MANAGERIAL

ECONOMICS
CHAPTER 4
PRODUCTION PROCESS AND COST ANALYSIS
PRODUCTION THEORY
 Production is the process of converting input
into output. It is represented by the figure
below:

INPUT PROCESS OUTPUT

 Therefore, production paves the way for the

creation of utility or usefulness of a product
or service.
PRODUCTION FUNCTION
 
 The production function expresses the
amount of output that can be produced given
certain amounts of input. In general, the
production function can be expresses as:

Q (L, K)

where: Q is the level of output

L is the number of units of labor
The production function expresses the amount of output that can be
is the
producedKgiven number
certain amounts inof units of capital
input.
COSTS

 In the world of business, costs are always

associated with its success. A business firm
would not be able to generate sales without
incurring any cost. Thus, business tycoons
also need to consider and analyze costs.

 Costs are the firms’ expenses.

FIXED COSTS (FC)

 Fixed costs are expenses that does not

change even though there is an increase or
decrease in the volume of goods produced.

 These are required to be paid by companies,

independent of any business activity.
VARIABLE COSTS (VC)
 Variable costs are expenses that vary with the
volume of production output; they rise as
production increases and fall as production
decreases.

 For example, a company may have variable costs,

such as supplies associated with the production
of goods. As the company produce more goods,
the costs for suppliers will increase. Contrariwise,
when fewer of these goods are produced the costs
for supplies will consequently decrease.
 TOTAL COSTS (TC)
 Total costs are the sum of variable costs and fixed
costs.

 Assume that a business firm has the following

costs for the following volume of output:
Output Fixed Costs Variable Costs Total Costs
1 Php 1,500 Php 400 Php 1,900
2 Php 1,500 Php 700 Php 2,200
3 Php 1,500 Php 1,100 Php 2,600
4 Php 1,500 Php 1,700 Php 3,200
5 Php 1,500 Php 2,700 Php 4,200
6 Php 1,500 Php 4,500 Php 6,000
TOTAL COSTS (TC)
 The relationship of the costs may be observed
through a graph.

7,000
6,000
5,000
4,000
Prices

3,000 Total Costs

2,000 Fixed Costs
1,000 Variable Costs
0
2 3 4 5 6
Quantity
 MARGINAL COSTS (MC)
 Marginal, in economic terms, means additional.
Thus, the concept of marginal cost to produce one
more unit.

 Using the data in the table from the preceding

example, we compute the marginal cost of producing
the 6th unit. We get it by deducting the total cost of
the 6th unit from the 5th unit produced. Thus,

Php 6,000 – Php 4,200 = Php 1,800

The marginal cost for adding the 6th unit is Php 1,800
AVERAGE COSTS (AC)

 This is the cost divided by the number of units

produced.

 Average Fixed Costs (AFC)

 Average Variable Costs (AVC)

 Average Total Costs (ATC)

 AVERAGE FIXED COSTS (AFC)
 
 Average fixed cost is fixed costs divided by
output. It drops as output rise because we divide a
larger denominator into a numerator that is
constant.

 Suppose that the fixed cost is still Php1,500, the

average fixed cost for a unit is:

Average Fixed Costs = = = Php1,500

 AVERAGE FIXED COSTS (AFC)
 
 If the output would increase to 2, the AFC would
be:

AFC = = Php 750

Average Fixed
Fixed Costs Output
Costs
Php 1,500 1 Php 1,500
Php 1,500 2 Php 750
Php 1,500 3 Php 500
Php 1,500 4 Php 375
Php 1,500 5 Php 300
Php 1,500 6 Php 250
 AVERAGE VARIABLE COSTS
(AVC)
 
 Average Variable Cost is variable cost divided by
output. As we all know variable costs increases as
production increases. However, it does not mean
that AVC increases progressively too. Usually, it
level offs at the beginning and gradually rises.

Average Variable Costs = = = Php 400

 AVERAGE VARIABLE COSTS
(AVC)

Average
Variable Cost Output
Variable Cost
Php 400 1 Php 400
Php 700 2 Php 350
Php 1,100 3 Php 367
Php 1,700 4 Php 425
Php 2,700 5 Php 540
Php 4,500 6 Php 750
AVERAGE TOTAL COSTS (ATC)
 Average Total Cost is the total cost divided by
output. Like AVC, ATC declines for a while but
eventually it will begin to rise.

Average Total
Total Cost Output
Cost
Php 1,900 1 Php 1,900
Php 2,200 2 Php 1,100
Php 2,600 3 Php 867
Php 3,200 4 Php 800
Php 4,200 5 Php 840
Php 6,000 6 Php 1,000
 EXAMPLE

Fixed Variable Total Marginal

Output AFC AVC ATC
Cost Cost Cost Cost

1 P 1,500 P 400 P 1,900 P 1,500 P 400 1900 -----

2 1,500 700 2,200 750 350 1100 P 300

3 1,500 1,100 2600 500 366.67 866.67 400

4 1,500 1,700 3,200 375 425 800 600

5 1,500 2,700 4200 300 540 840 1,000

6 1,500 4,500 6,000 250 750 1000 1,800

WHY AVC AND ATC CURVES U-SHAPED?
 Each is U-shaped because it start off with
relatively high but falling cost for small quantities
of output, reaches a minimum value, then has
rising cost at large quantities of output.

 When we look at the comparison, we can see that

AVC rises first before ATC, why so?

 This is explained through concepts of: Law of

Diminishing Returns, Economies of Scale and
Diseconomies of Scale.
LAW OF DIMINISHING RETURNS
 An economic concept that states that if one
variable factor of production is increased while
other factors are held constant, the output per
unit of the variable factor will eventually decline.

 While the marginal productivity of labor drops as

output increases, diminishing returns do not
mean negative returns until the number of
workers exceeds the available machines or
workspace.
ECONOMIES OF SCALE

 Economies of scale is the cost advantage that

arises with added output of production. It
arises because of the inverse relationship
between the quantity produced and per-unit
fixed costs.

 It is the one responsible for declining phase of

the ATC curve.
DISECONOMIES OF SCALE
 Diseconomies of scale is an economic concept
referring to a situation in which economies of
scale no longer work for a business.

 To a certain extent of experiencing continued

decreasing costs per increase in output, firms
see an increase in marginal cost when output is
increased.

 It is the one responsible for the rising part of the

ATC curve.
 MANAGERIAL
ECONOMICS
CHAPTER 5.1
MARKET STRUCTURE AND IMPERFECT COMPETITION
PERFECT COMPETITION
 This is a type of market where many seller
offer identical products and there is freedom
of entry and exit and perfect information in the
market.

 It has the characteristics: Large Number of

Small Firms; Homogeneous or Identical
Product and; Very Easy Entry and Exit
LARGE NUMBER OF SMALL FIRMS
 One of the characteristics of a perfectly
competitive market is composed of many firms
and buyers, that is, a large number of
independently-acting firms and buyers with each
firm and buyer sufficiently small to be unable to
influence the price of product transacted in the
market.

 This is fulfilled only when each firm in a market

has no significant share of total output and
therefore, no ability to affect the product’s price.
HOMOGENEOUS OR IDENTICAL
PRODUCT

 In a perfectly competitive market, the products

offered by the competing firms are identical
not only in physical attributes but also
regarded as identical by buyers who have no
preference between the products of various
producers.
VERY EASY ENTRY, AND EXIT

 There are no barriers to entry of new sellers or

impediments to the exit of existing sellers.

 Barriers can be in the form of financial,

technical, long term contracts, or government-
imposed barriers such as licenses, patents,
permits, copyrights, franchises, etc.
MONOPOLY
 A firm that is the only seller and controller of the
entire supply of a certain good or service, with no
close substitutes in the market.

 In the absence of government intermediation, this

firm is free to set the prices that it chooses and
will usually set the price that will generate the
largest possible profit.

 A firm that sets and chooses its price based on its

output decision is called a price setter, and they
obtains monopoly power.
MONOPOLY

 Characterized by:

1. A single seller or producer

2. A unique product or service and;
3. Impossible entry into the market
SINGLE SELLER OR PRODUCER

 A monopoly market is composed of a

single supplier selling to a multitude of
small, independently-acting buyers.

 One firm provides the total supply of a

product in a given market.
UNIQUE PRODUCT
 Means that there are no close substitutes
for the monopolist’s product.

 The monopolist faces little or no

competition.

IMPOSSIBLE ENTRY
 Barriers to entry are so severe in a monopoly
that it is impossible for new firms to enter the
market.
PRICE DISCRIMINATION
 Is the practice of charging a specific product at
different prices which are not justified by cost
differences. There are three forms of price
discrimination:

1. Charging the market the minimum price that a

consumer is willing to pay.
2. Charging the specific price for the first set of
purchases and then reducing it for subsequent
purchases.
3. Charging some customers a certain price and then the
another price for other customers.
PRICE DISCRIMINATION
 It is not possible for all firms to engage in price
discrimination , it can only exist when the following
conditions are met:

1. Monopoly Power – the firm must be a monopolist or, at

least possess monopoly power at some degree, giving
them the ability to control its price and output.
2. Market Segregation – the market must be able to
segregate its consumers into unique classes, each
having different ability and willingness to pay for a
product.
3. No resale – the original purchaser cannot resell the
 MANAGERIAL
ECONOMICS
CHAPTER 5.2
MARKET STRUCTURE AND IMPERFECT COMPETITION
OLIGOPOLY

 A market dominated by a few large producers

or sellers of a homogeneous or differentiated
product. Because of their ‘fewness’,
oligopolists have considerable control over
their prices, but each must consider the
possible reaction of rivals to its own pricing,
output, and advertising decisions.
OLIGOPOLY
 Basically, an oligopoly is a consequence of mutual
interdependence (a condition in which action of
one firm may cause a reaction from other
competing firms in the industry)

 In other words, a market structure with a few

powerful firms makes it easier for oligopolists to
collude.

 Hence, ‘few-sellers’ condition is met when these

firms are relatively large to the total market that
they can affect the market price.
 OLIGOPOLY

 Characterized by:

1. Few sellers

2. Homogeneous or Differentiated Products and;

3. Difficult Market Entry
ILLUSTRATION OF OLIGOPOLY
Mr. Tan and Mr. Kim are initially selling gasoline at Php60.00
per liter (E). Mr. Tan decides to lower its price to Php50.00 per
liter. Sales increase from 20,000 liters per week to 30,000 liters
per week from point E to E1. Mr. Kim is unhappy losing so
many sales to Mr. Tan, and matches Mr. Tan’s price of Php50.00
per liter.

Mr. Kim then decides to decrease the price of his gasoline

to Php30.00 per liter to make more profits similar to what Mr.
Tan did when he lowered the price of his gasoline further from
Php50.00 to Php30.00. The move of Mr. Kim is shown as the
movement from point E1 to E2. However, sales volume only
increased from 30,000 liters per week to 35,000 liters per week.
ILLUSTRATION OF OLIGOPOLY

 Many oligopolies face Kinked Demand Curves.

This is a curve that explains why prices changed
by competing oligopolists, once established,
tends to be stable. Basically, the demand curve for
the product of oligopolists has two segments: one
elastic, and the other inelastic.
OLIGOPOLY FEATURES
 Product Branding – Each firm in the market is
selling a branded (differentiated) product.
 Entry Barriers – Significant entry barriers prevent the
dilution of competition in the long run which maintains
supernormal profits for the dominant firms. It is
perfectly possible for many smaller firms to operate
on the periphery of an oligopolistic market, but none
of them is large enough to have any significant effect
on market prices and output.
OLIGOPOLY FEATURES

 Interdependent Decision-making – Interdependent

means that firms must take into account likely
reactions of their rivals to any change in price, output,
or forms of nonprice competition.
 Nonprice Competition – a consistent feature of the
competitive strategies of oligopolistic firms. (Example:
Free Deliveries and Installation, Extended Warranties
for consumers and credit facilities etc.)
DUOPOLY
 Another form of oligopoly wherein two corporations
produce similar goods or services which are almost
identical.

 Only two companies have the entire control of the

market and the firms’ interactions with one another
shape of the market.

 When there’s a duopoly in the market, the consumers

may tend to benefit from the actions of the two firms
when they compete on price since firms will drive the
price down in order to keep up in the competition with
each other.
DUOPOLY
 However, since there are only two firms sharing in
the market, this condition gives the duopolists an
opportunity to agree and charge a monopolistic
price in order to gain profit.

 There are two types of duopoly. The Courtnot

Duopoly and the Bertrand Duopoly named after
mathematician Antoine Augustin Courtnot and
French economist, Joseph Bertrand.
THE COURTNOT DUOPOLY
 The competition of the two companies is based on the
quantity of products supplied, saying that it is the quantity
which shapes the competition between two firms.

 The Courtnot Model believes that each company receives

price values on the availability of goods and services.

 The price each company receives for the product is based

on numerical count or quantity of the produced goods.

 Equilibrium is achieved when the two companies react to

the changes in production of each other.
THE BERTRAND DUOPOLY

 The Bertrand Duopoly focused on the price

since this is what drives competition in the
market between two companies. When given a
choice between two goods and services which
tend to be equal or similar, consumers will go
for the firm that will offer best price.
MONOPSONY
 Monopsony is similar to the concept of monopoly
that has one seller and many buyers. For
monopsony, there is only one buyer but many
sellers. The buyer is called monopsonist.

 Monopsony occurs when there is a market power

exercised by a firm when employing factors of
production, giving the monopsonist the control
when negotiating prices.