ECO6201 - Chapter 5 - Production and Cost Analysis in The Short Run (Amended)

Business Economics
ECO6201
Master of Business Administration Programme
Lecturer: Genesh Kumar Subramaniam

Email: [email protected]
Class syllabus
Topic ( Microeconomic Analysis)
1- Managers and Economics
2- Demand, Supply, and Equilibrium Prices
3- Demand Elasticities
4- Externality
5- Production and Cost Analysis in the Short-run
6- Production and Cost Analysis in the Long-run
7- Market Structure: Perfect Competition
8- Market Structure: Monopoly and Monopolistic
Competition
9- Market Structure: Oligopoly
10- Pricing Strategies for the Firm
2
Class syllabus
Topic ( Macroeconomic Analysis)
11- Measuring Macroeconomic Activity
12- Spending by Individuals, Firm, and Government on Real
Goods and Services
13- The Role of Money in the Macro Economy
14- The Aggregate Model of the Macro Economy
15- International and Balance of Payments Issues in the
Macro Economy
16- Combining Micro and Macro Analysis for managerial
Decision- Making
3
Chapter 5
Production and Cost Analysis in the
Short run
The Firm’s Production Function
Alternative Different
Input
Production Quantities of
Combinations Function Output
5
All firms must make several basic decisions to achieve what
we assume to be their primary objective—maximum
profits.
The Three Decisions That All Firms Must Make
6
Basic concepts of production theory
Definition: Productive resources, such as labour
and capital equipment, that firms use to
manufacture goods and services are called inputs
or factors of production.
Definition: The amount of goods and services

produces by the firm is the firm’s output.
Definition: Production transforms a set of inputs

into a set of outputs
Definition: Technology determines the quantity of

output that is feasible to attain for a given set of
7
inputs.
Basic concepts of production theory
• Production efficiency
– Maximum amount of output that can be produced
from any specified set of inputs, given existing
technology
• Technical efficiency
– Achieved when maximum amount of output is
produced with a given combination of inputs
• Economic efficiency
– Achieved when firm is producing a given output at
the lowest possible total cost
8
Production theory begins with the assumption that every
producer has a technology available to convert various inputs
into output. Its usually convenient to represent this
technology with a production function
Set of inputs Output
9
A firm owner’s decisions can be categorized as
short run decisions and long run decisions.
•The short run is a time frame in which the
quantities of some resources are fixed. The fixed
resources include the firm’s management
organization structure, level of technology,
buildings and large equipment. These factors
are called the firm’s plant.
•The long run is a time frame in which the
quantities of all resources can be varied.
difference between the long run and short run is not

related to calendar time! 10
Short Run vs. Long Run
It is important in production theory to distinguish the short run
from the long run. In the short run, some of the inputs into
production are fixed. In the long run, all inputs are changeable.
“Fixed”
Inputs
Output Variable
Output
Inputs
Variable
Inputs
Short Run Long Run
11
Total , Average and Marginal Product
The total quantity of output The amount of output per unit

produced with given of variable input.
quantities of fixed and APL = TP÷L or Q÷L, where
variable inputs. APL = average product of
labor
TP or Q = f(L, K ), where
TP or Q = total product or The additional output
total quantity produced produced with an additional
L = quantity of labor input unit of variable input.
(variable) MPL = ΔTP÷ΔL or ΔQ÷ΔL
K = quantity of capital
where
(fixed)
MPL = marginal product of 12
labor
Law of Diminishing Marginal Returns
The phenomenon illustrated by that region

of the marginal product curve where the
curve is positive, but decreasing, so that
total product is increasing at a decreasing
rate.
Assumptions to analyze Law of Diminishing Marginal Return,
(a) Firms operating in short run

(b) Fixed input is ‘land’ and variable input is ‘labour’
(c) Labours are homogeneous
13
SHORT-RUN PRODUCTION
Stages of Production
15
Relationships between
Product Curves
• MPP is slope of TPP.

• At inflection point (point of diminishing
MPP): TPP from increasing at an
increasing rate to increasing at a
decreasing rate.
• MPP reaches a maximum at inflection
point.
• MPP = 0 occurs when TPP is maximum.
• MPP is negative, beyond TPP max.
• APP measures the average productivity of
each unit of variable input (labor) being
used.
• At point where APP is max, MPP crosses
APP (MPP=APP).
16
Summary of
Relationships
• When MPP > APP, APP is
increasing
• When MPP = APP, APP is at a
max
• When MPP < APP, APP is
decreasing
• The relationship between TPP,

APP, & MPP is very specific.
• If we have COMPLETE
information about one curve,
the other two curves can be
derived.
17
Stages of Production:
In stage 1:
TPP is increasing
APP is increasing
MPP increases, reaches a
maximum & decreases to APP
18
In stage 2:
TPP is increasing
APP is decreasing
MPP is decreasing and less than
APP, but still positive
19
In stage 3:
TPP is decreasing
APP is decreasing
MPP is decreasing and negative
20
Cost Function
• A mathematical or graphic
expression that shows the
relationship between the cost of
production and the level of
output, all other factors held
constant.
21
Economic Cost of Using Resources
=
22
Explicit and Implicit Costs
• A cost is explicit if it is • A cost that represents the
reflected in a payment to value of using a resource
another individual, such as that is not explicitly paid out
a wage paid to a worker, and is often difficult to
that is recorded in a firm’s measure because it is
bookkeeping or accounting typically not recorded in a
system. firm’s accounting system.
23
Short Run Cost Function
A cost function for a short-run production process in
which there is at least one fixed input of production
Fixed vs Variable Costs

Fixed cost is the total cost of using the fixed input, which
remains constant regardless of the amount of output
produced.
Variable cost is the total cost of using the variable input,

which increases as more output is produced.
24
Question 1

Say a company known as Alba produces mini hand phones. It
produces 10 phones and it incurred TFC as much as RM2,000.
Assume the company produces 13 phones, what will be the TFC
that incurred to the company?
If your answer is RM2,600. You have got it

wrong. Why?
25
Short Run Costs
COST FUNCTION DEFINITION
Total fixed cost TFC = TC – TVC = AFC x Q
Total variable cost TVC = TC – TFC = AVC x Q
Total cost TC = TFC + TVC = ATC x Q
Average fixed cost AFC = ATC – AVC = TFC ÷ Q
Average variable cost AVC = ATC – AFC = TVC ÷ Q
Average total cost ATC = AFC + AVC = TC ÷ Q
Marginal cost MC = ΔTC ÷ ΔQ = ΔTVC ÷ ΔQ
26
27
Profit
Profit = TR – TC
Economists measure a firm’s economic

profit as total revenue minus total cost
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.
When total revenue exceeds both explicit and implicit
costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.
29
30
Question:
The following table shows the total cost ($) and price ($) for
a firm at each level of output. Complete the table below.
Output Price TC TFC TVC AFC AVC ATC MC TR Profit

0 7 120 - - - -
5 7 140
25 7 200
45 7 250
60 7 320
70 7 380
90 7 500
31
Answer:
The following table shows the total cost ($) and price ($) for
a firm at each level of output. Complete the table below.
Output Price TC TFC TVC AFC AVC ATC MC TR Profit

0 7 120 120 0 - - - - 0 -120
5 7 140 120 20 24 4 28 4 35 -105
25 7 200 120 80 4.8 3.2 8 3 175 -25
45 7 250 120 130 2.67 2.89 5.56 2.5 315 65
60 7 320 120 200 2 3.33 5.33 4.67 420 100
70 7 380 120 260 1.71 3.71 5.42 6 490 110
90 7 500 120 380 1.33 4.22 5.55 6 630 130
32
SHORT-RUN COST CURVES
TC
COST
TVC
TFC
QUANTITY
SHORT-RUN COST CURVES
COST
MC ATC
AVC
AFC
QUANTITY
Relationship between Marginal Cost and Average Costs
The MC cuts both AVC and ATC at
their minimum.
When both the MC and AVC are
falling, AVC will fall at a slower rate.
When both the MC and AVC are
rising, MC will rise at a faster rate.
As a result, MC will attain its
minimum before the AVC.
In other words, when MC is less than
AVC, the AVC will fall, and when MC
exceeds AVC, AVC will rise. This
means that as long as MC lies below
AVC, the latter will fall and where MC
is above AVC, AVC will rise.
35
Business Economics
ECO6201
The End!

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Business Economics

Lecturer: Genesh Kumar Subramaniam

The Three Decisions That All Firms Must Make

Definition: The amount of goods and services

Definition: Production transforms a set of inputs

Definition: Technology determines the quantity of

Set of inputs Output

difference between the long run and short run is not

Short Run Long Run

The total quantity of output The amount of output per unit

The phenomenon illustrated by that region

Assumptions to analyze Law of Diminishing Marginal Return,

(a) Firms operating in short run

• MPP is slope of TPP.

• The relationship between TPP,

Fixed vs Variable Costs

Variable cost is the total cost of using the variable input,

If your answer is RM2,600. You have got it

Economists measure a firm’s economic

Economists measure a firm’s economic profit as total

Output Price TC TFC TVC AFC AVC ATC MC TR Profit

Output Price TC TFC TVC AFC AVC ATC MC TR Profit

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