ECN 1100

Lecture 6
Purpose
The purpose of this presentation is to give an
introduction to Cost, Production and Firms.
 Learning Objectives
At the completion of this presentation you should be
able to have an understanding of:

• Total Product, Average Product, Marginal Product

• Diminishing Marginal Returns.

• Break even, shut down points, economies of scale

and scope. Long run vs short run costs
 Cost Production and Firms
In market economies, a wide variety of businesses
produce an even wider variety of goods and services.
Each of those businesses requires economic resources in
order to produce it products. In obtaining and using
resources, a firm makes monetary payments to resource
owners (workers) and incurs opportunity costs when
using resources it already owns (entrepreneurial talent).
Those payments and opportunity costs together make up
the firm’s cost of production.
 Factors Influencing Economic
Decisions made by Firms
There are four main factors that influence economic
decisions made by firms are:
1) Costs
2) Profits
3) Resource base
4) Industrial relations.
 Costs
Economic Costs
Costs exist because resources are scarce,
productive, and have alternative uses. When society
uses a combination of resources to produce a
particular product, it forgoes all alternative
opportunities to use those resources for other
purposes. The measure of the economic costs, or
opportunity costs of any resource used to produce a
good is the value or worth the resource would have
in its best alternative use.
 Costs
Economic Costs Cont’d
E.g. the paper used for printing economics textbooks is not
available for printing encyclopedias or magazine so the
opportunity cost of printing economics textbooks is the
encyclopedias or magazines that could have been printed instead
Costs also play a vital role in determining whether the firm will
be a success. If a firm is unable to cover costs, it will bear losses
which will eventually lead to a closure of the business.
Costs tend to change depending on the time period. There are
two time periods, the short run and the long run.
 Costs Cont’d
Explicit and Implicit Costs
Economic costs are the payments a firm must make, or the incomes
it must provide, to attract the resources it needs away from
alternative production opportunities. In producing products firms
incur explicit costs and implicit costs.
 
Explicit Costs- a firm’s explicit costs are the monetary payments
(or cash expenditures) it makes to those who supply labour services,
materials, fuel, transportation services and the like. These money
payments are for the use of resources owned by others.
 
Implicit Costs- a firm’s implicit costs are the opportunity costs
using its self-owned, self-employed resources. To the firm, implicit
costs are the money payments that self employed resources could
have earned in their best alternative use.
 Costs Cont’d
Example: Suppose you are earning $22,000 a year as a
sales representative for a T-shirt manufacturer. At some
point you decide to open a retail store of your own to sell
T-shirts. You invest $20,000 of saving that has been
earning you $1000 per year. And you decide that your new
firm will occupy a small store you owned and have been
renting out for $5000 per year. You hire one clerk to help
you in the store, paying her $18,000 annually. After one
year you total up your accounts and find the following:
 Costs Cont’d
Total sales revenue…………………………….$120,000

Cost of T-shirts………………………………...$
40,000
Clerk’s salary…………………………………..$ 18,000

Utilities……………………………................... $ 5000

Total
(explicit) costs……………………………$ 63,000

Accounting profit……………………………….$ 57,000

 Costs Cont’d
Unfortunately your accounting profits of $57,000
ignore your implicit costs and thus overstate the
economic success of your venture. By providing
your own financial capital, building and labour, you
incur implicit cost (foregone incomes) of $1000 of
interest, $5000 of rent and $22,000 of wages. If
your entrepreneurial talent is worth, say, $5000
annually in other business endeavors of similar
scope, you have also ignored that implicit cost.
 Costs Cont’d
Accounting profit…………………..$57,000

Less foregone interest………………$.1,000

Less foregone rent…………………..$ 5,000

Less foregone wages………………..$22,000

Less foregone
entrepreneurial income$5,000

Total implicit
costs…………………..$33,000

Economic profit………………………$24,000
 Economic vs. Accounting Profit
Economic Profit (Pure Profit)
The term profit is used differently by economists
and accountants. To an accountant, profit is the
firm’s total revenue less its explicit costs
(accounting costs). To the economist, economic
profit is total revenue less economic costs (explicit
and implicit costs).

Economic Profit= Total Revenue- Economic Costs

Accounting profit = Total Revenue – Explicit Costs

 Short Run vs Long Run
The Short Run- this is the period of time where at least
one factor of production is fixed in supply. As a result, a
firm can only change its output by using more or less of the
variable factors (labour, materials and other resources).

The Long Run- this is the length of time a firm needs in

order to change the amounts of all the factors of production
it uses (both fixed and variable)
 Short Run
The short run is a period too brief for a firm to alter
its plant capacity, yet long enough to permit a
change in the degree to which the fixed plant is
used. The firm’s plant capacity is fixed in the short
run. However, the firm can vary its output by
applying larger or smaller amounts of labour,
materials and other resources to that plant. It can
use its existing plant capacity more or less
intensively in the short run. In essence, in the short
run some of the firm’s resources or at least one is
fixed (the plant capacity) while the others are
variable.
 Long Run
The long run on the other hand, is a period long
enough for the firm to adjust the quantities of all
the resources that it employs, including plant
capacity. From the industry’s viewpoint, the long
run also includes enough time for existing firms to
dissolve and leave the industry or for new firms to
be created and enter into the industry. In the long
run there are no fixed resource or input, that is, all
resources or inputs are variable.
 Short vs Long Run Cont’d
The short run and the long run are conceptual
periods rather than calendar time periods. E.g. In
light manufacturing industries, changes in plant
capacity may be accomplished almost overnight.
A small T-shirt manufacturer can increase its plant
capacity in a matter of days by ordering and
installing two or three new cutting tables and
several extra sewing machines. But for heavy
industry the long run is a different matter. Rubis
may require several years to construct a new oil
station in Guyana.
 Short Run Production Costs
Short run Production Costs
In the short run some resources, those associated
with the firm’s plant, are fixed. Other resources,
however, are variable. So short run costs are either
fixed or variable. When totaled we arrive at the
total costs of the firm.
 Total Fixed Costs
Total Fixed Costs- total fixed costs are those costs
that in total do not vary with changes in output.
Fixed costs are associated with the very existence of
a firm’s plant and therefore must be paid even if its
output is zero. Such costs are termed overheads of
a firm and include costs such as rental payments,
interest on a firm’s debts, a portion of
depreciation on equipment and buildings, and
insurance premiums are generally fixed costs.
These costs do not increase even if the firm produce
more and are not expected to change suddenly,
hence, total fixed costs is always a straight line. The
firm cannot avoid paying fixed costs in the short run.
 Total Variable Costs
Total Variable Costs- variable costs are those costs
that change with the level of output. They include
payments for materials, fuel, power,
transportation services, most labour and the like.
Total variable costs changes directly with output.
But note that the increases in variable cost
associated with succeeding 1-unit increases in
output are not equal.
 Total Costs
Total Costs- total cost is the sum of fixed cost and
variable cost at each level of output. At zero units
the firms total cost is equal to the firm’s fixed
cost. Then for each unit during the production
process, total cost increases by the same amount as
variable cost. Variable costs can be controlled or
altered in the short run by changing production
levels. Fixed costs on the other hand, are beyond
the business manager’s current control; they are
incurred in the short run and must be paid
regardless of output level.
 Average Costs
Per Unit or Average Cost- producers are certainly
interested in their total costs, but they are equally
concerned with per- unit, or average, costs. In
particular, average data are more meaningful for
making comparisons with product price, which is
always stated on a per- unit basis.
Fixed, Variable and Total Costs
 Average Costs
Average Fixed Cost- (AFC)- average fixed cost
for any output level is found by dividing total fixed
cost by output. AFC= TFC/Q
Because the total fixed cost is by definition the
same regardless of output, AFC must decline as
output increase. As output rises, total fixed cost is
spread over a larger and larger output. At one unit
of output, AFC and TFC is the same at $100, but at
2 units of output, AFC drops to $50. This process is
sometimes referred to as spreading the overhead.
Hence, the AFC curve is a continuously declining
curve as total output is increased.
 Average Costs
Average Variable Cost (AVC)- average variable
cost (AVC) for any output level is calculated by
dividing total Variable cost (TVC) by output (Q).
AVC=TVC/Q.
 Average Variable Costs
As added variable resources increase output, AVC
declines initially, reaches a minimum, and then
increases again. An AVC curve is a U-shaped or
saucer –shaped. Because total variable cost reflects
the law of diminishing returns, so must AVC, which
is derived from the firm’s total variable cost. Because
marginal returns increase initially, it takes fewer and
fewer additional variable resources to produce each
of the first 4 units of output. As a result, variable cost
per unit declines. AVC hits minimum with the fifth
unit of output, and beyond that point AVC rises as
diminishing returns require more and more variable
resources to produce each additional unit of output.
 Average Costs
Average Total Cost (ATC)- for any output level is
found by dividing total cost (TC) by that
Output(Q). ATC=TC/Q= (TFC/Q) +(TVC/Q)=
AFC+AVC.
 Marginal Costs
Marginal Cost- marginal cost is the extra or additional,
cost of producing 1 more unit of output. MC= change in
TC/ change in Q. The marginal cost (MC) curve cuts
through the average Total cost (ATC) curve and the
average variable cost (AVC) curve at their minimum
points. When MC is below average total cost, ATC falls;
when MC is above average total cost, ATC rises.
Similarly, when MC is below average variable cost, AVC
falls; when MC is above average variable cost, AVC rises.
For example, think in terms of your grade point average.
If you have a B average and you get a C on the next test
(that’s is, your marginal grade is a C), your grade point
average will fall below a B.
 
Marginal and Average Costs
Relationship of Curves.
1) Marginal cost always
cuts AVC and ATC at their
minimum point

2) When MC is below AVC

and ATC, AVC and ATC
would be falling as more
output is produced.

3) When MC is above AVC

and ATC, AVC and ATC
would be rising as more
output is produced.
 Marginal and Average Costs
Total – Cost Data Average – Cost Data Marginal
Cost
TP (Q) TFC TVC TC AFC AVC ATC MC
0 $100 $ 0 $ 100        
1 100 90 $ 190        
2 100 170 $ 270        
3 100 240 $ 340        
4 100 300 $ 400        
5 100 370 $ 470        
6 100 450 $ 550        
7 100 540 $ 640        
8 100 650 $ 750        
9 100 780 $ 880        
10 100 930 $ 1030        
 Marginal and Average Costs
Total Cost Data Average Cost Data Marginal
Cost
Total Total Total Total Cost (TC) Average Fixed Average Variable Average Total Marginal
Product Fixed Variable TC=TFC+TVC Cost (AFC) Cost (AVC) Cost (ATC) Cost (MC)
(Q) Cost Cost AFC=TFC/Q AVC=TVC/Q ATC=TC/Q  
(TFC) (TVC) MC=
∆TC/∆Q
 
 

0 100 0 100 - - - -

1 100 90 190 100 90 190 90

2 100 170 270 50 85 135 80

3 100 240 340 33.33 80 113.33 70

4 100 300 400 25 75 100 60

5 100 370 470 20 74 94 70

6 100 450 550 16.67 75 91.67 80

7 100 540 640 14.29 77.14 91.43 90

8 100 650 750 12.50 81.25 93.75 110

9 100 780 880 11.11 86.67 97.78 130

10 100 930 1030 10 93 103 150

 Short Run Production Relationships
A firm’s costs of producing a specific output
depend on the prices of the needed resources and
the quantities of resources (inputs) needed to
produce that output. Resource supply and demand
determine resource prices. The technological
aspects of production, specifically the relationships
between inputs and output, determine the quantities
of resources needed.
The study of production begins with understanding
the production function.
 Production Function
The production function is a technical specification
of relating Inputs to output with a given state of
technology. This can be mathematically represented
by the equation that follows:
Q=f(L,K) Where;
Q= Output produced
L= Labour used
K= Capital used
Even though it is not stated Capital is held fixed in
the short run and the state of technology.
 Short Run Production Relationships
Total Product (TP)- is the total quantity or total output
produced over a given period of time through the factors of
production used by the firm. If the units of one factor are
changed then the total product will change as well,
depending on the amount of that factor used.
 
Marginal Product (MP)-is the additional or extra unit(s) of
output or added product associated with adding a unit of a
variable resource, in this case labour, to the production
process.
 
Average Product (AP)- is also called labour productivity; is
output per unit of labour input employed. AP=TP/units of
labour
In the short run, a firm can for a time increase its
output by adding units of labour to its fixed plant.
But how much will output rise when it adds the
labour?
 Law of Diminishing Returns
The Law of Diminishing Returns- also called the
law of diminishing marginal product and the law of
variable proportions. The law assumes that
technology is fixed and thus the techniques of
production do not change. It states that as successive
units of a variable resource (labour) are added to a
fixed resource (capital or land) beyond some point
the extra, or marginal, product that can be attributed
to each additional unit of the variable resource will
decline. For example, if additional workers are hired
to work with constant amount of capital equipment,
output will eventually rise by smaller and smaller
amounts as more workers are hired.
Law of Diminishing Returns

VIDEO
 Law of Diminishing Returns
For example, the use of fertilizer improves crop
production on farms and in gardens; but at some
point, adding more and more fertilizer improves the
yield less and less, and excessive quantities can
even reduce the yield. A common sort of example is
adding more workers to a job, such as assembling a
car on a factory floor. At some point, adding more
workers causes problems such as getting in each
other's way, or workers frequently find themselves
waiting for access to a part. In all of these
processes, producing one more unit of output per
unit of time will eventually cost increasingly more,
due to inputs being used less and less effectively.
 Law of Diminishing Returns
Units of Total Marginal Average
Labour Production Product (MP) Product (AP)

   
0 0
   
1 10
   
2 25
   
3 45
   
4 60
   
5 70
   
6 75
   
7 75
   
8 70
 Law of Diminishing Returns
Units of Variable Total Product Average Product Marginal Product Marginal
Resource (AP/Labour) (MP) Returns
(Labour) MP=
∆TP/∆labour
 
0 0 - -  

1 10 10 10 Increasing

2 25 12.5 15 Increasing

3 45 15 20 Increasing

4 60 15 15 Diminishing

5 70 14 10 Diminishing

6 75 12.5 5 Diminishing

7 75 10.71 0 Negative

8 70 8.75 -5 Negative
 Law of Diminishing Returns
Note that with no labour input, total product is zero;
a plant with no workers will not produce no output.
The first three units of labour, reflects increasing
marginal returns with marginal products of 10, 15,
and 20 respectively. However, at the beginning of
the fourth unit of labour, marginal product
diminishes continuously, becoming zero with the
seventh and eight unit of labour negative.
Law of Diminishing Returns
The law of Diminishing
Returns; as a variable
resource (labour) is
added to fixed amounts
of other resources
(land) is added to fixed
amounts of other
resources (land and
Capital), the total
product that results will
eventually increase by
diminishing amounts,
reach a maximum and
then decline. Marginal
product intersects
average product at the
maximum average
product.
 Law of Diminishing Returns
In the graph above, total product (TP) goes through three phases.
It rises initially an increasing rate; then it increases, but at a
diminishing rate; finally, after reaching maximum, it declines.
Marginal product measures the change in total product associated
with each succeeding unit of labour. Thus, the three phases of
total product are also reflected in marginal product. Where total
product is increasing at an increasing rate, marginal product is
rising. Here, extra units of labour are adding larger and larger
amounts of total product. Similarly, where total product is
increasing but at a decreasing rate, marginal product is positive
but falling. Each additional unit of labour adds less to total
product than did the previous unit. When total product is at a
maximum, marginal product is zero, when total product declines,
marginal product becomes negative.
 Law of Diminishing Returns
Average product displays the same tendencies as
marginal product. It increases, reaches a maximum,
and then decreases as more and more units of
labour are added to the fixed plant. Where marginal
product exceeds average product, average product
rises and where marginal product is less than
average product, average product declines. Further,
marginal product intersects average product where
average product is at a maximum.
Productivity and Cost Curves
The marginal cost curve and
the average variable cost
curve are the mirror images of
the marginal product and
average product curves.
Assuming that labour is the
only variable input and that
its price (wage rate) is
constant, then when marginal
product is rising, marginal
cost is falling, and when
marginal product is falling,
marginal cost is rising. Under
the same assumptions, when
average product is rising,
average variable cost is
falling, and when average
product is falling, average
variable cost is rising.
 Marginal Cost and Marginal
Product
Looking back at the table which shows diminishing
returns, we can see the relationship between
marginal product and marginal cost. If all units of
variable resource (labour) are hired at the same
price, the marginal cost of extra unit of output will
fall as long as marginal product of each additional
worker is rising. Marginal cost is the cost (here
constant) of an extra worker divided by his/her
marginal product. Suppose that the cost of hiring
each worker is $10. Because the first worker’s
marginal product is 10 units of output and hiring this
worker increases the firm’s cost by $10, the marginal
cost of each 10 units of output is $1 ($10/10units).
 Marginal Cost and Marginal
Product
The second worker also increases cost by $10 but the
marginal product is 15 units of output, so the marginal
cost of these 15 units extra units of output is $0.67
($10/15units). Hence to generalize, as long as marginal
product is rising, marginal cost will fall. But with the
fourth worker diminishing returns set in and marginal cost
begins to rise. For the fourth worker, marginal cost is
$0.67 ($10/15 Units), for the fifth worker, MC is 1
($10/10 units), the sixth, MC is $2 ($10/5units) and so on.
If the price of the variable resource remains constant,
increasing marginal returns will be reflected in a declining
marginal cost, and diminishing marginal returns in a rising
marginal. Similarly, MC curve is a mirror reflection of the
MP curve.
 Marginal Cost and Marginal
Product
When MP is at its maximum, MC is at its minimum
and when marginal product is falling, marginal cost
is rising.
When marginal cost lies below ATC, ATC will fall,
and whenever MC lies above ATC, ATC will rise.
Marginal cost intersects ATC and AVC curves at the
minimum point.
However, no such relationship exists between MC
and AFC because the two are not related; marginal
cost includes only those costs that change with
output and fixed costs by definition are those that
are independent of output.
 Long Run Production Costs
In the long run an industry and the individual firms
it comprises can undertake all desired resource
adjustments. That is, they can change the amount of
all inputs used. The firm can alter its plant capacity;
it can build a larger plant or revert to a smaller
plant. The long run also allows sufficient time for
firms to enter or for existing firms leave the
industry. We will focus on average total cost,
making no distinction between fixed and variable
costs because all resources and costs are varied in
the long run.
 Long Run Production Costs
Firm Size and Cost
Suppose a single-plant manufacturer begins on a
small scale and ,as a result of successful operations,
expands to successively larger plant sizes with
larger output capacities. For a time, successively
larger plant will lower average total costs.
However, eventually the building of a still larger
plant may cause ATC to rise.
Long Run Production Costs
The long run average total
cost curve: five possible
plant sizes. The long run
average total cost curve is
made up to segments of the
short run cost curves (ATC-
1, ATC-2, etc) of the various
size plants from which the
firm might choose. Each
point on the bumpy planning
curve shows the lowest unit
cost attainable for any
output when the firm has
had time to make all desired
changes in its plant size.
 Long Run Production Costs
The vertical lines perpendicular to the output axis indicates that
output at which the firm should change plant size to realize the
lowest attainable average total costs of production. For all
outputs up to 100 units, the lowest average total costs are
attainable with plant size 1. However, if the firm’s volume of
sales expands beyond 100 units but less than 200, it can
achieve lower per unit costs by constructing a larger plant, size
2 and so on.
Tracing these adjustments, we find the long run average total
cost curve for the enterprise is made up of segments of the
short run ATC curves for the various plant sizes that can be
constructed. The long run ATC curve shows the lowest average
total cost at which any output level can be produced after the
has had time to make all desired changes in its plant size. The
firm’s bumpy long run ATC curve is often called the firm’s
planning curve.
Long Run Production Costs
The long run average
total cost curve:
unlimited number of
plant sizes. If the
number of possible
plant sizes is very
large, the long run
average total cost
curve approximates a
smooth curve.
Economies of scale,
followed by
diseconomies of
scale, because the
curve is U shaped.
 Economies and Diseconomies of
Scale
It is assumed that for a time larger and larger plant sizes
will lead to lower unit costs but that beyond some point
successively larger plants will mean higher average total
costs. That is, we have assumed the ATC curve is U
shaped. It is this way because:
The law of diminishing returns does not apply in the long
run. That’s because diminishing returns presume one
resource is fixed in supply while in the long run means all
resources are variable. Also we assume resource prices are
constant.
It can also be explained through the U-shaped long run
ATC in terms of economies and diseconomies of large-
scale production.
 Economies of Scale
When long run average total costs decreases as
output increases.
Economies of scale or economies of mass
production, explain the down sloping part of the
long run ATC curve. As plant sizes increases, a
number of factors will for a time lead to lower
average costs of production. Factors which can lead
to lower average costs of production for a time are:
 Economies of Scale
Labour specialization- increased specialization in
the use of labour becomes more achievable as a
plant increases in size. Hiring more workers means
jobs can be divided and subdivided. Each worker
may now have just one task to perform instead of
five or six.
Managerial Specialization- large scale production
also means better use of, and greater specialization
in, management. A supervisor who can handle 20
workers is underuse in a small plant that employs
only 10 people. The production staff could be
doubled with no increase in costs.
 Economies of Scale
Efficient Capital- small firms often cannot afford the most
efficient equipment. In many lines of production such
machinery is available only in very large and extremely
expensive units. Furthermore, effective use of the equipment
demands a high volume of production, and that again requires
large scale producers. As a result, small scale producers are
faced with a dilemma of using other equipment which
inefficient and therefore more costly per unit.
Other factors- many products entail design and development
costs, as well as other startup costs, which must be incurred
irrespective of project sales. These costs decline per unit as
output in increased. Also, the firm’s production and marketing
expertise usually rises as it produces and sells more output.
This learning by doing is a further source of economies of
scale.
 Economies of Scale
Efficient Capital- small firms often cannot afford the most
efficient equipment. In many lines of production such
machinery is available only in very large and extremely
expensive units. Furthermore, effective use of the equipment
demands a high volume of production, and that again requires
large scale producers. As a result, small scale producers are
faced with a dilemma of using other equipment which
inefficient and therefore more costly per unit.
Other factors- many products entail design and development
costs, as well as other startup costs, which must be incurred
irrespective of project sales. These costs decline per unit as
output in increased. Also, the firm’s production and marketing
expertise usually rises as it produces and sells more output.
This learning by doing is a further source of economies of
scale.
 Economies of Scope
Economies of scale for a firm involve reductions in
the average cost (cost per unit) arising from
increasing the scale of production for a single
product type, economies of scope however, involve
lowering average cost by producing more types of
products.
 Constant Returns to Scale
When long run average total costs do not change
with increases in output.
In some industries there may exist a rather wide
range of output between the output at which
economies of scale end and the output at which
diseconomies of scale begin. That is there maybe a
range of constant returns to scale over which long
run average costs does not change.
 Diseconomies of Scale
When long run average total cost increases as output increases.
In time the expansion of a firm may lead to diseconomies and
therefore higher average total costs. The main factor causing
diseconomies of scale is the difficulty of efficiently controlling
and coordinating a firm’s operations as it becomes a large scale
producer. In a small plant a single key executive may make all
the basic decisions for the plant’s operation. Since the firm is
small, the executive is close to the production line, understands
the firm’s operations, and can digest information and make
efficient decisions. As the firm expands, it becomes harder for
one person to assemble, digest understand all the information
essential to design making on a large scale. Hence, tasks must
be delegated to managers, supervisors, etc and as a result, the
decision making can be slowed down to reflect consumer tastes
or technology quickly enough. The result is impaired efficiency
and rising average total costs.
 Cost Minimization
Cost minimization is normally referred to as
producer equilibrium.

Isoquant- shows various combinations of labour

(L) and capital (K) with which a firm can produce a
specific quantity of output. The level of output is
constant along any isoquant. A higher isoquant
refers to a greater quantity of output and a lower
one, to a smaller quantity of output.
Isoquants

The level of
output along
any isoquant is
constant but the
factor inputs
varies
 The Marginal Rate of Technical
Substitution
The slope of the isoquant is called the marginal rate
of technical substitution of capital K for labour L
(MRTSLK) refers to the amount of capital (K) that a
firm can give up so as to increase the amount of
labour (L) used by one unit and still remain on the
same isoquant.
The MRTSLK is also equal to the marginal product of
labour divide by the marginal product of capital that
is MPL / MPK.
MRTSLK = MPL / MPK
As the firm moves down an isoquant, the MRTSLK
diminishes.
 Special Cases Perfect Compliments
If the two inputs are perfect complements, the
isoquant map takes the form of the figure below
with a level of production Q3, input X and input Y
can only be combined efficiently in the certain ratio
occurring at the kink in the isoquant. The firm will
combine the two inputs in the required ratio to
maximize profit.
 Special Cases Perfect Substitutes
If the two inputs are perfect substitutes, the
resulting isoquant map generated is represented in
fig. below; with a given level of production Q3,
input X can be replaced by input Y at an
unchanging rate. The perfect substitute inputs do
not experience decreasing marginal rates of return
when they are substituted for each other in the
production function.

.
 Isocosts
An isocosts shows the combination of factor
inputs (K, L) that are affordable given the
price of the factors and the financial resources
available to the producer. The slope of an
isocost is given by – PL /PK, where PL refers to
the price of labour and PK to the price of
capital.
TO = PL * QL + PK * QK
Slope of the isocosts line is relative price ratio of
factor inputs
I = -P /P
Isocosts
 Equilibrium
Producer Equilibrium
A producer is in equilibrium when he or she
maximizes output for the give total outlay. Another
way of saying this is that a producer is in
equilibrium when the highest isoquant is reached,
given the particular isocost. This occurs where an
isoquant is tangent to the isocost.
At the point of tangency, the absolute slope of the
isoquant is equal to the absolute slope of the
isocosts.
 Equilibrium
Producer Equilibrium
That is at producer equilibrium MRTSLK = PL /PK.
This is completely analogous to the concept of
consumer equilibrium. Since,
MRTSLK = MPL / MPK, at equilibrium

Cost minimization rule MPL / MPK = PL / PK .

Equilibrium
 Equilibrium
This means that at equilibrium the MP of the last dollar spent on
labour is the same as the MP of the last dollar spent on capital.
 Resource Base
The resource base will also influence the economic
decisions taken by a firm since the factors of production
available to it will have to be considered. Additionally, a
firm may need to calculate the amount of land it can afford
to rent and whether labour can be readily found which is
adequately skilled. Capital also has to be sourced since its
important to the firm to start and continue its operations.
There must also be entrepreneurial talent available as the
other three factors cannot be brought together and utilized
without this factor of production.
 Industrial Relations
The economic decisions made by firms depend significantly
upon the existence of trade unions.
Industrial relations also affect the economic decisions taken
by firms. Industrial relations involve the regulation of the
existing relationships between employers and employees
(trade unions if they exist) as well as between the
representatives of these bodies and the state. This
regulation carried out through rules and processes are
meant to ensure that the relationships are harmonious, with
a minimum amount of conflict which in turn would
stimulate an environment of economic efficiency,
motivation as well as productivity, mutual trust and
employee loyalty.
 Market Structures
Market structure can be defined as those characteristics
which affect the behaviour of firms within the industry in
which they operate. There are four distinct market
structures:
Pure Competition
Pure Monopoly
Monopolistic Competition
Oligopoly.
 Market Structures
These four market models differ in several respects:
the number of firms in the industry, whether those
firms produce standardized product or try to
differentiate their products from those of other
firms, and how easy or difficult it is for firms to
enter the industry.
Very briefly the four models exhibit certain traits as
follows:
 Market Structures
Pure competition- involves a very large number of
firms producing a standardized product (that is, a
product identical to that of other producers, such as
corn and cucumbers). New firms enter and exit the
industry very easily.
Pure monopoly- is a market structure in which one
firm is the sole seller of a product or service (for
example, a local electric utility). Since the entry of
additional firms is blocked, one firm constitutes the
entire industry. Because the monopolistic produces
a unique product, it makes no effort to differentiate
its product.
 Market Structures
Monopolistic Competition- is characterized by
relatively large number of sellers producing
differentiated products (clothing, furniture, books).
There is widespread non price competition, a selling
strategy in which one firm tries to distinguish its
product or service from all competing products on the
basis of attributes like design and workmanship (an
approach called product differentiation) wither entry to
or exit from monopolistically competitive industries is
quite easy.
Oligopoly- involves only a few sellers of an identical or
similar product; consequently each firm is affected by
the decisions of its rivals and must take those decisions
into account in determining its own price and output.
END