Business Economics & International

Business

Md. Jahidul Islam MBA, FCMA, CAMS, CGIA

General Manager
Pubali Bank PLC
Theory of Production and Cost:
The production Function;
Types of Costs;
Marginal Cost;
Average Cost;
Short-Run Vs Long-Run Costs;
Cost Curves;
Economic of Scale;

Market Structure and Equilibrium Price and Output Levels:

Perfectly Competitive Market and Imperfectly Competitive Markets (Monopoly, Oligopoly and Monopolistic
Markets);
Determination of Equilibrium Price and Output in Different Markets;
Price Discrimination and Distortions; Anti-Trust Laws.
THE THEORY OF PRODUCTION

Production involves transformation of

inputs such as capital, equipment,
labor, and land into output - goods and
services
In this production process, the
manager is concerned with efficiency in
the use of the inputs
- technical vs. economical efficiency

<number>
Two Concepts of Efficiency
Economic efficiency:
occurs when the cost of producing a given
output is as low as possible
Technological efficiency:
occurs when it is not possible to increase
output without increasing inputs

<number>
You will see that basic production theory is simply
an application of constrained optimization:
the firm attempts either to minimize the cost of
producing a given level of output
or
to maximize the output attainable with a given
level of cost.

Both optimization problems lead to same rule

for the allocation of inputs and choice of
technology

<number>
 Production Function

A production function is purely technical relation

which connects factor inputs & outputs. It
describes the transformation of factor inputs
into outputs at any particular time period.
Q = f( L,K,R,Ld,T,t)
where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time
For our current analysis, let’s reduce the inputs to two,
capital (K) and labor (L):
Q = f(L, K)
<number>
Short-Run and Long-Run
Production
In the short run some inputs are fixed and
some variable
e.g. the firm may be able to vary the amount of
labor, but cannot change the amount of capital
in the short run we can talk about factor
productivity / law of variable proportion/law of
diminishing returns

<number>
In the long run all inputs become variable
e.g. the long run is the period in which a firm
can adjust all inputs to changed conditions

in the long run we can talk about returns to

scale

<number>
 Short-Run Changes in Production
Factor Productivity

How much does the quantity of Q change,

when the quantity of L is increased? <number>
 Long-Run Changes in Production
Returns to Scale

How much does the quantity of Q change, when

the quantity of both L and K is increased?
<number>
Relationship Between Total, Average, and Marginal Product: Short-
Run Analysis

Total Product (TP) = total quantity of output

Average Product (AP) = total product per total input
Marginal Product (MP) = change in quantity when one additional unit
of input used

<number>
 The Marginal Product of Labor

The marginal product of labor is the increase in output

obtained by adding 1 unit of labor but holding constant
the inputs of all other factors
Marginal Product of L:
MPL= Q/L (holding K constant)
= Q/L

Average Product of L:
APL= Q/L (holding K constant)

<number>
Law of Diminishing Returns (Diminishing Marginal
Product)

The law of diminishing returns states that when more

and more units of a variable input are applied to a
given quantity of fixed inputs, the total output may
initially increase at an increasing rate and then at a
constant rate but it will eventually increases at
diminishing rates.
Assumptions. The law of diminishing returns is based on
the following assumptions: (i) the state of technology is
given (ii) labour is homogenous and (iii) input prices are
given.

<number>
Short-Run Analysis of Total,
Average, and Marginal Product

If MP > AP then AP is
rising

If MP < AP then AP is
falling

MP = AP when AP is
maximized

TP maximized when
MP = 0 <number>
Three Stages of Production in Short Run

AP,MP
Stage I Stage II Stage III

APX

TPL Increases at MPX X

TPL Increases
Diminshing rate. TPL begins to
at increasing MPL Begins to
rate. decline. decline
MP Increases TP reaches MP becomes
at decreasing maximum level at the negative
rate. end of stage II, MP = AP continues to
AP is 0. decline
increasing and APL declines
<number>
reaches its
<number>
Application of Law of Diminishing Returns:

It helps in identifying the rational and

irrational stages of operations.
It gives answers to question –
How much to produce?
What number of workers to apply to a given
fixed inputs so that the output is maximum?

<number>
 Production in the Long-Run

All inputs are now considered to be variable

(both L and K in our case)
How to determine the optimal combination of
inputs?
To illustrate this case we will use production
isoquants.
An isoquant is a locus of all technically
efficient methods or all possible combinations
of inputs for producing a given level of output.

<number>
 Production Table

Units of K Isoquan
Employed
t

<number>
Isoquant

<number>
 Types of Isoquant

There exists some degree of substitutability between inputs.

Different degrees of substitution:

Sugar
Cane Natural
flavoring Capital
syrup

K₄
K₁ K₂ K₃
Q

Sugar All other L₁ L₂ L₃ L₄ Labor

ingredients
b) Input – Output/ L- c) Kinked/Acitivity
a. Linear Isoquant Shaped Isoquant Analysis Isoquant –
(Perfect substitution) (Perfect (Limited substitutability)
complementarity) <number>
Marginal Rate of Technical Substitution MRTS

The degree of imperfection in

substitutability is measured with
marginal rate of technical substitution
(MRTS- Slope of Isoquant):
MRTS = L/K

(in this MRTS some of L is removed

from the production and substituted by
K to maintain the same level of output)

<number>
Properties of Isoquants

Isoquants have a negative slope.

Isoquants are convex to the origin.

Isoquants cannot intersect or be tangent to

each other.

Upper Isoquants represents higher level of

output

<number>
 Isoquant Map

Isoquant map is a set of

isoquants presented on
a two dimensional
plain. Each isoquant
shows various
combinations of two
inputs that can be used
to produce a given level
of output.

<number>
Laws of Returns to Scale
It explains the behavior of output in response to a
proportional and simultaneous change in input.
When a firm increases both the inputs, there are
three technical possibilities –
i. TP may increase more than proportionately –
Increasing RTS
ii. TP may increase proportionately – constant RTS
iii. TP may increase less than proportionately –
diminishing RTS

<number>
 Increasing RTS

K
Product Line

3K

3X
2K

2X
K
X

0 L 2L 3L
L
<number>
 Constant RTS

K
Product Line

3K

3X
2K

2X
K
X

0 L 2L 3L
L
<number>
Total revenue
Amount a firm receives for the sale of its output
Total cost
Market value of the inputs a firm uses in production
Profit
Total revenue minus total cost

Costs are critically important to many business

decisions, including production, pricing, and hiring.
Costs: Definition
Cost is the fiscal value of commodities and facilities that
manufacturers and customers buy.
According to the fundamental economic discern, the cost
price is the estimate of the substitute opportunities by
gone in the option of one commodity or pursuit over others.
More ordinarily, cost price has an association between the
value of production inputs and the degree of output. TC
(total cost) price is mentioned to be the total expenditure
sustained in attaining a particular degree of output. If such
TC is divided by the unit manufactured, then the aggregate
or quantity cost is procured.
Costs: Definition
Costs can be divided into two broad categories – fixed and
variable.
A fixed cost is a cost that does not change with an
increase or decrease in the amount of goods or services
produced or sold.
Variable costs are costs that change as the quantity of the
good or service that a business produces changes.
Total cost is the sum of fixed and variable cost.
Marginal cost is the change in total cost that occurs when
an extra unit of product is produced. The behavior of
marginal cost is further explained by the law of
diminishing marginal returns.
Types of Costs
Types of Costs
Fixed Costs (FC) The costs which don’t vary with changing
output. Fixed costs might include the cost of building a factory,
insurance and legal bills. Even if your output changes or you
don’t produce anything, your fixed costs stay the same. In the
above example, fixed costs are always £1,000.

Variable Costs (VC) Costs which depend on the output

produced. For example, if you produce more cars, you have to
use more raw materials such as metal. This is a variable cost.

Marginal Costs (MC) – Marginal cost is the cost of producing an

extra unit. If the total cost of 3 units is 1550, and the total cost
of 4 units is 1900. The marginal cost of the 4th unit is 350.
Types of Costs
Total cost (TC) = Variable cost (VC) + fixed costs (FC)

ATC (Average Total Cost) = Total Cost / quantity

ATC (Average Total Cost) = AVC + AFC

AVC (Average Variable Cost) = Variable cost / quantity

AFC (Average Fixed Cost) = Fixed cost / quantity

Fixed, variable and total cost curves
Types of Costs
Long Run Vs Short Run
The short run is a period of time where one factor of production is fixed, e.g.
capital. This means that if a firm wants to increase output, it could employ
more workers, but not increase capital in the short run (it takes time to
expand.)
The long run is a situation where all main factors of production are variable.
The firm has time to build a bigger factory and respond to changes in demand.
Law of diminishing marginal returns
The Law of diminishing marginal returns state that as more of a variable factor
(e.g. labour) is added to a fixed factor (e.g. capital), a firm will reach a point
where it has a disproportionate quantity of labour to capital and so the
marginal product of labour (the additional output from each extra unit of
labour) will fall, thus raising marginal cost and average variable cost.
Types of Costs
Diminishing returns occur in the short run when one factor is
fixed (e.g. capital)
If the variable factor of production is increased (e.g. labour),
there comes a point where it will become less productive and
therefore there will eventually be a decreasing marginal and then
average product.
This is because, if capital is fixed, extra workers will eventually get
in each other’s way as they attempt to increase production. E.g.
think about the effectiveness of extra workers in a small café. If
more workers are employed, production could increase but more
and more slowly.
This law only applies in the short run because, in the long run, all
factors are variable.
Law of diminishing marginal
Assume the wage rate is £20
returns explained
MC = Change in TC/Change in TP
MP = Change in TP/Change in Quantity of workers

Marginal product
Quantity of workers Total product (TP) Total Cost (TC) Marginal Cost (MC)
(MP)
0 0 0 0 0
1 2 2 20 10
2 6 4 40 5
3 12 6 60 3.33
4 20 8 80 2.5
5 30 10 100 2
6 38 8 120 2.5
7 43 5 140 4
Law of diminishing marginal returns explained
The first worker adds two goods. If a worker costs £20. The
MC of those two units is 20/2 = 10.
The 3ʳᵈ worker adds six goods. The MC of those six units are
20/6 = 3.3
The 5ᵗʰ worker adds an extra ten goods. The MC of these 10
is just 2.
After the 5ᵗʰ worker, diminishing returns sets in, as the MP
declines. As extra workers produce less, the MC increases.
Measuring Cost: Which Cost Matter?

Accounting Cost
Consider only explicit cost, the out of pocket cost for such items
as wages, salaries, materials, and property rentals
Economic Cost
Considers explicit and opportunity cost. Opportunity cost is the
cost associated with opportunities that are foregone by not
putting resources in their highest valued use.
Sunk Cost
An expenditure that has been made and cannot be recovered--
they should not influence a firm’s decisions.
Opportunity cost
One of the main types of costs in economics is opportunity cost. Opportunity
cost refers to the benefits a business or an individual loses when choosing to
pursue one alternative over the other. These benefits that are missed due to
choosing one option over the other are a type of cost.
Opportunity cost is the cost an individual or business incurs from choosing one
alternative over the other.
Opportunity costs arise when a company does not put its resources to the
greatest possible alternative use.
For example, consider a company that uses land in its production. The company
does not pay for the land because it owns the land. This would suggest that the
company does not incur an expense for renting land. However, according to the
opportunity cost, there is a cost associated with using the land for production
purposes. The company could rent out the land and receive monthly income
from it.
The opportunity cost for this company would be equal to the rental income
forgone due to using the land rather than renting it.
Cost in the Short Run
Total output is a function of variable inputs and fixed inputs.
Therefore, the total cost of production equals the fixed cost (the
cost of the fixed inputs) plus the variable cost (the cost of the
variable inputs), or

Fixed costs do not change with changes in output

Variable costs increase as output increases.
A Firm’s Short-Run Costs ($)
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Variable Total
(FC) (VC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (ATC)
0 50 0 50 --- --- --- ---
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
Cost in the Short Run
Marginal Cost (MC) is the cost of expanding output by
one unit. Since fixed cost have no impact on marginal
cost, it can be written as:
Cost in the Short Run
Average Total Cost (ATC) is the cost per unit of output,
or average fixed cost (AFC) plus average variable cost
(AVC). This can be written:
Isocost and Isoquant
An isoquant shows all the combination of two factors that produce a given output

In this diagram, the isoquant shows all the combinations of labour and capital
that can produce a total output (Total Physical Product TPP) of 4,000. In the
above isoquant, this could be
20 capital and 18 labour or (more capital intensive)
9 capital and 35 labour. (more labour intensive
Isocost An isocost shows all the combination of
factors that cost the same to employ.

In this example, a unit of labour and capital cost £6,666 each.

If we employ 30K and 30L, the total cost will be £200,000 + £200,000
If we employ 10 K and 50L, the total cost will be £66,666 +£333,333 =
£400,000