Business Economics

Theory of production

Production means the process of using the factors of production

to produce goods and services.

Inputs refers to the things used in production

Output refers to what we get at the end of the production

process i.e., finished products.
 Classification of factors of production
Land
Labour
Capital
Entrepreneur
 Production function
Functional relationship between inputs and outputs
Total product is the amount of output produced when a given amount of input is used.

Average product is obtained by dividing the total product by the amount of input used.

APL= TP/units of labour

APK= TP/units of capital

Marginal product is the change in the total product of input, corresponding to an additional unit change in its labour.

Marginal product is the addition to total output when one more unit of labour is employed.

MPL= ∆TP/ ∆ L

MPK= ∆TP/∆K
 Law of Variable Proportion
This law basically explains the behavior of production function in the short run.

The output can be varied by changing the quantities of variable factors only.

The law of diminishing returns states that if quantities of certain factors are increased
while the quantities of one or more factors are held constant beyond a certain level of
production the rate of increase in output will decrease and eventually the marginal
product declines.
Capital Labour Total product Marginal product Average product
10 0 0 0 0
10 1 8 8 8
10 2 20 12 10
10 3 33 13 11
10 4 44 11 11
10 5 50 6 10
10 6 54 4 9
10 7 56 2 8
10 8 56 0 7
10 9 54 -2 6
10 10 50 -4 5
 Relation between TP and MP
When MP is increasing, TP will increase at an increasing rate

When MP is decreasing, TP will increase at a decreasing rate

When MP is zero, TP is at its maximum

When MP is negative, TP declines

 Relationship between MP and AP

When MP is above AP, AP is increasing

When MP is below AP, AP is decreasing

When MP equals AP, AP is at its maximum

Cost
Cost of production refers to the expense incurred by the producer in producing a
particular quantity of output.
Cost concepts
Total fixed cost
Total variable cost
Total cost
Average fixed cost: TFC/Q
Average variable cost: TVC/Q
Average total cost: TC/Q
Marginal cost:
Total fixed cost
Total variable cost
Total cost
Average fixed cost: TFC/Q
Average variable cost: TVC/Q
Average total cost: TC/Q
Marginal cost:
Relationship between ATC and MC
MC>AVC; AVC is increasing

MC<AVC; AVC is decreasing

MC=AVC; AVC is minimum

Relationship between productivity
curve and cost curve
There is an inverse relationship between AVC and MC with AP and MP.

When MP is maximum then MC will be minimum

When MP will fall then MC will increase

Short run average total cost curve
Stage I: AFC begins to fall with an increase in output. As long as the falling effect of AFC is
higher than the rising effect of AVC, the short-run ATC tends to decrease.

Stage II: AFC continues to decline and when firms produce the optimum output, SATC will
reach its minimum. AC remains constant at this stage since the falling effect of AFC and the
rising effect of AVC are in balance.

Stage III: AFC will fall slowly due to the production with a negative MP for variable input.
AVC increases quickly due to diminishing returns of the variable factors. The falling effect of
AFC is lower than the rising effect of AVC.
Long run cost curves
•The long run is a period which involves only variable factors and not
fixed cost.
•A firm can alter its scale of operation; i.e. expand its plant if demand is
high.
•Long run total cost start from the origin, due to the absence of any
total cost.
•A long run average cost curve is a curve that shows the minimum cost
of producing any given output, when all inputs are variable.
LRAC curve is U shaped due to law of returns to scale.

As the firm expands in size or scale of production, its LRAC curve will
decrease and increase at a later stage.

Economies of scale are benefits firm enjoys as it grow larger, whereas

diseconomies of scale are the problem faced by a firm as it grows larger.
Economies of scale

Internal economies of scale: economies that arise from the actions

of an individual firm. Internal economies of scale can reduce the
average cost.
Labour economies Managerial economies(Risk-
bearing, Storage)
Marketing economies Technical economies
Financial economies Transport economies
External economies

External economies of scale refer to the advantage of an industry as a whole.

External economies of scale causes the downward slope of the LRAC curve.
Economies of government action
Economies of concentration
Economies of information (Exogeneous)
Economies of marketing
Internal diseconomies of scale

Internal diseconomies of scale are those factors which arise the cost of
production of a firm as the firm expands. Internal diseconomies of scale show
the upward sloping of the long run average cost.

Labour diseconomies

Management problems

Technical difficulties
 External diseconomies of scale

These refer to the disadvantage faced by the industry as whole. Upward

sloping long run average cost curve are due to external diseconomies of
scale.
a. Scarcity of raw material
b. Wage differentials
c. Concentration problems
Economies and diseconomies of scope

Economies of scope happens when an individual firm’s output for two

different products is higher than output of two different firms, each producing
a single product.

Diseconomies of scope, on the other hand, happen if an individual firm’s

output for two different product is lower than the output of different firms.
 Revenue
Total revenue: TR refers to the total amount of money that a firm can obtain from sales of its product.
(TR= P×Q)

Average revenue: is defined as the total revenue per unit output sold.

AR= TR/Q

Marginal revenue: refers to the change in total revenue, resulting from a one unit increase in quantity
sold.

MR= ∆TR/ ∆Q
 Relationship between price, AR and
MR (Perfect competition)
Quantity Price TR AR MR
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
 Imperfect competition
Quantity Price TR AR MR
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
Firm
A firm is an institution that buys or hires factors of production and organize them
to produce and then sell goods and services.
Objective of firm
Minimize cost
Maximize profits (Profit= TR-TC)
Equilibrium of Firm
A firm will be in equilibrium when it has no tendency to change output.
Total approach
Marginal approach
Market structure

Market: is an arrangement that facilitates the buying and selling of a

product, service, factor of production or future commitment.

Market structure: refers to the number and distribution size of buyers

and sellers in the market for particular goods and services.
Market structure
Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Perfect competition

Perfect competition is a market where there is a large number of buyers and

sellers, buying and selling identical products, without any restriction on entry
and exit, having perfect knowledge of the market at the same time.
 Characteristics

Large number of buyers and sellers

Homogeneous product
Free entry and exit
Perfect knowledge of the market
Perfect mobility of factors of production
Absence of transport cost
Price determination
Equilibrium conditions

MC=MR
MC cuts the MR curve from below
Short run equilibrium (Supernormal
profit)
Normal profit
Shut down point
Short run supply curve

Only the part of the short-

run
marginal cost curve which
lies
above the average variable
cost forms the short-run
the supply curve of the firm.
Long run equilibrium
Long run equilibrium
Long-run Equilibrium of the Competitive Firm with Zero Economic Profits
 Effect of entry and exit
When a firm earns economic profits, other seller will be attracted to industry.

More firms will enter the market, hoping to obtain similar profits.

This influx of firms will cause an increase in the market supply.

The equilibrium market price will fall and the individual firms will lower their
prices until profit is eliminated.

In the long run can earn normal profit or zero profit due to free entry.
Monopoly
Monopoly is made up of the word mono which means single and poly means
sellers.

Monopoly means existence of single seller in the market producing a product

that has no substitutes.
Characteristics
One seller and a large number of buyers
Product has no close substitutes
Price maker
Restriction on the entry of new firms
Advertising
Barriers to entry
Control over raw material
Patent and copyright
Cost of establishing an efficient plant
Government franchises
 Demand curve and elasticity of demand
The demand curve for the output of a monopoly is downward sloping.

Monopolist will fix a higher price if demand is inelastic and lower price if the demand is
elastic.
mu i rb i l i uq e n u r t r o hS

Quantity Price Total Revenue Total Cost Profit/loss

0 200 0 120 -120

1 180 180 170 10

2 160 320 230 90

3 140 420 300 120

4 120 480 400 80

5 100 500 550 -50

Marginal approach

The firm will maximize profits at a point where MR=MC

Supernormal profits
Normal profits
Long run equilibrium
Long run is the time period in which the firm can adjust its input used in
production.
All factors of production are variable.
A monopolist firm will be in equilibrium when MR=MC
Price discrimination
Price discrimination refers to the selling or charging of different prices to
different buyers for the same good
Conditions of price discrimination
Existence of monopoly
Existence of different markets for the same commodity
Existence of different degrees of elasticity of demand
Legal sanction
Degree of price discrimination

First degree price discrimination

Second degree price discrimination
Third degree price discrimination
Monopolistic Competition
Monopolistic competition is a market structure in which a large number of
seller, sell close substitute products.

Monopolistic competition is a combination of perfect competition and

monopoly.
Characteristics
Large number of sellers
Differentiated products
Free entry and exit
Non-price competition
Selling cost
Equilibrium conditions
MR=MC
Oligopoly
In oligopoly market structure there are only a few firms in the industry.

Firms produce either identical or differentiated products.

Entry of new firms is difficult or impossible.

If only two firms exist in the market, it is called duopoly.

Characteristics
Few in the number but large in size

Homogeneous or differentiated product

Mutual interdependence

Barriers to entry
Kinked demand curve
Kinked demand curve was given by Sweezy.

This model explain the price rigidity

Kinked demand curve is a kind of demand curve faced by an oligopolist. It

assumes that rivals will match a price cut but ignore a price increase.
 Assumptions
If an oligopolist reduces the price of his products, his rivals will follow and reduce
their prices too, so as to avoid losing customers.

If an oligopolist increases the price of his products, his rivals will not increase their
prices but instead maintain the same prices, thereby gaining customers from firms
which increase their price.
Why price rigidity under oligopoly?

Since the oligopolist will not gain a large share of the market by
reducing his price below the prevailing level, and will have a
substantial reduction in sales by increasing his price above the
prevailing level, he will be extremely reluctant to change the
prevailing price.
Price leadership model

Price leadership means a pricing strategy in which the firm in

an oligopoly industry follows the price set by the leader firm.

Price leadership is one form of collusion under an oligopoly.