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Managerial economics B
Berlinschi, De Ridder, Rogge
CHAPTER 6 PART 1 (20/02/2023)
Background to supply: firms in competitive markets (the cost of production)
The goal of a firm
• Is to maximize profit
• Profit = Total revenue - Total cost
• Total Revenue = the amount a firm receives for the sale of its output (P*Q).
• Total Cost = the market value of the inputs used for producing the output.
• In order to take optimal decisions (how much to produce and at which price to sell in
order to maximize profits), managers need to look at several different measures of
the firm’s cost.
The cost of a firm
• The cost of something is what you give up to get it
• The opportunity cost of an item refers to all things that must be forgone to acquire
that item.
• A firm’s cost of production includes both explicit costs and implicit costs.
o Explicit costs are input costs that require a payment of money.
§ e.g., wage of an employee
o Implicit costs are input costs that do not require a payment of money.
§ e.g., income that the firm owner could have earned by doing
something else
Economic Profit versus Accounting Profit
• The distinction between explicit and implicit costs highlights an important difference
between how economists and accountants analyze a business
• Economic profit < Accounting profit
o Economists are interested in how firms make production and pricing
decisions. These decisions are based on both explicit and implicit costs
→ economists include explicit and implicit when measuring a firm’s costs
o Accountants have to keep track of the money that flows into and out of firms
→ accountants measure explicit costs and ignore implicit costs
• Economists measure a firm’s economic
profit as total revenue minus total cost,
including both explicit and implicit costs.
Economists consider the opportunity costs.
• Accountants measure the accounting profit
as the firm’s total revenue minus the firm’s
explicit costs.
• See example on slide 11-13
1
,Cato Sluyts
Production and costs
• Firms incur costs when they buy inputs to produce the goods and services they plan
to sell, important simplifying assumption:
o The short run: period in which some factors of production can’t be changed
o The long run: the period in which all factors of production can be altered
The production function
• The production function shows the relationship between the quantity of inputs used
to produce a good and the quantity of output of that good.
• Q = f(K,L) with: Q=output, K=capital, L=labor
o This is a simplified production function, in reality more production factors are
used: e.g., natural resources like air and water, industrial enterprise
• The average product of an input in the production process is the units of output
produced per unit of input (while keeping other inputs constant).
• Average product is a global concept (total output is divided by total input)
• The higher the average product, the more productive an input is and vice versa.
o Average product of labor: Average product of capital:
! !
APL = " APK = #
• The marginal product of an input in the production process is the increase in output
that arises from an additional unit of that input.
change in total product
MPF =
change in quantity of the factor
• Local concept as the additional amount of output is divided by the additional amount
of input invested.
• Marginal product of labor: Marginal product of capital:
𝛥Q 𝛥Q
MP! = MP" =
𝛥L 𝛥K
• Or, for an infinitesimal small change in labor/capital input (partial derivative, will be
studied in mathematics later):
𝜕Q and 𝜕Q
MP! = MP" =
𝜕L 𝜕K
• Diminishing marginal product is the property whereby the marginal product of an
input declines as the quantity of the input increases.
o Example: As more and more workers are hired at a firm, each additional
worker contributes less and less to production, because equipment is limited.
• The slope of the production function measures the marginal product of an input,
such as a worker.
• When the marginal product declines, the slope decreases, and the production
function becomes flatter.
o If the production function is linear, the MP of labor is constant (is atypical)
o See typical curves on next page
2
,Cato Sluyts
Calculating derivatives
From the Production Function to the Total Cost Curve
• The relationship between the quantity a firm produces and the cost of producing
that quantity is important, as it determines the firm’s production and pricing
decisions. This can be represented by a table, a function or a graph.
• The total cost curve shows this relationship graphically.
• The production function and the total cost function are opposite sides of the coin.
• The total cost curve gets steeper as the amount produced
rises, whereas the production function gets flatter as
production rises
o Explanation: when the kitchen is crowded each
additional worker adds less to production (=
diminishing MP) so producing an additional pizza
requires a lot of additional labor which is costly.
The various measures of costs
• Costs of production may be divided into fixed costs and variable costs
o Fixed costs are those that do not vary with the quantity of output produced.
o Variable costs are those that do vary with the quantity of output produced.
• Total Costs TC(Q) = FC + VC(Q)
o Total Fixed Costs FC
o Total Variable Costs VC(Q)
o Note: FC is not a function of Q, VC is a
function of Q and TC is a function of Q.
3
, Cato Sluyts
Average and marginal costs
• A firm owner has to decide how much to produce. This decision is based on how
costs vary when the level of production is changed.
• The following questions are important:
o How much does it cost to produce a typical unit of output?
§ = ATC = average total cost
o How much does it cost to produce an additional unit of output?
§ = MC = marginal cost
The average cost
• The cost of a typical unit of output.
• Global concept
• It is calculated by dividing the firm’s total costs by the quantity of output produced.
TC
ATC=
Q
Fixed cost FC
AFC = =
• Average Fixed Costs (AFC) Quantity Q
Variable cost VC
AVC = =
• Average Variable Costs (AVC) Quantity Q
Total cost TC
ATC = =
• Average Total Costs (ATC) Quantity Q
(ATC = AFC + AVC)
Marginal cost
• How much does it cost to produce an additional unit of output?
• Local concept as it is the ratio of the change in total production cost and the change
in the total output
• Marginal cost (MC) measures the increase in total cost that arises from an extra unit
(change in total cost) ΔTC
MC= =
of production: (change in quantity) ΔQ
dTC
MC=
• Or for an infinitesimal small change in Q (derivative): dQ
4
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