DEMAND, SUPPLY, AND

MARKET EQUILIBRIUM
CHAPTER TWO
THE BASIC DECISION-MAKING UNITS

• A firm is an organization that transforms resources

(inputs) into products (outputs). Firms are the primary
producing units in a market economy.
• An entrepreneur is a person who organizes, manages,
and assumes the risks of a firm, taking a new idea or a
new product and turning it into a successful business.
• Households are the consuming units in an economy.
THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

• The circular flow of economic

activity shows the connections
between firms and households in
input and output markets.
INPUT MARKETS AND OUTPUT MARKETS

• Output, or product, markets are the

markets in which goods and services are
exchanged.
• Input markets are the markets in which
resources—labor, capital, and land—used
to produce products, are exchanged.
• Payments flow in the opposite
direction as the physical flow of
resources, goods, and services
(counterclockwise).
INPUT MARKETS
Input markets include:

• The labor market, in which households supply work for wages to firms
that demand labor.

• The capital market, in which households supply their savings, for interest
or for claims to future profits, to firms that demand funds to buy capital
goods.

• The land market, in which households supply land or other real property in
exchange for rent.
 DETERMINANTS OF HOUSEHOLD DEMAND

A household’s decision about the quantity of a particular output to demand depends on:

• The price of the product in question.

• The income available to the household.
• The household’s amount of accumulated wealth.
• The prices of related products available to the household.
• The household’s tastes and preferences.
• The household’s expectations about future income, wealth, and prices.
QUANTITY DEMANDED

• Quantity demanded is the amount (number of

units) of a product that a household would buy in
a given time period if it could buy all it wanted at
the current market price.
 DEMAND IN OUTPUT MARKETS

ABEBE'S DEMAND
SCHEDULE FOR
• A demand schedule is a table
TELEPHONE CALLS showing how much of a given
QUANTITY
DEMANDED
product a household would be
PRICE (CALLS PER willing to buy at different
(PER CALL) MONTH)
$ 0 30 prices.
0.50 25
3.50
7.00
7
3
• Demand curves are usually
10.00 1 derived from demand
15.00 0
schedules.
THE DEMAND CURVE

ABEBE'S DEMAND
SCHEDULE FOR • The demand curve is a
TELEPHONE CALLS
QUANTITY
graph illustrating how
PRICE
DEMANDED
(CALLS PER
much of a given product
(PER CALL) MONTH) a household would be
$ 0 30
0.50 25 willing to buy at
3.50
7.00
7
3 different prices.
10.00 1
15.00 0
THE LAW OF DEMAND

• The law of demand states that there is

a negative, or inverse, relationship
between price and the quantity of a
good demanded and its price.

• This means that demand curves

slope downward.
OTHER PROPERTIES OF DEMAND CURVES

• Demand curves intersect the quantity (X)-

axis, as a result of time limitations and
diminishing marginal utility.
• Demand curves intersect the (Y)-axis, as a
result of limited incomes and wealth.
INCOME AND WEALTH

• Income is the sum of all households wages, salaries,

profits, interest payments, rents, and other forms of
earnings in a given period of time. It is a flow measure.
• Wealth, or net worth, is the total value of what a
household owns minus what it owes. It is a stock
measure.
 RELATED GOODS AND SERVICES

• Normal Goods are goods for which demand goes up

when income is higher and for which demand goes
down when income is lower.
• Inferior Goods are goods for which demand falls
when income rises.
RELATED GOODS AND SERVICES

• Substitutes are goods that can serve as replacements for one

another; when the price of one increases, demand for the other
goes up. Perfect substitutes are identical products.
• Complements are goods that “go together”; a decrease in the
price of one results in an increase in demand for the other, and
vice versa.
SHIFT OF DEMAND VERSUS MOVEMENT
ALONG A DEMAND CURVE
• A change in demand is not the same as
a change in quantity demanded.
• In this example, a higher price causes
lower quantity demanded.
• Changes in determinants of demand,
other than price, cause a change in
demand, or a shift of the entire
demand curve, from DA to DB.
A CHANGE IN DEMAND VERSUS A
CHANGE IN QUANTITY DEMANDED
• When demand shifts to the right,
demand increases. This causes
quantity demanded to be greater
than it was prior to the shift, for
each and every price level.
 A CHANGE IN DEMAND VERSUS A CHANGE IN
QUANTITY DEMANDED
To summarize:

Change in price of a good or service

leads to
Change in quantity demanded
(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to
Change in demand
(Shift of curve).
 THE IMPACT OF A CHANGE IN INCOME

• Higher income decreases the • Higher income increases the demand for
demand for an inferior good a normal good
 THE IMPACT OF A CHANGE IN THE PRICE
OF RELATED GOODS
• Demand for complement good
(ketchup) shifts left

• Demand for substitute good (chicken)

shifts right

• Price of hamburger rises

• Quantity of hamburger demanded falls
FROM HOUSEHOLD TO MARKET DEMAND

• Demand for a good or service can be defined for an individual

household, or for a group of households that make up a market.
• Market demand is the sum of all the quantities of a good or
service demanded per period by all the households buying in the
market for that good or service.
FROM HOUSEHOLD DEMAND TO
MARKET DEMAND
• Assuming there are only two households in the market, market
demand is derived as follows:
 SUPPLY IN OUTPUT MARKETS

SELAM BALTNA'S
SUPPLY SCHEDULE • A supply schedule is a table showing how much
FOR SOYBEANS
of a product firms will supply at different prices.
QUANTITY
SUPPLIED
PRICE (THOUSANDS
(PER OF BUSHELS • Quantity supplied represents the number of units
BUSHEL) PER YEAR)
$ 2 0 of a product that a firm would be willing and able to
1.75 10
2.25 20
offer for sale at a particular price during a given
3.00 30 time period.
4.00 45
5.00 45
 THE SUPPLY CURVE AND THE SUPPLY
SCHEDULE
• A supply curve is a graph illustrating how much of a product
a firm will supply at different prices.
6

Price of soybeans per bushel ($)

SELAM BALTNA'S
SUPPLY SCHEDULE 5
FOR SOYBEANS
QUANTITY
4
SUPPLIED
PRICE (THOUSANDS
3
(PER OF BUSHELS 2
BUSHEL) PER YEAR)
$ 2 0 1
1.75 10
2.25 20 0
3.00 30
4.00 45 0 10 20 30 40 50
5.00 45 Thousands of bushels of soybeans
produced per year
 THE LAW OF SUPPLY
Price of soybeans per bushel ($)

6 • The law of supply states that

5
4 there is a positive relationship
3
2
between price and quantity of a
1 good supplied.
0
0 10 20 30 40 50 • This means that supply curves
Thousands of bushels of soybeans
produced per year
typically have a positive slope.
DETERMINANTS OF SUPPLY

• The price of the good or service.

• The cost of producing the good, which in turn depends on:
• The price of required inputs (labor, capital, and land),
• The technologies that can be used to produce the product,
• The prices of related products.
A CHANGE IN SUPPLY VERSUS
A CHANGE IN QUANTITY SUPPLIED
• A change in supply is not the
same as a change in quantity
supplied.

• In this example, a higher price

causes higher quantity
supplied, and a move along the
demand curve.

• In this example, changes in determinants of supply, other than price, cause an

increase in supply, or a shift of the entire supply curve, from SA to SB.
A CHANGE IN SUPPLY VERSUS
A CHANGE IN QUANTITY SUPPLIED

• When supply shifts to the right,

supply increases.

• This causes quantity supplied

to be greater than it was prior to
the shift, for each and every
price level.
 A CHANGE IN SUPPLY VERSUS
A CHANGE IN QUANTITY SUPPLIED
To summarize:
Change in price of a good or service
leads to

Change in quantity supplied

(Movement along the curve).

Change in costs, input prices, technology, or prices of related goods and

services leads to

Change in supply(Shift of curve).

 FROM INDIVIDUAL SUPPLY
TO MARKET SUPPLY

• The supply of a good or service can be defined for an

individual firm, or for a group of firms that make up a
market or an industry.
• Market supply is the sum of all the quantities of a good or
service supplied per period by all the firms selling in the
market for that good or service.
 MARKET SUPPLY

• As with market demand, market supply is the horizontal summation

of individual firms’ supply curves.
MARKET EQUILIBRIUM

• The operation of the market depends on the interaction

between buyers and sellers.
• An equilibrium is the condition that exists when quantity
supplied and quantity demanded are equal.
• At equilibrium, there is no tendency for the market price to
change.
MARKET EQUILIBRIUM

• Only in equilibrium is quantity

supplied equal to quantity demanded.

• At any price level other than P0,

the wishes of buyers and sellers
do not coincide.
MARKET DISEQUILIBRIA

• Excess demand, or shortage, is the condition

that exists when quantity demanded exceeds
quantity supplied at the current price.

• When quantity demanded exceeds

quantity supplied, price tends to rise until
equilibrium is restored.
MARKET DISEQUILIBRIA

• Excess supply, or surplus, is the

condition that exists when quantity
supplied exceeds quantity demanded
at the current price.

• When quantity supplied exceeds

quantity demanded, price tends
to fall until equilibrium is restored.
INCREASES IN DEMAND AND SUPPLY

• Higher supply leads to lower equilibrium

• Higher demand leads to higher equilibrium
price and higher equilibrium quantity.
price and higher equilibrium quantity.
 DECREASES IN DEMAND AND SUPPLY

• Lower demand leads to lower price and • Lower supply leads to higher price and lower
lower quantity exchanged. quantity exchanged.
 RELATIVE MAGNITUDES OF CHANGE

• The relative magnitudes of change in supply and demand determine the

outcome of market equilibrium.
RELATIVE MAGNITUDES OF CHANGE

• When supply and demand both increase, quantity will increase, but price may
go up or down.
CHAPTER THREE
OPTIMIZATION TECHNIQUES
MAXIMIZING THE VALUE OF THE FIRM

• In managerial economics, the primary objective of management is

assumed to be maximization of the value of the firm.
• Maximizing the above equation is a complex task that involves
consideration of future revenues, costs, and discount rates.
• For many day-to-day operating decisions, managers typically use less
complicated, partial optimization techniques.
 EXPRESSING ECONOMIC RELATIONSHIPS

Common ways of specifying Economic functions are:

• Set form
• Functional form
• Graphs
• table
TOTAL, AVERAGE, AND MARGINAL RELATIONS

• Total, average, and marginal relations are very useful in

optimization analysis. The relationship between total,
average and marginal concepts is extremely important
in optimization analysis
MARGINAL REVENUE

• Marginal Revenue
• Change in total revenue associated with a one-unit change in output.
• Revenue Maximization
• Quantity with highest revenue, MR = 0. 32
MARGINAL REVENUE

• Marginal revenue is the change in total revenue associated with

a one-unit change in output; marginal cost is the change in total
cost following a one-unit change in output; and marginal profit
is the change in total profit due to a one-unit change in output.
 COST RELATIONS

Total Cost
• Total Cost = Fixed Cost + Variable Cost.
Marginal and Average Cost
• Marginal cost is the change in total cost associated with a one unit change in output.
• Average Cost = Total Cost/Quantity
AVERAGE COST MINIMIZATION

Average Cost Minimization

• Average cost is minimized when MC = AC.
• Reflects efficient production of a given output level.
• Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)
 PROFIT RELATION

Total and Marginal Profit

• Total profit= Total Revenue – Total Cost
• Marginal profit is the change in total profit due to a one unit change in output.
Profit Maximization
• Profit is maximized when MP = MC, MC=0 , or MR=MC assuming profit declines as
quantity rises
MARGINAL INCREMANTAL PROFIT

• Marginal profit is the gain from producing one more unit of

output(Q).
• Incremental profit gain is tied to a managerial decision, possibly
involving multiple unit of quantity(Q)
 CHAPTER FOUR:
DECISION MAKING UNDER RISK AND
UNCERTAINTY
• Managerial economics is about the criteria for rational decision making by managers of
business enterprises.
• In regard to most of the things that humans consume, scarcity is the rule and abundance is
the exception. A scarcity of something means that the total of human wants for it exceeds
the quantity of it available for human consumption.
• It is because of scarcity that humans have to make choices. The "economic problem" is the
juxtaposition of productive resource scarcity against human want insatiability. In
attempting to resolve the economic problem, humans must make choices in how to use their
scarce resources as efficiently as possible in the satisfaction of human wants.
 THE NATURE OF DECISION MAKING

• Some of the decisions are trivial in the sense that the consequences of them
do not matter very much. The consequences of other decisions, for example,
what employee health insurance plan to adopt or whether to add or drop a
product line from the company's product mix may be monumental.
• Human approaches to decisions may be categorized as capriciousness,
conditioned response, and deliberate, reasoned choice.
• The more trivial the consequences of the decision, the less time and effort
are devoted to the decision process.
THE NATURE OF DECISION MAKING

• Sometimes people seem to act without engaging in any apparent decision-making

process. The choices underlying such actions may have been nearly automatic, based
upon an implicit summing-up of the current circumstance compared with the
decision maker's accumulated stock of past experiences under similar
circumstances.
• Occasionally, however, human beings indulge themselves in a capricious action (an
act without deliberate choice), even when the consequences may be non-trivial. If a
capricious action constitutes a "bad" decision, the actor must suffer the
consequences.
DIMENSIONS OF THE DECISION PROBLEM

• Multiple Goals - The decision maker may be confronted with a multiplicity of goals.
Since it is technically not possible to try to maximize simultaneously the values of
multiple conflicting goals, the decision maker has to choose one of the goals for primary
pursuit.
• Multiple Strategies. With respect to any single goal, a decision involves multiple
possible courses of action, or strategies. If there were no alternatives, no decision would
be required other than selecting the goal for pursuit.
 DIMENSIONS OF THE DECISION PROBLEM…

• Marginal Changes - In many cases, the choices are not mutually-exclusive

alternative courses of action; rather they involve more or less of the same course of
action. The range of possible alternatives includes larger or smaller quantities to be
selected.
• Economists speak of such additions and subtractions as incremental changes,
or marginal changes if they are the smallest possible changes that can be
made. The rational choice in such cases is to make a quantitative change that
will yield the greatest marginal benefit relative to marginal cost.
RISK AND EXPECTED VALUES OF AN
INVESTMENT
• Multiple Outcomes - Often the possible alternative courses of action can be
identified, but each decision alternative may have several outcome possibilities.
• If the decision maker can in some meaningful sense assess the probability, p, of
the occurrence of each possible outcome, V, for each of the alternative courses of
action, he may then compute the expected value of each alternative.

• EV = p1V1 + p2V2 + ... + pkVk, or

• EV = j=1,k (pjVj),
 RISK AND EXPECTED VALUES OF AN INVESTMENT…

• Risk - Other things may not be the same, however, if the range of
outcome variability differs from one alternative to another.
• It is typical for decision alternatives to have different expected values,
but even if two decision alternatives have approximately the same
expected values, one may have a wider range of possible outcome
variability than the other.
• Risk is inherent in the dispersion of possible outcomes about the mean
of all such outcomes.
RISK AND PROBABILITY DISTRIBUTIONS

• Decision makers' attitudes toward risk may vary widely. People who have strong preferences
for risk assumption may turn out to be chronic gamblers. Such people get their "kicks" from
accepting adverse-odds bets (long shots) with negative expected values.
• Risk preferrers are likely to lose (on net balance) over the long run.
• It is theoretically possible for a decision maker to be essentially risk-neutral, having neither
preference for nor aversion toward risk.
• The vast majority of all people who regard themselves as rational thinkers are risk-averse, and
the more extreme of them are risk avoiders (they expect bad things to happen to them each
morning as soon as they get out of bed).
RISK AND PROBABILITY DISTRIBUTIONS…

• Manage risk by seeking more information in order to diminish it, by attempting to take
offsetting positions, or by attempting to insure against the risk.
• Personal utility functions for decision makers, it would be possible to include the
decision maker's attitude toward risk as an argument (i.e., one of the independent
variables) in the function. We might find the risk preferrer to "consume" risky items
under conditions of increasing marginal utility, the risk-indifferent decision maker to
exhibit a linear risk utility function, and one who is averse to risk to experience
diminishing marginal utility with respect to risk.
APPROACHES OF INCORPORATING RISK INTO
DECISION MAKING PROCESS
• A first approach to dealing with risk is to seek more information about the decision
alternative.
• Additional information often reveals that the range of outcome variability is narrower
than at first thought, and that the decision alternative is thus less risky than earlier
imagined.
APPROACHES OF INCORPORATING RISK INTO
DECISION MAKING PROCESS
• A potentially useful concept for short-run decision analysis is that of the certainty
equivalent. In this approach, the decision maker must ask himself what certain sum he
would be willing to accept in lieu of the risky outcome at issue.
• The risk-averse decision maker can be expected to indicate a lesser certain sum than the
risky possibility ("a bird in the hand is worth two in the bush"), whereas the risk
preferrer would have to have a larger certain sum as a compensation for the insult of
removing the gamble from his consideration.
DECISION MAKING UNDER UNCERTAINTY

• Decision maker simply cannot in any meaningful way assess the probabilities of the
possible outcomes. How can the decision maker decide whether or not to invest in the
venture
THEORY OF PRODUCTION
CHAPTER FIVE
OBJECTIVES

• Explain how managers should determine the optimal method of production by applying
an understanding of production processes
• Understand the linkages between production processes and costs
PRODUCTION PROCESSES

• Production processes include all activities associated with providing goods and services,
including
• Employment practices
• Acquisition of capital resources
• Product distribution
• Managing intellectual resources
PRODUCTION PROCESSES

• Production processes define the relationships between resources used and goods and
services produced per time period.
• Managers exert control over production costs by understanding and managing production
technology.
PRODUCTION FUNCTION WITH ONE VARIABLE
INPUT
• A production function shows the maximum amount that can be produced per time period
with the best available technology from any given combination of inputs.
• Table
• Graph
• Equation
PRODUCTION FUNCTION WITH ONE VARIABLE
INPUT
• Production Function Example
• Q = f(X1, X2)
• Q = Output rate
• X1 = Input 1 usage rate
• X2 = Input 2 usage rate
• Q = 30L + 20L2 – L3
• Q = Hundreds of parts produced per year
• L = Number of machinists hired
• Fixed Capital = Five machine tools
PRODUCTION FUNCTION WITH ONE VARIABLE
INPUT
• Unit Functions
• Average Product of Labor = APL = Q/L
• Common measuring device for estimating the units of output, on average, per worker
PRODUCTION FUNCTION WITH ONE VARIABLE
INPUT
• Unit Functions (Continued)
• Marginal Product of Labor = MPL = Q/L
• Metric for estimating the efficiency of each input in which the input’s MP is equal to the incremental
change in output created by a small increase in the input
• Using calculus (assumes that labor can be varied continuously): MP = dQ/dL
PRODUCTION FUNCTION WITH ONE VARIABLE
INPUT
• Unit Functions (Continued)
• Unit function examples from Q = 30L + 20L2 – L3
• Table 4.2 and Figure 4.2
• APL = 30 + 20L – L2
• Using calculus: MPL = 30 + 40L – 3L2
• APL is at a maximum, and MPL = APL, at L = 10 and MPL = APL = 130
• MPL is at a maximum at L = 6.67 and MPL = 163.33
PRODUCTION FUNCTION WITH ONE VARIABLE
INPUT

• Unit Functions (Continued)

• Why does MPL = APL when APL is at a maximum?
• If MPL > APL, then APL must be increasing
• If MPL < APL, then APL must be decreasing
THE LAW OF DIMINISHING MARGINAL RETURNS

• Law of diminishing returns

• When managers add equal increments of an input while holding other input levels constant, the
incremental gains to output eventually get smaller
THE PRODUCTIONN FUNCTION WITH TWO
VARIABLE INPUTS
• Q = f(X1, X2)
• Q = Output rate
• X1 = Input 1 usage rate
• X2 = Input 2 usage rate
• AP1 = Q/X1 and MP1 = Q/X1 or dQ/dX1
• AP2 = Q/X2 and MP2 = Q/X2 or dQ/dX2
• Example
• Table 4.3 and Figure 4.3
ISOQUANTS

• Isoquant: Curve showing all possible (efficient) input bundles capable of producing a
given output level.
• Graphically constructed by cutting horizontally through the production surface at a given
output level
• Isoquants representing different output levels are shown in Figure 4.4.
ISOQUANTS

• Properties
• Isoquants farther from the origin represent higher input and output levels.
• Given a continuous production function, every possible input bundle is on an isoquant and
there is an infinite number of possible input combinations.
• Isoquants slope downward to the left and are convex to the origin.
MARGINAL RATE OF TECHNICAL SUBSTITUTION

• Marginal rate of technical substitution (MRTS): Shows the rate

at which one input is substituted for another (with output
remaining constant)
• Q = f(X1, X2)
• MRTS = –X2/X1 with Q held constant and X2 on the vertical axis
• MRTS = MP1/MP2
• MRTS = Absolute value of the slope of an isoquant
MARGINAL RATE OF TECHNICAL SUBSTITUTION

• MRTS and isoquants (with X2 on the vertical axis)

• If the MRTS is large, it takes a lot of X2 to substitute for one unit of X1, and isoquants will be
steep.
• If the MRTS is small, it takes little X2 to substitute for one unit of X1, and isoquants will be
flat.
MARGINAL RATE OF TECHNICAL SUBSTITUTION

• MRTS and isoquants (with X2 on the vertical axis) (Continued)

• If X1 and X2 are perfect substitutes, MRTS is constant, and isoquants
will be straight lines.
• If X1 and X2 are perfect complements, no substitution is possible,
MRTS is undefined, and isoquants will be right angles.
MARGINAL RATE OF TECHNICAL SUBSTITUTION

• Ridge Lines
• Ridge lines: The lines that profit-maximizing firms operate within, because outside of them,
marginal products of inputs are negative
• Economic region of production is located within the ridge lines.
THE OPTIMAL COMBINATION OF INPUTS

• Isocost curve: Curve showing all the input bundles that can be purchased at a specified
cost
• PLL + PKK = M
• L = Labor use rate
• PL = Price of labor
• K = Capital use rate
• PK = Price of capital
• M = Total outlay
THE OPTIMAL COMBINATION OF INPUTS

• Isocost curve (Continued)

• K = M/PK – (PL/PK)L
• Vertical intercept = M/PK
• Horizontal intercept = M/PL
• Slope = – PL/PK
THE OPTIMAL COMBINATION OF INPUTS

• Optimal Combination of Inputs

• Tangency between isocost and isoquant
• MRTS = MPL/MPK = PL/PK
• MPL/PL = MPK/PK
• Marginal product per dollar spent should be the same for all inputs.
• MPa/Pa = MPb/Pb =  = MPn/Pn

• Maximize output for given cost: Figure 4.8

• Minimize cost for a given output: Figure 4.9
CORNER SOLUTIONS

• Optimal input combination does not occur at a point of tangency between isocost and
isoquant curves.
• In a two-input case, one of the inputs will not be used at all in production.
• Example: Figure 4.10
CORNER SOLUTIONS

• If two inputs are perfect complements (isoquants are right

angles), then both inputs will be used, but the optimal
combination will not occur at a point of tangency between
isocost and isoquant curves.
RETURNS TO SCALE

• Long-run effect of an equal proportional increase in all inputs

• Increasing returns to scale: When output increases by a larger
proportion than inputs
• Decreasing returns to scale: When output increases by a smaller
proportion than inputs
• Constant returns to scale: When output increases by the same
proportion as inputs
RETURNS TO SCALE

• Sources of increasing returns to scale

• Indivisibilities: Some technologies can only be implemented at a large scale of production.
• Subdivision of tasks: Larger scale allows increased division of tasks and increases
specialization.
RETURNS TO SCALE

• Sources of increasing returns to scale (Continued)

• Probabilistic efficiencies: Law of large numbers may reduce risk as
scale increases.
• Geometric relationships: Doubling the size of a box from 1 X 1 X 1 to
2 X 2 X 2 multiplies the surface area by four times (from 3 to 12) but
increases the volume by eight times (from 1 to 8). This applies to
storage devices, transportation devices, etc.
RETURNS TO SCALE

• Sources of decreasing returns to scale

• Coordination inefficiencies: Larger organizations are more difficult to manage.
• Incentive problems: Designing efficient compensation systems in large organizations is
difficult.
THE OUTPUT ELASTICITY

• Output elasticity: The percentage change in output resulting

from a 1 percent increase in all inputs.
• Note: A more common definition of output elasticity is the percentage
change in output resulting from a 1 percent increase in a single input.
Accordingly, the coefficients 0.3 and 0.8 in the Cobb-Douglas function
below would be referred to as the output elasticities of labor and
capital, respectively.
THE OUTPUT ELASTICITY

• Cobb-Douglas production function example: Q = 0.8L 0.3K0.8

• Q = Parts produced by the Lone Star Company per year
• L = Number of workers
• K = Amount of capital
• Output elasticity = 1.1 for infinitesimal changes in inputs
• Example calculation for 1 percent increase in both inputs
• Q' = 0.8(1.01L)0.3(1.01K)0.8 = 1.011005484Q
ESTIMATIONS OF PRODUCTION FUNCTIONS

• Cobb-Douglas Mathematical form: Q = aLbKc

• MPL = Q/L = b(Q/L) = b(APL)
• Linear estimation: log Q = log a + b log L + c log K
• Returns to scale
• b + c > 1 => increasing returns
• b + c = 1 => constant returns
• b + c < 1 => decreasing returns
THEORY OF COST
CHAPTER SIX
THE COSTS OF PRODUCTION

• The Market Forces of Supply and Demand

• Supply and demand are the two words that economists use most often.
• Supply and demand are the forces that make market economies work.
• Modern microeconomics is about supply, demand, and market equilibrium.
WHAT ARE COSTS?

• According to the Law of Supply:

• Firms are willing to produce and sell a greater quantity of a good when the price of the good is
high.
• This results in a supply curve that slopes upward.
WHAT ARE COSTS?

• The Firm’s Objective

• The economic goal of the firm is to
maximize profits.
TOTAL REVENUE, TOTAL COST, AND PROFIT

• Total Revenue
• The amount a firm receives for the sale of its output.

• Total Cost
• The market value of the inputs a firm uses in production.
TOTAL REVENUE, TOTAL COST, AND PROFIT

• Profit is the firm’s total revenue minus its total cost.

• Profit = Total revenue - Total cost

COSTS AS OPPORTUNITY COSTS

• A firm’s cost of production includes all the opportunity costs of making its output of
goods and services.
• Explicit and Implicit Costs
• A firm’s cost of production include explicit costs and implicit costs.
• Explicit costs are input costs that require a direct outlay of money by the firm.
• Implicit costs are input costs that do not require an outlay of money by the firm.
ECONOMIC PROFIT VERSUS ACCOUNTING
PROFIT
• Economists measure a firm’s economic profit as total revenue minus total cost, including
both explicit and implicit costs.
• Accountants measure the accounting profit as the firm’s total revenue minus only the
firm’s explicit costs.
ECONOMIC PROFIT VERSUS ACCOUNTING
PROFIT
• When total revenue exceeds both explicit and implicit costs, the firm earns economic
profit.
• Economic profit is smaller than accounting profit.
 FIGURE 1 ECONOMISTS VERSUS
ACCOUNTANTS
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs
PRODUCTION AND COSTS

• The Production Function

• The production function shows the relationship between quantity of inputs used to make a
good and the quantity of output of that good.
THE PRODUCTION FUNCTION

• Marginal Product
• The marginal product of any input in the production process is the increase in output that
arises from an additional unit of that input.
TABLE 1 A PRODUCTION FUNCTION AND
TOTAL COST: JIMMA WATER FACTORY
THE PRODUCTION FUNCTION

• Diminishing marginal product is the property whereby the marginal product

of an input declines as the quantity of the input increases.
• Example: As more and more workers are hired at a firm, each additional worker
contributes less and less to production because the firm has a limited amount of
equipment.
 FIGURE 2 JIMMA WATER PRODUCTION
FUNCTION
Quantity of output
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
0 1 2 3 4 5 6 7
Number of Workers Hired
THE PRODUCTION FUNCTION

• Diminishing Marginal Product

• The slope of the production function measures the marginal product of an input, such as a
worker.
• When the marginal product declines, the production function becomes flatter.
FROM THE PRODUCTION FUNCTION TO THE
TOTAL-COST CURVE
• The relationship between the quantity a firm can produce and its costs determines pricing
decisions.
• The total-cost curve shows this relationship graphically.
TABLE 1 A PRODUCTION FUNCTION AND
TOTAL COST: JIMMA WATER FACTORY
FIGURE
Total
Cost
2 JIMMA WATER TOTAL-COST CURVE

100
90
80
70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160
Quantity
of Output
(waters per hour)
THE VARIOUS MEASURES OF COST

• Costs of production may be divided into fixed costs and variable costs.
• Fixed costs are those costs that do not vary with the quantity of output
produced.
• Variable costs are those costs that do vary with the quantity of output
produced.
FIXED AND VARIABLE COSTS

• Total Costs
• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC)
• TC = TFC + TVC
TABLE 2 THE VARIOUS MEASURES OF
COST: THIRSTY THELMA’S LEMONADE
STAND
FIXED AND VARIABLE COSTS

• Average Costs
• Average costs can be determined by dividing the firm’s costs by the quantity of output it
produces.
• The average cost is the cost of each typical unit of product.
FIXED AND VARIABLE COSTS

• Average Costs
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)
• ATC = AFC + AVC
AVERAGE AND MARGINAL COSTS

Fixed cost FC
AFC  
Quantity Q

Variable cost VC
AVC  
Quantity Q

Total cost TC
ATC  
Quantity Q
AVERAGE AND MARGINAL COSTS

• Marginal Cost
• Marginal cost (MC) measures the increase in total cost that arises from an extra unit of
production.
• Marginal cost helps answer the following question:
• How much does it cost to produce an additional unit of output?
AVERAGE AND MARGINAL COST

(change in total cost) TC

MC  
(change in quantity) Q
THIRSTY THELMA’S LEMONADE STAND
Note how Marginal Cost changes with each change in Quantity.

Quantity Total Marginal Quantity Total Marginal

Cost Cost Cost Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
5 6.50 1.10 10 15.00 2.10
FIGURE 3 THIRSTY THELMA’S TOTAL-COST
Total Cost

CURVES$15.00 Total-cost curve

14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
FIGURE
Costs
4 THIRSTY THELMA’S AVERAGE-COST
AND MARGINAL-COST
$3.50 CURVES
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC
1.25 AVC
1.00
0.75
0.50
0.25 AFC

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
COST CURVES AND THEIR SHAPES

• Marginal cost rises with the amount of output produced.

• This reflects the property of diminishing marginal product.
COST CURVES AND THEIR SHAPES

• The average total-cost curve is U-shaped.

• At very low levels of output average total cost is high because fixed cost is spread over
only a few units.
• Average total cost declines as output increases.
• Average total cost starts rising because average variable cost rises substantially.
COST CURVES AND THEIR SHAPES

• The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average
total cost. This quantity is sometimes called the efficient scale of the firm.
COST CURVES AND THEIR SHAPES

• Relationship between Marginal Cost and Average Total Cost

• Whenever marginal cost is less than average total cost, average total cost is falling.
• Whenever marginal cost is greater than average total cost, average total cost is rising.
COST CURVES AND THEIR SHAPES

• Relationship between Marginal Cost and Average Total Cost

• The marginal-cost curve crosses the average-total-cost curve at the efficient scale.
• Efficient scale is the quantity that minimizes average total cost.
TYPICAL COST CURVES

• It is now time to examine the relationships that exist between the different measures of
cost.
FIGURE 5 COST CURVES FOR A TYPICAL FIRM
Note how
Marginal MCdeclines
Cost hits both
at ATC and then
first and AVCincreases
at their
Costs minimum
due points.marginal product.
to diminishing

$3.00 AFC, a short-run concept, declines throughout.

2.50
MC
2.00

1.50
ATC
AVC
1.00

0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output
TYPICAL COST CURVES

• Three Important Properties of Cost Curves

• Marginal cost eventually rises with the quantity of output.
• The average-total-cost curve is U-shaped.
• The marginal-cost curve crosses the average-total-cost curve at the minimum of average total
cost.
COSTS IN THE SHORT RUN AND IN THE LONG
RUN

• For many firms, the division of total costs between fixed and variable costs
depends on the time horizon being considered.
• In the short run, some costs are fixed.
• In the long run, all fixed costs become variable costs.
• Because many costs are fixed in the short run but variable in the long run, a
firm’s long-run cost curves differ from its short-run cost curves.
ECONOMIES AND DISECONOMIES OF SCALE

• Economies of scale refer to the property whereby long-run average total cost falls as the
quantity of output increases.
• Diseconomies of scale refer to the property whereby long-run average total cost rises as
the quantity of output increases.
• Constant returns to scale refers to the property whereby long-run average total cost stays
the same as the quantity of output increases.
FIGURE 6 AVERAGE TOTAL COST IN THE SHORT
AND LONG RUN ATC in short ATC in short
ATC in short
Cost run with run with run with
Average small factory medium factory large factory ATC in long run
Total

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
• The goal of firms is to maximize profit, which equals total revenue minus total cost.
• When analyzing a firm’s behavior, it is important to include all the opportunity costs of
production.
• Some opportunity costs are explicit while other opportunity costs are implicit.
• A firm’s costs reflect its production process.
• A typical firm’s production function gets flatter as the quantity of input increases, displaying
the property of diminishing marginal product.
• A firm’s total costs are divided between fixed and variable costs. Fixed costs do not change
when the firm alters the quantity of output produced; variable costs do change as the firm
alters quantity of output produced.
• Average total cost is total cost divided by the quantity of output.
• Marginal cost is the amount by which total cost would rise if output were increased by
one unit.
• The marginal cost always rises with the quantity of output.
• Average cost first falls as output increases and then rises.
• The average-total-cost curve is U-shaped.
• The marginal-cost curve always crosses the average-total-cost curve at the minimum of
ATC.
• A firm’s costs often depend on the time horizon being considered.
• In particular, many costs are fixed in the short run but variable in the long run.