ECO80001 ECONOMICS

Module 02

Production Costs & Business Decisions

 Essentials
• Marginal Benefit vs Marginal Cost

• Average Total Cost vs Marginal Cost, relationship

• Diminishing Returns vs Returns to Scale

• Relationship between a firm’s inputs and outputs

2
 A Question:
• Your company has invested $5 million in
developing a product but the development work is
not finished.
• Your main competitor has just introduced another
product, and this is expected to reduce the sales
from your new product when it comes out, to $3
million.
• If it would cost you an additional $1 million to
complete your product’s development, should you
go ahead with it?
3
 Rules for making good decisions

• Think at the margin: focus on the marginal units

• Compare marginal benefit and marginal cost
• Let bygones be bygones: Ignore sunk costs

4
 “Golden rule” of decision-making

• To maximise profit -
- increase output as long as MR > MC
- decrease output as long as MR < MC

5
 Profit maximisation

• We assume: the economic goal of the firm is to

maximise profits –
- This is a simplification to gain insight into the
key issues
- We recognise that, in real world, a firm and its
managers often have other motives too:
e.g. max sales, prestige, good “corporate
citizen”, executives’ personal goals.

6
 Marginal cost (MC)

MC is the change in total cost due to a one-unit

increase in total output.

Change in total cost

Marginal cost =
Change in output
DTC
MC =
DQ

7
 Average total cost, or average cost
(ATC or AC)

Average cost can be calculated by dividing the

firm’s total cost by the quantity of output produced.

Total cost
__________
Average cost =
Total output

TC
AC =
Q

8
 A Group Exercise:

• Fill in the blanks for AC and MC in the table on the

following slide.

• What decision would you use MC for?

• What decision would you use AC for?

9
 Marginal cost and Average cost

Total output Total cost Average cost Margin. cost

0 25 --
…
4 50 …
…
10 75 …
…
13 100 …
…
15 125 …
…
10
 Marginal Cost and Average Costs

15
ATC = AFC + AVC
MC
Cost (dollars per T-shirts)

10 ATC
AVC

AFC

0 5 10 15
Output (T-shirts per hr)
11
 Challenge:

What is the relationship between ATC and MC?

Which one influences the other?

Hint: imagine MC>ATC

12
 Draw and label a typical
marginal cost curve

13
 Draw and label typical short run
average and marginal cost curves
The MC curve always crosses the AC
curve at the minimum level of AC

14
 *Returns to scale and marginal returns

• We should distinguish
- marginal returns (short run): relate to marginal
product of one input (only one input is being
increased). Marginal returns are often
diminishing
- returns to scale (long run): relate to the effect of
varying all inputs. Returns to scale may be
increasing, constant or decreasing

15
 Returns to scale

In the long run, as output increases

if then there are
AC falls increasing returns to scale
(economies of scale)
AC is constant constant returns to scale
AC rises decreasing returns to scale
(diseconomies of scale)

16
 Increasing, constant and decreasing
returns to scale (RTS)

AC
in Increasing RTS Decreasing RTS
long (AC falling) (AC rising) A firm facing
run increasing
Constant RTS returns to
(AC constant) scale will have
an incentive
to go on
expanding
output,
because AC
falls as it does
so

Q
17
 Marginal Revenue (MR)

• MR is the addition to total revenue due to a

one-unit increase in output.
Change in total revenue
Marginal revenue =
Change in quantity
DTR
MR = DQ

18
 Break

19
 A recap question
Lisa is a Vice-President at the Head Office of a national insurance
company and Fred is State Manager for Queensland branch.
Lisa and Fred are discussing the Queensland branch’s budget for
next year. They both expect that the branch’s client base will
expand by about 10%.
Fred is asking for a 10% increase in the budget (after adjustment
for inflation). Lisa is offering only a 5% increase.
Fred worries that this will mean a fall in the quality of services for
Queensland clients. Lisa is confident that the new budget will allow
Fred to maintain, or even improve, service quality.
From your knowledge of economic theory, what factors would you
see as relevant in assessing whether Lisa's offer is a reasonable one?

20
 Is AC falling? What is MC?

• Is the AC of servicing each client likely to be constant,

or to fall, as more & more clients are serviced?
• If there are fixed overheads (like front office, IT
infrastructure, etc. already in place and with spare
capacity), these costs could be spread across more
clients, so AC could fall
• So Lisa could be right
• But Fred should still make sure that the MC of servicing
the extra clients is being adequately covered by the
increase in the budget.
21
 Numerical example

• Suppose there are 100,000 clients. Current budget is

$10,000,000. AC of servicing each client is $100.
• Next year there will be 110,000 clients, and Lisa is
offering Fred $10,500,000 (after inflation adjustments)
• Fred has to check that the cost of servicing the extra
10,000 clients is no more than $500,000, i.e., the MC
(marginal cost) is no more than $50 per client.

22
 Decision time frames: the short run

1. The short run is a time frame in which the quantity

of one or more resources used in production is fixed.
• For most firms, capital, in the form of the firm’s
plant, is the fixed resource.
• Other resources (e.g., labour, raw materials, and
energy) can be changed in the short run.
• Short-run decisions are easily reversed.

23
 Decision time frames: the long run

2. The long run is a time frame in which the quantities

of all resources—including the plant size—can be
varied.
- Long-run decisions are not easily reversed.
• A sunk cost is a cost already incurred by the firm
and cannot be changed.
- If a firm’s plant has no resale value, the amount
paid for it is a sunk cost.
- Sunk costs are irrelevant to a firm’s decisions.

24
 Production function: an example

Labour Output = Total product

(number of workers) (number of T-shirts per hour)

0 0

1 4

2 10

3 13

4 15

5 16
25
 TP and MP (of labour)

• Total product is the maximum output that a quantity

of labour can produce, given technology level and
fixed amounts of other inputs
• The marginal product of labour is the change in total
product that results from a one-unit increase in the
quantity of labour employed, with all other inputs
remaining the same.

26
 Question for Thought

• If we increase one input (like labour), holding all

other inputs constant, what do you expect will
happen to the marginal product of labour?

27
 Marginal Product

Labour Output = Total product Marginal product of labour

(number of workers) (number of T-shirts per hour) (number of T-shirts per hour)

0 0

1 4 4

2 10 6

3 13 …..

4 15 …..

5 16 1
28
 Question for Thought

• What level of profits will attract new businesses?

• What level of losses or profits will cause businesses to
shut down in the long run?

29
 *Total cost in economics

• Economic concept of cost (“opportunity cost”)

includes both explicit and implicit costs.
• Simple book-keeping concept of cost focuses
on explicit costs but usually ignores the
implicit costs.

30
 Explicit costs

• Involve direct money payments.

• Example:

Cloth & material $80,000

Vehicle rental cost $20,000
Wages for employees $120,000
Interest payable to bank $10,000
Total explicit costs $230,000

31
 Implicit costs

• When a firm uses its own resources, especially

capital and owners’ time, without making a direct
monetary payment, it incurs an implicit cost.
• Examples:–

- wages of the owner/operator (if not paid explicitly)

- returns which the owners could have earned if they
had invested their capital (equity) elsewhere

32
 Example of implicit costs

Example:
Owner’s wages foregone $65,000
Returns on equity expected $70,000
(or required)
Total implicit costs $135,000

33
 “Normal” profit

• If the firm’s owner(s) were to take their equity (capital

invested in this firm) and use it elsewhere, what would
be the best returns that they could confidently expect?
• That benchmark is regarded as “normal” profit.
• The opportunity to earn this normal profit elsewhere
has been foregone, so it is counted as an implicit cost
(part of total cost) here. The owners expect, or
implicitly require, the same level of returns (or better)
when they invest in this firm.
34
 “Supernormal” profit

• Economic profit is typically smaller than

book-keeping profit
• When TR exceeds TC, there is “economic”
or “above-normal” or “super-normal”
profit: returns to owners’ resources are
higher than elsewhere.

35
 “Normal” profit

Profit = Total revenue – Total cost

• If total revenue = total (economic) cost, then

there is zero economic profit
• But even in that case, the firm still earns
“normal” profit, an implicit component of TC
(Note: all of TC is being covered by revenue).

36
 Economic loss

• If TR is less than TC, there is an “economic” loss.

• The firm might be making a loss in a book-keeping

(explicit-costs only) sense.
• Or it might be making some book-keeping profit,
but this profit is below “normal”
- the firm (or its owners) would generate better
returns if they do something else

37
 A review SAQ

Last year Acme Ltd achieved a turnover of $10m.

Payments for supplies, employees' wages and salaries
(including the owner’s salary), rent for the premises,
depreciation charges, and interests on loans amounted
to $9.950m, leaving an operating surplus of $50,000.
The owner’s capital was $1m. The rate of interest on
long-term business loans is about 10%. Is Acme doing
very well or rather poorly?

38
 Acme Ltd

Total revenue is $10m.

Most costs have been made explicit, including
payments of owner’s salary and depreciation charges.
Total explicit cost is $9.950m
So book-keeping profit is $50,000.
But at least one implicit cost has not been covered:
interest foregone on owner’s capital:
……………………………………..

39
 END
of LECTURE

START
of SELF-STUDY
MATERIAL
40
 Make sure you read
the textbook!
These slides are a
complementary good,
not a substitute.
41
 TP, AP and MP (of labour)

• Total product is the maximum output that a quantity

of labour can produce, given technology level and
fixed amounts of other inputs
• The marginal product of labour is the change in total
product that results from a one-unit increase in the
quantity of labour employed, with all other inputs
remaining the same.
• The average product of labour is equal to total
product divided by the quantity of labour employed.

42
 Output and total cost

• The relationship between the quantity of a firm’s

output and its total cost helps to determine its
production and pricing decisions.
• The total-cost curve shows this relationship
graphically.
• Suppose labour cost = $25 per worker
other, fixed costs = $25

43
 Calculating total cost

Total Total
fixed variable Total
cost cost cost
Labour Output (TFC) (TVC) (TC)
(workers (T-shirts
per day) per hr) (dollars per hour)
A 0 0 25 0 25
B 1 4 25 25 50
C 2 10
D 3 13
E 4 15 25 100 125
F 5 16 25 125 150
44
 Total Cost Curves
150 TC
TC = TFC + TVC
TVC
Cost (dollars per hour)

100

50

TFC

0 5 10 15
Output (T-shirts per hour)
45
 A quick review question

Which of the following costs are explicit? Which are

implicit?
a) payment of $500 to technician for repair work done
b) the owner is not drawing a salary from the firm (she
could earn $85,000 a year as an employee elsewhere)
c) the firm pays the owner $4,000 in interest on a
$100,000 loan she made to the firm last year
d) the owner estimates that if she were to take her equity
in the firm ($1M) and invest it in shares, she would
earn a total of $100,00 per year in dividends and
capital gains (assume the estimate is sound).
46
 Total Product curve
Figure 13.2
TP
15 F
E
Unattainable
Output (T-shirts per hour)

D
10
C
Attainable
5
B
A

0 1 2 3 4 5
Labour (workers per day)
47
 Marginal Product = slope of Total Product

The red highlights

the point of
35 diminishing returns
Output (T-shirts per hour)

F TP

Marginal product
(T-shirts per hour per worker)
95 E 30
90
25
D
80 20
60 15
C
10

5
25 B
A MP

0 1 2 3 4 5 0 1 2 3 4 5
Labour (workers per day) Labour (workers per day)
48
 Challenge:

What is the relationship between ATC and MC?

Which one influences the other?

Hint: imagine MC>ATC

49
 Focusing on MC and ATC

• To simplify, we’ll
- concentrate on MC and ATC only
- call ATC simply AC for convenience

• When MC < AC, AC is falling as Q rises.

• When MC > AC, AC is rising as Q rises.
• When MC = AC, AC is at its lowest level

50
 Question for Thought

• If we increase one input (like labour), holding all

other inputs constant, what do you expect will
happen to the marginal product of labour?

51
 Question for Thought

• “Law” of diminishing marginal product

• If we increase one input (like labour), holding all

other inputs constant, the marginal product of the
increasing input (labour) will eventually fall, and
may become zero or negative.

• Lesson to be drawn: good outcomes generally require

a balanced mix of ingredients

52
 Marginal cost and Average cost

Total output Total cost Average cost Margin. cost

0 25 --
6.25
4 50 12.50

10 75 7.50

13 100 7.69
12.50
15 125 8.33
25.00
53