Gsb728 lecture note topic 2a

Economics for Management

GSB728

Topic 3:

Organisation of the Firm

1

Note: This lecture note was prepared based on the teaching material provided

by the publisher of the textbook Principles of Economics.

2

Learning Objectives

1. Short-run costs – How do a firm’s costs vary with output over the short term?

2. Long-run costs – How do a firm’s costs vary with output over the longer term?

3. Revenue - How does a firm’s revenue vary with its level of sales?

4. Revenue, costs and profit – How much output should a firm produce if it wants to maximise its profit?

3

Short-Run and Long-Run

• Short-run is the period of time which at least one factor is fixed, while in the long-run all factors can be varied.

• There are short-run and long-run changes in production due to the fact that in the short run we have:

– Fixed factors of production.

– Variable factors of production.

4

Production with One Variable Input

5Source: Pindyck & Rubinfeld. (2013).

• Total Output changes as the amount of labour varies,

considering that capital is fixed.

• Average Product of Labour (APL) = Output/Labour input = q/L.

• Marginal Product of Labour (MPL) = Change in output . Change in labour input

= Dq/DL

6

Production with One Variable Input (contd.)

Production with One Variable Input (contd.)

7Source: Pindyck & Rubinfeld. (2013).

Law of Diminishing Returns

“When one or more factors are held fixed, there will come a point

beyond which the additional output to be obtained from each additional unit

of the variable factor will progressively diminish”.

8

• Costs and output:

– Relationship between costs and the productivity of factors of production. As the productivity increases, costs decreases.

– Relationship between costs and the price of factors of production. As the price of factors increase, costs increase.

– Note that variable and total costs vary as we modify output, while fixed costs are not related to the level of output.

Short-Run Costs

9

• Total Cost:

– Total Fixed Cost (TFC).

– Total Variable Cost (TVC).

• TVC and the law of diminishing returns.

– Total Cost (TC = TFC + TVC).

Short-Run Costs (contd.)

10

11

Costs for firm X

Source: Sloman et al. (2014).

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TVCOutput(Q)

01234567

TFC($)

1212121212121212

TVC($)

010162128406091

TFC

Total Fixed and Total Variable Costs for “Firm X”

Source: Sloman et al. (2014). 12

Co

sts

($)

Output (Q)

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TVC

TFC

Diminishing marginalreturns set in about here.

Total Fixed and Total Variable Costs for “Firm X” (contd.)


Co

sts

($)

Output (Q)

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TCOutput(Q)

01234567

TFC($)

1212121212121212

TVC($)

010162128406091

TC($)

12222833405272103

TVC

TFC

Total Costs for “Firm X”


Co

sts

($)

Output (Q)

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TC

TVC

TFC

Diminishing marginalreturns set in about here.

Total Costs for “Firm X”


Co

sts

($)

Output (Q)

• Average and Marginal Costs:

– Marginal Cost (DC/DQ):• Marginal cost (MC) and the law of diminishing

returns.

• Relationship between MC and Average Cost Curves.

– Average Cost (C/Q):• Average Fixed Cost (AFC).

• Average Variable Cost (AVC).

• Average (Total) Cost (AC).

– Relationship between AC and MC.

16

Short-Run Costs (contd.)

17Output (Q)

Co

sts

($)

MC

Diminishing marginalreturns set in here.

Marginal Costs

Source: Sloman et al. (2014).

Output (Q)

Co

sts

($)

AFC

MC

Average Costs and Marginal Costs

ATC

AVC

z

y

x

18Source: Sloman et al. (2014).

19

Marginal Product, Average Product and Cost Curves

Source: Frank (2010).

Long-Run Costs• Long run production: we vary the scale of

production.

– ‘Long run’ - all input factors variable.

– ‘Short run’ - at least one factor input fixed.

– Returns to scale:• Constant returns to scale.• Increasing returns to scale.• Decreasing returns to scale.

20

Short run Long run

Input 1 Input 2 Output Input 1 Input 2 Output

3 1 25 1 1 15

3 2 45 2 2 35

3 3 60 3 3 60

3 4 70 4 4 90

3 5 75 5 5 125

Short-run and Long-Run Increases in Output


Economies of Scale– Economies of scale: When increasing the scale of

production leads to a lower cost per unit of output.

– Achieved through:• Specialisation and division of labour.• Indivisibilities.• The ‘container principle’.• Greater efficiency of large machines.• By-products.• Multi-stage production.• Organisational economies.• Spreading overheads.• Financial economies.

22

Diseconomies of Scale– Diseconomies of scale: where cost per unit of

output increase as the scale of production increases.

– Incurred through:• Management problems.• Repetitive work fosters worker alienation.• More complex industrial relations.• Production-line processes and interdependencies.

23

Economies of Scope and Size of the Whole Industry

– Economies of scope: When increasing the range of products produced by a firm, the cost of producing each one is reduced.

– The size of the whole industry:• External economies of scale (a firm’s cost per unit of

output decrease as the size of the whole industry grows).• Industry infrastructure has a direct effect.• External diseconomies of scale (also costs could increase

per unit of output as the size of the whole industry increases).

24

Long-Run Average Cost• Long-run Average Cost:

– Assumptions behind the curve:• Factor prices and quality do not vary.

• State of technology does not vary.

• Firms choose least-cost combination of factors.

– Shape of the LRAC curve.

– Typical LRAC curve.

25

OutputO

Cost

s

Economiesof scale

Constantcosts

Diseconomiesof scale

Long-Run Average Cost Curve

LRAC


Long-Run Costs (contd.)

• Relationship between long-run and short-run average costs:

• The envelope curve!!

27

Co

sts

Output

O

SRAC1 SRAC2SRAC3

SRAC4

SRAC5

Constructing a Long-Run Average Cost Curve from a Sequence of Short-Run Average Cost Curves

LRAC

Examples of short-runaverage cost curves


Revenue

• Definitions:

– Total Revenue: TR = P × Q

– Average Revenue: AR = TR / Q

– Marginal Revenue: MR = TR / Q

29

• When the demand ‘curve’ is horizontal, output does not affect price and the firm must take the price set by the market. The firm is a ‘price-taker’.

• How are the following?:– Average Revenue (AR)

– Marginal Revenue (MR)

– Total Revenue (TR)

30

Revenue (contd.)

O O

AR

, M

R (

$)

Q (millions) Q (hundreds)

S

D

(a) The market (b) The firm

Average Revenue and Marginal Revenue: The Industry and The ‘Price-Taking’ Firm

Pric

e ($

)

Pe

D = AR = MR


0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TRQuantity

(units)

0200400600800

10001200

Price = AR= MR ($)

5555555

TR($)

0100020003000400050006000

Total Revenue (TR) for a Price-Taking Firm

Rev

enue

($)

QuantitySource: Sloman et al. (2014). 32

• When the demand ‘curve’ slopes downwards to the right, the firm can maximise profit by selling larger quantities at lower prices up to a certain point. The firm becomes a ‘price maker’.

• Consider:

– Average Revenue (AR).

– Marginal Revenue (MR).

– Total Revenue (TR).

– Revenue curves and price elasticity of demand.

33

Revenue (contd.)

Revenues for a Firm Facing a Downward-Sloping Demand Curve


-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

Q(units)

1234567

P =AR($)

8765432

TR($)

8141820201814

MR($)

6420024

MR

Ave

rage

, m

argi

nal R

even

ues

($)

Quantity

D = P = AR

Average Revenue and Marginal Revenue Curves

Elastic

Inelastic

Unit elasticity


0

4

8

12

16

20

0 1 2 3 4 5 6 7

TR

Elasticity = -1

Elas

tic

Inelastic

Rev

enue

($)

Total Revenue (TR) Curve and Elasticity

QuantitySource: Sloman et al. (2014). 36

Quantity(units)

1234567

P = AR($)

8765432

TR($)

8141820201814

Revenue, Costs and Profit

• Profit () = TR-TC

• Short-run profit maximisation:

– Using total curves to maximise profit.

– Maximising the difference between TR and TC.

– Profit curve.

37

Revenues, Costs and Profits for a Firm


-8

-4

0

4

8

12

16

20

24

1 2 3 4 5 6 7

Rev

enue

, co

st (

$)

TR

TC

Quantity

Finding Profit-Maximising Production Point

Loss-making areas (TC > TR)

Profit-making area (TR > TC)


-8

-4

0

4

8

12

16

20

24

1 2 3 4 5 6 7

Rev

enue

, co

st,

prof

it ($

)

= P Profit = (TR-TC)

TR

TC

Quantity

Finding profit-maximising production point (contd.)

Profit-making area (TR > TC)

Profit = TR – TC


• Using marginal and average curves to maximise profit:

– Stage 1: Profit maximised where MR = MC.

– Stage 2: Using AR and ATC curves to measure maximum profit.

41

Revenue, Costs and Profit (contd.)

-4

0

4

8

12

16

1 2 3 4 5 6 7 Quantity

MC=DTC/DQ

Profit-maximising output, where MR = MC

Rev

enue

s, c

osts

($)

Profit-yielding output,where MR > MC

MR=DTR/DQ



-4

0

4

8

12

16

1 2 3 4 5 6 7Quantity

MC=DTC/DQ

AR=TR/Q

MR=DTR/DQ

Rev

enue

s, c

osts

($)



1 2 3 4 5 6 7

-4

0

4

8

12

16

Quantity

MC = DTC/DQ

AC = TC/Q

AR = TR/Q

Total profit =($6-4.5) x 3 = $4.50

MR = DTR/DQ

Finding the Profit-Maximising Production Point with Average Analysis

Rev

enue

s, c

osts

($)

Profit is maximised where The difference between ARand AC curves is maximised

PROFIT4.56.0


LOSS

OQuantity

MCATC

AR

MR

AC

AR

Loss-minimising production point where MR=MC, difference between ATC and AR minimised

Rev

enue

s, c

osts

($)

Loss-minimising output

Q


O Quantity

AR

AVC

ACP

Shut-Down point Where P = AVCR

even

ues,

cos

ts (

$) If variable cost per unit (AVC) is abovethe selling price per unit (P), there is nomargin made towards the recovery offixed costs. At this point, the firm could‘shut down’ production and minimise its loss, ATC – AR.

LOSS

QSource: Sloman et al. (2014). 46

References

Frank, R. (2010). Microeconomics and Behaviour (8th ed.). New York: McGraw-Hill/Irwin.

Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business.

Pindyck, R. and Rubinfeld, D. (2013). Microeconomics (8th ed.). New Jersey: Pearson.

47

References (contd.)

Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson.

48

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