BEC 30325 Managerial Economics Output Optimization Production Cost

BEC 30325 Managerial Economics Output Optimization (Production, Cost and Revenue)

Determining the optimal use of the variable input • Assuming that the capital input, or indeed any input in general terms, is fixed, – a firm can determine the optimal amount of the variable input. • This involves an explanation of the concepts of marginal revenue product (MRP) and marginal factor cost (MFC). 2

Marginal Revenue Product (MRP) • 3

Marginal Factor Cost (MFC) • 4

An example: • 5

Contd… • 6

Contd… • 7

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Increasing and Diminishing Returns Stage 2 Stage 1 Ep>1 0<Ep<1 TP Q • Stage 1: average product rising. • Stage 2: average product declining (but marginal product positive). • Stage 3: marginal product is negative, or total product is declining. Pt of Marginal Returns Increasing Returns Ep=1 Stage 3 Ep<0 Ep=0 TP Negative Returns Decreasing Returns AP, M P L 1 L 2 L 3 L AP L 1 L 2 L 3 MP L

Returns to Scale • An increase in scale involves a proportionate increase in all the inputs of the firm. • The resulting proportionate increase in output determines the physical returns to scale for the firm. 10

Extreme Cases of Input Substitutability 11

Types of Returns to Scale • Constant returns to scale (CRTS) – This refers to the situation where an increase in inputs results in an exactly proportional increase in output. • Increasing returns to scale (IRTS) – This refers to the situation where an increase in inputs results in a more-than-proportional increase in output. • Decreasing returns to scale (DRTS) – This refers to the situation where an increase in inputs results in a less-than-proportional increase in output. 12

Economies of Scale • Economies of scale (EOS) can be defined as aspects of increasing scale that lead to falling long-run unit costs. – Internal economies arise from the growth of the firm itself • In this sense they are controllable and under the influence of management decision-making. – External economies arise from the growth of the industry, and are independent of the size of the firm. • They are therefore further removed from managerial decision-making, though not entirely so; location decisions in particular may depend on these economies 13

• Technical Economies – These arise mainly from increased specialization and indivisibilities. • Managerial Economies – Large firms find it easier to attract and use more specialized managers, who are more skilled and productive at performing specific managerial functions 14

• Marketing Economies – These relate mainly in obtaining bulk discounts and advertising economies. • Financial Economies – Large firms can often borrow at a lower interest rate, because they have a better credit rating, representing a lower default premium. 15

Diseconomies of Scale • Diseconomies of scale (DOS) are aspects of increasing scale that lead to rising long-run unit costs. • Again they can be internal or external, physical or monetary, and can arise at the level of product, plant or firm. • Technical, managerial, marketing and financial diseconomies. 16

Economies of Scope • Economies of scope occur when changing the mix of operations has cost benefits. Ex: Producing 100, 000 units of product X may involve a unit cost of $100 if X is produced by itself; but if 100, 000 units of X are produced along with a quantity of product Y, then the unit cost of producing X may fall. • There are two (02) main causes of this. – The products may use common processing facilities; for example, different car models being produced at the same plant. – There may be cost complementarity, especially when there are joint products or by-products, for example petrochemicals 17

Short-run and long-run average cost functions in the absence of EOS and DOS 18

Short-run and long-run average cost functions with EOS and DOS 19