannot be traced,
assignment is made through the use of cost
drivers (cost allocation)
 Product and Service
Costing Concepts
(GAAP)
• Product costs include only the costs
necessary to complete the product at the
manufacturing step in the value chain
(manufacturing) or to purchase and
transport the product to the location of sale
(merchandising)

• Period costs include all other costs

incurred by the firm in managing or selling
the product (indirect costs outside the
manufacturing step of the value chain)
 Cost Information for Short-
term Planning: Classification
by Behavior
• What is meant by “cost behavior”?
• Common classifications of cost behavior:
– Fixed (capacity) cost is the portion of total cost
that does not change with changes in output
– Variable cost is the change in total cost
associated with each change in quantity of the
cost driver
– Mixed cost is used to refer to a total cost figure
that includes both a fixed and variable
component
 Fixed Costs

Total
Cost

$6,600

$6,500

Total Fixed Cost

$3,000
3,500 3,600
Units of the Cost
Driver
 Variable Costs

Total
Total Cost
Cost

$6,600
Total Variable Cost
$6,500
3,500 3,600
Units of the Cost
$3,000 Driver
 Short-Run Decision-Making
Cost Concepts

• Relevance is the most important

characteristic for information used in
decision making
– Relevant costs have two properties: they differ
for each decision option and they will be incurred
in the future

• Opportunity cost is the benefit lost when

choosing one option precludes receiving
the benefits from the alternative option

• Sunk costs are costs that have been

incurred or committed in the past and are
therefore irrelevant in current decision
 Opportunity Cost
• The income that would have been
received if the input had been used
in its most profitable alternative use.
• The value of the product not
produced because an input was used
for another purpose.
• An “economic concept” not an
“accounting concept.”
– As economic decision-makers, we
assume costs include opportunity costs.
 Behavior of Total (Linear)
Costs
$ Total Costs

If costs are linear, then total costs graphically

look like this.

Cost Driver
Total fixed costs do not change as the cost
$ Total Fixed Costs driver increases.

Higher total fixed costs are higher above the x

axis.

Cost Driver
Behavior of Total (Linear) Costs
$ Total Costs
If costs are linear, then total costs graphically
look like this.

Cost Driver

Total variable costs increase as the cost driver

$ Total Variable Costs increases.

A steeper slope represents higher variable

costs per unit of the cost driver.

Cost Driver
 Total Versus Per-unit (Average)
Cost Behavior
$ Total Variable Costs
If total variable costs
look like this . . .
slope = $m/unit

Cost Driver

$/unit Per-Unit Variable Costs . . . then variable costs per

unit look like this.

Cost Driver
 Total Versus Per-Unit (Average)
Cost Behavior
$ Total Fixed Costs
If total fixed costs look
like this . . .

Cost Driver

$/unit Per-Unit Fixed Costs . . . then fixed costs per

unit look like this.

Cost Driver
 The Cost Function
When costs are linear, the cost function is:
TC = F + V x Q, where
F = total fixed cost, V = variable cost per unit of
the cost driver, and Q = the quantity of the cost
driver.
$ Total Costs
The intercept is the total fixed cost.

The slope is the variable cost per unit of

the cost driver.

slope = $V/unit of cost driver

F A cost that includes a fixed cost
element and a variable cost element is
known as a mixed cost.
Cost Driver
 Nonlinear Cost Behavior
Sometimes nonlinear costs exhibit linear cost
behavior over a range of the cost driver. This is the
relevant range of activity.
intercept = total fixed costs
Total
Costs

slope = variable cost per

unit of cost driver

Cost Driver

Relevant Range
 Scatterplot
• A scatterplot shows cost observations
plotted against levels of a possible
cost driver.
• A scatterplot can assist in determining:

• which cost driver might be the best for

analyzing total costs, and
• the cost behavior of the cost against the
potential cost driver.
 Which Cost Driver Has the Best
Cause & Effect Relationship with Total Cost?
8 observations of total selling expenses plotted against 3 potential cost drivers

# units sold
$

# customers

# salespersons
 Regression Analysis
• Regression analysis estimates the parameters for a
linear relationship between a dependent variable
and one or more independent (explanatory)
variables.
• When there is only one independent variable, it is called
simple regression.

• When there is more than one independent variable, it is

called multiple regression.

Y=α+βX+
dependent independent
variable variable

α and β are the parameters;  is the error term (or residual)

 Regression Analysis Used to
Estimate a Mixed Cost Function
We can use regression to separate the
fixed and variable components of a
mixed cost.
Yi = α + β Xi +
i is the difference
Yi is the i between the predicted total
actual total cost for Xi and the actual
costs for total cost for observation i
data point i
Xi is the actual quantity
of the cost driver for
data point i
the intercept
term is total
fixed costs the slope
term is the
variable cost
per unit
 Costs
• Total fixed costs (TFC)
• Average fixed costs (AFC)
• Total variable costs (TVC)
• Average variable cost (AVC)
• Total cost (TC)
• Average total cost (ATC)
• Marginal cost (MC)
 Short-Run & Long-
Run
• “Time concepts” rather than fixed
periods.
• Short-run:
– One or more production input is fixed:

• Long-run:
– The quantity of all necessary
production inputs can be changed.
– Expand or acquire additional inputs.
 Fixed Costs
• Result from owning a fixed input or
resource.
• Incurred even if the resource isn’t used.
• Don’t change as the level of production
changes (in the short run).
• Exist only in the short run.
• Not under the control of the manager in
the short run.
• The only way to avoid fixed costs is to
sell the item.
 Fixed Costs

1. Depreciation
2. Interest • Cash
3. Rent
4. Taxes • Noncash
(property)
5. Insurance
 Important Fixed
Costs
• Total fixed cost (TFC):
– All costs associated with the fixed input.
• Average fixed cost per unit of output:

AFC = TFC
Output
 Variable Costs
• Can be increased or decreased by
the manager.
• Variable costs will increase as
production increases.
• Total Variable cost (TVC) is the
summation of the individual
variable costs.
• VC = (the quantity of the input)
X (the input’s price).
 Variable Costs
• Variable costs exist in the short-run
and long-run:
– In fact, all costs are considered to be
variable costs in the long run.
 Important Variable
Costs
• Total variable cost (TVC):
– All costs associated with the variable
input.
• Average variable cost per unit of
output:

AVC = TVC
Output
 Total Cost
• The sum of total fixed costs
and total variable costs:

TC = TFC + TVC

• In the short run TC will only

increase as TVC increases.
 Average Total Cost
• Average total cost per unit of output:

AFC + AVC

ATC = TC
Output
 Marginal Cost
• The additional cost incurred from
producing an additional unit of
output:

MC =  TC
 Output
MC =  TVC
 Output
Typical Total Cost
Curves
 Typical Total Cost Curves
(selected attributes)
• TFC is constant and unaffected by
output level.
• TVC is always increasing:
– First at a decreasing rate.
– Then at an increasing rate.
• TC is parallel to TVC:
– TC is higher than TVC by a distance
equal to TFC.
 Fixed Costs

1. Depreciation
2. Interest • Cash
3. Rent
4. Taxes • Noncash
(property)
5. Insurance
 Typical Total Cost Curves
(selected attributes)
• TFC is constant and unaffected by
output level.
• TVC is always increasing:
– First at a decreasing rate.
– Then at an increasing rate.
• TC is parallel to TVC:
– TC is higher than TVC by a distance
equal to TFC.
 Typical Average &
Marginal Cost Curves
 Typical Average &
Marginal Cost Curves
• AFC is always • MC is generally
declining at a increasing.
decreasing rate. MC crosses ATC and AVC
• ATC and AVC decline at their minimum point.
at first, reach a If MC is below the
minimum, then average value:
increase at higher Average value will be
levels of output. decreasing.
• The difference If MC is above the
between ATC and average value:
AVC is equal to AFC. Average value will be
increasing.
Production Rules for the
Short-Run

• If expected selling price >

minimum ATC (which implies TR >
TC):
– A profit can be made.
• Maximize profit by producing
where:
MR = MC
 Production Rules
for the Short-Run

• If expected selling price < minimum ATC

• but > minimum AVC:

(which implies TR > TVC but < TC)
– A loss cannot be avoided.
– Minimize loss by producing where

– MR = MC.
– The loss will be between 0 and TFC.
 Production Rules for the
Short-Run

• If expected selling price < minimum

AVC (which implies TR < TVC):
– A loss cannot be avoided.
– Minimize loss by not producing.
– The loss will be equal to TFC.
Short Run Production
Decisions
 Production Rules
for the Long-Run
• If selling price > ATC (or TR > TC):
– Continue to produce.
– Maximize profit by producing where

– MR = MC.
 Production Rules
for the Long-Run

• If selling price < ATC (or TR < TC):

– There will be a continual loss.
– Sell the fixed assets to eliminate fixed
costs.
– Reinvest money in a more profitable
alternative.
Long-Run Average Cost
Curve
(Economies of Size)
Long­Run Average Cost
Curve
(Diseconomies of size)