Managerial Economics

Laurice M. Capila
 Table of Contents

Module 8: Introduction to Market and Pricing Strategies 69

Introduction 69
Learning Objectives 70
Lesson 1. Price Concepts 70
Lesson 2. Types of Pricing Objectives 71
Lesson 3. Price Determinants 73
Assessment Task 75
Summary 75
References 76

Module 9: Market 77
Introduction 77
Learning Objectives 77
Lesson 1. What Is a Market? 78
Lesson 2. Understanding Markets 78
Lesson 3. Types of Markets 79
Lesson 4. How Markets Work 80
Lesson 5. Different Market Structures 80
Assessment Task 83
Summary 84
References 85

Module 10: The Production Function 86

Introduction 86
Learning Objectives 86
Lesson 1. Defining the Production Function 87
Lesson 2. The Law of Diminishing Returns 88
Lesson 3. The Law of Diminishing Returns and Average Cost 89
Lesson 4. Inputs and Outputs of the Function 90
Assessment Task 92
Summary 93
References 93
 MODULE 8
INTRODUCTION TO MARKET AND
PRICING STRATEGIES

Introduction

Pricing is an important, if not the most important function of all enterprises.

Since every enterprise is engaged in the production of some goods or/and service. Incurring
some expenditure, it must set a price for the same to sell it in the market. It is only in extreme
cases that the firm has no say in pricing its product; because there is severe or rather perfect
competition in the market of the good happens to be of such public significance that its price
is decided by the government. In an overwhelmingly large number of cases, the individual
producer plays the role in pricing its product.

It is said that if a firm were good in setting its product price it would certainly flourish in the
market. This is because the price is such a parameter that it exerts a direct influence on the
products demand as well as on its supply, leading to firm’s turnover (sales) and profit. Every
manager endeavors to find the price, which would best meet with his firm’s objective. If the
price is set too high the seller may not find enough customers to buy his product. On the other
hand, if the price is set too low the seller may not be able to recover his costs. There is a need
for the right price further, since demand and supply conditions are variable over time what is
a right price today may not be so tomorrow hence, pricing decision must be reviewed and
reformulated from time to time.

69
 Learning Outcomes

At the end of this module, students should be able to:

1. Explain and interpret what is price;

2. Analyze and determine the different price concepts;

3. Identify the types of pricing objectives;

4. Discuss the salient features of price;

4. Examine the major determinants of price of a product.

Lesson 1. Price Concepts (Nitisha, n d)

Price denotes the exchange value of a unit of good expressed in terms of money. Price
of a well-defined product varies over the types of the buyers, place it is received, credit sale
or cash sale, time taken between final production and sale, etc. It should be obvious to the
readers, that the price difference on account of the above four factors are more significant.
The multiple prices is more serious in the case of items like cars refrigerators, coal, furniture
and bricks and is of little significance for items like shaving blade, soaps, tooth pastes, creams
and stationeries. Differences in various prices of any good are due to differences in transport
cost, storage cost accessories, interest cost, intermediaries’ profits etc. Once can still
conceive of a basic price, which would be exclusive of all these items of cost and then
rationalize other prices by adding the cost of special items attached to the particular
transaction, in what follows we shall explain the determination of this basis price alone and
thus resolve the problem of multiple prices.

Pricing can be defined as a process of determining the value that is received by an

organization in exchange of its products or services. It acts as a crucial element of generating
revenue for an organization. Therefore, the pricing decisions of an organization have a direct
impact on its success.

70
The price of a product is influenced by a number of factors, such as manufacturing cost,
competition, market conditions, and quality of the product. An organization, while setting the
prices of its products, needs to ensure that prices must cover costs incurred for producing
products and profit margins. If the price of a product does not cover costs, then financial
resources of the organization would exhaust, which would ultimately result in the failure of
business.

Lesson 2. Types of Pricing Objectives (Nitisha, n d)

An organization uses a number of methods and strategies to determine the prices of

its products. In economic terms, an efficient pricing strategy is the one that aims at gaining
consumer surplus to the producer. The pricing strategy of an organization should be realistic,
flexible, and profitable.

Moreover, it should be focused on achieving the financial goals of an organization. Some of

the most common pricing strategies used by an organization include differential pricing,
promotional pricing, product line pricing, and psychological pricing.

Setting prices as per the level where marginal revenue is equal to marginal cost is called
marginality rule. However, there is evidence produced by some researchers that most of the
organizations do not follow marginality rules rather they follow different pricing methods and
strategies based on different market conditions. Pricing decisions play an important role in an
organization since they help in generating revenue. Pricing contributes to the success or
failure of the organization’s marketing strategy. Price is also called a demand regulator.
Setting the prices involves a deep understanding of factors that affect the marketing
environment. Every organization sets the prices of its products for fulfilling various objectives.
Let us discuss the three types of pricing objectives in brief:

i. Profit-oriented Objectives: It includes the following objectives below:

a. Maximizing Profit: It implies that prices are set in such a way that they help in achieving
maximum profit. Profit maximization is more beneficial in the long run as compared to short
run. For instance, an organization selling a new product tries to build a customer base by

71
selling the product at low prices in the short run. This helps the organization to gain profit in
the long run by winning loyal customers.

b. Achieving a Target Return: It refers to earn an adequate rate of return on the investment
done by an organization in manufacturing a product. The main focus of marketers is on
maintaining a specific return on sales or investment. This is done by adding extra cost to the
product for earning a desired profit.

ii. Sales-oriented Objectives: Include the following objectives:

a. Increasing the sales volume: It implies sales expansion by giving discounts to customers.
In the short run, an organization might be ready to bear losses by reducing the prices to
increase the sales volume. For instance the hotel industry faces low demand during off–
season; therefore, it prefers to decrease its prices and offers discounts to increase sales.

b. Increasing or maintaining market share: It plays a crucial role in the success of an

organization. The organization tries to gain market share by lowering down the prices as
compared to its competitors.

iii. Status quo-oriented Objectives: Includes the following objectives:

a. Stabilizing the Prices: It prevents price wars between competitors. The prices are stabilized
in those industries where product is standardized in nature. The stabilization of the prices
helps in maintaining the demand and reducing competitive threats.

b. Meeting the Competition: It implies that the changes made in the price of a product help an
organization to gain competitive advantage. Sometimes, the organization also tries to
neutralize competitive pressures by price movement.

c. Determining prices according to consumer’s paying capacity: It Implies that the purchasing
power of the consumers should be taken into consideration while setting prices. The sales of
an organization depend entirely upon the purchasing power of consumers.

72
An organization also adopts pricing objectives to promote developmental activities in the
society. For instance, an organization may reduce the prices of a product for the low-income
sections of the society. Thus, the pricing objectives play a significant role in the overall growth
of the organization.

Lesson 3. Price Determinants (Siddharth, n d)

However, a buyer does not buy a physical product alone; he/she also acquires certain
services and benefits along with the product e.g. free home delivery, repair facilities, credit
facilities; warranty/ guarantee etc. Therefore, price is the amount of money which is needed
to acquire a product and its accompanying services and benefits.

Following salient features of price might be observed:

(i) Price is the only element of marketing-mix that generates revenue for the firm; other
elements of marketing-mix viz. product, place (i.e. channels or distribution) and promotion –
give rise to costs.

(ii) Price is the most flexible element; as it can be adjusted quickly. Other elements viz.
product, place and promotion are less flexible to adjust.

(iii) Price is a silent information provider. It helps the customer judge product benefits. In fact,
higher prices are taken as an indicator of higher product quality; especially when the product
is new and it is difficult to measure product benefits objectively.

Major Determinants of Price of a Product

While pricing a product, the important factors to be considered are usually the following:

(1) Cost of Production:

The price of the product must be so fixed as to recover the full cost of production from the
price charged; otherwise all production activities will have to be stopped, in the long-run.

73
(2) Profit-Margin Desired:
The price of the product should include a reasonable (or targeted) margin of profits; to ensure
profitable selling.

(3) Competitors’ Pricing:

In the present-day competitive marketing world, no businessman could ignore the pricing
policies adopted by competitors; while doing the pricing his own product. In any case, the
price of the product to be charged by a manufacturer must not be substantially different from
the prices charged by competitors for similar types of products.

(4) Government’s Policy of Price-Control:

Where, in particular cases, the Government has fixed maximum retail prices; the pricing policy
followed by a manufacturer must have to be in tune with governmental regulations, in that
regard.

(5) Consumers’ Buying Capacity:

Since under the modern marketing concept, a product is made according to the needs and
preferences of target consumers; the pricing of the product must be done in a manner so as
to suit the pocket of the target consumers. In case otherwise, the product may not appeal to
them; and selling the product may become a ‘big’ problem.

(6) Product-Life Cycle Stage:

While pricing a product, the manufacturer must pay attention to the particular stage of the
product-life cycle; which a product is passing through. For example, price of the product must
be kept low during introductory stage; it could be slightly raised at the growth stage and finally
at the saturation point, the price must be again lowered.

(7) Demand-Supply Conditions:

Whether the price of the product should be high or low; would much depend on the demand-
supply conditions relevant to the product in question. If demand is more than supply; even a
high price might work well. On the contrary, when demand is less than supply, only a low price
could attract the consumers.

74
 Assessment Task 8

Think Critically

 There are factors/determinants influencing the price of a product.

Which is the MOST and LEAST important among the factors
influencing the price of a product and why? Cite 5 examples each.

Summary

Price denotes the exchange value of a unit of good expressed in terms of

money. Price of a well-defined product varies over the types of the buyers, place it is received,
credit sale or cash sale, time taken between final production and sale, etc. An organization
uses a number of methods and strategies to determine the prices of its products. In economic
terms, an efficient pricing strategy is the one that aims at gaining consumer surplus to the
producer. The pricing strategy of an organization should be realistic, flexible, and profitable.
There are three types of pricing objectives: profit-oriented, sales-oriented, and status quo-
oriented objectives. The major determinants of price of a product are cost of production, profit-
margin desired, competitors’ pricing, government’s policy of price-control, consumers’ buying
capacity, product-life cycle stage and demand-supply conditions:

References

75
Nitisha (n,d). “Pricing Process: Concept of Product Pricing & Pricing Objectives”.
Retrieved from https://www.economicsdiscussion.net/price/pricing-process-
concept-of-product-pricing-pricing-objectives/3837

Siddharth (n,d). “Price of a Product: Definition and Determinants”. Retrieved from

https://www.yourarticlelibrary.com/product-pricing/price-of-a-product-
definition-and- determinants/69576

MODULE 9
76
 MARKET

Introduction

Market is a place where buyer and seller meet, goods and services are offered
for the sale and transfer of ownership occurs. A market may be also defined as the demand
made by a certain group of potential buyers for a good or service. The former one is a narrow
concept and later one, a broader concept.

Economists describe a market as a collection of buyers and sellers who transact over a
particular product or product class (the housing market, the clothing market, the grain market
etc.). For business purpose we define a market as people or organizations with wants (needs)
to satisfy, money to spend, and the willingness to spend it.

Broadly, market represents the structure and nature of buyers and sellers for a
commodity/service and the process by which the price of the commodity or service is
established. In this sense, we are referring to the structure of competition and the process of
price determination for a commodity or service. The determination of price for a commodity or
service depends upon the structure of the market for that commodity or service (i.e.,
competitive structure of the market). Hence the understanding on the market structure and
the nature of competition are a pre-requisite in price determination.

Learning Outcomes

At the end of this module, students should be able to:

1. Identify what market is in both narrow and broader concept;

2. Analyze and understand the markets;

3. Distinguish the different types of market;

77
4. Discuss how markets work;

5. Interpret and contrast the different market structures.

Lesson 1. What Is a Market? (Kenton, 2020)

A market is a place where two parties can gather to facilitate the exchange of goods
and services. The parties involved are usually buyers and sellers. The market may be physical
like a retail outlet, where people meet face-to-face, or virtual like an online market, where there
is no direct physical contact between buyers and sellers.

The term market also takes on other forms. For instance, it may refer to the place where
securities are traded—the securities market. Alternatively, the term may also be used to
describe a collection of people who wish to buy a specific product or service such as the
Brooklyn housing market or as broad as the global diamond market.

Lesson 2. Understanding Markets (Kenton, 2020)

Technically speaking, a market is any place where two or more parties can meet to
engage in an economic transaction—even those that don't involve legal tender. A market
transaction may involve goods, services, information, currency, or any combination of these
that pass from one party to another.

Markets may be represented by physical locations where transactions are made. These
include retail stores and other similar businesses that sell individual items to wholesale
markets selling goods to other distributors. Or they may be virtual. Internet-based stores and
auction sites such as Amazon and eBay are examples of markets where transactions can
take place entirely online and the parties involved never connect physically.

Lesson 3. Types of Markets (Kenton, 2020)

78
 Markets vary widely for a number of reasons, including the kinds of products sold,
location, duration, size, and constituency of the customer base, size, legality, and many other
factors. Aside from the two most common markets—physical and virtual—there are other
kinds of markets where parties can gather to execute their transactions.

Black Market
A black market refers to an illegal market where transactions occur without the
knowledge of the government or other regulatory agencies. Many black markets exist in order
to circumvent existing tax laws. This is why many involve cash-only transactions or other forms
of currency, making them harder to track.

Many black markets exist in countries with planned or command economies—wherein the
government controls the production and distribution of goods and services—and in countries
that are developing. When there is a shortage of certain goods and services in the economy,
members of the black market step in and fill the void.

Black markets can also exist in developed economies as well. This is prevalent when prices
control the sale of certain products or services, especially when demand is high. Ticket
scalping is one example. When demand for concert tickets are high, scalpers will step in and
sell them at inflated prices on the black market.

Auction Market
An auction market brings many people together for the sale and purchase of specific
lots of goods. The buyers or bidders try to top each other for the purchase price. The items
up for sale end up going to the highest bidder.

The most common auction markets involve livestock and homes, or websites like eBay where
bidders may bid anonymously to win auctions.

Financial Market

79
 The blanket term financial market refers to any place where securities, currencies,
bonds, and other securities are traded between two parties. These markets are the basis of
capitalist societies, and they provide capital formation and liquidity for businesses. They can
be physical or virtual.
The financial market includes the stock market or exchanges such as the New York Stock
Exchange, Nasdaq, the LSE, and the TMX Group. Other kinds of financial markets include
the bond market and the foreign exchange market, where people trade currencies.

Lesson 4. How Markets Work (Kenton, 2020)

Markets are arenas in which buyers and sellers can gather and interact. In general,
only two parties are needed to make a trade, at minimum a third party is needed to introduce
competition and bring balance to the market. As such, a market in a state of perfect
competition, among other things, is necessarily characterized by a high number of active
buyers and sellers.

The market establishes the prices for goods and other services. These rates are determined
by supply and demand. Supply is created by the sellers, while demand is generated by
buyers. Markets try to find some balance in price when supply and demand are themselves
in balance. But that balance can in itself be disrupted by factors other than price including
incomes, expectations, technology, the cost of production, and the number of buyers and
sellers in the market.

Markets may emerge organically or as a means of enabling ownership rights over goods,
services, and information. When on a national or other more specific regional level, markets
may often be categorized as “developed” markets or “developing” markets, depending on
many factors, including income levels and the nation or region’s openness to foreign trade.

Lesson 5. Different Market Structures (www.toppr.com, n. d.)

As we have seen, in economics the definition of a market has a very wide scope. So
understandably not all markets are the same or similar. We can characterize market structures

80
based on the competition levels and the nature of these markets. Let us study the four basic types
of market structures.

A variety of market structures will characterize an economy. Such market structures essentially
refer to the degree of competition in a market.
There are other determinants of market structures such as the nature of the goods and products,
the number of sellers, number of consumers, the nature of the product or service, economies of
scale etc. We will discuss the four basic types of market structures in any economy.

One thing to remember is that not all these types of market structures actually exist. Some of
them are just theoretical concepts. But they help us understand the principles behind the
classification of market structures.

Figure 9.1 Market Structures (www.toppr.com, n. d.)

1) Perfect Competition
In a perfect competition market structure, there are a large number of buyers and sellers.
All the sellers of the market are small sellers in competition with each other. There is no one big
seller with any significant influence on the market so all the firms in such a market are price
takers. There are certain assumptions when discussing the perfect competition. This is the
reason a perfect competition market is pretty much a theoretical concept.
These assumptions are as follows,
 The products on the market are homogeneous, i.e. they are completely identical
 All firms only have the motive of profit maximization
 There is free entry and exit from the market, i.e. there are no barriers

81
  And there is no concept of consumer preference

2) Monopolistic Competition
This is a more realistic scenario that actually occurs in the real world. In monopolistic competition,
there are still a large number of buyers as well as sellers. But they all do not sell homogeneous
products. The products are similar but all sellers sell slightly differentiated products.

Now the consumers have the preference of choosing one product over another. The sellers can
also charge a marginally higher price since they may enjoy some market power. So the sellers
become the price setters to a certain extent.

For example, the market for cereals is a monopolistic competition. The products are all similar
but slightly differentiated in terms of taste and flavors. Another such example is toothpaste.

3) Oligopoly
In an oligopoly, there are only a few firms in the market. While there is no clarity about
the number of firms, 3-5 dominant firms are considered the norm. So in the case of an oligopoly,
the buyers are far greater than the sellers. The firms in this case either compete with another to
collaborate together. They use their market influence to set the prices and in turn maximize their
profits. So the consumers become the price takers. In an oligopoly, there are various barriers to
entry in the market, and new firms find it difficult to establish themselves.

4) Monopoly
In a monopoly type of market structure, there is only one seller, so a single firm will control
the entire market. It can set any price it wishes since it has all the market power. Consumers do
not have any alternative and must pay the price set by the seller. Monopolies are extremely
undesirable. Here the consumer loses all their power and market forces become irrelevant.
However, a pure monopoly is very rare in reality.

Assessment Task 9

82
Answer the following questions.

1. In the year 2000, the town of Cuenca in Batangas did not have
mountain resorts. Because of the influx of mountaineers to Mount
Maculot during weekends, there are now five resorts operating in the
said town and more than 10 resorts in nearby towns. All these resorts
offer the same amenities—swimming pools and affordable lodgings.
What feature of competitive markets does this demonstrate? Explain
your answer.
2. Identify a firm that operates in your community that you think has a
significant amount of market power. Explain why you chose this firm.
3. At one time, PLDT had a great deal of monopoly power and earned
large profits. The growth in the use of cellular technology caused PLDT
to lose money. What happened to PLDT's monopoly power?
4. There are probably 20 or more brands of laundry detergent in the
grocery store where your family shops, Make a list of different ways in
which producers try to differentiate one detergent brand from Why can
some brands have prices that are much higher than the price of others
and still sell well?
5. Why would a new oil refinery have difficulty competing successfully
with large oil refiners such as Chevron, Shell Oil, or ExxonMobil?

Summary

83
 Market is a place where buyer and seller meet, goods and services are offered
for the sale and transfer of ownership occurs. A market may be also defined as the demand
made by a certain group of potential buyers for a good or service. The former one is a narrow
concept and later one, a broader concept.

Markets vary widely for a number of reasons, including the kinds of products sold, location,
duration, size, and constituency of the customer base, size, legality, and many other factors.
Aside from the two most common markets—physical and virtual—there are other kinds of
markets where parties can gather to execute their transactions.

Markets may emerge organically or as a means of enabling ownership rights over goods,
services, and information. When on a national or other more specific regional level, markets
may often be categorized as “developed” markets or “developing” markets, depending on
many factors, including income levels and the nation or region’s openness to foreign trade.
To better understand the market, there are four different market structures: perfect
competition, monopolistic competition, oligopoly and monopoly.

References

Kenton W. (2020, April 7). “Market”. Retrieved from

https://www.investopedia.com/terms/m/market.

“Types of Market Structures”. Retrieved from

https://www.toppr.com/guides/business-economics/meaning-and-
types-of-markets/types-of-market-structures/

MODULE 10
THE PRODUCTION FUNCTION
84
 Introduction

In economics, a production function relates physical output of a production

process to physical inputs or factors of production. It is a mathematical function that relates
the maximum amount of output that can be obtained from a given number of inputs – generally
capital and labor. The production function, therefore, describes a boundary or frontier
representing the limit of output obtainable from each feasible combination of inputs.

Learning Outcomes

At the end of this module, students should be able to:

1. Distinguish what the production function is;

2. Analyze and determine production function by using some common examples;

3. Identify the law of diminishing returns;

4. Examine the relation of law of diminishing returns and average cost;

5. Understand the inputs and outputs of the function.

85
Lesson 1. Defining the Production Function
(www.courses.lumenlearning.com, n d)

The production function relates the maximum amount of output that can be obtained
from a given number of inputs. Firms use the production function to determine how much
output they should produce given the price of a good, and what combination of inputs they
should use to produce given the price of capital and labor. When firms are deciding how much
to produce they typically find that at high levels of production, their marginal costs begin
increasing. This is also known as diminishing returns to scale – increasing the quantity of
inputs creates a less-than-proportional increase in the quantity of output. If it weren’t for
diminishing returns to scale, supply could expand without limits without increasing the price of
a good.

Increasing marginal costs can be identified using the production function. If a firm has a
production function Q=F(K,L) (that is, the quantity of output (Q) is some function of capital (K)
and labor (L)), then if 2Q<F(2K,2L), the production function has increasing marginal costs and
diminishing returns to scale. Similarly, if 2Q>F(2K,2L), there are increasing returns to scale,
and if 2Q=F(2K,2L), there are constant returns to scale.

Examples of Common Production Functions

One very simple example of a production function might be Q=K+L, where Q is the
quantity of output, K is the amount of capital, and L is the amount of labor used in production.
This production function says that a firm can produce one unit of output for every unit of capital
or labor it employs. From this production function we can see that this industry has constant
returns to scale – that is, the amount of output will increase proportionally to any increase in
the amount of inputs.

Another common production function is the Cobb-Douglas production function. One example
of this type of function is Q=K 0.5L0.5. This describes a firm that requires the least total number
of inputs when the combination of inputs is relatively equal. For example, the firm could
produce 25 units of output by using 25 units of capital and 25 of labor, or it could produce the
same 25 units of output with 125 units of labor and only one unit of capital.

86
Finally, the Leontief production function applies to situations in which inputs must be used in
fixed proportions; starting from those proportions, if usage of one input is increased without
another being increased, output will not change. This production function is given by
Q=Min(K,L). For example, a firm with five employees will produce five units of output as long
as it has at least five units of capital.

Lesson 2. The Law of Diminishing Returns

(www.courses.lumenlearning.com, n.d.)

In economics, diminishing returns (also called diminishing marginal returns) is the

decrease in the marginal output of a production process as the amount of a single factor of
production is increased, while the amounts of all other factors of production stay constant.
The law of diminishing returns states that in all productive processes, adding more of one
factor of production, while holding all others constant (“ceteris paribus”), will at some point
yield lower per-unit returns. The law of diminishing returns does not imply that adding more of
a factor will decrease the total production, a condition known as negative returns, though in
fact this is common.

Figure 10. 1 Diminishing Returns (www.courses.lumenlearning.com, n.d.)

87
For example, the use of fertilizer improves crop production on farms and in gardens; but at
some point, adding more and more fertilizer improves the yield less per unit of fertilizer, and
excessive quantities can even reduce the yield. A common sort of example is adding more
workers to a job, such as assembling a car on a factory floor. At some point, adding more
workers causes problems such as workers getting in each other’s way or frequently finding
themselves waiting for access to a part. In all of these processes, producing one more unit of
output will eventually cost increasingly more, due to inputs being used less and less
effectively.

This increase in the marginal cost of output as production increases can be graphed as the
marginal cost curve, with quantity of output on the x axis and marginal cost on the y axis. For
many firms, the marginal cost curve will initially be downward sloping, representing added
efficiency as production increases. If the law of diminishing returns holds, however, the
marginal cost curve will eventually slope upward and continue to rise, representing the higher
and higher marginal costs associated with additional output.

Lesson 3. The Law of Diminishing Returns and Average Cost

(www.courses.lumenlearning.com, n. d.)

The average total cost of production is the total cost of producing all output divided by
the number of units produced. For example, if the car factory can produce 20 cars at a total
cost of $200,000, the average cost of production is $10,000. Average total cost is interpreted
as the the cost of a typical unit of production. So in our example each of the 20 cars produced
had a typical cost per unit of $10,000. Average total cost can also be graphed with quantity of
output on the x axis and average cost on the y-axis.

What will this average total cost curve look like? In the short run, a firm has a set amount of
capital and can only increase or decrease production by hiring more or less labor. The fixed
costs of capital are high, but the variable costs of labor are low, so costs increase more slowly
than output as production increases. As long as the marginal cost of production is lower than
the average total cost of production, the average cost is decreasing. However, as marginal
costs increase due to the law of diminishing returns, the marginal cost of production will
eventually be higher than the average total cost and the average cost will begin to increase.
The short run average total cost curve (SRAC) will therefore be U-shaped for most firms.

88
 Figure 10. 2 The long-run average cost curve (LRAC) (www.courses.lumenlearning.com, n.d.)

The long-run average cost curve (LRAC) depicts the cost per unit of output in the long run—
that is, when all productive inputs’ usage levels can be varied. The typical LRAC curve is also
U-shaped but for different reasons: it reflects increasing returns to scale where negatively-
sloped, constant returns to scale where horizontal, and decreasing returns (due to increases
in factor prices) where positively sloped.

Lesson 4. Inputs and Outputs of the Function

(www.courses.lumenlearning.com, n. d.)
In the basic production function, inputs are typically capital and labor and output is
whatever good the firm produces. A production function relates the input of factors of
production to the output of goods. In the basic production function inputs are typically capital
and labor, though more expansive and complex production functions may include other
variables such as land or natural resources. Output may be any consumer goods produced
by a firm. Cars, clothing, sandwiches, and toys are all examples of output.

Capital refers to the material objects necessary for production. Machinery, factory space, and
tools are all types of capital. In the short run, economists assume that the level of capital is
fixed – firms can’t sell machinery the moment it’s no longer needed, nor can they build a new

89
factory and start producing goods there immediately. When looking at the production function
in the short run, therefore, capital will be a constant rather than a variable. Although in reality
a firm may own the capital that it uses, economists typically refer to the ongoing cost of
employing capital as the rental rate because the opportunity cost of employing capital is the
income that a firm could receive by renting it out. Thus, the price of capital is the rental rate.

Labor refers to the human work that goes into production. Typically economists assume that
labor is a variable factor of production; it can be increased or decreased in the short run in
order to produce more or less output. The price of labor is the prevailing wage rate, since
wages are the cost of hiring an additional unit of capital.

The marginal product of an input is the amount of output that is gained by using one additional
unit of that input. It can be found by taking the derivative of the production function in terms of
the relevant input. For example, if the production function is Q=3K+2L (where K represents
units of capital and L represents units of labor), then the marginal product of capital is simply
three; every additional unit of capital will produce an additional three units of output. Inputs
are typically subject to the law of diminishing returns: as the amount of one factor of production
increases, after a certain point the marginal product of that factor declines.

Assessment Task 10

90
Think Critically

1. The law of diminishing returns indicates that:

a. as extra units of a variable resource are added to a fixed resource the marginal
product will decline beyond some point.
b. because of economies and diseconomies of scale a competitive firm's long-run
average cost curve will be U-shaped.
c. the demand for goods produced by purely competitive industries is down
sloping.
d. beyond some point the extra utility derived from additional units of a product will
yield the consumer smaller and smaller extra amounts of satisfaction.
Why do marginal costs tend to rise, and marginal benefits tend to fall?
2. Is it possible to avoid Diminishing Marginal Return? Why?
3. Suppose that the Law of Diminishing Returns sets in immediately (that is, there
is no range of output over which the Division of Labor holds). What would the short
run marginal cost, average cost, and average variable cost curves look like?
Explain.
4. Which situation below describes the increasing returns stage of the production
function?
a. Hiring one more tailor results in three more suits produced per hour.
b. Hiring one more baker results in the same output because there is now less than
one oven available per baker.
c. Buying one more office computer causes there to be more computers than
workers.
d. Extending the workday results in more tired and less productive workers

Summary

91
 The production function relates the maximum amount of output that can be
obtained from a given number of inputs. Firms use the production function to determine how
much output they should produce given the price of a good, and what combination of inputs
they should use to produce given the price of capital and labor. The law of diminishing returns
states that in all productive processes, adding more of one factor of production, while holding
all others constant (“ceteris paribus”), will at some point yield lower per-unit returns. The
average total cost of production is the total cost of producing all output divided by the number
of units produced. In the basic production function, inputs are typically capital and labor and
output is whatever good the firm produces. A production function relates the input of factors
of production to the output of goods

Reference

“The Production Function | Boundless Economics” (n d).

Retrieved from https://courses.lumenlearning.com/boundless-

economics/chapter/the-production-function

92