Running head: OPTIMISATION 1

Iyanai Walter Chawheta

Cost Minimization in Production and Monopoly Theory

EBS5032 / Managerial Economics

Dr Tapati Sarmah

11 October 2024
OPTIMISATION 2

Cost Minimization in Production and Monopoly Theory

As companies seek to optimise production, it is vital for them to understand their cost

structure in order to optimise production processes. With competitive era abound, companies

must deal with rigid cost structures, economies of scale, etc. In doing so they should address

efficiency issues that arises from monopolistic attitudes. This assignment submission shall try to

analyse economic concepts such as average variable cost (AVC), average total cost (ATC),

economies of scale etc. strategies. This examination shall seek to understand the behaviour of

companies under different cost structures, explores the relationship between economies of scale

and scope, and scrutinises monopolistic inefficiencies. The submission shall also proffer a

critical evaluation of how monopolies can distort cost curves and market efficiency.

Question 1: Average Variable Cost(AVC) and Average Total Cost(ATC) Curves

The relationship between a firm's production costs and output levels is reflected in the U-

shaped nature of the AVC and ATC curves. The AVC curve reaches its minimum at a lower

level of output than the ATC curve due to differences in the components of each cost curve and

how these costs behave as production expands. AVC includes variable costs that fluctuate with

changes in output, initially decreasing due to increasing returns to scale, but eventually rising

because of diminishing marginal returns. On the other hand, ATC incorporates both fixed costs

and variable costs. Fixed costs do not change with output and are spread over more units as

production increases, leading to a continuous decline in AFC and a delayed rise in ATC. As a

firm increases output, it may experience increasing returns to scale initially. This through

benefiting from factors like labour specialization, machinery use, and improved techniques that

reduce per-unit variable costs. However, diminishing marginal returns eventually set in, causing

AVC to increase beyond its minimum point. Fixed costs play a significant role in spreading costs

over more units and leading to a decline in AFC. This offsets the rising AVC to some extent,
OPTIMISATION 3

allowing ATC to continue declining even after AVC reaches its minimum. Eventually, as

diminishing returns impact AVC, the rise in AVC outweighs the decline in AFC, leading to an

increase in ATC.

The difference in the minimum points of AVC and ATC is due to the fact that AVC only

reflects variable costs, while ATC accounts for both fixed and variable costs. The U-shaped

nature of these curves highlights the importance of optimizing costs across different levels of

output. In capital-intensive industries like manufacturing, firms benefit from spreading fixed

costs over higher output volumes, leading to a slower decline in ATC compared to AVC. In

industries with high fixed costs, like energy or infrastructure, spreading fixed costs optimally can

result in significant efficiency gains.

It is important for companies to understand cost curves dynamic in order to optimise

production costs. The behaviour/shapes of these curves are influenced by the relationship

between increasing and diminishing returns. In addition, the spreading of fixed costs, also affect

the shapes of the AVC and ATC curves.

Question 2: Economies of Scale and Economies of Scope

These are two important concepts about cost saving in production, emanating from

different origins and applying to different parts of a company's activities. Although these

concepts frequently coexist, they can also be present and identifiable separately.

Economies of scale happen when increased production results in lower costs per unit.

This results from the operational efficiencies gained by increasing production scale, including

purchasing materials in bulk, specialized labour, and efficient use of capital equipment.

Industries such as manufacturing and energy, which have high fixed costs, usually experience

advantages due to economies of scale (Young, & Erfle, 2013).

OPTIMISATION 4

Cost savings from producing various products at the same time with shared resources are

known as economies of scope. This enables companies to lower the cost of making more

products by using shared resources and procedures. For example, Apple (Inc.) and other similar

companies, gain advantages from economies of scope when they produce various products that

complement each other and can share research and development resources, supply chains, and

distribution networks (Pisano, 2015; Corporate Finance Institute, 2023).

Although economies of scale and economies of scope are frequently interrelated, they can

also function autonomously. Companies can obtain cost advantages through increased production

levels of a specific item, even if they do not diversify their product offerings. On the other hand,

companies can gain advantages from having a wide range of products without requiring large

production quantities for each, known as economies of scope, even in the absence of economies

of scale (Keat et al., 2013).

Industries requiring a large amount of capital, such as energy, are more likely to take

advantage of economies of scale by spreading fixed costs over more units through increased

production volume. Nevertheless, specialized production processes in these industries may limit

the presence of economies of scope (Syverson, 2020).

Ultimately, firms must grasp the distinctions between economies of scale and economies of

scope to enhance production efficiency.

Question 3: Labor-Capital Combinations

Analysis of the Current Input Mix

The chair manufacturer currently uses 3 hours of labour and 1 hour of machine time to

produce each chair. Given the costs:

 Labor cost = $30 per hour

 Machine (capital) cost = $15 per hour
OPTIMISATION 5

The total cost for producing one chair with the current input mix is:

 Labor cost: 3 hours × $30/hour = $90

 Machine cost: 1 hour × $15/hour = $15
 Total cost: $90 + $15 = $105 per chair
While this input combination allows the firm to produce chairs, it does not necessarily

indicate cost minimization. To determine whether the firm is minimizing its production costs, we

need to compare the Marginal Rate of Technical Substitution (MRTS) with the ratio of input

prices.

Understanding MRTS and Cost Optimization

The MRTS measures the rate at which one input (e.g., labour) can be substituted for

another (e.g., machinery) while maintaining the same level of output. For this chair

manufacturer, the MRTS is 1:1, meaning one hour of labour can be substituted for one hour of

machine time without changing the output.

Next, we compare the MRTS with the ratio of input prices:

 Labor cost: $30 per hour

 Machine cost: $15 per hour
 Input price ratio = $30/$15 = 2:1
The price ratio indicates that labour is twice as expensive as machinery. However, the

firm is currently using 3 hours of labour for every 1 hour of machinery, which means it is

overusing the more expensive input (labour). Therefore, the firm is not minimizing its costs.

Improving the Situation

To minimize costs, the firm should adjust its input mix to use more machinery and less

labour. The goal is to equalize the MRTS with the price ratio (2:1), meaning the firm should use

more of the cheaper input (machinery) and less of the expensive input (labour).
OPTIMISATION 6

The optimal input mix would be 2 hours of labour and 2 hours of machine time. Let’s

calculate the total cost with this optimal combination:

 Labor cost: 2 hours × $30/hour = $60

 Machine cost: 2 hours × $15/hour = $30
 Total cost: $60 + $30 = $90 per chair
By adjusting its input mix, the firm can reduce its total cost from $105 per chair to $90 per

chair, thereby achieving cost minimization.

Graphical Representation

We can illustrate this scenario graphically by plotting an isoquant curve and isocost lines.

1. Isoquant Curve: This curve represents all combinations of labour and capital that produce

the same level of output (1 chair). The isoquant is downward sloping because labour and

machinery can substitute each other in the production process.

2. Isocost Lines: These lines represent combinations of labour and capital that result in the

same total cost. The slope of the isocost line is determined by the ratio of input prices

(labour to capital), which is 2:1 in this case.

OPTIMISATION 7

 The current input combination (3 hours labour, 1 hour machine) is on a higher

isocost line corresponding to a total cost of $105.

 The optimal input combination (2 hours labour, 2 hours machine) is on a lower

isocost line corresponding to a total cost of $90.

The firm should shift its input combination along the isoquant to the point where the

isocost line is tangent to the isoquant curve, indicating that the MRTS is equal to the price ratio.

This point represents the cost-minimizing input combination.

Summary

The chair manufacturer is currently not minimizing its production costs. By using more

labour (the more expensive input) and less machinery, the firm is incurring unnecessary costs.

By adjusting its input mix to 2 hours of labour and 2 hours of machine time, the firm can reduce

its total cost per chair from $105 to $90, thereby achieving cost minimization. The graphical

illustration of the isoquant and isocost lines further demonstrates this optimal point, where the

firm balances input usage and minimizes production costs.

Question 4: Shape of the Long-Run Average Cost(LRAC) Curve

The LRAC curve depicts the minimum cost for producing a certain output with all inputs

variables. The curve is usually U-shaped, reflecting economies of scale, constant returns to scale,

and diseconomies of scale (Keat, Young, & Erfle, 2013). Initially, as output increases,

economies of scale lead to cost reduction through factors like spreading fixed costs, labour

specialization, and efficient capital use. Larger firms benefit from bulk discounts and advanced

technology, enhancing operational efficiency (Stiglitz, 2015). Once the firm reaches its most

efficient scale, constant returns to scale are experienced, indicating constant average costs.
OPTIMISATION 8

Beyond this point, diseconomies of scale set in, causing costs to rise due to coordination issues

and input inefficiencies (Keat et al., 2013).

The LRAC curve shows a downward slope in the economies of scale phase, becomes flat

in constant returns to scale, and then slopes upward in diseconomies of scale. Empirical studies

confirm this pattern, with firms in countries like China and India facing rising costs due to

resource misallocation (Hsieh & Klenow, 2009). Understanding the LRAC curve is crucial for

firms to optimize output and manage costs effectively as they expand.

Question 5: Average Fixed, Variable, and Total Costs

Average Fixed Cost (AFC) represents a firm's fixed costs divided by the number of units

produced, resulting in a decrease as production increases. On the other hand, Average Variable

Cost (AVC) is the variable cost per unit, which decreases at first due to increasing returns to

scale but eventually rises as output expands (Keat, Young, & Erfle, 2013). Average Total Cost

(ATC) is the sum of AFC and AVC, leading to a U-shaped ATC curve as both AFC and AVC

behaviours are combined. In capital-intensive industries, fixed costs are more dominant,

affecting the shape of the ATC curve (Syverson, 2020). Conversely, in labour-intensive

industries, variable costs play a greater role in influencing the ATC curve.

Understanding the relationship between AFC, AVC, and ATC is crucial for firms to

make optimal production decisions. By managing both fixed and variable costs efficiently, firms

can determine the best scale of production to minimize ATC. This balance is essential for

profitability and operational efficiency as production increases (Keat et al., 2013).

To summarise, AFC, AVC, and ATC are interconnected aspects of a firm's cost structure.

As output expands, AFC decreases, while AVC initially declines before rising due to

diminishing returns. The U-shaped ATC curve reflects the combined behaviour of AFC and
OPTIMISATION 9

AVC. This balance is pivotal in guiding a firm's production strategy, particularly in capital-

intensive and labour-intensive industries (Syverson, 2020).

Conclusion

This assignment has sought to explore important economic concepts related to how

businesses manage costs and improve production. It focused on issues/concepts like Average

Variable Cost (AVC), Average Total Cost (ATC), and ways to lower costs through economies of

scale and economies of scope. Understanding how these are interlinked is really important for

companies to make smart decisions about production. In so doing, they can become more

efficient and more profitable. The U-shaped ATC curve demonstrates the balance between

spreading fixed costs and managing variable costs as output levels change. Economies of scale

help reduce per-unit costs by spreading fixed costs over larger volumes, while economies of

scope allow firms to lower costs by producing multiple products that share resources. Academic

sources used in the paper support these concepts, showing how industries vary in cost behaviour

based on factors like fixed and variable costs, emphasizing the need for firms to adapt economic

principles to their specific conditions.

OPTIMISATION 10

References

Boehm, J., & Oberfield, E. (2020). Misallocation in the market for inputs: Enforcement and the

organization of production. American Economic Review, 110(6), 1711-1750.

Retrieved from [Link]

Corporate Finance Institute. (2023). Economies of scale and scope – Definition, effects, types,

and sources.

Retrieved from [Link]

Hsieh, C.-T., & Klenow, P. J. (2009). Misallocation and manufacturing TFP in China and India.

Quarterly Journal of Economics, 124(4), 1403-1448.

Retrieved from [Link]

Keat, P. G., Young, P. K. Y., & Erfle, S. E. (2013). Managerial economics: Economic tools for

today’s decision makers (7th ed.). Pearson.

Pisano, G. P. (2015). You need an innovation strategy. Harvard Business Review, 93(6), 44-54.

Retrieved from [Link]

Schmitz, J. A. (2016). The costs of monopoly: A new view. Federal Reserve Bank of

Minneapolis.

Retrieved from [Link]

Stiglitz, J. E. (2015). Rewriting the rules of the American economy: An agenda for growth and

shared prosperity. W.W. Norton & Company.

Syverson, C. (2020). What determines productivity? Journal of Economic Literature, 58(2), 326-

365.

Retrieved from [Link]