1. BUSINESS ECONOMICS Class 7 7 December, 2009

2. Recap  Production Theory  Factors of Production  Cobb-Douglas, Linear function  Isoquants, Isocosts  Law of Diminishing Returns  Economies of Scale  Capital Budgeting  NPV, Internal Rate of Return  Profitability Index, Payback period

3. Capital Budgeting  The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time.  Present value (PV) = Future Value (FV) – (rate x PV)

4. Scale of production  Returns to scale refers to changes in output subsequent to a proportional change in all inputs, where all inputs increase by a constant factor.  CRTS, DRS, IRS  Economies of scale refer to an economic property of production that affects cost if quantity of all input factors are increased by some amount.  If costs increase proportionately, there are no economies of scale  If costs increase by a greater amount, there are diseconomies of scale  If costs increase by a lesser amount, there are positive economies of scale.

5. Law of Diminishing Returns  Also known as Law of Variable proportions  The law states “the marginal product of each unit of input will decline as the amount of that input increases holding all other inputs constant”

6. Cost concepts  Fixed costs are costs which do not vary with output, for example, rent. In the long run all costs can be considered variable.  Variable cost also known as, operating costs, prime costs, on costs and direct costs, are costs which vary directly with the level of output, for example, labour, fuel, power and cost of raw material.  Social costs of production are costs incurred by society, as a whole, resulting from private production.  Average total cost is the total cost divided by the quantity of output.  Average fixed cost is the fixed cost divided by the quantity of output.  Average variable cost are variable costs divided by the quantity of output.

7. Marginal Cost  Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good.  Mathematically, the marginal cost (MC) function is expressed as the first derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next unit produced.  The equation for MC is

8. Average Total Cost  This can be compared with average total cost or ATC, which is the total cost divided by the number of units produced and does include fixed costs.

9. Cost Curve  MC curve is above average cost or average variable cost curves, then curves are rising.  If MC is below average cost curve or average variable cost curve, then curves are falling.  If MC equals average cost, then average cost is at its minimum value.  If MC equals average variable cost, then average variable cost is at its minimum value.

10. Short and long run costs  Short-run marginal cost takes fixed costs as unchanged, for example, the capital equipment and overhead of the producer, any change in its production involves only changes in the inputs of labour, materials and energy.  Long-run marginal cost allows all inputs, including capital items (plant, equipment, buildings) to vary.  Economies of scale are said to exist when marginal cost according to the textbook concept falls as a function of output and is less than the average cost per unit.  This means that the average cost of production from a larger new built-from-scratch installation falls below that from a smaller new built-from-scratch installation.

11. Short-run Average cost  The average total cost curve is constructed to capture the relation between cost per unit and the level of output.  A productively efficient firm organizes its factors of production in such a way that the average cost of production is at lowest point and intersects Marginal Cost.  In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity and no further opportunities for decreasing costs exist.  This is usually not U shaped, it is a checkmark shaped curve. This is at the minimum point in the diagram on the right.  Short run average cost equals average fixed costs plus average variable costs. Average fixed cost continuously falls as production increases. The shape of the average variable cost curve is directly determined by diminishing marginal returns to the variable input.

12. Long-run Average cost  The long-run average cost curve depicts what the minimum per-unit cost of producing a certain number of units would be if all productive inputs could be varied. Given that LRAC is an average quantity, one must not confuse it with the long- run marginal cost curve, which is the cost of one more unit. The  LRAC curve is created as an envelope of an infinite number of short- run average total cost curves. The typical LRAC curve is U-shaped, reflecting economies of scale.  In some industries, the LRAC is always declining (economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly.  The average cost is the total cost divided by the number of units produced.