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Business Economics (ECO 341) Lecture 6 Fall: 2012 Semester

Business Economics (ECO 341) Lecture 6 Fall: 2012 Semester. Khurrum S. Mughal. 1. Theme of the Lecture. Cost Theory & Analysis Short-Run Cost Function Link Between Production and Cost Least Cost Rule Economic Concept of Cost Economies of Scale Diseconomies of Scale Revenue Analysis.

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Business Economics (ECO 341) Lecture 6 Fall: 2012 Semester

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  1. Business Economics (ECO 341)Lecture 6 Fall: 2012 Semester Khurrum S. Mughal 1

  2. Theme of the Lecture • Cost Theory & Analysis • Short-Run Cost Function • Link Between Production and Cost • Least Cost Rule • Economic Concept of Cost • Economies of Scale • Diseconomies of Scale • Revenue Analysis

  3. Short-Run A period of time so short that the firm cannot alter the quantity of some of its inputs • Typically plant and equipment are fixed inputs in the short run • Fixed inputs determine the scale of the firm’s operation

  4. Short-Run Cost Functions Total Cost = TC = f(Q) Total Fixed Cost = TFC Total Variable Cost = TVC TC = TFC + TVC

  5. Short-Run Cost Functions

  6. Short-Run Cost Functions TFC

  7. Short-Run Cost Functions Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q Average Variable Cost = AVC = TVC/Q ATC = AFC + AVC Marginal Cost = TC/Q = TVC/Q

  8. Short-Run Cost Functions

  9. Short-Run Cost Functions

  10. Short-Run Cost Functions

  11. Theme of the Lecture • Cost Theory & Analysis • Short-Run Cost Function • Link Between Production and Cost • Least Cost Rule • Economic Concept of Cost • Economies of Scale • Diseconomies of Scale • Revenue Analysis

  12. The Link Between Production and Cost • The cost curves are derived from the • Prices of factors of production (Inputs) • Production Function • What are diminishing returns to factors? • The cost curves are U-Shaped. Why?

  13. Theme of the Lecture • Cost Theory & Analysis • Short-Run Cost Function • Link Between Production and Cost • Least Cost Rule • Economic Concept of Cost • Economies of Scale • Diseconomies of Scale • Revenue Analysis

  14. Choice of Inputs by the Firm MPL = MPK ………….. w r • Marginal Product and the least-cost rule • Marginal Product of a factor divided by the factor price • Marginal product per dollar of input • Substitution Rule: when price of a factor changes

  15. Theme of the Lecture • Cost Theory & Analysis • Short-Run Cost Function • Link Between Production and Cost • Least Cost Rule • Economic Concept of Cost • Economies of Scale • Diseconomies of Scale • Revenue Analysis

  16. Economic Concept of Cost • Opportunity costsare the value of the other products that the resources used in production could have produced at their next best alternative

  17. Theme of the Lecture • Cost Theory & Analysis • Short-Run Cost Function • Link Between Production and Cost • Least Cost Rule • Economic Concept of Cost • Economies of Scale • Diseconomies of Scale • Revenue Analysis

  18. Economies of Scale • Economies of scale refers to the phenomena of decreased per unit cost as the number of units of production increase. • The initial investment in capital is diffused with reduction in marginal cost of producing • Economies of scale means a reduction in the per unit costs of a product as a firm's production increases.

  19. Economies of Scale • Tend to occur in industries with high capital costs • Types of economies of scale: • Internal Economies of scale • External Economies of scale

  20. Internal Economies of Scale • Result of mass production. As the firm produces more and more goods, the average cost begin to fall because of: • Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, intensively. • Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc. • Financial economies made by borrowing money at lower rates of interest than smaller firms.

  21. Internal Economies of Scale • Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output. • Commercial economies made when buying supplies in bulk and therefore gaining a larger discount. • Research and development economies made when developing new and better products.

  22. External Economies of Scale • These are economies made outside the firm as a result of its location, and occur when: • A local skilled labour force is available. • Specialist, and local back-up firms can supply parts or services. • An area has a good transportation network. • An area has an excellent reputation for producing a particular good. For example………….

  23. Economies of Scale Unit Cost Scale A 82p Scale B 54p LRAC Output

  24. Theme of the Lecture • Cost Theory & Analysis • Short-Run Cost Function • Link Between Production and Cost • Least Cost Rule • Economic Concept of Cost • Economies of Scale • Diseconomies of Scale • Revenue Analysis

  25. The other side • As with all things, as industries get bigger so does the infrastructure and the problems associated with economies of scale. • This can result in: • Internal Diseconomies of Scale • External Diseconomies of Scale

  26. Internal Diseconomies of Scale • As the firm increases production, after some point average costs begin to rise because: • The disadvantages of the division of labour take effect- too many people doing different jobs add to costs. • Management becomes out of touch with the shop floor and some machinery becomes over-manned- costs increase. • Decisions are not taken quickly and there is too much formalities. • Lack of communication in a large firm means that management tasks sometimes get done twice. • Poor labour relations may develop in large companies.

  27. External Diseconomies of Scale • These occur when too many firms have located in one area. Unit costs begin to rise because: • Local labour becomes scarce and firms now have to offer higher wages to attract new workers. • Land and factories become scarce and rents begin to rise. • Local roads become congested and so transportation costs begin to rise.

  28. Theme of the Lecture • Cost Theory & Analysis • Short-Run Cost Function • Link Between Production and Cost • Least Cost Rule • Economic Concept of Cost • Economies of Scale • Diseconomies of Scale • Revenue Analysis

  29. Revenue Analysis • Revenue (or turnover) is the income generated from the sale of output in product markets. There are two main revenue concepts to grasp at this stage: • Average Revenue (AR) = Price per unit = total revenue / output • Marginal Revenue (MR) = the change in revenue from selling one extra unit of output

  30. Revenue Analysis

  31. Revenue Analysis

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