CH 1

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The Basics of
Supply and
Demand
1
C

H

A

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CHAPTER 1 OUTLINE
1.1 Definitions
1.2 Supply and Demand
1.3 The Market Mechanism
1.4 Changes in Market Equilibrium
1.5 Elasticities of Supply and Demand
1.6 Production Function
1.7 Production Cost Function

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Professor R. Jassim Engineering Economy
Definitions 1.1
Economics
Application of technology, guided by economic principles, to the design,
implementation and operation of systems and processes.

SCARCE
RESOURCES
PRODUCTION MARKET
Allocation
Distribution
- Land
- Labour
- Capital
- Managerial skills
- Goods
- Services
- Right time and
place
- Right clients
- Right quantity and
quality
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Definitions 1.1
Microeconomics
Analysis of the economic behavior of individual decision-making units in a free
market economy.
Issues:
Supply and demand of goods and services
Price and production costs of goods and services
Objectives (profit, growth, and survival) and competitiveness of business firm
Theory of production

Macroeconomics
Analysis of aggregate behavior at the national and international levels.
Issues:
Level of growth of consumption and income
Level and trends in prices, wages, and investment
Government policies and incentives
Interactions between businesses, government and society, and between
business sectors

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Definitions 1.1
Finance
Study of how businesses raise and spend capital
Issues:
Sources and costs of funds
Capital markets
Dividend policies
Capital budgeting

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Definitions
Study of how society, i.e. individuals, businesses and government, should allocate
scarce resources to the production and distribution of goods and services to the
appropriate consumers.

1.1
Engineering
Engineering Design
PROJECT DESIGN
ISSUES
ANALYTICAL
SOLUTIONS
DECISION
Design issues at the development,
implementation and operation stages
Quantitative techniques for the analysis
and comparison of options
Choice and implementation of preferred
option
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Definitions 1.1
Engineering Design
The focus is on economic and resource allocation issues associated with
engineering projects.
Thus, there is a need for knowledge in:
Engineering design
Operations research
Economic theory
Corporate finance
Environmental and societal impact assessment
Decision theory

Quantitative Analysis Techniques
Systematic assessment of:
Costs: implementation (present and future)
production (future)
Benefits: future revenues or cost savings
Profits: benefits less costs
If profits are positive, wealth is created, i.e. project/option is justified.

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Definitions 1.1
Decision
Choice of preferred option based on a combination of various objectives such as:

Creation of wealth
Most efficient use of scarce resources
Survival and growth strategies of company
Safeguard of society and the environment
Other intangible issues

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1 - Problem Definition
2 - Data Collection
3 - Analysis
4 - Development of Technically
Feasible Options
5 - Evaluation of Options
6 - Choice of Preferred Option
7 - Implementation
8 - Monitoring and Adjustment
ENGINEERING ECONOMIC
ANALYSIS
Definitions 1.1
Problem Solving Steps in Engineering
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Economic Analysis
Consideration of non-quantifiable factors that may eventually affect the project
(public opinion, changing government policy, disasters, societal and environmental
issues)
Intangibles
Choice of source(s) of capital
Capital budgeting
Financial Analysis
Assessment of costs and benefits
Evaluation of investment criteria
Definitions 1.1
Evaluation of Options
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Production and Cost Analysis Chapter 4
Accounting Chapter 2
INFLATION
TAXATION
Time Value of Money Chapter 3
Project Evaluation Criteria Chapter 6
Cost of Capital Chapter 5
Applications Chapter 10
Sensitivity and Risk Analyses Chapter 9
Chapter 7
Chapter 8
DESIGN
ESTIMATION
AFTER-TAX CASH FLOWS
DCF CRITERIA
SENSITIVITY AND RISK ANALYSES
DECISION
BEFORE-TAX CASH FLOWS
Definitions 1.1
Steps in the Economic Evaluation of a Project/Option
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SUPPLY AND DEMAND
Basics
1.2

Supply-demand analysis is a fundamental and powerful tool that can be applied to a
wide variety of interesting and important problems. To name a few:
Understanding and predicting how changing world economic conditions affect
market price and production

Evaluating the impact of government price controls, minimum wages, price
supports, and production incentives

Determining how taxes, subsidies, tariffs, and import quotas affect consumers and
producers
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SUPPLY AND DEMAND
The Supply Curve
1.2
supply curve Relationship between the quantity of a good that producers
are willing to sell and the price of the good.
The Supply Curve
The supply curve, labeled S in
the figure, shows how the
quantity of a good offered for
sale changes as the price of the
good changes. The supply
curve is upward sloping: The
higher the price, the more firms
are able and willing to produce
and sell.

If production costs fall, firms
can produce the same quantity
at a lower price or a larger
quantity at the same price. The
supply curve then shifts to the
right (from S to S).
Figure 1.1

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SUPPLY AND DEMAND
The Supply Curve
1.2
The supply curve is thus a relationship between the quantity supplied and the
price. We can write this relationship as an equation:
Q
S
= Q
S
(P)
The quantity that producers are willing to sell depends not only on the price
they receive but also on their production costs, including wages, interest
charges, and the costs of raw materials.

When production costs decrease, output increases no matter what the
market price happens to be. The entire supply curve thus shifts to the right.

Economists often use the phrase change in supply to refer to shifts in the
supply curve, while reserving the phrase change in the quantity supplied to
apply to movements along the supply curve.
Other Variables that Affect Supply
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SUPPLY AND DEMAND
The Demand Curve
1.2
We can write this relationship between
quantity demanded and price as an equation:

Q
D
= Q
D
(P)
demand curve Relationship between
the quantity of a good that consumers
are willing to buy and the price of the
good.
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The Demand Curve
The demand curve, labeled D,
shows how the quantity of a good
demanded by consumers
depends on its price. The
demand curve is downward
sloping; holding other things
equal, consumers will want to
purchase more of a good as its
price goes down.
The quantity demanded may also
depend on other variables, such
as income, the weather, and the
prices of other goods. For most
products, the quantity demanded
increases when income rises.
A higher income level shifts the
demand curve to the right (from D
to D).
SUPPLY AND DEMAND
The Demand Curve
1.2
Figure 1.2
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SUPPLY AND DEMAND
The Demand Curve
1.2
Shifting the Demand Curve
If the market price were held constant at P
1
, we
would expect to see an increase in the quantity
demandedsay from Q
1
to Q
2
, as a result of
consumers higher incomes. Because this
increase would occur no matter what the market
price, the result would be a shift to the right of
the entire demand curve.
Shifting the Demand Curve
substitutes Two goods for which an increase in the price of one
leads to an increase in the quantity demanded of the other.
complements Two goods for which an increase in the price of
one leads to a decrease in the quantity demanded of the other.
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THE MARKET MECHANISM 1.3
Supply and Demand
The market clears at price P
0

and quantity Q
0
.

At the higher price P
1
, a surplus
develops, so price falls.

At the lower price P
2
, there is a
shortage, so price is bid up.
Figure 1.3
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Equilibrium
equilibrium (or market clearing) price
Price that equates the quantity supplied
to the quantity demanded.
market mechanism Tendency in a free
market for price to change until the
market clears.
surplus Situation in which the quantity
supplied exceeds the quantity demanded.
shortage Situation in which the quantity
demanded exceeds the quantity supplied.
free No price controls, production
quotas or rationing.
competitive The actions of individual
consumers and suppliers has no effect on
the overall state of the market.
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When Can We Use the Supply-Demand Model?
We are assuming that at any given price, a given quantity will be produced and
sold.

This assumption makes sense only if a market is at least roughly competitive.

By this we mean that both sellers and buyers should have little market power
i.e., little ability individually to affect the market price.

Suppose instead that supply were controlled by a single producera
monopolist.

If the demand curve shifts in a particular way, it may be in the monopolists
interest to keep the quantity fixed but change the price, or to keep the price
fixed and change the quantity.
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CHANGES IN MARKET EQUILIBRIUM 1.4
New Equilibrium Following
Shift in Supply
When the supply curve
shifts to the right, the
market clears at a lower
price P
3
and a larger
quantity Q
3
.
Figure 1.4
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Shift in Demand
When the demand curve
shifts to the right,
the market clears at a
higher price P
3
and a
larger quantity Q
3
.
Figure 1.5
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Shifts in Supply and Demand
Supply and demand curves
shift over time as market
conditions change.
In this example, rightward
shifts of the supply and
demand curves lead to a
slightly higher price and a
much larger quantity.
In general, changes in price
and quantity depend on the
amount by which each
curve shifts and the shape
of each curve.
Figure 1.6
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1.4
From 1970 to 2007, the price of eggs fell by 49 percent, while the
price of a college education rose by 105 percent.

The mechanization of poultry farms sharply reduced the cost of
producing eggs, shifting the supply curve downward. The demand
curve for eggs shifted to the left as a more health-conscious
population tended to avoid eggs.

As for college, increases in the costs of equipping and maintaining
modern classrooms, laboratories, and libraries, along with increases
in faculty salaries, pushed the supply curve up. The demand curve
shifted to the right as a larger percentage of a growing number of
high school graduates decided that a college education was
essential.
CHANGES IN MARKET EQUILIBRIUM
Example 1.1
The Price of Eggs and the Price of a College Education
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Example 1.1

1.4 CHANGES IN MARKET EQUILIBRIUM

(a) Market for Eggs
The supply curve for eggs
shifted downward as
production costs fell; the
demand curve shifted to the
left as consumer
preferences changed.
As a result, the price of
eggs fell sharply and egg
consumption rose.
Figure 1.7
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(b) Market for College
Education
The supply curve for a
college education shifted
up as the costs of
equipment, maintenance,
and staffing rose.
The demand curve shifted
to the right as a growing
number of high school
graduates desired a
college education.
As a result, both price and
enrollments rose sharply.
Figure 1.8
Example 1.1
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Over the past two decades, the wages of skilled high-income workers
have grown substantially, while the wages of unskilled low-income
workers have fallen slightly.

From 1978 to 2005, people in the top 20 percent of the income
distribution experienced an increase in their average real (inflation-
adjusted) pretax household income of 50 percent, while those in the
bottom 20 percent saw their average real pretax income increase by
only 6 percent.

While the supply of unskilled workerspeople with limited
educationshas grown substantially, the demand for them has risen
only slightly.

On the other hand, while the supply of skilled workerse.g.,
engineers, scientists, managers, and economistshas grown slowly,
the demand has risen dramatically, pushing wages up.
Example 1.2
Wage Inequality in the United States
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Consumption and the Price
of Copper
Although annual
consumption of copper
has increased about a
hundredfold, the price
has not changed much.
Figure 1.9
Example 1.3
The Long-Run Behavior of natural Resource Prices
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Long-Run Movements of
Supply and Demand for
Mineral Resources
Although demand for
most resources has
increased dramatically
over the past century,
prices have fallen or
risen only slightly
because cost reductions
have shifted the supply
curve to the right just as
dramatically.
Figure 1.10
Example 1.3
The Long-Run Behavior of natural Resource Prices
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Supply and Demand for
New York City Office Space
Following 9/11 the
supply curve shifted to
the left, but the demand
curve also shifted to the
left, so that the average
rental price fell.
Figure 1.11
Example 1.4
The Effects of 9/11 on the Supply and Demand for New
York City Office Space
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ELASTICITIES OF SUPPLY AND DEMAND
Price Elasticity of Demand
1.5
elasticity Percentage change in one variable resulting from a percent
change in another.
price elasticity of demand the responsiveness of the quantity demanded
of a good or service to a change in its price.

P
Q
dP
dQ
P
dP
Q
dQ
E
D
= =
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ELASTICITIES OF SUPPLY AND DEMAND 1.5
1 E
D
>
Demand is elastic, i.e. change in Q is relatively significant
(e.g. luxury items)
1 E
D
<
Demand is inelastic, i.e. change in Q is relatively non-
significant (e.g. essential items)
1 E
D
=
Demand is unitary elastic, i.e. relative changes in Q and P
are equal
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Linear Demand Curve
1.5
linear demand curve Demand curve that is a straight line.
Linear Demand Curve
Figure 1.12
The price elasticity of demand
depends not only on the slope
of the demand curve but also
on the price and quantity.

The elasticity, therefore, varies
along the curve as price and
quantity change. Slope is
constant for this linear demand
curve.

Near the top, because price is
high and quantity is small, the
elasticity is large in magnitude.

The elasticity becomes smaller
as we move down the curve.
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Linear Demand Curve
1.5
infinitely elastic demand Principle that consumers will buy as much of
a good as they can get at a single price, but for any higher price the
quantity demanded drops to zero, while for any lower price the quantity
demanded increases without limit.
(a) Infinitely Elastic Demand
Figure 1.13
(a) For a horizontal demand
curve, Q/P is infinite.
Because a tiny change in price
leads to an enormous change
in demand, the elasticity of
demand is infinite.
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Linear Demand Curve
1.5
completely inelastic demand Principle that consumers will buy a fixed
quantity of a good regardless of its price.
(b) Completely Inelastic Demand
Figure 1.13
(b) For a vertical demand curve,
Q/P is zero. Because the
quantity demanded is the same
no matter what the price, the
elasticity of demand is zero.
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price elasticity of supply the responsiveness of the quantity supplied
of a good or service to a change in its price
Elasticities of Supply
P
Q
dP
dQ
E
S
=
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Point versus Arc Elasticities
1.5
point elasticity Price elasticity at a particular point on the curve.
arc elasticity Price elasticity calculated over a range of prices
(
(
(
(
|
.
|
\
|
+
(
(
(
(
|
.
|
\
|
+
=
|
|
.
|
\
|
A
|
|
.
|
\
|
A
=
2
P P
P P
2
Q Q
Q Q
P average
P
Q average
Q
AE
1 2
1 2
1 2
1 2
D
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During recent decades, changes in the wheat market
had major implications for both American farmers and
U.S. agricultural policy.
To understand what happened, lets examine the behavior of supply and
demand beginning in 1981.
By setting the quantity supplied equal to the quantity demanded, we can
determine the market-clearing price of wheat for 1981:
Example 1.5
The Market for Wheat
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Substituting into the supply curve equation, we get
We use the demand curve to find the price elasticity of demand:
We can likewise calculate the price elasticity of supply:
Because these supply and demand curves are linear, the price
elasticities will vary as we move along the curves.
Thus demand is inelastic.
Example 1.5
The Market for Wheat
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1.5 ELASTICITIES OF SUPPLY AND DEMAND
Total Consumer Expenditure
Gross revenue from the sale of a particular product on the market, i.e.
Demand Inelastic Unitary Elastic Elastic
P incr. TCE incr. TCE stable TCE decr.
P decr. TCE decr. TCE stable TCE incr.
Changes in TCE along the demand curve reflect the elasticity of demand.
Q P TCE - =
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PRICE
T
O
T
A
L

C
O
N
S
U
M
E
R

E
X
P
E
N
D
I
T
U
R
E
Maximum
when E
D
= 1
Inelastic
Demand
Unitary Elastic
Demand
Elastic
Demand
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Consumer Surplus
Amount saved by all those consumers who would buy the product at a price higher
than the market price.
Q
*
Quantity
Demand
Supply
Price
P
*
Consumer
surplus
Consumer
expenditure
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P 30 240 Q =
0
1
2
3
4
5
6
7
8
9
10
0 50 100 150 200 250 300
QUANTITY (units)
P
R
I
C
E

(
$
/
u
n
i
t
)
P is price in $/unit and Q is quantity
demanded in units per period
Example 1.6
Demand Function
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30
dP
dQ
=
Point Elasticity
( )
67 . 1
5
90
30
) 5 (
=
|
.
|
\
|
= E
At P=5
Q = 240 - 30 (5) = 90
At P=3
Q = 240 - 30 (3) = 150
( )
60 . 0
3
150
30
) 3 (
=
|
.
|
\
|
= E
P
Q
dP
dQ
E
D
=
At P=4
Q = 240 - 30 (4) = 120
( )
00 . 1
4
120
30
) 4 (
=
|
.
|
\
|
= E
2
P 30 P 240 ) P 30 240 ( P =
Maximum when
4 P
0 P 60 240
0
dP
) Q P ( d
=
=
=
-
P Q
Example 1.6
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Price
($/unit)
Quanti ty
(units/period)
PQ
($/period)
100 2 000 200 000
80 4 000 320 000
60 7 000 420 000
40 11 000 440 000
20 16 000 320 000
10 22 000 220 000
5 30 000 150 000

0
20
40
60
80
100
120
0 5 10 15 20 25 30 35
QUANTITY ('000 units/period)
P
R
I
C
E

(
$
/
u
n
i
t
)
Example 1.7
Demand Schedule
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0
20
40
60
80
100
120
0 5 10 15 20 25 30 35
QUANTITY ('000 units/period)
P
R
I
C
E

(
$
/
u
n
i
t
)
|
.
|
\
|
A
|
.
|
\
| A
=
P
P
Q
Q
AE
D
P
P A
Q
Q A
( )
|
|
.
|
\
|
+
2 7000 000 11
000 11 7000
( )
|
|
.
|
\
|
+
2 60 40
40 60
AE =
= 1.11
Example 1.7
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|
.
|
\
|

=
2
6000
4000 2000
AE
) 100 80 (
00 . 3
2
180
80 100
=
|
.
|
\
|

|
.
|
\
|

=
2
000 18
000 11 7000
AE
) 60 40 (
11 . 1
2
100
40 60
=
|
.
|
\
|

|
.
|
\
|

=
2
000 38
000 22 000 16
AE
) 20 10 (
47 . 0
2
30
10 20
=
|
.
|
\
|

|
.
|
\
|

=
2
000 52
000 30 000 22
AE
) 10 5 (
46 . 0
2
15
10 5
=
|
.
|
\
|
|
.
|
\
|

=
2
000 46
000 30 000 16
AE
) 20 5 (
51 . 0
2
25
5 20
=
|
.
|
\
|

Elastic at high price end
Inelastic at low price end
Unitary Elastic somewhere in between
Typical characteristics of demand
curves:
Example 1.7
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PRODUCTION FUNCTION 1.6
Represents all technically efficient combinations of resources required to
produce a particular product for, or provide a particular service to, the market.
Production is a function of n number of resources.
fixed resources are constant over a particular range of output
variable resources are those that increase with output
) ,..., , , (
3 2 1 n
S S S S f Q =
Production Function
Types of Resources
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average product Output per unit of a particular input.
marginal product Additional output produced as an input is increased
by one unit.
S
Q
AP =
dS
dQ
MP =
Average and Marginal Products
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The Slopes of the Product Curve
The total product curve in (a) shows
the output produced for different
amounts of labor input.
The average and marginal products
in (b) can be obtained from the total
product curve.
At point A in (a), the marginal
product is 20 because the tangent
to the total product curve has a
slope of 20.
At point B in (a) the average product
of labor is 20, which is the slope of
the line from the origin to B.
The average product of labor at
point C in (a) is given by the slope
of the line 0C.
Production with One Variable Input
Figure 1.14
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To the left of point E in (b), the
marginal product is above the
average product and the average is
increasing; to the right of E, the
marginal product is below the
average product and the average is
decreasing.
As a result, E represents the point
at which the average and marginal
products are equal, when the
average product reaches its
maximum.
At D, when total output is
maximized, the slope of the tangent
to the total product curve is 0, as is
the marginal product.
Production with One Variable Input
(continued)
Figure 1.14
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S
Q
STAGE I STAGE II STAGE III
AP increases AP decreases
MP increases MP decreases
negative
MP
Maximum MP
Maximum AP
Point of inflexion
Point of tangency
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The Law of Diminishing Marginal Returns
Labor productivity (output
per unit of labor) can
increase if there are
improvements in technology,
even though any given
production process exhibits
diminishing returns to labor.
As we move from point A on
curve O
1
to B on curve O
2
to
C on curve O
3
over time,
labor productivity increases.
The Effect of Technological
Improvement
Figure 1.15
law of diminishing marginal returns Principle that as the use of an
input increases with other inputs fixed, the resulting additions to output will
eventually decrease.
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0
50
100
150
200
250
300
0 1 2 3 4 5 6 7 8 9 10
INPUT ('000 units/period)
O
U
T
P
U
T

(
'
0
0
0

u
n
i
t
s
/
p
e
r
i
o
d
)
3 2
S S 9 S 21 Q + =
S is input in 000 of units, Q is output in 000 of units
Example 1.8
Production Function
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At input = 4000, Q= 21(4)+9(4)
2
(4)
3
= 164 164 000 units
41
4000
000 164
AP = =
At input = 3000, Q=21(3) + 9(3)
2
-(3)
3
= 117 117 000 units
39
3000
000 117
AP = =
Incremental Product (3 4) =
47
3000 4000
000 117 000 164
=
units
units
units
Example 1.8
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Average Product: Output obtained per unit of input, on average, i.e. productivity
2
S S 9 21
S
Q
AP + = = (in units)
Marginal Product: Additional output obtained by increasing level of input by one unit
2
S 3 S 18 21
dS
dQ
MP + = = (in units)
At input = 4000,
45 ) 4 ( 3 ) 4 ( 18 21 MP
2
= + =

At input = 3000, 48 ) 3 ( 3 ) 3 ( 18 21 MP
2
= + =
At S=3, AP = 39
At S=4, AP = 41
From S=3 to 4,
IP = 47
Example 1.8
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-80
-60
-40
-20
0
20
40
60
0 1 2 3 4 5 6 7 8 9 10
INPUT ('000 units/period)
U
N
I
T

O
U
T
P
U
T

(
u
n
i
t
s
/
p
e
r
i
o
d
)
Average Product
Marginal Product
Maximum AP
Maximum MP
dAP/dS: 9 - 2S = 0
dMP/dS: 18 - 6S = 0
Example 1.8
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Labour
(person-hours/period)
Product
(units/period)
0 0
10 100
20 260
30 450
40 600
50 715
60 810
70 840
80 840
90 810

0
200
400
600
800
1000
0 10 20 30 40 50 60 70 80 90 100
LABOUR (person-hours/period)
P
R
O
D
U
C
T

(
u
n
i
t
s
/
p
e
r
i
o
d
)
Example 1.9
Production Schedule
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Average Product (AP) = Product / Labour
Incremental Product (IP) = (Product
2
- Product
1
) / (Labour
2
- Labour
1
)
Labour
(person-hours/period)
Product
(units/period)
Average Product
(units/person-hour)
Incremental Product
(units/person-hour)
0 0 -
10.0
10 100 10.0
16.0
20 260 13.0
19.0
30 450 15.0
15.0
40 600 15.0
11.5
50 715 14.3
9.5
60 810 13.5
3.0
70 840 12.0
0.0
80 840 10.5
-3.0
90 810 9.0

450 / 30 = 15.0
(810 - 715)
(60 - 50)
= 9.5
MAX
MAX
Example 1.9
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LABOR INPUT
TABLE 1.2 Production with Two Variable Inputs
Capital Input 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120
Isoquants
isoquant Curve showing
all possible combinations
of inputs that yield the
same output.
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Isoquants
isoquant map Graph combining a number of isoquants,
used to describe a production function.
A set of isoquants, or isoquant
map, describes the firms
production function.
Output increases as we move
from isoquant q
1
(at which 55
units per year are produced at
points such as A and D),
to isoquant q
2
(75 units per year at
points such as B) and
to isoquant q
3
(90 units per year at
points such as C and E).
Production with Two Variable Inputs
Figure 1.17
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Diminishing Marginal Returns
Holding the amount of capital
fixed at a particular levelsay
3, we can see that each
additional unit of labor
generates less and less
additional output.
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returns to scale Rate at which output increases as inputs are
increased proportionately.
increasing returns to scale Situation in which output more
than doubles when all inputs are doubled.
constant returns to scale Situation in which output doubles
when all inputs are doubled.
decreasing returns to scale Situation in which output less
than doubles when all inputs are doubled.
Returns to Scale
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PRODUCTION COST FUNCTION 1.7
Represents the total cost (TC) associated with the production of given levels
of output per unit of time.
Production cost is a function of n number of costs and output.
fixed costs are constant over a particular range of output
variable costs are those that change with output
) , ,..., , , (
3 2 1
R C C C C f TC
n
=
Production Cost Function
Types of Cost
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PRODUCTION RATE
T
O
T
A
L

C
O
S
T
Fixed Cost
Variable Cost
TC
Characteristics
Decreasing cost of each
additional unit, i.e.
increasing returns to
variable input
Increasing cost of each
additional unit, i.e.
decreasing returns to
variable input
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average cost Cost per unit of a particular input.
marginal cost Additional cost incurred as an input is increased by one
unit.
R
TC
AC =
dR
dTC
MC =
Average and Marginal Cost
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PRODUCTION RATE
T
O
T
A
L

C
O
S
T
Fixed Cost
Variable Cost
MC decreases MC increases
AC decreases AC increases
Minimum MC
Minimum AC
Point of inflexion
Point of tangency
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TC = 10 + 26R 5R
2
+ 0.5R
3
with R and TC in `00 units.
MC = dTC/dR = 26 10R

+ 1.5R
2

@ 400 units
TC = 10 + 26(4) 5(4)
2
+ 0.5(4)
3
= 66 = $6 600
AC = $6 600/400 = $16.50
MC = 26 10(4)

+ 1.5(4)
2
= $10

@ 500 units
TC = 10 + 26(5) 5(5)
2
+ 0.5(5)
3
= 77.5 = $7 750
AC = $7 750/500 = $15.50
MC = 26 10(5)

+ 1.5(5)
2
= $13.50

Incremental Cost of going from 400 to 500

(7 750 6 600)/(500 400) = 1 150 / 100 = $11.50
Example 1.10
1.7 PRODUCTION COST FUNCTION
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69
0
10
20
30
40
50
60
70
80
0 1 2 3 4 5 6 7 8 9 10 11
PRODUCTION RATE ('00 units/period)
U
N
I
T

C
O
S
T
S

(
$
)
Average Cost
Marginal Cost
Minimum AC
Minimum MC
dMC/dR: -10 + 3R = 0
dAC/dR: -10R
-2
- 5 + R = 0
Example 1.10
70 of 75
Production Rate
('000 units/period)
Total Cost
('000 $/period)
0 80
10 120
20 140
30 150
40 160
50 185
60 234
70 301
80 384
90 486

0
100
200
300
400
500
0 10 20 30 40 50 60 70 80 90 100
PRODUCTION RATE ('000 units/period)
T
O
T
A
L

C
O
S
T

(
'
0
0
0

$
/
p
e
r
i
o
d
)
Example 1.11
Production Cost Schedule
71 of 75
Average Cost (AC) = Total Cost / Production Rate
Incremental Cost (IC) = (Total Cost
2
- Total Cost
1
) / (Rate
2
- Rate
1
)
Production Rate
('000 units/period)
Total Cost
('000 $/period)
Average Cost
($/unit)
Incremental Cost
($/unit)
0 80 -
4.0
10 120 12.0
2.0
20 140 7.0
1.0
30 150 5.0
1.0
40 160 4.0
2.5
50 185 3.7
4.9
60 234 3.9
6.7
70 301 4.3
8.3
80 384 4.8
10.2
90 486 5.4

160 / 40 = 4.0
(301 - 234)
(70 - 60)
= 6.7
MIN
MIN
Example 1.11
72 of 75
2
R 2 R 10 20 TC + + =
R in 000 units/year and
TC in 000 $/year
At 2000 units/year,
year / 000 48 $ 48 ) 2 ( 2 ) 2 ( 10 20 TC
2
= + + =
unit / 24 $
2000
000 48 $
AC = =
unit / 24 $ ) 2 ( 2 10
2
20
= + + =
or
R 2 10
R
20
AC + + = $/unit
units '000
$ '000
Example 1.12
Beware of Units
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If we want to specify R in 000 units/year but obtain TC in $/year:

Multiply all terms of the function by 1000
2
R 2000 R 000 10 000 20 TC + + =
At 2000 units/year:
unit / 24 $ or units 000 ' / 000 24 $ ) 2 ( 2000 000 10
2
000 20
AC = + + =
R
R
AC 2000 000 10
000 20
+ + =
units $/'000
units '000
$
$/year
Example 1.12
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If we want to specify R in units/year and obtain TC in 000/year:

Divide the variable R by 1000 before calculating terms
2 6
2
R 10 2 R 01 . 0 20
1000
R
2
1000
R
10 20 TC
+ + =
(
(
|
.
|
\
|
+
(
+ =
At 2000 units/year:
unit or unit AC / 24 $ / $ 000 ' 024 . 0 ) 2000 ( 10 2 01 . 0
2000
20
6
= + + =

R 10 2 01 . 0
R
20
AC
6
+ + =
$/unit '000
unit
$ '000
000 $/year
Example 1.12
75 of 75
3 2
R 002 . 0 R 18 . 0 R 5 . 7 200 TC + + =
R in 00 units/period
TC in 000$/period
At 2000 units/period,
period / 000 294 $ 294 ) 20 ( 002 . 0 ) 20 ( 18 . 0 ) 20 ( 5 . 7 200 TC
3 2
= + + =
2
R 002 . 0 R 18 . 0 5 . 7
R
200
AC or + + =
$/unit '0
units '00
$ '000
unit / 147 $
2000
000 294 $
AC = =
unit or unit / 147 $ / $ 0 ' 7 . 14 ) 20 ( 002 . 0 ) 20 ( 18 . 0 5 . 7
20
200
2
= + + =
Example 1.13
Mixed Units

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