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Managerial Economics

PGP - 1, Section A
Term 1

Lecture 11 and 12
Instructor: Tirthatanmoy Das
Indian Institute of Management Bangalore
July 22-23, 2019
Why would a manager care?

§ The knowledge of the relationship between costs and
output can be useful for managerial decisions that
maximize the value of the firm.

§ Making distinction between short-run and long-run

costs can be helpful for managerial decisions.

Different types costs

Accounting cost: Actual expenses plus depreciation

charges for capital equipment.

Economic cost: Cost to a firm of utilizing economic

resources in production.

Different types costs

Sunk cost: Expenditure that has been made and cannot

be recovered.

Opportunity cost: Cost associated with opportunities

forgone when a firm’s resources are not put to their best
alternative use.
Economic cost = Opportunity cost

Fixed Costs and Variable Costs
Total cost (TC or C): Total economic cost of production,
consisting of fixed and variable costs.

Fixed cost (FC): Cost that does not vary with the level of
output and that can be eliminated only by shutting

Variable cost (VC): Cost that varies as output varies.

Shutting down

§ Shutting down doesn’t necessarily mean going out of

§ By reducing the output to zero, the company could
eliminate the costs of raw materials and much of the
§ Still incur the fixed costs of paying the factory’s
managers, security guards, and ongoing maintenance.
§ To eliminate those fixed costs: close the doors, turn off
the electricity, and perhaps even sell off or scrap the
Fixed and variable costs

§ Over a very short time horizon: some costs are fixed (e.g.
contracted shipments of materials, contracted wages

§ Over a very long time horizon: nearly all costs are

variable (e.g. workers and managers can be laid off,
machineries can be sold off etc.).

Fixed vs. sunk costs
§ Fixed costs can be avoided if the firm shuts down a
plant or goes out of business.

§ Sunk costs are costs that have been incurred and cannot
be recovered.

§ Scale of plant: This scale is determined by fixed inputs.

Short run: marginal and average costs
Marginal cost (MC): Increase in cost resulting from the
production of one extra unit of output.
MC = ∆VC⁄∆𝑞 = ∆TC⁄∆𝑞
Average costs:
Average total cost (ATC): Firm’s total cost divided by its
level of output.
Average fixed cost (AFC): Fixed cost divided by the level
of output.
Average variable cost (AVC): Variable cost divided by the
level of output. 9
Short run: marginal and average costs

Costs in short run

Marginal cost: MC = ∆VC ⁄∆𝑞 = 𝑤∆𝐿⁄∆𝑞

Suppose labor (L) is the only variable input. Then

MC = ∆VC ⁄∆𝑞 = 𝑤∆𝐿 ⁄∆𝑞 = 𝑤 ⁄MP+

Average variable cost: AVC = VC⁄𝑞

Average fixed cost: AFC = FC⁄𝑞
Average total cost: ATC or AC = 𝐴𝐹𝐶 + 𝐴𝑉𝐶
Shapes of cost curves

Relationship: AC and MC

Vertical distance between the ATC and AVC curves

decreases as output increases. Why? Because average
fixed cost declines as output q rises.

MC intersects AVC and AC at their minimum.

Costs in long run

User cost of capital: Annual cost of owning and using a

capital asset, equal to economic depreciation plus
forgone interest.
𝑟 = Depreciation rate + Interest rate

Costs in long run

Short run average costs for different scale of plant:

Relationship between SR and LR Costs

Long run AC and MC

Cost minimizing input choice

We will work with two variable inputs: labor and capital

Price of capital: r, the rental rate equal to the user cost

(competitive market)

Price of labor: w, wage paid to labor.

Isocost line
Isocost line: Graph showing all possible combinations of
labor and capital that can be purchased for a given total
or, 𝐶 = 𝑤𝐿 + 𝑟𝐾
𝐾 = 𝐶 ⁄𝑟 − 𝑤 ⁄𝑟 𝐿
It follows that the isocost line has a slope of ΔK/ΔL =
−(w/r), which is the ratio of the wage rate to the rental
cost of capital.

Choosing inputs: given q at min cost

Choosing inputs: given q at min cost

Firm minimizes the cost of producing a particular

output, the following condition holds:

MRTS = MP+ ⁄MPD = 𝑤 ⁄𝑟

MP+ ⁄𝑤 = MPD ⁄𝑟

Input substitution: change in w and/or r

Cost minimization with varying output levels
Expansion path: Curve passing through points of
tangency between a firm’s isocost lines and its isoquants.

Cost: SR and LR with varying output levels

Economies of scale
Economies of scale: When the firm’s average unit cost
decreases as output increases.
§ Workers can specialize

§ Flexible organization of the production process;

§ Better negotiated input cost because inputs are bought

in large quantities.
Diseconomies of scale
Diseconomies of scale: When the average unit costs
increase as output increases .
§ In the short run, limited factory space and machinery
may make it more difficult for workers to do their jobs
§ Managing a larger firm may become more complex and
inefficient as the number of tasks increases.
§ At some point, available supplies of key inputs may be
limited, pushing their costs up. 26
Economies of scale

Increasing Returns to Scale: Output more than doubles

when the quantities of all inputs are doubled.

Economies of Scale: A doubling of output requires less

than a doubling of cost.
𝐸F = ∆C⁄C ⁄ ∆𝑞⁄𝑞 = 𝑀𝐶 ⁄𝐴𝐶

Economies of scope

§ Economies of scope: Situation in which cost of jointly

producing two (or more products) products is less than
producing each one alone. Ex. Automobile company:
truck, car; University: teaching, research
§ Diseconomies of scope: Situation in which cost of jointly
producing two (or more products) products is more
than producing each one alone.
§ Source: When cost of one/some inputs do not change
with scope of production.
Degrees of economies of scope

§ Source: When cost of one/some inputs do not change

with scope of production.

§ Degree of economies of scope (SC): Percentage of cost

savings resulting when two or more products are
produced jointly rather than Individually.
C 𝑞H + C 𝑞I − C 𝑞H , 𝑞I
SC =
C 𝑞H , 𝑞I 29
Dynamic changes in costs— the learning

§ Learning curve: Graph relating amount of inputs

needed by a firm to produce each unit of output to its
cumulative output.

Dynamic changes in costs— the learning
§ Workers often take longer to accomplish a given task
the first few times they do it. As they become more
adept, their speed increases.

§ Managers learn to schedule the production process

more effectively, from the flow of materials to the
organization of the manufacturing itself.

Dynamic changes in costs— the learning
§ Engineers who are initially cautious in their product
designs may gain enough experience to be able to
allow for tolerances in design that save costs without
increasing defects. Better and more specialized tools
and plant organization may also lower cost.

§ Suppliers may learn how to process required

materials more effectively and pass on some of this
advantage in the form of lower costs.