Chapter-2: Basic Tools

Functional Relationship: Total, Average

and Marginal
In mathematics, an equation
y = ʄ(x) or y = ʄ(x, z, m)
The value of y depends on the value of x.
y is called dependent variable and x is
called independent variable.
i. Univariate ii. Multivariate
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 Chapter-2: Basic Tools
In many economic models, a special set
of functional relationship called total,
average and marginal relationships is
used.
Such functions are involved in the theory
of demand, cost, production and market
structure,
A basic command of these concepts is
essential to understand the principles of
Managerial Economics 2
 Chapter-2: Basic Tools
The following production example will help to
understand the relationships. Suppose that there is
a small building containing four machines and a
stock of raw materials ready to be processed. Ten
equally skilled and diligent workers are lined up
outside ready to go to work in this factory. If there
are no workers, output will be zero. As workers
added, output in creases. The total amount of
output associated with a particular input of labor
working with those four machines is called the total
product of labor. As labor changes, so does total
output changes. See the table… 3
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Workers Total Average Marginal
(L) Product (Q) Product (AP) Product (MP)

0 0 - -
1 2 2 2
2 5 2.5 3
3 9 3 4
4 14 3.5 5
5 22 4.4 8
6 40 6.7 18
7 57 8.1 17
8 63 7.9 6
9 64 7.1 1
10 63 6.3 -1 4
 Chapter-2: Basic Tools
The change in output associated with a
one unit change in workers is called the
marginal product of labor. The marginal
product function
MP = ∆Q / ∆L
The average product of labor function
(AP) measures the average output per
unit of labor used.
AP = TP / L 5
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Product (Q)

70
60
50
Total Product Q

40
Product (Q)
30
20
10
0
1 2 3 4 5 6 7 8 9 10 11
Labor L
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15

10
Product (AP) -
Product Q

Product (MP) -
5

0
1 2 3 4 5 6 7 8 9 10
-5
Labor L
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 Chapter-2: Basic Tools

There are important relationship among

the three functions that are true for all
total, average and marginal functions.

The value of the average function at any

point along the curve is equal to the slope
of a ray drawn from the origin to the
total function at the corresponding point.
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 Chapter-2: Basic Tools
For any set of average and marginal
functions, if the marginal function is
greater than the average function, the
average must be rising.
If the marginal is below average, the
average must be falling.
If the marginal function is positive, the
total function must be rising and if
negative, the total function must be
declining. 9
 Chapter-2: Basic Tools
Because the total function increases as
long as the marginal function positive
and decreases when marginal is negative,
if follows the total product at maximum
when the marginal function is zero.
Terms such as average cost, marginal
product and total revenue are integral
part of the manager’s vocabulary, and
associated principles are powerful tools.
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 Chapter-2: Basic Tools
Economic Models:
In economics, graphs, and/or equations
are used to explain economic relation-
ships and phenomena and to predict the
effects of changes of such phenomenon as
prices, wage rates, & the price of capital.
Although, such models are abstractions
from reality and may seem unrealistic,
they are useful in economics. 11
 Chapter-2: Basic Tools
An economic model usually consists of
several related functions, some restric-
tions on one or more of the coefficients of
these functions & equilibrium conditions

The Demand Curve: Slopes downward

from the left to the right shows the
quantity of output that consumers are
willing and able to buy at each price.
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Negative slope implies that a larger
quantity is demanded at lower prices
than at higher prices.
The Supply Curve: Slopes upward from
the left to the right shows the amount
that firms will produce and offer for sale
at each price.
The positive slope implies that a larger
quantity is supplied at higher prices. 13
 Chapter-2: Basic Tools

Pe e1

Qe Q
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Equilibrium in a market exists when the
quantity demanded equals quantity supplied.
Pe is the equilibrium price and Qe is the
equilibrium quantity. Suppose,

Demand function:
Qd = a + bP where b ˂ 0 (negative slope)

Supply function:
Qs = c + dP where d ˃ 0 (positive slope).
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 Chapter-2: Basic Tools
By adding an equilibrium condition that
the quantity supplied equals the quantity
demanded, i.e. Qd = Qs
Therefore, a + bP = c + dP
Solving the equation,
Pe = c – a / b – d,
Qe = a + b (c-a)/(b-d)
If the values of a, b, c and d are known,
then values of Pe & Qe can be calculated.
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 Chapter-2: Basic Tools
Example-1:
Suppose parameters of the demand and
supply have been estimated, and that the
equations are:
Qd = 14 – 2P
Qs = 2 + 4P
Determine the equilibrium price and
quantity.
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Example-2:
Qd = 100 – 5P, and Qs = 10 + 5P
Where Qd and Qs represented quantity demanded and
supplied and P is price.
a. Determine equilibrium price and quantity
b. If government sets a minimum price of tk 10 per
unit, how many units would be supplied & how many
units would be demanded? How to maintain that?
c. If demand increases to Qd = 200 – 5P, determine the
new equilibrium price and quantity.
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Calculus and Optimization:
Example: A company has estimated its
cost structure and revenue structure and
has determined that C the total cost, R
total revenue, and X the number of units
produced are related as TC = 100 + 0.015
X2 and TR = 3X. Find the production rate X
that will maximize profits of the company,
find profit, also profit when X = 120.
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Example:
The average cost function (AC) is given
by X+5+36/X in terms of the output X.
Find the output for which AC is
increasing and AC is decreasing. With
the increasing output, find total cost
(TC), marginal cost (MC) as function of
X.
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