Economic Environment of Business

ECOC 514

Session 2

Chapter 5 - Theory of Production and Cost

Chapter 6 - Perfect Competition
Chapter 7 - Monopoly
Theory of Production
and Cost

5
CHAPTER
LO2 Law of Diminishing Marginal Returns
The Short-Run Relationship Between Units of
Labor and Tons of Furniture Moved

Marginal product increases as the firm hires each of the first three workers, reflecting
increasing marginal returns. Then marginal product declines, reflecting diminishing
marginal returns. Adding more workers may, at some point, actually reduce total product
(as occurs here with an eighth worker) because workers start getting in each other’s way.
 Total and Marginal Product of Labour
LO2
Total product 15 (a) Total product
Total
(tons/day)
product
10
Exhibit 3

0 5 10 Workers per day

Increasing Diminishing but

5 (b) Marginal product
Marginal product

marginal positive
4 marginal returns Negative
returns
3 marginal
(tons/day)

2 Marginal returns
1 product
0

5 10 Workers per day

Units of capital per month A Firm’s Isoquants

MRTS = MPL/MPC

8 - negative slope
E - convex to the origin
A
F
4 B G Q3 (36) Q3: 36 units of output
H
C Q2 (28) Q2: 28 units of output
D
Q1 (12)

0 4 8
Units of labor per month

Q1: all technologically efficient combinations of labor and capital

that can be used to produce 12 units of output
 Exhibit C
A Firm’s Isocost Lines
Slope = -w/r = -$1,500/$2,500 = -0.6
Units of capital per month

Each isocost line

10
– Combinations of labor and
capital that can be purchased
for a given amount of total cost
5 – Slope is negative wage
divided by the rental cost of
capital

0 5 10 15
Units of labor per month

Higher costs: isocost lines farther from origin

 A Firm’s Optimal Combination
of Inputs
Exhibit D

TC = $19,000 e: isoquant Q2 is tangent

Units of capital per month

to the isocost line

18

f
a
5 g Q3 (36)
Q2 (28)
Q1 (12)

0 5 10
Units of labor per month
 A Firm’s Expansion Path
Expansion path
- Slopes up to the right
- More of both
Exhibit E

resources is needed
Units of capital per month

to increase output
Expansion path

d
c Q4
b h
C a Q3
Q2
Q1

0 L L’
Units of labor per month
LO3 Costs in the Short Run
 Fixed cost FC  Average variable cost AVC = VC/q
 For fixed resources  Average total cost ATC = TC/q
 Variable cost VC  U-shape of average cost curves
 For variable  Law of diminishing marginal
resources returns
 Total cost TC = FC + VC
 Marginal cost MC =
∆TC/∆q
 Change in TC to
produce one more
unit of output
LO3 Exhibit 4
Short-Run Total and Marginal Cost
Data for Smoother Mover

First 3 workers: increasing marginal returns: MC declines

With the 4th worker: diminishing marginal returns: MC increases
LO3 Total and Marginal Cost Curves
for Smoother Mover
TC is the vertical
sum of FC and VC

VC starts from
origin; increases
slowly at first; with
diminishing returns,
VC increases rapidly
FC = $200 at all
levels of output

MC first declines: increasing

marginal returns; then increases:
diminishing marginal returns
LO3 Exhibit 7
Average and Marginal Cost Curves
for Smoother Mover

ATC, MC and AVC: decline,

reach minimum, then rise.

When AVC(ATC) is falling

then MC lies below AC

When AVC(ATC) is rising

then MC lies above

When AVC (ATC) is at its

minimum
Average Fixed Cost then MC = AVC (ATC)
LO4 Short-Run Average Total Cost Curves Form
the Long-Run Average Cost Curve, or
Planning Curve
Exhibit 8

SS’, MM’, LL’ are short run ATC curves

S L’

M M’
Cost per unit

a S’ L
b

Long run ATC curve: SabL’

0 q qa q’ qb Output per period

LO4 Exhibit 9
Many Short-Run ATC Curves Form a Firm’s
LRAC Curve, or Planning Curve
ATC1 ATC10

ATC9
ATC2 Long-run
$11
a b ATC8 average cost
10
Cost per unit

9 ATC3 ATC7
c ATC4 ATC6
ATC5

0 q q’ Output per period

Each point of tangency represents the least cost way of producing that level of output
LO4 A Firm’s Long-Run Average
Cost Curve
Exhibit 10

Long-run
Cost per unit

average cost

0 A B Output per period

Economies Constant Diseconomies

of scale average cost of scale
 LO4 Scale Economies and Diseconomies at McDonald's
 Economies of scale
 At plant level – particular location
Case Study
 Specialization
 At firm level – collection of plants
 Sharing: information; technology
 Diseconomies of scale
 At firm level
 Uniform
menu
Perfect Competition

CHAPTER
6 Designed by
Amy McGuire, B-books, Ltd.
LO1 Exhibit 1
Market Equilibrium and a Firm’s Demand
Curve in Perfect Competition
(a) Market equilibrium (b) Firm’s demand
S

Price per bushel

Price per bushel

$5 $5 d

0 1,200,000 Bushels of 0 5 10 15 Bushels of

wheat per day wheat per day
Market price ($5)- determined by the intersection of the market demand and market supply
curves. A perfectly competitive firm can sell any amount at that price. The demand curve facing
the perfectly competitive firm - horizontal at the market price.
LO2 Exhibit 3
Total cost Total revenue Short-Run Profit
Maximization
(=$5 × q)
$60
e’
Total dollars

Maximum economic
48
a’ profit = $12
(a) Total revenue minus
total cost
15 TR: straight line, slope=5=P
TC increases with output
Bushels of wheat per day Max Economic profit:
0 5 7 10 12 15
where TR exceeds TC by
Marginal cost the greatest amount
Dollars per bushel

f e Average total cost

$5 d = Marginal revenue (b) Marginal cost equals
Profit
4 = Average revenue marginal revenue
b a
MR: horizontal line at P=$5
Max Economic profit:
at 12 bushels,
Bushels of wheat per day where MR=MC
0 5 7 10 12 15
LO3 Exhibit 5
Total cost Total revenue
(=$3 × q)
Short-Run Loss
Minimization
Total dollars

a’
$40
30 Minimum economic (a) Total revenue minus
e’ loss = $10
total cost
15
TC>TR; loss
Bushels of wheat per day Minimize loss: 10
0 5 10 15 bushels
Marginal cost Average total cost
Dollars per bushel

(b) Marginal cost equals

$4.00
a Average variable cost
marginal revenue
Loss e
3.00 d = Marginal revenue MR=MC=$3; ATC=$4
2.50 b = Average revenue P=$3; P>AVC
d Continue to produce
Bushels of wheat per day in short run
0 5 10 15
Perfect Competition in the Long Run

 Long run
 Market:
 Firms enter/exit the
 S shifts; P changes
market
 Firm
 Firms adjust scale of
operations until  d(P=MR=AR) shifts
average cost is  Long run equilibrium
minimized  MR=MC =ATC=LRAC
 All resources are  Normal profit
variable  Zero economic profit

LO5
LO4 Exhibit 9
Long-Run Equilibrium for a Firm and the Industry
(a) Firm (b) Industry or market

MC S
Dollars per unit

Price per unit

ATC
LRAC
e
p d p

Quantity Quantity
0 q per period 0 Q
per period
Long run equilibrium: P=MC=MR=ATC=LRAC. No reason for new firms to enter the market
or for existing firms to leave. As long as the market demand and supply curves remain
unchanged, the industry will continue to produce a total of Q units of output at price p.
 Monopoly

Micro

7
CHAPTER
 Monopoly
 Barriers to entry  Monopoly
1. Legal restrictions – Local
2. Government Regulation – National
3. Economies of scale – International
4. Control of essential
resources

LO1
 Revenue for the Monopolist
 Monopoly - Supplies the
market demand
 Marginal revenue
• Downward sloping
MR=∆TR/∆Q
inelastic demand
curve – For monopolist: MR<p
• To sell more: must – Declines, can be negative
lower P on all units  MR curve is downward
sold sloping & lies below D/AR
– For monopolist: p=AR curve
 Demand curve is also AR  TR curve
curve • Reaches maximum
where MR=0

LO2
LO3 Exhibit 6
Marginal cost Monopoly Costs and Revenue
Dollars per diamond

Average total cost

a
$5,250
Profit b
4,000 A profit-maximizing monopolist
e supplies 10 diamonds per day
and charges $5,250 per
MR D=Average revenue
diamond.
Diamonds per day
0 10 16 32 Profit = $12,500
(profit per unit × Q)
Maximum Total cost
profit a’
$52,500
Maximize profit where TR
exceeds TC by the greatest
Total dollars

40,000 Total revenue amount: Q=10

b’
Maximum profit =
15,000 TR-TC = $12,500

Diamonds per day

0 10 16 32
LO3 Exhibit 7
The Monopolist Minimizes Losses in the Short Run

Marginal cost For Q, ATC is at point a

P<ATC, monopolist suffers

a loss
Average total cost
a
For Q, price=p at point b,
Loss Average variable cost on D curve
p
b
Dollars per unit

MR=MC at point e:
c quantity Q

Monopolist continue to
e Demand=Average revenue produce because p>AVC
Marginal revenue (AVC is at point c)

0 Q Quantity per period