+Managerial Economics & Business Strategy

Chapter 1
The Fundamentals of Managerial
Economics

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 1-2
+
Managerial Economics

■ Manager
■ A person who directs resources to achieve a stated goal.

■ Economics
■ The science of making decisions in the presence of scare resources.

■ Managerial Economics
■ The study of how to direct scarce resources in the way that most efficiently
achieves a managerial goal.
 1-3
+
Economic vs. Accounting Profits

■ Accounting Profits
■ Total revenue (sales) minus dollar cost of producing goods or services.
■ Reported on the firm’s income statement.

■ Economic Profits
■ Total revenue minus total opportunity cost.
+ Opportunity Cost
1-4

■ Accounting Costs
■ The explicit costs of the resources needed to produce produce goods or
services.
■ Reported on the firm’s income statement.

■ Opportunity Cost
■ The cost of the explicit and implicit resources that are foregone when a
decision is made.

■ Economic Profits
■ Total revenue minus total opportunity cost.
 1-5
+
Profits as a Signal

■ Profits signal to resource holders where resources are most highly

valued by society.
■ Resources will flow into industries that are most highly valued by society.
Marginal (Incremental) Analysis 1-6

■ Control Variable Examples:

■ Output
■ Price
■ Product Quality
■ Advertising
■ R&D

■ Basic Managerial Question: How much of the control variable should

be used to maximize net benefits?
 1-7
+
Net Benefits

■ Net Benefits = Total Benefits - Total Costs

■ Profits = Revenue - Costs

 1-8

Marginal Benefit (MB)

■ Change in total benefits arising from a change in the control variable, Q:

■ Slope (calculus derivative) of the total benefit curve.

 1-9

Marginal Cost (MC)

■ Change in total costs arising from a change in the control variable, Q:

■ Slope (calculus derivative) of the total cost curve

 1-10
+ Marginal Principle

■ To maximize net benefits, the managerial control variable should be

increased up to the point where MB = MC.

■ MB > MC means the last unit of the control variable increased benefits
more than it increased costs.

■ MB < MC means the last unit of the control variable increased costs
more than it increased benefits.
 1-11
+ The Geometry of Optimization: Total
Benefit and Cost
Total Benefits Costs
& Total Costs
Benefit
Slope =MB s

B
Slope = MC
C

Q* Q
 1-12
+ The Geometry of Optimization: Net
Benefits

Net Benefits

Maximum net
benefits

Slope =
MNB

Q* Q
 +Managerial Economics & Business Strategy

Chapter 2
Market Forces: Demand and Supply

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 2-14

Overview

I. Market Demand Curve III. Market Equilibrium

■ The Demand Function
■ Determinants of Demand IV. Price Restrictions
■ Consumer Surplus
V. Comparative Statics

II. Market Supply Curve

■ The Supply Function
■ Supply Shifters
■ Producer Surplus
 2-15
+
Market Demand Curve
■ Shows the amount of a good that will be purchased at alternative prices,
holding other factors constant.

■ Law of Demand
■ The demand curve is downward sloping.

Price

D
Quantity
 2-16

Determinants of Demand

■ Income
■ Normal good
■ Inferior good

■ Prices of Related Goods

■ Prices of substitutes
■ Prices of complements

■ Advertising and consumer

tastes
■ Population
■ Consumer expectations
 2-17
+
The Demand Function
■ A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)

■ Qxd = quantity demand of good X.

■ Px = price of good X.
■ PY = price of a related good Y.
■ Substitute good.
■ Complement good.
■ M = income.
■ Normal good.
■ Inferior good.
■ H = any other variable affecting demand.
 2-18
+
Inverse Demand Function

■Price as a function of quantity

demanded.
■Example:
■ Demand Function
■ Qxd = 10 – 2Px
■ Inverse Demand Function:
■ 2Px = 10 – Qxd
■ Px = 5 – 0.5Qxd
 2-19
Change in Quantity Demanded
Pric
e
A to B: Increase in quantity demanded

A
10

B
6

D0

4 7 Quantit
y
 2-20

Change in Demand
Pric D0 to D1: Increase in Demand
e

6
D1

D0
1
7 Quantit
3
y
 2-21

Consumer Surplus:

■ The value consumers get from a

good but do not have to pay for.

■ Consumer surplus will prove

particularly useful in marketing
and other disciplines
emphasizing strategies like value
pricing and price discrimination.
 2-22

I got a great deal!

■ That company offers a lot of

bang for the buck!
■ Dell provides good value.
■ Total value greatly exceeds
total amount paid.
■ Consumer surplus is large.
 2-23

I got a lousy deal!

■ That car dealer drives a hard
bargain!
■ I almost decided not to buy it!
■ They tried to squeeze the very
last cent from me!
■ Total amount paid is close to
total value.
■ Consumer surplus is low.
+ Consumer Surplus:
2-24

The Discrete Case

Pric
e Consumer Surplus:
10 The value received but not
8 paid for. Consumer surplus =
(8-2) + (6-2) + (4-2) = $12.
6

2
D
1 2 3 4 5 Quantit
y
Consumer Surplus:
2-25
+
The Continuous Case

Price $

10
Value
Consumer 8 of 4 units = $24
Surplus =
$24 - $8 =
$16
6
4 Expenditure on 4 units = $2
x 4 = $8

2
D
1 2 3 4 5 Quantity
 2-26
+ Market Supply Curve

■ The supply curve shows the amount of a good that will be produced at
alternative prices.

■ Law of Supply
■ The supply curve is upward sloping.

Price
S0

Quantity
 2-27

Supply Shifters
■ Input prices
■ Technology or government
regulations
■ Number of firms
■ Entry
■ Exit

■ Substitutes in production
■ Taxes
■ Excise tax
■ Ad valorem tax

■ Producer expectations
 2-28
+
The Supply Function

■ An equation representing the supply curve:

QxS = f(Px , PR ,W, H,)

■ QxS = quantity supplied of good X.

■ Px = price of good X.
■ PR = price of a production substitute.
■ W = price of inputs (e.g., wages).
■ H = other variable affecting supply.
 2-29
+
Inverse Supply Function

■Price as a function of quantity

supplied.
■Example:
■ Supply Function
■ Qxs = 10 + 2Px
■ Inverse Supply Function:
■ 2Px = 10 + Qxs
■ Px = 5 + 0.5Qxs
 2-30
+
Change in Quantity Supplied

Pric A to B: Increase in quantity

e supplied
S0
B
20

A
10

5 10 Quantit
y
 2-31
+ Change in Supply
S0 to S1: Increase in supply
Pric
e
S0

S1

5 7 Quantit
y
 2-32
+ Producer Surplus

■ The amount producers receive in excess of the amount

necessary to induce them to produce the good.

Pric
e

S0
P*

Q* Quantit
y
 2-33

Market Equilibrium

■ The Price (P) that Balances

supply and demand
■ QxS = Qxd
■ No shortage or surplus

■ Steady-state
 2-34

If price is too low…

Pric S
e

7
6

Shortage D
12 - 6 = 6
6 12 Quantit
y
 2-35
If price is too high…
Surplus
Pric 14 - 6 = 8
S
e
9
8
7

6 8 14 Quantit
y
 2-36
+ Price Restrictions
■ Price Ceilings
■ The maximum legal price that can be charged.
■ Examples:
■ Gasoline prices in the 1970s.
■ Housing in New York City.
■ Proposed restrictions on ATM fees.

■ Price Floors
■ The minimum legal price that can be charged.
■ Examples:
■ Minimum wage.
■ Agricultural price supports.
 2-37
Impact of a Price Ceiling

Pric
S
e
PF

P*

P Ceiling

Shortag D
e

Qs Qd Quantit
Q*
y
 2-38
+
Impact of a Price Floor

Pric Surplus S
e F
P

P*

Qd Q* QS Quantit
y
 2-39
+
Comparative Static Analysis
■ How do the equilibrium price and quantity change when a determinant
of supply and/or demand change?
 2-40
+
Applications of Demand and Supply
Analysis

■ Event: The WSJ reports that the prices of PC components are

expected to fall by 5-8 percent over the next six months.

■ Scenario 1: You manage a small firm that manufactures PCs.

■ Scenario 2: You manage a small software company.

 2-41
+ Use Comparative Static Analysis to see
the Big Picture!
■ Comparative static analysis shows how the equilibrium price and
quantity will change when a determinant of supply or demand changes.
 2-42
+
Scenario 1: Implications for a Small PC
Maker
■ Step 1: Look for the “Big Picture.”

■ Step 2: Organize an action plan (worry about details).

Big Picture: Impact of decline in 2-43

component prices on PC market

Pric S
e
of S*
PCs
P0
P*

Quantity of PC’s
Q0 Q*
 2-44
+ Big Picture Analysis: PC Market

■ Equilibrium price of PCs will fall, and equilibrium quantity of

computers sold will increase.

■ Use this to organize an action plan

■ contracts/suppliers?
■ inventories?
■ human resources?
■ marketing?
■ do I need quantitative estimates?
 2-45
+ Scenario 2: Software Maker
■ More complicated chain of reasoning to arrive at the “Big Picture.”

■ Step 1: Use analysis like that in Scenario 1 to deduce that lower

component prices will lead to
■ a lower equilibrium price for computers.
■ a greater number of computers sold.

■ Step 2: How will these changes affect the “Big Picture” in the software
market?
 2-46
Big Picture: Impact of lower PC prices on the
software market
Price S
of
Software
P1
P0

D*

Q0 Q1 Quantity
of
 3-47
+ Overview

I. The Elasticity Concept

■ Own Price Elasticity
■ Elasticity and Total Revenue
■ Cross-Price Elasticity
■ Income Elasticity

II. Linear Demand Functions

 2-48
+
Big Picture Analysis: Software Market

■ Software prices are likely to rise, and more software will be sold.

■ Use this to organize an action plan.

 +Managerial Economics & Business Strategy

Chapter 3
Quantitative Demand Analysis

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 3-50
+
The Elasticity Concept

■ How responsive is variable “G” to a change in variable “S”

If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
 3-51
+
The Elasticity Concept Using Calculus

■ An alternative way to measure the elasticity of a function G = f(S) is

If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
 3-52
+
Own Price Elasticity of Demand

■ Negative according to the “law of demand.”

Elastic:
Inelastic:
Unitary
:
 3-53
+
Perfectly Elastic &
Inelastic Demand

Price Price
D

Quantity Quantity
 3-54
+
Own-Price Elasticity
and Total Revenue
■ Elastic
■ Increase (a decrease) in price leads to a decrease (an increase) in total
revenue.

■ Inelastic
■ Increase (a decrease) in price leads to an increase (a decrease) in total
revenue.

■ Unitary
■ Total revenue is maximized at the point where demand is unitary elastic.
 3-55
+
Elasticity, Total Revenue and Linear
Demand

P
TR
100

0 10 20 30 40 50 Q 0 Q
 3-56
+
Elasticity, Total Revenue and Linear
Demand

P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-57
+
Elasticity, Total Revenue and Linear
Demand

P
TR
100

80
60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-58
+
Elasticity, Total Revenue and Linear
Demand

P
TR
100

80

1200
60
40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-59
+
Elasticity, Total Revenue and Linear
Demand

P
TR
100

80
1200
60
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-60
+
Elasticity, Total Revenue and Linear
Demand

P
TR
100
Elasti
80 c

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elasti
c
 3-61
+
Elasticity, Total Revenue and Linear
Demand

P
TR
100
Elasti
80 c

1200
60 Inelasti
40 c
800
20

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elasti Inelasti
c c
 3-62
+
Elasticity, Total Revenue and Linear
Demand

P TR
100
Elasti Unit
80 c Unit elastic
elastic
1200
60 Inelasti
40 c
800
20

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elasti Inelasti
c c
 3-63
+
Demand, Marginal Revenue (MR) and
Elasticity

P ■ For a linear inverse

100 demand function,
Elasti
c Unit
MR(Q) = a + 2bQ,
80
elastic where b < 0.
60 Inelasti ■ When
40 c ■ MR > 0, demand is elastic;
■ MR = 0, demand is unit
elastic;
20
■ MR < 0, demand is
inelastic.
0 10 20 40 50 Q

MR
+ Factors Affecting 3-64

Own Price Elasticity

■ Available Substitutes
■ The more substitutes available for the good, the more elastic the demand.
■ Time
■ Demand tends to be more inelastic in the short term than in the long term.
■ Time allows consumers to seek out available substitutes.
■ Expenditure Share
■ Goods that comprise a small share of consumer’s budgets tend to be more
inelastic than goods for which consumers spend a large portion of their
incomes.
 3-65
+
Cross Price Elasticity of Demand

If EQX,PY > 0, then X and Y are substitutes.

If EQX,PY < 0, then X and Y are complements.

 3-66
+
Income Elasticity

If EQX,M > 0, then X is a normal good.

If EQX,M < 0, then X is a inferior good.
 3-67
+
Uses of Elasticities

■ Pricing.

■ Managing cash flows.

■ Impact of changes in competitors’ prices.

■ Impact of economic booms and recessions.

■ Impact of advertising campaigns.

■ And lots more!

 3-68
+
Example 1: Pricing and Cash Flows

■ According to an FTC Report by Michael Ward, AT&T’s own price

elasticity of demand for long distance services is -8.64.

■ AT&T needs to boost revenues in order to meet it’s marketing goals.

■ To accomplish this goal, should AT&T raise or lower it’s price?

 3-69
+
Answer: Lower price!

■ Since demand is elastic, a reduction in price will increase quantity

demanded by a greater percentage than the price decline, resulting in
more revenues for AT&T.
 3-70
+ Example 2: Quantifying the Change

■ If AT&T lowered price by 3 percent, what would happen to the volume

of long distance telephone calls routed through AT&T?
 3-71
+ Answer

• Calls would increase by 25.92 percent!

 3-72
+ Example 3: Impact of a change in a
competitor’s price
■ According to an FTC Report by Michael Ward, AT&T’s cross price
elasticity of demand for long distance services is 9.06.

■ If competitors reduced their prices by 4 percent, what would happen

to the demand for AT&T services?
 3-73
+ Answer
• AT&T’s demand would fall by 36.24 percent!
 3-74
+
Interpreting Demand Functions
■ Mathematical representations of demand curves.

■ Example:

■ Law of demand holds (coefficient of PX is negative).

■ X and Y are substitutes (coefficient of PY is positive).
■ X is an inferior good (coefficient of M is negative).
 +Managerial Economics & Business Strategy

Chapter 4
The Theory of Individual Behavior

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
+ Overview
4-76

I. Consumer Behavior
■ Indifference Curve Analysis
■ Consumer Preference Ordering

II. Constraints
■ The Budget Constraint
■ Changes in Income
■ Changes in Prices

III. Consumer Equilibrium

IV. Indifference Curve Analysis & Demand Curves
■ Individual Demand
■ Market Demand
 4-77
+ Consumer Behavior
■ Consumer Opportunities
■ The possible goods and services consumer can afford to consume.

■ Consumer Preferences
■ The goods and services consumers actually consume.

■ Given the choice between 2 bundles of goods a consumer either

■ Prefers bundle A to bundle B: A  B.
■ Prefers bundle B to bundle A: A  B.
■ Is indifferent between the two: A ~ B.
 4-78

Indifference Curve Analysis

Indifference Curve Good Y

■ A curve that defines the
III.
combinations of 2 or more goods
that give a consumer the same level II.
of satisfaction. I.
Marginal Rate of Substitution
■ The rate at which a consumer is
willing to substitute one good for
another and maintain the same
satisfaction level.

Good X
 4-79
+ Consumer Preference Ordering Properties

■ Completeness

■ More is Better

■ Diminishing Marginal Rate of Substitution

■ Transitivity
 4-80

Complete Preferences
■ Completeness Property
■ Consumer is capable of expressing Good Y
preferences (or indifference) III.
between all possible bundles. (“I
don’t know” is NOT an option!) II.
■ If the only bundles available to a I.
consumer are A, B, and C, then A
B
the consumer
■ is indifferent between A and C (they
are on the same indifference curve).
C
■ will prefer B to A.
■ will prefer B to C.

Good X
 4-81

More Is Better!
■ More Is Better Property
■ Bundles that have at least as much of Good Y
every good and more of some good are III.
preferred to other bundles.
■ Bundle B is preferred to A since B II.
contains at least as much of good Y
and strictly more of good X. I.
■ Bundle B is also preferred to C since
B contains at least as much of good X A B
10
and strictly more of good Y. 0
■ More generally, all bundles on ICIII
are preferred to bundles on ICII or ICI. C
33.3
And all bundles on ICII are preferred 3
to ICI.
1 3
Good X
Diminishing Marginal Rate of Substitution 4-82

■ Marginal Rate of Substitution

■ The amount of good Y the consumer is Good Y
willing to give up to maintain the same
satisfaction level decreases as more of good X
is acquired. III.
■ The rate at which a consumer is willing to
substitute one good for another and maintain II.
the same satisfaction level.
I.
■ To go from consumption bundle A to B
A
the consumer must give up 50 units of 100
Y to get one additional unit of X.
■ To go from consumption bundle B to B
C the consumer must give up 16.67
50
units of Y to get one additional unit of 33.33 C
D
X.
25
■ To go from consumption bundle C to
D the consumer must give up only
8.33 units of Y to get one additional 1 2 3 4 Good X
unit of X.
 4-83

Consistent Bundle Orderings

■ Transitivity Property
■ For the three bundles A, B, and C, Good Y
the transitivity property implies that III.
if C  B and B  A, then C  A.
II.
■ Transitive preferences along with
the more-is-better property imply I.
that 100 A

■ indifference curves will not C

intersect. 75 B

■ the consumer will not get caught 50

in a perpetual cycle of indecision.

1 2 5 7 Good X
 4-84

The Budget Constraint

■ Opportunity Set The Opportunity Set
Y
■ The set of consumption bundles that are
affordable.
Budget Line
■ PxX + PyY ≤ M.
M/PY Y = M/PY – (PX/PY)X
■ Budget Line
■ The bundles of goods that exhaust a
consumers income.
■ PxX + PyY = M.

■Market Rate of Substitution M/PX

■ The slope of the budget line
X

■ -Px / Py
 4-85

Changes in the Budget Line

Y
M1/PY
■ Changes in Income
■ Increases lead to a parallel,
M0/PY
outward shift in the budget line
(M1 > M0).
■ Decreases lead to a parallel, M2/PY
downward shift (M2 < M0).

■ Changes in Price M2/PX M0/PX M1/PX

X
■ A decreases in the price of good Y
X rotates the budget line counter- New Budget Line for
clockwise (PX0 > PX1). M0/PY a price decrease.
■ An increases rotates the budget
line clockwise (not shown).

M0/PX0 M0/PX1
X
 4-86

Consumer Equilibrium

■ The equilibrium Y
consumption bundle is Consumer
the affordable bundle M/PY
Equilibrium
that yields the highest
level of satisfaction.
■ Consumer equilibrium occurs
at a point where
MRS = PX / PY.
■ Equivalently, the slope of the III.
indifference curve equals the II.
budget line.
I.
M/PX
X
 4-87
+ Price Changes and Consumer Equilibrium

■ Substitute Goods
■ An increase (decrease) in the price of good X leads to an increase (decrease)
in the consumption of good Y.
■ Examples:
■ Coke and Pepsi.
■ Verizon Wireless or AT&T.

■ Complementary Goods
■ An increase (decrease) in the price of good X leads to a decrease (increase)
in the consumption of good Y.
■ Examples:
■ DVD and DVD players.
■ Computer CPUs and monitors.
 4-88
+
Complementary Goods

When the price of

Pretzels (Y)
good X falls and the
consumption of Y
rises, then X and Y M/PY1
are complementary
goods. (PX1 > PX2)

B
Y2

Y1 A II

I
0 X1 M/PX1 X2 M/PX2 Beer (X)
 4-89
+
Income Changes and Consumer
Equilibrium
■ Normal Goods
■ Good X is a normal good if an increase (decrease) in income leads to an
increase (decrease) in its consumption.

■ Inferior Goods
■ Good X is an inferior good if an increase (decrease) in income leads to a
decrease (increase) in its consumption.
 4-90
+
Normal Goods

Y
An increase in
income increases
the consumption of M1/Y

normal goods.
(M0 < M1).

B
Y1
M0/Y

II
A
Y0
I
X0 M0/X X1 M1/X X
0
 4-91
+
Decomposing the Income and
Substitution Effects
Initially, bundle A is consumed. Y
A decrease in the price of good
X expands the consumer’s
opportunity set.
The substitution effect (SE) C
causes the consumer to move
from bundle A to B. A II
A higher “real income” allows B
the consumer to achieve a
higher indifference curve. I
The movement from bundle B to
C represents the income effect IE
0 X
(IE). The new equilibrium is SE
achieved at point C.
 4-92
+
A Classic Marketing Application

Other
goods
(Y)

A
A buy-one,
C E
get-one free
D
pizza deal. II
I

0 0.5 1 2 B F Pizza
(X)
 4-93
Individual Demand Curve
Y

■ An individual’s
demand curve is
derived from each new II

equilibrium point I

found on the $ X

indifference curve as
the price of good X is P0

varied. P1 D

X0 X1 X
 4-94

Market Demand
■ The market demand curve is the horizontal summation
of individual demand curves.
■ It indicates the total quantity all consumers would
purchase at each price point.

$ Individual Demand $ Market Demand Curve

Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q
 4-95
+
Conclusion

■ Indifference curve properties reveal information

about consumers’ preferences between bundles of
goods.
■ Completeness.
■ More is better.
■ Diminishing marginal rate of substitution.
■ Transitivity.

■ Indifference curves along with price changes

determine individuals’ demand curves.
■ Market demand is the horizontal summation of
individuals’ demands.
 +Managerial Economics & Business Strategy

Chapter 5
The Production Process and Costs

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 5-97
+
Overview
I. Production Analysis
■ Total Product, Marginal Product, Average Product
■ Isoquants
■ Isocosts
■ Cost Minimization

II. Cost Analysis

■ Total Cost, Variable Cost, Fixed Costs
■ Cubic Cost Function
■ Cost Relations
 5-98
+
Production Analysis

■ Production Function
■ Q = F(K,L)
■ Q is quantity of output produced.
■ K is capital input.
■ L is labor input.
■ F is a functional form relating the inputs to output.
■ The maximum amount of output that can be produced with K units of
capital and L units of labor.

■ Short-Run vs. Long-Run Decisions

■ Fixed vs. Variable Inputs
 5-99

Production Function Algebraic Forms

■ Linear production function: inputs are perfect

substitutes.

■ Leontief production function: inputs are used in fixed

proportions.

■ Cobb-Douglas production function: inputs have a degree

of substitutability.
 5-
+ 100
Productivity Measures:
Total Product
■ Total Product (TP): maximum output produced with
given amounts of inputs.
■ Example: Cobb-Douglas Production Function:
Q = F(K,L) = K.5 L.5
■ K is fixed at 16 units.
■ Short run Cobb-Douglass production function:
Q = (16).5 L.5 = 4 L.5
■ Total Product when 100 units of labor are used?

Q = 4 (100).5 = 4(10) = 40 units

 5-
+ 101

Productivity Measures: Average

Product of an Input
■ Average Product of an Input: measure of output
produced per unit of input.
■ Average Product of Labor: APL = Q/L.
■ Measures the output of an “average” worker.
■ Example: Q = F(K,L) = K.5 L.5
■ If the inputs are K = 16 and L = 16, then the average product of labor
is APL = [(16) 0.5(16)0.5]/16 = 1.
■ Average Product of Capital: APK = Q/K.
■ Measures the output of an “average” unit of capital.
■ Example: Q = F(K,L) = K.5 L.5
■ If the inputs are K = 16 and L = 16, then the average product of
capital is APK = [(16)0.5(16)0.5]/16 = 1.
 5-
+ Productivity Measures: Marginal Product 102

of an Input
■ Marginal Product on an Input: change in total
output attributable to the last unit of an input.
■ Marginal Product of Labor: MPL = ΔQ/ΔL
■ Measures the output produced by the last worker.
■ Slope of the short-run production function (with respect to labor).
■ Marginal Product of Capital: MPK = ΔQ/ΔK
■ Measures the output produced by the last unit of capital.
■ When capital is allowed to vary in the short run, MPK is the slope
of the production function (with respect to capital).
 5-

Increasing, Diminishing and 103

Negative Marginal Returns

Q Increasi Diminish Negati

ng ing ve
Marginal Marginal Margi
Returns Returns nal
Retur
ns Q=F(K,L)

AP
L
MP
 5-
+ 104

Guiding the Production Process

■ Producing on the production function

■ Aligning incentives to induce maximum worker effort.

■ Employing the right level of inputs

■ When labor or capital vary in the short run, to maximize profit a manager
will hire
■ labor until the value of marginal product of labor equals the wage: VMPL
= w, where VMPL = P x MPL.
■ capital until the value of marginal product of capital equals the rental
rate: VMPK = r, where VMPK = P x MPK .
 5-
105

Isoquant

■ Illustrates the long-run combinations of inputs (K, L) that yield the

producer the same level of output.

■ The shape of an isoquant reflects the ease with which a producer can
substitute among inputs while maintaining the same level of output.
 5-
106

Marginal Rate of Technical Substitution (MRTS)

■ The rate at which two inputs are substituted while maintaining the
same output level.
 5-
107

Linear Isoquants

■ Capital and labor are

K
perfect substitutes Increasing
■ Q = aK + bL Output
■ MRTSKL = b/a
■ Linear isoquants imply that
inputs are substituted at a
constant rate, independent of
the input levels employed.

Q1 Q2 Q3
L
 5-
108

Leontief Isoquants

■ Capital and labor are perfect Q3

complements.
K
Q2
Q1 Increasing
■ Capital and labor are used in
Output
fixed-proportions.
■ Q = min {bK, cL}
■ Since capital and labor are
consumed in fixed proportions
there is no input substitution
along isoquants (hence, no
MRTSKL).
L
 5-
109

Cobb-Douglas Isoquants

■ Inputs are not perfectly K

substitutable. Q3
Increasing
Q2
■ Diminishing marginal rate of Output
technical substitution. Q1
■ As less of one input is used in the
production process, increasingly
more of the other input must be
employed to produce the same
output level.

■ Q = KaLb

■ MRTSKL = MPL/MPK
L
 5-
110
Isocost
■ The combinations of inputs that
produce a given level of output at K New Isocost Line
the same cost: C1/ associated with
higher costs (C0
wL + rK = C r
C0/ < C1).
■ Rearranging, r
C C
K= (1/r)C - (w/r)L C0/0 C11/ L
K w w
■ For given input prices, isocosts New Isocost
farther from the origin are C/ Line for a
associated with higher costs. r decrease in the
■ Changes in input prices change the wage (price of
slope of the isocost line. labor: w0 >
w1). L
C/ C/
w0 w1
 5-111
+
Cost Minimization

■ Marginal product per dollar spent should be equal for all inputs:

■ But, this is just

 5-
+ 112

Cost Minimization

Point of
Slope of Isocost Cost
=
Slope of Isoquant Minimizatio
n

L
 5-
+ 113

Optimal Input Substitution

■ A firm initially produces Q0 by K

employing the combination of
inputs represented by point A
at a cost of C0.
■ Suppose w0 falls to w1.
■ The isocost curve rotates
counterclockwise; which represents K A
the same cost level prior to the
wage change.
0
■ To produce the same level of
output, Q0, the firm will produce on K B
a lower isocost line (C1) at a point
B. 1
■ The slope of the new isocost line
represents the lower wage relative
Q0
to the rental rate of capital.

0 L L C0/ C1/ C0/ L

0 1 w0 w1 w1
 5-
114

Cost Analysis

■ Types of Costs
■ Short-Run
■ Fixed costs (FC)
■ Sunk costs
■ Short-run variable costs
(VC)
■ Short-run total costs (TC)
■ Long-Run
■ All costs are variable
■ No fixed costs
 5-
115
Total and Variable Costs
C(Q): Minimum total cost $
of producing alternative C(Q) = VC +
levels of output: FC
VC(
C(Q) = VC(Q) + FC Q)

VC(Q): Costs that vary

with output. F
C
FC: Costs that do not vary
0 Q
with output.
 5-
116

Fixed and Sunk Costs

FC: Costs that do not change $
as output changes. C(Q) = VC +
FC
Sunk Cost: A cost that is VC(
forever lost after it has been Q)
paid.

Decision makers should

ignore sunk costs to F
maximize profit or minimize C
losses
Q
 5-
117
Some Definitions
Average Total Cost
ATC = AVC + AFC $
ATC = C(Q)/Q M AT
C CAV
C
Average Variable Cost
AVC = VC(Q)/Q
MR
Average Fixed Cost
AFC = FC/Q

Marginal Cost AF
MC = ΔC/ΔQ C
Q
 5-
118
Fixed Cost
Q0×(ATC-AVC)
M
$ = Q0× AFC C ATC
= Q0×(FC/ Q0) AVC

= FC
ATC
AFC Fixed Cost
AVC

Q0 Q
 5-
119

Variable Cost
Q0×AVC MC
$
ATC
= Q0×[VC(Q0)/ Q0]
AVC
= VC(Q0)

AVC
Variable Cost Minimum of
AVC
Q0 Q
 5-
120

Total Cost
Q0×ATC
MC
$
= Q0×[C(Q0)/ Q0] ATC

= C(Q0)
AVC

ATC

Total Cost Minimum of

ATC

Q0 Q
 5-
+ 121

Cubic Cost Function

■ C(Q) = f + a Q + b Q2 + cQ3

■ Marginal Cost?
■ Memorize:

MC(Q) = a + 2bQ + 3cQ2

■ Calculus:

dC/dQ = a + 2bQ + 3cQ2

 5-
+ An Example 122

■ Total Cost: C(Q) = 10 + Q + Q2

■ Variable cost function:

VC(Q) = Q + Q2
■ Variable cost of producing 2 units:

VC(2) = 2 + (2)2 = 6
■ Fixed costs:

FC = 10
■ Marginal cost function:

MC(Q) = 1 + 2Q
■ Marginal cost of producing 2 units:

MC(2) = 1 + 2(2) = 5
 5-
123

Long-Run Average Costs

$

LRAC

Economie Diseconomie
s s
of Scale of Scale Q
Q*
 5-
+ 124

Economies of Scope

■ C(Q1, 0) + C(0, Q2) > C(Q1, Q2).

■ It is cheaper to produce the two outputs jointly instead of separately.

■ Example:
■ It is cheaper for Time-Warner to produce Internet connections and Instant
Messaging services jointly than separately.
 5-
+ 125

Cost Complementarity

■ The marginal cost of producing good 1 declines as more of good two

is produced:

ΔMC (Q1,Q2) /ΔQ

1 2 < 0.

■ Example:
■ Cow hides and steaks.
 5-
+ Conclusion 126

■ To maximize profits (minimize costs) managers

must use inputs such that the value of marginal of
each input reflects price the firm must pay to
employ the input.
■ The optimal mix of inputs is achieved when the
MRTSKL = (w/r).
■ Cost functions are the foundation for helping to
determine profit-maximizing behavior in future
chapters.