Weeks 5

1
Weeks 5 6 Production and Costs
2
Demand analysis and estimation
Elasticity
Try problems 3.1 3.13 from the text
Problem I
Kitty Russells Longbranch Café recently reduced
a price for Nachos Supreme appetizers from 5 to
3 and enjoyed a resulting increase in sales from
60 to 180 orders a day. Beverage sales also
increased from 30 to 150 units a day.
A. Calculate the arc elasticity of demand for
Nachos Supreme appetizers
B. Calculate the arc cross-price elasticity of
demand between beverage sales and appetizer
prices
C. Holding all else equal, would you expect an
additional appetizer price decrease to 2.50 to
cause both appetizer and revenue to rise.
3
Demand analysis and estimation
Elasticity
Problem II
During the past year Ironside 15 million square
yards (units) of carpeting at average price
7.75 per unit. This year GNP per capita is
expected to surge from 17,250 to 18,750.
Without any price change the sales are expected
to rise to 25 million units.
A. Calculate the income arc elasticity of demand
B. Calculate the arc cross-price elasticity of
demand between beverage sales and appetizer
prices
C. Holding all else equal would a further
increase in price result in higher or lowe rtotal
revenue.
4
Demand analysis and estimation
Elasticity
Cross-Price elasticity
Problem III
Sales of a sporting companys garment bag
declined from 10000 to 4800 units. At the same
time a competitor offered a 52 discount off
their regular 137 price on a competitive
product.
A. Calculate the arc cross-price elasticity of
demand
B. They recovered there sales to 6000 units
following reduction in price from 140 t0 130.
Calculate the price elasticity of demand
C. If the price elasticity is constant, determine
the further price reduction necessary to fully
recover lost sales (regain a volume of 10000
units)
5
Demand analysis and estimation
Elasticity
Price and Cross-Price elasticity
Problem I
Kitty Russells Longbranch Café recently reduced
a price for Nachos Supreme appetizers from 5 to
3 and enjoyed a resulting increase in sales from
60 to 180 orders a day. Beverage sales also
increased from 30 to 150 units a day.
A. Calculate the arc elasticity of demand for
Nachos Supreme appetizers
6
Demand analysis and estimation
Elasticity
Price and Cross-Price elasticity
Problem I
Kitty Russells Longbranch Café recently reduced
a price for Nachos Supreme appetizers from 5 to
3 and enjoyed a resulting increase in sales from
60 to 180 orders a day. Beverage sales also
increased from 30 to 150 units a day.
B. Calculate the arc cross-price elasticity of
demand between beverage sales and appetizer
prices
7
Demand analysis and estimation
Elasticity
Price and Cross-Price elasticity
Problem I
Kitty Russells Longbranch Café recently reduced
a price for Nachos Supreme appetizers from 5 to
3 and enjoyed a resulting increase in sales from
60 to 180 orders a day. Beverage sales also
increased from 30 to 150 units a day.
C. Holding all else equal, would you expect an
additional appetizer price decrease to 2.50 to
cause both appetizer and revenue to rise.
The answer does not require further
calculations. Yes, Ep2gt1 implies an elastic
demand for appetizers and that an additional
price reduction will increase appetizer revenues.
Epx-2.67 lt 0 indicates that the items are
complements. Therefore a further decrease in
appetizer prices will cause further increase in
beverage sales and revenues.
8
Demand analysis and estimation
Elasticity
Problem II
Price income elasticity
During the past year Ironside 15 million square
yards (units) of carpeting at average price
7.75 per unit. This year GNP per capita is
expected to surge from 17,250 to 18,750.
Without any price change the sales are expected
to rise to 25 million units.
A. Calculate the income arc elasticity of demand
9
Demand analysis and estimation
Elasticity
Problem II
Price income elasticity
During the past year Ironside 15 million square
yards (units) of carpeting at average price
7.75 per unit. This year GNP per capita is
expected to surge from 17,250 to 18,750.
Without any price change the sales are expected
to rise to 25 million units.
B. The marketing director believes, that current
volume of 15 million units could be maintained
despite an increase in price of 50c per unit. On
this basis calculate the implied arc price
elasticity of demand
Without the price increase the sales would be 25
million units. The manager is looking at
increase in price and maintaining the previous
year sales of 15 million units.
10
Demand analysis and estimation
Elasticity
Problem II
Price income elasticity
During the past year Ironside 15 million square
yards (units) of carpeting at average price
7.75 per unit. This year GNP per capita is
expected to surge from 17,250 to 18,750.
Without any price change the sales are expected
to rise to 25 million units.
C. Holding all else equal would a further
increase in price result in higher or lowe rtotal
revenue.
Lower. The product is elasic.
11
Demand analysis and estimation
Elasticity
Cross-Price elasticity
Problem III
Sales of a sporting companys garment bag
declined from 10000 to 4800 units. At the same
time a competitor offered a 52 discount off
their regular 137 price on a competitive
product.
A. Calculate the arc cross-price elasticity of
demand
The goods are substitutes
12
Demand analysis and estimation
Elasticity
Cross-Price elasticity
Problem III
Sales of a sporting companys garment bag
declined from 10000 to 4800 units. At the same
time a competitor offered a 52 discount off
their regular 137 price on a competitive
product.
B. They recovered there sales to 6000 units
following reduction in price from 140 t0 130.
Calculate the price elasticity of demand
The demand is elastic
13
Demand analysis and estimation
Elasticity
Cross-Price elasticity
Problem III
Sales of a sporting companys garment bag
declined from 10000 to 4800 units. At the same
time a competitor offered a 52 discount off
their regular 137 price on a competitive
product.
C. If the price elasticity is constant, determine
the further price reduction necessary to fully
recover lost sales (regain a volume of 10000
units)
14
Structure
Weeks 7-8 Competition, market structures and
business decisions
Week 9 Pricing strategies and practices
Week 10 Business and Government.
Weeks 5 - 6 Production and Costs
Managerial Economics
Week 11 Capital budgeting
Weeks 3-4 Demand analysis and estimation
Week. 12 Research question Business and current
economic situation.
Week 2 Basic economics principles demand and
supply.
Week1 Introduction. The nature of managerial
economic decision making
15
Production and Costs
Production functions
Factors of production
Total, marginal and average product, revenue and
costs
Return to factors versus return to scale
Firm and plant size
Economies and diseconomies of scale
Optimal level of single input and optimal
combination of multiple inputs
Fixed and variable costs
Explicit and implicit costs
Short run versus long run in cost analysis
16
Production and Costs
Learning objectives

• This topic addresses the following questions
• At given demand conditions, how does a firm
  determine the optimal level of output during any
  production period?
• How does a firm choose the best technology
  (production process) out of existing ones?
• How does investment in a new equipment affects
  employment and productivity of labour?
• How do costs and output are interrelated?

17
Production and Costs
Reading
Mansfield, Chapters 7, 8 9.
18
Production and Costs
Production functions
Descriptive statement/variable that relates
Inputs to outputs. Specifies the maximum
output that can be produced at a given level of
input (inputs) Is determined by the level of
technology.
19
Production and Costs
Factors of production
Labour Capital
Labour Capital Mineral resources
Land Materials Energy, Seeds Live stock Rolling
stock Rail tracks Roads Plant equipment Farm
machinery and equipment
20
Production and Costs
Total, marginal and average product
A numerical example
21
Production and Costs
Total, marginal and average product
A numerical example
22
Production and Costs
Total, marginal and average product
23
Production and Costs
Return to factors
Total output (Q )
C
TP
x

Q
B
(a)
A
X
X
X
3
2
1
Input
X
24
Production and Costs
Return to factors
Law of diminishing returns
Average and
marginal output
Q
?
Q
,
?
X
X
Diminishing
Negative
Increasing
returns
returns
returns
'
A
(b)
'
B
AP
x
C
'
X
X
X
3
2
1
MP
x
Input
X
As the quantity of variable input increases the
resulting rate of output increase eventually
diminishes
25
Production and Costs
Isoquants
Each point on the Isoquant represents A
different combination of two inputs that can be
used to produce the same amount of output
The slope of the isoquant at a particular point
26
Production and Costs
Isoquants
Perfect substitution
Gas
Q

3
Q
2

Q

1
Oil
27
Production and Costs
Isoquants
Zero substitution
Frames
5
4
3
Q
3
3
2
Q
2
2
1
Q
1 Bicycle
1
2
4
6
0
Wheels
28
Production and Costs
Isoquants
Imperfect substitution
Cloth
Decrease in one factor Requires more and
more Of the other one for substitution
C
1
Q
C

3
2
Q
C
2
3
Q
1
L
L
L
1
2
3
Labor
29
Production and Costs
Isoquants
Marginal rate of technical substitution the
slope of an isoquant at a particular point
30
Production and Costs
Return to scale
Output elasticity
31
Production and Costs
Return to scale
Increasing
returns
0.5
0.5
0.8
0.7
Constant returns (
Q

15
X
Y
)
(
Q

10
X
Y
)
Total product Q
Decreasing
returns
0.4
0.2
(
Q

20
X
Y
)
Units of Input
X
,
Y
32
Production and Costs
Marginal Revenue product
Marginal revenue product Amount of revenue
generated By employing the last input unit
In particular, used for the optimisation of
factor usage
33
Production and Costs
Solutions
Problem 1 Marginal Rate of Technical Subsitution
The following table of data is given

• Do the two inputs exhibit the characteristics of
  constant, increasing, or decreasing marginal rate
  of technical substitution?

34
Production and Costs
Solutions
Problem 1 Marginal Rate of Technical Subsitution

• Do the two inputs exhibit the characteristics of
  constant, increasing, or decreasing marginal rate
  of technical substitution?

Diminishing marginal return to factor corresponds
to decreasing MRTS
35
Production and Costs
Solutions
Problem 1 Marginal Rate of Technical Subsitution

• Do the two inputs exhibit the characteristics of
  constant, increasing, or decreasing marginal rate
  of technical substitution?

Q188
36
Production and Costs
Solutions
Problem 1 Marginal Rate of Technical Subsitution
B. Assuming the oputput sells for 3 per unit and
that X is fixed at 2 units or That y is fixed at
3 units Complete the table
X is fixed at 2 units
y is fixed at 3 units
37
Production and Costs
Solutions
Problem 1 Marginal Rate of Technical
Substitution
C. Assume that the quantity of x is fixed at 2
units. If output sells for 3 and the cost of Y
is 120 per day, how many units per day will be
employed?
X is fixed at 2 units
Y3 will be employed. The marginal revenue
product of the Y3 is 138 is greater than the
marginal cost per day. At y4 marginal revenue
product is 6 units less than the marginal cost.
38
Production and Costs
Solutions
Problem 1 Marginal Rate of Technical
Substitution
D. Assume that the company is currently producing
162 units of output per day using 1 unit of X and
3 units of Y. The daily cost per unit X is 120
and that of Y is also 120. Would you recommend
the present input combination. Why or why not?
May be logically solved. We leave until one
more concept is introduced.
39
Production and Costs
Solutions
Problem 1 Marginal Rate of Technical
Substitution
E. What the nature of return to scale for this
production system if the optimal input
combination requires XY
470/945 376/944 282/943 188/942 Constant
return to scale
40
Production and Costs
Solutions
Problem 2. Production Function concepts
Indicate whether the each following statements is
true or false. Explain.
B. If the marginal product of capital falls as
capital usage grows, the returns to capital are
decreasing.
True. This follows from the definition of the
return to factor. Returns to capital factor are
decreasing when the marginal product of capitals
falls as capital usage grows
41
Production and Costs
Solutions
Problem 2. Production Function concepts
Indicate whether the each following statements is
true or false. Explain.
C and D the reflection of definitios only
E. The marginal rate of technical substitution
will be affected by a given percentage increase
in the marginal productivity of all inputs.
False. The MRTS is measured by the relative
marginal productivity of input factors. The
proportional change does not affect MRTS.
42
Production and Costs
Solutions
Problem 3 Factor Productivity
During recent years, computer aided design (CAD)
and computer aided manufacturing (CAM) have
become prevalent in many industries. Holding all
else equal, indicate, whether each of the
following factors would be responsible for
increasing or decreasing of this prevalence.
A. Rising worker pension costs
Increasing. Increases the cost of labour and
makes CAD/CAM capital investment more attractive.
B. Technical advances in computer mainframe
design.
Increasing. Lower the relative cost of CAD/CAM.
43
Production and Costs
Solutions
Problem 3 Factor Productivity
During recent years, computer aided design (CAD)
and computer aided manufacturing (CAM) have
become prevalent in many industries. Holding all
else equal, indicate, whether each of the
following factors would be responsible for
increasing or decreasing of this prevalence.
C. An increase of the import share of the market.
Decreasing. As imports rise, domestic output
falls, holding all else equal. Thus, output
demand and MRQ would fall as would CAD/CAM usage.
D. Falling prices of industry output.
Decreasing. As prices of industry output fall,
so does MRQ and MRP of CAD/CAM. This would
reduce CAD/CAM usage.
44
Production and Costs
Solutions
Problem 3 Factor Productivity
During recent years, computer aided design (CAD)
and computer aided manufacturing (CAM) have
become prevalent in many industries. Holding all
else equal, indicate, whether each of the
following factors would be responsible for
increasing or decreasing of this prevalence.
E. Computer software that is increasingly
user-friendly
Increasing. The cost of CAD/CAM falls.
45
Production and Costs
Optimal combination of multiple inputs
Isocost curves.
All combinations of products that can be
purchased for a fixed dollar amount
Sloping downward curve.
Units of
X
0
2
4
6
46
Production and Costs
Optimal combination of multiple inputs
Optimal combination corresponds to the point of
tangency isoquant and isocost.
47
Production and Costs
Solutions
Problem 1 Marginal Rate of Technical
Substitution
D. Assume that the company is currently producing
162 units of output per day using 1 unit of X and
3 units of Y. The daily cost per unit X is 120
and that of Y is also 120. Would you recommend
the present input combination. Why or why not?
y is fixed at 3 units
A change would be recommended, since the firm
could produce 188 units at the same cost using
two units of each input that is, the marginal
product to price ratios of the two inputs are not
equal at the current input proportion.
Relatively less Y and more X is needed to provide
an optimal combination.
48
Accounting and Economic Valuations
Production and Costs
Costs analysis

• Accounting actual
• Economic - alternative

49
Historical vs Current Costs
Production and Costs
Costs analysis

• Historical for accounting purposes
• Current based on prevailing market conditions
  for decision making
• Replacement what is required to renew the
  productive capacity at the existing technology
  for efficiency evaluation

50
Opportunity cost
Production and Costs
Costs analysis

• The second best alternative forgone to allow th
  current use.

51
Explicit and implicit cost
Production and Costs
Costs analysis

• Explicit out-of-pocket
• Wages
• Utilities
• Materials
• Interest
• Rent
• Implicit
• Forgone earning if not explicitly spent for the
  chosen alternative

52
Incremental and Sunk Costs
Production and Costs
Costs analysis

• Incremental costs - towards increase in
  output/productive capacity implied by a
  particular managerial decision
• Sunk costs does not vary across decion
  alternatives
• Arise from past irreversible decisions
• Irrelevant to current and future decisions

53
Short and long run in managerial economics
Production and Costs
Short run and long run costs

• Short run operating decision are made
• At least one input is fixed
• Long run planning decision are made
• Complete flexibility of inputs
• No fixed costs

54
Production and Costs
Short run and long run costs
Short run costs

• TCTFCTVC
• AFCTFC/Q
• AVCTVC/Q
• ATC/TC/Q
• MC?TC/ ?Q ? TVC/Q

per time period
MC
ATC
AVC
AFC
Q
Q
Q
3
2
1
Output per time period (units)
(
b
) Unit costs
55
Production and Costs
Short run and long run costs
Short run costs
per time period
Total
cost
Decreasing
Increasing
returns
returns
Output per time period (units)
56
Production and Costs
Short run and long run costs
Short run costs
Output per
time period (units)
Total product
Decreasing
returns
Increasing
returns
Input per time period (units)
57
Production and Costs
Short run and long run costs
Long run costs
per unit
of output
SRAC
A
SRAC
B
SRAC
C
SRAC
M
D

Q
Q
Q
Q
1
2
3
Output per time period (units)
58
Production and Costs
Short run and long run costs
Long run costs
per unit of output
Long-run average cost
Minimum LRAC
Least-cost plant
Q
Output per time period (units)
59
Production and Costs
Short run and long run costs
Long run costs, return to scale nd the optimal
size of plant and firm
Q - the size of plant QF The size of firm
Cost per unit
Cost per unit
Cost per unit
Long-run average cost
Long-run average cost
Long-run average cost
Q

Q

Q

Q


Q

Q




F
F
F
Output
Output
Output
(a)
Constant costs Constant return to scale
(b)
Declining costs- Increasing return to scale
(c)
U-shaped cost curve Decreasing return to
scale
60
Production and Costs
Short run and long run costs
Long run costs, return to scale nd the optimal
size of plant and firm
61
Production and Costs
Short run and long run costs
Cost output profit analysis
Net
profit
240
per time period
Profit
Total Revenue
210
(000)
180
Total Cost
150
Variable
cost
120
Breakeven point
90
Fixed cost
Loss
60
Fixed
30
cost
0
10
20
30
40
50
60
70
80
Units produced and sold per time period (000)
62
Production and Costs
Short run and long run costs
Firm
A
Selling price 2.00
Income and
Fixed cost 20,000
costs
Variable cost 1.50
Q
240
200
Units
Total Revenue
Sales
Cost
Profit
sold (
Q
)
160
Breakeven
20,000
40,000
50,000

10,000
Total Cost
120
point
40,000
80,000
80,000
0
60,000
120,000
110,000
10,000
80
80,000
160,000
140,000
20,000
40
100,000
200,000
170,000
30,000
Fixed cost
120,000
240,000
200,000
40,000
0
20
40
60
80
100
120
Units (
Q
)
63
Production and Costs
Short run and long run costs
Firm
B
Selling price 2.00
Income and
Fixed cost 40,000
costs
Variable cost 1.20
Q
240
200
Units
Total Revenue
Sales
Cost
Profit
sold (
Q
)
160
Breakeven
20,000
40,000
64,000

24,000
Total Cost
120
point
40,000
80,000
88,000

8,000
60,000
120,000
112,000
8,000
80
80,000
160,000
136,000
24,000
Fixed cost
40
100,000
200,000
160,000
40,000
120,000
240,000
184,000
56,000
0
20
40
60
80
100
120
Units (
Q
)
64
Production and Costs
Short run and long run costs
Firm
C
Selling price 2.00
Income and
Fixed cost 60,000
costs
Variable cost 1.00
Q
240
200
Units
Total Revenue
Sales
Cost
Profit
sold (
Q
)
160
Breakeven
20,000
40,000
80,000

40,000
Total Cost
point
120
40,000
80,000
100,000

20,000
60,000
120,000
120,000
0
Fixed cost
80
80,000
160,000
140,000
20,000
40
100,000
200,000
160,000
40,000
120,000
240,000
180,000
60,000
0
20
40
60
80
100
120
Units (
Q
)