Business Economics

Chapter 3
1

FIRM ANALYSIS
IN BUSINESS
 Topics to be Discussed
2

1. PRODUCTION
 to explore the nature of the production function and the
measurement of productive efficiency.

2. COSTS

 to examine the economic analysis of costs and demonstrate

how the successful management of costs can gain competitive
advantage for a firm over its rivals.
 3.1 PRODUCTION
3

1. The Technology of Production

2. Returns to Scale

3. Isoquants
 a. Production Technology
4

 Describe how inputs can be

transformed into outputs
 Inputs: land, labor, capital & raw
materials
 Outputs: cars, desks, books, etc.
 Firms can produce different
amounts of outputs using
different combinations of
inputs
 We can represent the firm’s
production technology in for
form of a production function
 Production Function
5

 Production Function:
 Indicates the highest output (q) that a firm can produce for
every specified combination of inputs.
 For simplicity, we will consider only labor (L) and capital (K)

 Shows what is technically feasible when the firm operates

efficiently
 The production function for two inputs:
q = F(K,L)
 Output (q) is a function of capital (K) and Labor (L)
 The production function is true for a given technology
 If technology increases, more output can be produced for a given
level of inputs
 Short- run and Long-run
6
 Short Run
◦ Period of time in which quantities of one or more
production factors cannot be changed.
◦ These inputs are called fixed inputs.
◦ Short-run Production Function:
Q = F(L) or Q = f(K)
 Long-run
◦ Amount of time needed to make all production inputs
variable.
◦ Long-run Production Function: Q = F(K, L)

 Short run and long run are not time specific

 Review: Production in the Short-run
7

 We assume capital (K) is fixed and labor (L) is

variable
 Output can only be increased by increasing labor
 Law of Diminishing Marginal Returns: As the use of an
input increases with other inputs fixed, the resulting additions
to output will eventually decrease.
 As we increase labor the additional output produced MPL
declines
 Quiz:
8

 Short-run Production technology of a firm can be

shown as: L3
Q  10 L  L2 
10
a. What are the function of MPL, APL
b. How much is the maximum quantity of this firm?
How much labor are used then?
c. At which level can the law of diminishing return of
labor be seen
d. At which level is the average product of labor
maximum?
 b. Returns to Scale
9

 In the long-run, capital and labor are both variable.

 Rate at which output increases as inputs are
increased proportionately
 Production technology : Q = f (K,L)
◦ Increasing returns to scale:
F (mK,mL) > mQ (m > 1)
◦ Constant returns to scale:

F (mK,mL) = mQ, (m > 1)

◦ Decreasing returns to scale:

F (mK,mL) < mQ (m > 1)

 Quiz

 How is the return to scale of the following

production technologies?
a. Q  K .L
0.7 0.6

b. Q  3K  5L
c. Q2 K L
d. Q  K  L2
 Cobb-Douglas Production Function
11

 
Q  f ( K , L)  aK L
 a, α, β >0, α, β <1
With α, β is the K and L elasticity of quantity

Q Q
EK   a. .K  1.L .K aK  L  
K K
Q Q
EL   a. .K  L 1. L aK  L  
L L
 c. Production with 2 variable inputs
12

 We can look at the output we can achieve with

different combinations of capital and labor
 Isoquants
13

 The information can be represented graphically

using isoquants
 Curves showing all possible combinations of inputs that yield
the same output
 Curves are smooth to allow for use of fractional
inputs
 Curve 1 shows all possible combinations of labor and capital
that will produce 55 units of output
 Isoquant Map
14

Capital 5 E
Ex: 55 units of output
per year can be produced with
3K & 1L (pt. A)
4 OR
1K & 3L (pt. D)
3
A B C

2
q3 = 90
D q2 = 75
1
q1 = 55
1 2 3 4 5 Labor per year
 Marginal rate of technical substitution
(MRTS)
15

 Substituting Among Inputs

 Companies must decide what combination of inputs to use to
produce a certain quantity of output
 There is a trade-off between inputs allowing them to use more
of one input and less of another for the same level of output.
 Slope of the isoquant shows how one input can be substituted
for the other and keep the level of output the same.
 Positive slope is the marginal rate of technical substitution
(MRTS)
 Amount by which the quantity of one input can be reduced when
one extra unit of another input is used, so that output remains
constant.
 Marginal rate of technical substitution
(MRTS)
16

 The marginal rate of technical substitution

equals:

Changein Capital input

MRTS 
Changein Labor input
MRTS   K (for a fixed level of q)
L
Marginal rate of technical substitution (MRTS)
17

Capital 5
per year
Slope measures MRTS
2 MRTS decreases as move down
4 the indifference curve

1
3
1
1
2
2/3 1
Q3 =90
1/3 Q2 =75
1 1
Q1 =55
1 2 3 4 5 Labor per month
 MRTS and Marginal Products
 If we are
holding
output
constant

18
 Marginal rate of technical substitution
(MRTS)
19

 As increase labor to replace capital

 Labor becomes relatively less productive

 Capital becomes relatively more productive

 Need less capital to keep output constant

 Isoquant becomes flatter

 Isoquants: Special Cases
20

 Two extreme cases show the possible range of

input substitution in production
1. Perfect substitutes
 MRTS is constant at all points on isoquant
 Same output can be produced with a lot of capital or a lot of
labor or a balanced mix
 Perfect Substitutes
21

Capital
per A
Same output can be
month reached with mostly
capital or mostly labor
(A or C) or with equal
amount of both (B)
B

C
Q1 Q2 Q3
Labor
per month
 Isoquants: Special Cases
22

 Extreme cases (cont.)

2. Perfect Complements
 Fixed proportions production function
 There is no substitution available between inputs
 The output can be made with only a specific proportion of
capital and labor
 Cannot increase output unless increase both capital and
labor in that specific proportion
 Fixed-Proportions
Production Function
23

Capital
per Same output
month can only be
produced with
one set of
inputs.
Q3
C
Q2
B

K1 Q1
A

Labor
per month
L1
 Case study: Returns to Scale: Carpet
Industry
24

 The carpet industry has grown from a small industry to

a large industry with some very large firms.
 There are four relatively large manufactures along with
a number of smaller ones
 Growth has come from
 Increased consumer demand
 More efficient production reducing costs
 Innovation and competition have reduced real prices
The U.S. Carpet Industry
25
 Returns to Scale: Carpet Industry
26

 Some growth can be explained by returns to scale

 Carpet production is highly capital intensive
 Heavy upfront investment in machines for carpet production

 Increases in scale of operating have occurred by

putting in larger and more efficient machines into
larger plants
 Returns to Scale: Carpet Industry Results
27

1. Large Manufacturers
 Increased in machinery & labor
 Doubling inputs has more than doubled output
 Economies of scale exist for large producers
 Returns to Scale: Carpet Industry Results
28

2. Small Manufacturers
 Small increases in scale have little or no impact on output
 Proportional increases in inputs increase output
proportionally
 Constant returns to scale for small producers
 Returns to Scale: Carpet Industry
29

 From this we can see that the carpet industry is one

where:
1. There are constant returns to scale for relatively
small plants
2. There are increasing returns to scale for relatively
larger plants
 These are however limited
 Eventually reach decreasing returns
 3.2: Costs
30

SHORT-RUN COST CURVES

LONG-RUN COST CURVES
COSTS AND THE MULTI-PRODUCT
ECONOMICS VERSUS ACCOUNTING COST
EMPIRICAL COST ANALYSIS
 a. Accounting Cost and Economic Cost
31

 Accountants tend to take a retrospective view of firms

costs, where as economists tend to take a forward-
looking view
 Accounting Cost
 Actual expenses plus depreciation charges for capital
equipment
 Economic Cost
 Cost to a firm of utilizing economic resources in production,
including opportunity cost
Economic cost = accounting cost + opportunity cost
32

 Economic costs distinguish between costs the firm

can control and those it cannot
 Concept of opportunity cost plays an important role
 Opportunity cost
 Cost associated with opportunities that are foregone when a
firm’s resources are not put to their highest-value use.
 An Example
 A firm owns its own building and pays no rent for office space
 Does this mean the cost of office space is zero?
 The building could have been rented instead
 Foregone rent is the opportunity cost of using the building for
production and should be included in economic costs of doing
business
 Sunk cost
33

 Although opportunity costs are hidden and should be

taken into account, sunk costs should not
 Sunk Cost
 Expenditure that has been made and cannot be recovered
 Should not influence a firm’s future economic decisions.
 Firm buys a piece of equipment that cannot be converted to
another use. Expenditure on the equipment is a sunk cost
 Prospective Sunk Cost
34

 An Example
 Firm is considering moving its headquarters
 A firm paid $500,000 for an option to buy a building.
 The cost of the building is $5 million or a total of $5.5 million.
 The firm finds another building for $5.25 million.
 Which building should the firm buy?
---
 The first building should be purchased.
 The $500,000 is a sunk cost and should not be
considered in the decision to buy
 What should be considered is
 Spending an additional $5,250,000 or
 Spending an additional $5,000,000
 Cost in the Long Run
35

 In the long run a firm can change all of its inputs

 In making cost minimizing choices, must look at the
cost of using capital – K and labor - L in production
decisions, assumed that price of K is r (rate) and
price of L is w (wage)
 Cost in the Long Run
36

 The Isocost Line

 A line showing all combinations of L & K that can be purchased
for the same cost
 Total cost of production is sum of firm’s labor cost, wL and its
capital cost rK
C = wL + rK
 For each different level of cost, the equation shows another
isocost line
 Cost in the Long Run
37

 Rewriting C as an equation for a straight line:

 K = C/r - (w/r)L

 Slope of the isocost:

 -w/r – is the ratio of the wage rate to rental cost of capital.
 This shows the rate at which capital can be substituted for labor

 r
with no change in cost.

K  w
L
 Minimizing Cost: Choosing Inputs
38

 We will address how to minimize cost for a given

level of output by combining isocosts with isoquants
 We choose the output we wish to produce and then
determine how to do that at minimum cost
 Isoquant is the quantity we wish to produce
 Isocost is the combination of K and L that gives a set cost
Producing a Given Output at Minimum Cost
39
Capital
per Q1 is an isoquant for output Q1.
year There are three isocost lines, of
which 2 are possible choices in
which to produce Q1
K2

Isocost C2 shows quantity

Q1 can be produced with
combination K2L2 or K3L3.
However, both of these
A are higher cost combinations
K1 than K1L1.

Q1
K3

C0 C1 C2
Labor per year
L2 L1 L3
 Cost in the Long Run
40

 How does the isocost line relate to the firm’s

production process?

MRTS  - K  MPL
L MPK

Slope of isocost line  K  w

L r
MPL w when firm minimizes cost
MPK r
 Cost in the Long Run
41

 The minimum cost combination can then be written

as:
MPL MPK

w r
 Minimum cost for a given output will occur when each dollar
of input added to the production process will add an
equivalent amount of output.
 Quiz
42

 If w = $10, r = $20, and MPL = MPK, which input

would be used more of?
 Cost in the Long Run
43

 Cost minimization with Varying Output Levels

 For each level of output, there is an isocost curve showing
minimum cost for that output level
 A firm’s expansion path shows the minimum cost
combinations of labor and capital at each level of output.
 Slope equals K/L
 Quiz
44
A firm operates with the production function Q = K2L. The manager has
been given a production target: Produce 8,000 units per day. She
knows that the daily rental price of capital is $400 per unit. The wage
rate paid to each worker is $200 day.
a) Currently the firm employs at 80 workers per day. What is the firm’s
daily total cost if it rents just enough capital to produce at its target?
b) Compare the marginal product per dollar sent on K and on L when
the firm operates at the input choice in part (a). What does this
suggest about the way the firm might change its choice of K and L if it
wants to reduce the total cost in meeting its target?
c) In the long run, how much K and L should the firm choose if it wants
to minimize the cost of producing 8,000 units of output day? What
will the total daily cost of production be?
 A Firm’s Expansion Path
45

Capital
per The expansion path illustrates
the least-cost combinations of
year
labor and capital that can be
150 $3000 used to produce each level of
output in the long-run.

Expansion Path
$200
100 0
C
75
B
50
300 Units
A
25
200 Units

Labor per year

50 100 150 200 300
 Expansion Path & Long-run Costs
46

 Firms expansion path has same information as long-

run total cost curve
 To move from expansion path to LR cost curve
 Find tangency with isoquant and isocost
 Determine min cost of producing the output level selected
 Graph output-cost combination
A Firm’s Long-Run Total Cost Curve
47

Cost/
Year
Long Run Total Cost
F
3000

E
2000

D
1000

Output, Units/yr
100 200 300
 Long-Run Versus
Short-Run Cost Curves
48

 Long-Run Average Cost (LAC)

 Most important determinant of the shape of the LR AC and
MC curves is relationship between scale of the firm’s
operation and inputs required to min cost
1. Constant Returns to Scale
 If input is doubled, output will double
 LAC cost is constant at all levels of output.
 Long-Run Versus Short-Run Cost Curves
49

2. Increasing Returns to Scale

 If input is doubled, output will more than double
 AC decreases at all levels of output.
3. Decreasing Returns to Scale
 If input is doubled, output will less than double
 AC increases at all levels of output
 Long-Run Versus Short-Run Cost Curves
50

 In the long-run:
 Firms experience increasing and decreasing returns to scale
and therefore long-run average cost is “U” shaped.
 Source of U-shape is due to returns to scale rather than
diminishing marginal returns to a factor of production
 Long-run marginal cost curve measures the change in long-run
total costs as output is increased by 1 unit
Long-Run Average and Marginal Cost
51

Cost
($ per unit
of output LMC

LAC

Output
Long-Run Versus Short-Run Cost Curves
52

 Long-run marginal cost leads long-run

average cost:
 If LMC < LAC, LAC will fall
 If LMC > LAC, LAC will rise
 Therefore, LMC = LAC at the minimum of LAC
 In special case where LAC if constant, LAC
and LMC are equal
 Long Run Costs
53

 As output increases, firm’s LAC of producing is

likely to decline to a point
1. On a larger scale, workers can better specialize
2. Scale can provide flexibility – managers can organize
production more effectively
3. Firm may be able to get inputs at lower cost if it can get
quantity discounts. Lower prices might lead to different
input mix
 Long Run Costs
54

 At some point, LAC will begin to increase

1. Factory space and machinery may make it more difficult for
workers to do their job efficiently
2. Managing a larger firm may become more complex and
inefficient as the number of tasks increase
3. Bulk discounts can no longer be utilized. Limited
availability of inputs may cause price to rise
 Long Run Costs
55

 When input proportions change, the firm’s

expansion path is no longer a straight line
 Concept of return to scale no longer applies
 Economies of scale reflects input proportions that
change as the firm change its level of production
 Unlike returns to scale, economies of scale allows
inputs proportions vary
 Economies and Diseconomies of Scale
56

 Economies of Scale
 Increase in output is greater than the increase in inputs.

 Diseconomies of Scale
 Increase in output is less than the increase in inputs.

 U-shaped LAC shows economies of scale for

relatively low output levels and diseconomies of scale
for higher levels
 Long-Run Versus Short-Run Cost Curves
57

 We will use short and long-run cost to determine the

optimal plant size
 We can show the short run average costs for 3
different plant sizes
 This decision is important because once built, the
firm may not be able to change plant size for a while
 Long-Run Cost with
Constant Returns to Scale
58

 The optimal plant size will depend on the anticipated

output
 If expect to produce q0, then should build smallest plant: AC =
$8
 If produce more, like q1, AC rises
 If expect to produce q2, middle plant is least cost
 If expect to produce q3, largest plant is best
Long-Run Cost with Economies
and Diseconomies of Scale
59
 Long-Run Cost with
Constant Returns to Scale
60

 What is the firms’ long-run cost curve?

 Firms can change scale to change output in the long-run.

 The long-run cost curve is the dark blue portion of the SAC
curve which represents the minimum cost for any level of
output.
 Firm will always choose plant that minimizes the average cost
of production
 The long-run average cost curve envelopes the short-
run average cost curves
 The LAC curve exhibits economies of scale initially
but exhibits diseconomies at higher output levels
 61

 The firm experiences diseconomies of scale if it changes

its level of output
 a. from Q1 to Q2.
 b. from Q2 to Q3.
 c. from Q3 to Q4.
 d. from Q4 to Q5.
 CASE STUDY
62

 Case Study 8.1 Estimating cost functions for

hospitals Cost concepts and strategic advantage
 Case Study 8.2 Economies of scope in car production
 Case Study 8.3 Economies of scale in building
societies and insurance
 d. Management of Cost
63

 Managing a business to ensure costs are minimized is a

major task.
 Raw materials: excessive use of materials, paying higher
prices and maintaining excessive stocks relative to
production levels.
 Labour: excessive labour may be employed, it may be
used inefficiently and may be rewarded with higher than
average wage rates.
 Quality of inputs: workers employed may be less skilled
than those employed elsewhere and lack training, capital
may be of an older vintage and more prone to
breakdown.
 d. Management of Cost
64

 Volume: average costs are a function of volume of

production, and too low (or too high) an output can lead
to higher costs of production. Similarly, a lack of
cumulative volume can also result in higher unit costs.
 Overheads: excessive levels of management, buildings
and machinery can also be a source of higher unit costs.
 Outsourcing: some activities undertaken within the firm
may not be justified on cost grounds. If they can be
purchased from other producers more cheaply, then
production should cease.