CHAPTER THREE

THEORY OF PRODUCTION AND COSTS

 The Theory and Estimation of Production

o Whatever be the objective of business firms, achieving

optimum efficiency in production or minimizing the cost of
production is one of the prime concerns of managers today.

o In fact, the very survival of the firms in a competitive

market depend on their ability to produce at a competitive
cost.

o Production means transforming inputs (Labor, land,

Machines, Raw materials, entrepreneur etc.) into an output
(goods and services).
 SOME BASIC CONCEPTS
❖Input and Output:
 An input is a factor of production (economic resources) that goes
into the process of production.
1. Land, (rent): refers to both the surface of the earth and all the
natural gifts carried by land and usable in the production of goods
and services. ,
2. Labor, (wage/salary): all physical and mental talents of people in
production and distribution of goods and services
3. Capital,( interest rate): all man-made resources and all the wealth
with the exception of land
4. Entrepreneur, (profit): refers to a special type of human talent that
helps organize and manage factors of production to produce goods
and services with associated risk of losses.
 BASIC CONCEPTS---

 Fixed inputs remains fixed (constant) up to certain level of output.

 Variable inputs change with the change in output.

❖ An output : is any good or service that comes out of the

production process.

 Short run refers to a period of time in which supply of certain

inputs i.e., plant, building and machinery etc. is fixed or inelastic.

 Long run refers to a time period in which the supply of all the
inputs is elastic or variable.
 PRODUCTION FUNCTION

❖ The production function

➢ A production function defines the r/nship b/n inputs and the maximum amount that
can be produced within a given time period with a given technology.
➢ Mathematically, the production function can be expressed as: Q=f(k, L)
➢ The common production function is Cobb-Douglas: Q= (AKα L1- α)
Where, Q is the level of output, K is units of capital, L is units of labor, and F(), or A
represents the production technology
• While discussing production, it is important to distinguish between two time frames.
• The short-run production function describes the maximum quantity of good or
service that can be produced by a set of inputs, assuming that at least one of the inputs
is fixed at some level.
• The long-run production function describes the maximum quantity of good or
service that can be produced by a set of inputs, assuming that the firm is free to adjust
the level of all inputs (i.e., no more fixed inputs).
Production in the Short Run
 SHORT RUN PRODUCTION---
• Consider the two input production function Q=f(X,Y) in which input
X is variable and input Y is fixed at some level.
• The average product and marginal product of input X is defined as
and , respectively.
• Given,

AP MP

- -
8 8
9 10
9.6 11
9.75 10
9.2 8
Production Curves in the Short Run
•If MP is positive then TP is
increasing.
•If MP is negative then TP is
decreasing.
•TP reaches a maximum when
MP=0
•If MP > AP then AP is rising.
•If MP < AP then AP is falling.
•MP=AP when AP is
maximized.
▪ The Law of Diminishing
Marginal Returns:
As additional units of a
variable input are combined
with a fixed input, at some
point the extra output (i.e.,
MP) starts to diminish. It is a
short run phenomenon
Short run Curves
Stages of Production
 Stages of Production---
o Stage I: From zero units of the variable input to where AP is maximized.
✓ Law of diminishing return to scale operates in this stage
✓ is excess capital for the very limited variable input (labor).
✓ is known as extensive margin
✓ labor is underemployed and capital is underutilized.
o Stage II: From the maximum AP to MP=0 (TP at its maximum/saturation point)
➢ APL is more than the MPL curve.
➢ Stage where rational producer advised to produce.
o Stage III: From where MP=0 onwards
✓ it is the stage of production where the marginal contribution of any additional
labor becomes negative or
✓ it is the level of production where the TP starts to decline with one more
labor employed
✓ labor is over employed and capital is over utilized.
✓ This stage of production is known as intensive margin.
 LAW OF DIMINISHING RETURNS

• Law of diminishing returns (law of variable proportions) has played a

vital role in the modern economics theory.
• The law can be stated as follows: “When total output or production of
a commodity is increased by adding units of a variable input (say labor)
while the quantities of other inputs (land, equipment, etc) are held
constant, the increase in total production becomes after some point,
smaller and smaller, i.e. first the marginal product and then the average
product of that factor will diminish”.
• The concept of variable proportions is a short-run phenomenon
 LAW OF DIMINISHING RETURNS AND MANAGERIAL
DECISIONS
• A Rational producer will never choose to produce in stage III where
Marginal Productivity of variable factor is negative. It should stop at the end
of the second stage where Marginal Productivity of the variable factor is
Zero, because at this point the producer is maximizing the total output and
will; thus, be making the maximum use of the available variable factors.
• A producer will also not choose to produce in Stage I where he/she won’t
be making full use of the available resources as the average product of the
variable factor continues to increase in this stage.
• A producer will like to produce in the second stage. At this stage marginal
and Average product of the variable factor falls but the total product of the
variable factor is maximum at the end of this stage. Thus, stage II represents
the stage of rational producer decision.
 LAW OF RETURNS TO SCALE
• The Law of returns to scale explains how a simultaneous and proportionate
increase in all the inputs affects the total output at its various levels (Cobb-
Douglas case)
• An increase in the scale means that all inputs or factors are changing or
increased in the same proportion.
• The Law of returns to scale is a long-run phenomena.
• When a firm expands, its scale increases all its inputs proportionally, then
technically there are three possibilities:
I. The total output may increase proportionately (Constant returns to scale, RTS=1)
II. The total output may increase more than proportionately (Increasing returns to scale, RTS > 1)

III. The total output may increase less than proportionately (Decreasing returns to scale, RTS < 1).
 OUTPUT ELASTICITY AND RETURNS TO SCALE
• Output elasticity (εQ) is the percentage change in output associated with a 1
percent change in all inputs and a practical means for returns to scale estimation.
• Letting X represent all input factors (labor, capital, energy, etc):
εQ = Percentage Change in Output (Q)/ Percentage Change in All Inputs (X)

= ∆Q/Q/ ∆X/X = ∆Q/∆X X/Q

❖Thus, returns to scale can be analyzed by examining the relationship between the
rate of increase in inputs and the quantity of output produced.
 RETURNS TO SCALE ESTIMATION
• In most instances, returns to scale can be easily estimated. For example, assume that
all inputs in the unspecified production function Q= f(X,Y, Z) are increased by using
the constant factor k, where k= 1.01 for a 1 percent increase, k= 1.02 for a 2
percent increase, and so on.
• Then, the production is:
hQ = f(kX, kY, kZ),
where his the proportional increase in Q resulting from a k-fold increase in each input factor.

➢ From the above Equation, it is evident that the following relationships hold:
✓ If h> k, then the percentage change in Q is greater than the percentage change in the
inputs, εQ > 1, and the production function exhibits increasing returns to scale.
✓ If h= k, then , εQ = 1, and the production function exhibits constant returns to scale.
✓ If h < k, then εQ < 1, and the production function exhibits decreasing returns to scale.
 RETURNS TO SCALE ESTIMATION---

• For certain production functions, called homogeneous production

functions, when each input factor is multiplied by a constant k, the
constant can be completely factored out of the production function
expression.
• Following a k-fold increase in all inputs, the production function takes
the form:
hQ= kn f(X,Y,Z).
• The exponent n provides the key to returns-to-scale estimation.
➢If n = 1, then h = k and the function exhibits constant returns to scale.
➢If n > 1, then h > k, indicating increasing returns to scale
➢If n < 1 indicates h < k and decreasing returns to scale.
 LAW OF RETURNS TO SCALE AND MANAGERIAL DECISIONS

• Production may be carried on a small scale or o a large scale by a firm.

• When a firm expands its size of production by increasing all the
factors, it secures certain advantages known as economies of
production/scale.
• Economies of scale can be grouped into internal economies (depend
upon the size of the firm) and external economies (depend upon the
size of the industry).

• Example of Internal economies:

- Specialization that lead to greater productive efficiency and to
reduction in costs)
 LAW OF RETURNS TO SCALE---
• Example of External economies:
- Economic concentration: When an industry is concentrated in a particular area,
all the member firms reap some common economies like skilled labour,
improved means of transport and communications, banking and financial
services, supply of power and benefits from subsidiaries.
- All these facilities tend to lower the unit cost of production of all the firms in
the industry.

❖ Diseconomies of Scale
❖ Diseconomies are the limits to large-scale production.
• It is possible that expansion of a firm’s output may lead to rise in costs and thus
result diseconomies instead of economies.
• When a firm expands beyond proper limits, it is beyond the capacity of the manager
to manage it efficiently. This is an example of an internal diseconomy.
 DISECONOMIES OF SCALE---

• In the same manner, the expansion of an industry may result in diseconomies,

which may be called external diseconomies.
➢Internal diseconomies: Financial Diseconomies (Lack of finance retards
the production plans thereby increasing costs of the firm), Managerial
diseconomies (difficulties of large-scale management), Marketing
Diseconomies (as business is expanded, prices of the factors of
production will rise; thus, cost will therefore rise).
➢External diseconomies: When many firm get located at a particular place,
they have to face shortage of various factors of production like labor and
capital, shortage of power, finance and equipments. All such external
diseconomies tend to raise cost per unit.
 ISOQUANTS ISO-COSTS AND PRODUCER’S EQUILIBRIUM

I. Isoquants
• Isoquants are the curves, which represent the different combinations
of inputs producing a particular quantity of output, where any
combination on the isoquant the represents the same level of output
• Since each combination yields the same output, the producer becomes
indifferent towards these combinations.
• Iso-quants (equal quantity) are the analogy of indifference curves; thus,
called Iso-product curve or equal product curve or production
indifference curve
ISOQUANTS---
 ISOQUANTS---

• Marginal Rate of Technical Substitution(MRTS) is the amount of one input

factor that must be substituted for one unit of another input factor to
maintain a constant level of output.
• Algebraically, MRTS = ∆K/∆L = Slope of an Isoquant
• The marginal rate of technical substitution usually diminishes as the amount
of substitution increases.
• The input substitution relation indicated by the slope of a production
isoquant is directly related to the concept of diminishing marginal
productivity.
• The marginal rate of technical substitution is equal to the ratio of the
marginal products of the input factors [MRTS = –1(MPL/MPK)].
 PRODUCER’S EQUILIBRIUM---

II. Isocosts
• Each point on an isocost line/curve represents a different combination of
inputs that can be purchased at a given expenditure level.
• These are a direct analogy of the budget line; thus, production budget line.
• The slope of isocost line is the ratio of prices of inputs (say PL/PK = w/r).
 PRODUCER’S EQUILIBRIUM---
II. Optimal combination of inputs
• At the point of optimal input combination, isocost and the isoquant curves
are tangent and have equal slope.
• Therefore, for optimal input combinations, the ratio of input prices must
equal the ratio of input marginal products(i.e., - w/r = MPL/MPK)
• A profit-maximizing firm will be using the optimal amount of an input at the
point at which the monetary value of the input’s marginal product is equal to
the additional cost of using that input (MRP = MLC).
• Alternatively, marginal product-to-price ratio must be equal for each input: (7
MPL/PL = MPK/PK
• Optimal input proportions are employed when an additional dollar spent on
any input yields the same increase in output.
• Any input combination violating this rule is suboptimal because a change in
input proportions could result in the same quantity of output at lower cost.
 PRODUCER’S EQUILIBRIUM---

oAssume the following graph

✓ This graph explains clearly that the isoquant
curve for 100 units of motor consists of ‘n’
number of input combinations to produce the
same quantity.
✓ For example at ‘a’ to produce 100 units of
motors, the firm uses OC amount of capital and
OL amount of labor i.e., more capital and less
labor force.
✓ At ’b’ OC1 amount of capital and OL1 labor
force is used to produce the same that means
more labor and less capital.
✓ Thus, the points of tangency between iso quant
and iso cost curves depict optimal input
combination at different activity levels.
 PRODUCER’S EQUILIBRIUM---

oExpansion Path
▪ By connecting points of tangency between isoquants and isocosts, we can have
an expansion path that depicts optimal input combinations as the scale of
production expands.

✓ From the graph it is clear that the

optimum combination is selected based on
the tangency point of iso cost (budget line)
and iso- quant i. e., a, b respectively.
✓ The point ‘a’ indicates that to produce 100
units of motor the best combination of
capital and labor are OC and OM which is
within the budget.
✓ Over a period of time a firm will face
various optimum levels if we connect all
points we derive expansion path of a firm.
 MANAGERIAL USES OF PRODUCTION FUNCTION

oProduction functions are logical and useful.

oProduction analysis can be used as aids in decision making
because they can give guidance to obtain the maximum
output from a given set of inputs and how to obtain a given
output from the minimum aggregation of inputs.
oThe complex production functions with large numbers of
inputs and outputs are analyzed with the help of computer
based programmes.
 NUMERICAL EXAMPLES
1. A certain company manufactures and sells different wood work products. The
company has estimated the following multiplicative cobb-Douglas production function
for basic lumber products in a market using monthly production data over the past 30
years (30 observations):

Q = b0Lb1Kb2Eb3
Where, Q = output, L = labor input in worker hours, K = capital input in machine hours, E = energy input

Each of the parameters of this model was estimated by regression analysis using monthly data over a recent
3-year period. Coefficient estimation results were as follows:

A. Estimate the effect on output of a 1% decline in worker hours (holding K and E constant).

B. Estimate the effect on output of a 5% reduction in machine hours availability accompanied by a 5%

decline in energy input (holding L constant).

C. Estimate the returns to scale for this production system.

 SOLUTIONS
A. For Cobb-Douglas production functions, calculations of the elasticity of output with respect to
individual inputs can be made by simply referring to the exponents of the production relation.

Here a 1% decline in L, holding all else equal, will lead to a 0.4% decline in output.

εQ = ∆Q/Q/ ∆L/L = ∆Q/∆L L/Q

= b0 b1Lb1-1Kb2Eb3 L/Q = b1

Since ∆Q/Q /∆L/L = b1, ∆Q/Q = b1∆L/L = 0.4(–0.01) = –0.004 or –0.4%

B. From part A, it is obvious that,

∆Q/Q = b2(∆K/K) + b3(∆E/E)

= 0.4(–0.05) + 0.2(–0.05) = –0.03 or –3%

C. In the case of Cobb-Douglas production functions, returns to scale are determined by simply summing
exponents because, Q = b0Lb1Kb2Eb3

hQ = b0(kL)b1(kK)b2(kE)b3 = kb1+b2+b3 b0Lb1Kb2Eb3 = kb1+b2+b3 Q

❖ Here b1+b2+b3 = 0.4 + 0.4 + 0.2 = 1 indicating constant returns to scale. This means that a 1% increase
in all inputs will lead to a 1% increase in output, and average costs will remain constant as output
increases.
 ASSIGNMENT
1. The relationship between inputs and outputs is given by the
production function: Q=3K0.5L0.5, where Q is value output, K
is the value of capital goods and L is hours of labor. The rental
cost of capital (interest rate plus depreciation rate) is 0.20.
The cost of labor is $7.20 per hour. The producer’s goal is to
obtain a value added of $18,000 as cheaply as possible.
a. Find the optimal values of K and L.
b. Can a producer make a profit?
 ASSIGNMENT---

2. Consider the following Cobb-Douglas production function for bus service in a

typical metropolitan area: Q = b0Lb1Kb2Fb3
Where, Q = output in millions of passenger miles, L = labor input in worker hours, K
= capital input in bus transit hours, F = fuel input in gallons.
Each of the parameters of this model was estimated by regression analysis using
monthly data over a recent 3-year period. Results obtained were as follows:

The standard error estimates for each coefficient are:

A. Estimate the effect on output of a 4% decline in worker hours (holding K and F

constant).
B. Estimate the effect on output of a 3% reduction in fuel availability accompanied by
a 4% decline in bus transit hours (holding L constant).
C. Estimate the returns to scale for this production system.
 3.2. THE THEORY OF COSTS

• The Short Run Cost Function

• The Short Run Relationship b/n Production & Cost

• The Long Run Relationship b/n Production and Cost

• The Long Run Cost Function

 COST ANALYSIS
• Profit is the ultimate aim of any business and the long-run
prosperity of a firm depends upon its ability to earn sustained profits.
• Profits are the difference between total revenue (selling
price*quantity sold) and cost of production.
• In general the selling price is not within the control of a firm but
many costs are under its control.
• The firm should therefore aim at controlling and minimizing cost.
• Since every business decision involves cost consideration, it is
necessary to understand the meaning of various concepts for clear
business thinking and application of right kind of costs.
 COST ANALYSIS---
• A managerial economist must have a clear understanding of the
different cost concepts for clear business thinking and proper
application.
• There are several alternative bases of classifying costs and their
relevance of each for different kinds of problems.
• The various relevant concepts of cost are:
- Out-of- pocket (EC) and books costs (IC)
- Short-run and long-run costs
- Incremental and sunk costs
• Incremental cost is the additional cost due to a change in the level or nature of
business activity. The change may be caused by managerial decisions like adding a
new product, adding new machinery, replacing a machine by a better one etc.
• Sunk costs are those which are retrospective (past) costs that have already been
incurred and cannot be recovered. Investments in fixed assets are examples of
sunk costs.
 COST ANALYSIS---
• Historical cost: The price paid for a plant originally at the time of
purchase.
• Replacement cost: The price that would have to be paid currently for
acquiring the same plant.
• Social cost: Total cost incurred by the society on account of production
of a good or service.
• Transaction cost: The cost associated with the exchange of goods and
services.
• Controllable cost: Costs which can be controllable by the executives
are called as controllable cost.
• Shut down cost: Cost incurred if the firm temporarily stops its
operation.These can be saved by continuing business.
 SHORT RUN COST FUNCTIONS
• A firm’s short run cost function tells us the minimum cost necessary
to produce a particular output level.
- Total, average and marginal costs
• Total cost (TC) is the total cash payment made for the input needed
for production. It may be explicit or implicit. It is the sum total of the
fixed and variable costs.
• Average cost (ATC/AC) is the cost per unit of output.
- ATC=TC/Q=(TFC+TVC)/Q =AFC+AVC, AVC = TVC/Q,AFC = TFC/Q
• Marginal cost (MC) is the additional cost incurred to produce and
additional unit of output or it is the cost of the marginal unit
produced.
• MC can also be expressed as the change in TVC associated with a
change in output.
SHORT RUN COST FUNCTIONS---
NUMERICAL EXAMPLE
 COST-OUTPUT RELATIONSHIP
• A proper understanding of the nature and behavior of costs is a
must for regulation and control of cost of production.
• The cost-output relationship plays an important role in
determining the optimum level of production.
• Knowledge of the cost-output relation helps the manager in cost
control, profit prediction, pricing, promotion etc.
• The relation between cost and its determinants is technically
described as the cost function.
C= f (S, O, P,T ….)
Where;
C = Cost (Unit or total cost), S= Size of plant/scale of production, O =
Output level, P = Prices of inputs, T = Technology
 SR R/S B/N PRODUCTION AND COST
• A firm’s cost structure is intimately related to its production process.
• Costs are determined by the production technology and input prices.
• AFC declines steadily over the range of production.
• In general, AVC,AC, and MC are u-shaped.
• MC measures the rate of change of TC
• When MC<AVC,AVC is falling
• When MC>AVC,AVC is rising
• When MC=AVC,AVC is at its minimum
• The distance between AC and AVC represents AFC
 LR R/S B/N PRODUCTION AND COST
• In the long run, all inputs are variable/no fixed costs.
• The long run cost structure of a firm is related to the firm’s long run production
process.
• The firm’s long run production process is described by the concept of returns to
scale.
• Economists hypothesize that a firm’s long-run production function may exhibit at
increasing returns, then constant returns, and finally decreasing returns to scale.
➢ When a firm experiences increasing returns to scale
• A proportional increase in all inputs increases output by a greater
percentage than costs. Thus, costs increase at a decreasing rate
➢ When a firm experiences constant returns to scale
• A proportional increase in all inputs increases output by the same
percentage as costs. Hence, costs increase at a constant rate
➢ When a firm experiences decreasing returns to scale
• A proportional increase in all inputs increases output by a smaller
percentage than costs. Thus, costs increase at an increasing rate
LR R/S B/N PRODUCTION AND COST---
 LONG RUN COST FUNCTIONS
▪ Long run marginal cost(LRMC) measures the
change in long run costs associated with a change
in output.

▪ Long run average cost(LRAC) measures the

average per-unit cost of production when all
LRAC
inputs are variable. LRAC decrease with increases
output.. Economies of with
▪ In general, the LRAC is u-shaped. size at ever level of output…
output diseconomi
• When LRAC is declining as output expands we
es of size at
say that the firm is experiencing economies of every level
scale. of output

• In small firms, workers generally do several jobs,

and proficiency sometimes suffers from a lack of
specialization. Labor productivity can be higher in LRAC remains as output
increases: all sizes of firm
large firms, where individuals are hired to
produce output at the
perform specific tasks. This can reduce unit costs same average cost
for large-scale operations.

• When LRAC is increasing we say that the firm is

experiencing diseconomies of scale.

• Diseconomies of scale implies that per-unit costs

 LR COST FUNCTION---

• The LRAC is the lower envelope of all of the SRAC curves.

 LR COST FUNCTION---
• The optimal scale for a plant is found at the point of minimum long-
run average costs. That is, average cost equals marginal cost at the
minimum efficient scale of plant.
 CAPACITY, MINIMUM EFFICIENT SCALE AND ECONOMIES OF
SCOPE
• When economies of scale are present, the least-cost plant will operate at less than
full capacity.
• Capacity refers to output level at which short-run average costs are minimized.
• Only for that single output level at which long-run average cost is minimized (output
Q*) is the optimal plant operating at the minimum point on its short-run average
cost curve.
• At any output level greater than Q*, diseconomies of scale prevail, and the most
efficient plant is operating at an output level slightly greater than capacity.
• Minimum efficient scale(MES) is the output level at which long-run average
costs are minimized.
• Economies of scope exist when the cost of joint production is less than the cost
of producing multiple outputs separately.
• A firm will produce products that are complementary in the sense that producing
them together costs less than producing them individually.
 NUMERICAL EXAMPLE
Assume the total cost function for a given firm is given as:
TC = $3,000 + $1,000Q + $0.003Q2
where TC, Q and MC are total costs, output and marginal costs in thousands of dollars,
respectively. Estimate minimum efficient scale in this industry.
-Minimum efficient scale is reached when average costs are first minimized. This occurs
at the point where MC = AC.
Average Costs = AC = TC/Q = ($3,000 + $1,000Q + $0.003Q2)/Q
= $3,000/Q + $1,000 + $0.003Q
MC = $1,000 + $0.006Q
Therefore, MC = AC
$1,000 + $0.006Q = $3,000/Q + $1,000 + $0.003Q
Q = 1,000 (000)
Thus, Q = 1, 000, 000
 COST ELASTICITIES AND ECONOMIES OF SCALE

• It is often easy to calculate scale economies by considering cost

elasticities.
• Cost elasticity, εC, measures the percentage change in total cost
associated with a 1 percent change in output.
• Algebraically, the elasticity of cost with respect to output is,
εC = Percentage Change in Total Cost (TC)/ Percentage Change in
Output (Q)
= ∆TC/TC/ ∆Q/Q
= ∆TC/∆Q x Q/TC

• Cost elasticity is related to economies of scale as follows:

 COST ELASTICITIES AND ECONOMIES OF SCALE---

• With a cost elasticity of less than one (εC < 1), costs
increase at a slower rate than output. Given constant input
prices, this implies higher output-to-input ratios and
economies of scale, implies increasing returns to scale.
• If εC = 1, output and costs increase proportionately,
implying no economies of scale, implies constant returns to
scale.
• Finally, if εC > 1, for any increase in output, costs increase by
a greater relative amount, because output is increasing
slower than input usage - diseconomies of scale, implying
decreasing returns to scale.
 COST-VOLUME-PROFIT ANALYSIS

• Cost-volume-profit analysis, sometimes called breakeven analysis, is an

important analytical technique used to study relations among costs, revenues,
and profits.
• Output levels below the breakeven point produce losses. As output grows
beyond the breakeven point, increasingly higher profits result.
 COST-VOLUME-PROFIT ANALYSIS---
• One useful application of cost-volume-profit analysis lies in the determination of
breakeven activity levels.
• A breakeven quantity is a zero profit activity level. At breakeven quantity levels, total
revenue (P*Q) exactly equals total costs (TFC+ AVC*Q):
Total Revenue = Total Cost
P * Q = TFC + AVC * Q
(P – AVC)Q = TFC
It follows that breakeven quantity levels occur where
QBE = TFC/P – AVC
= TFC/ πC
• Where, P = Price per unit sold, Q = Quantity produced and sold, TFC = Total fixed
costs, AVC = Average variable cost, and πC = Profit contribution
• On a per-unit basis, profit contribution equals price minus average variable cost (πC=
P – AVC).
• Profit contribution can be applied to cover fixed costs and then to provide profits.
It is the foundation of cost-volume-profit analysis.
 NUMERICAL EXAMPLE

• Suppose P = $3,AVC = $1.80, and TFC = $60,000.

Calculate profit contribution and the breakeven quantity.
a. πC = P – AVC
= $1.20 (= $3.00 – $1.80)

b. Q = $60,000/ $1.20 = 50,000 units

 PROFIT MAXIMIZATION AND COMPETITIVE SUPPLY

• Profit is likely to dominate decisions in owner managed

firms.
• Managers in larger companies may be more concerned with
goals such as: revenue maximization, dividend pay-out;
however, in the long run, they must have profit as one of
their highest priorities.
• Profit maximization condition for competitive firm:
• MR = MC
• Adequate Condition for Profit Maximization: P > = ATCmin
PROFIT MAXIMIZATION AND COMPETITIVE SUPPLY---
Thank you