J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.

Principles of
Business Economics

Joseph G. Nellis
Professor of International Management Economics
Cranfield School of Management
Cranfield University

David Parker
Professor of Business Economics and Strategy
Aston Business School
Aston University

Pearson Education Limited 2002
OHT 0.1
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
1 Business economics: an overview
2 The analysis of consumer demand
3 The analysis of production costs
4 Analysis of the firms supply decision
5 Demand, supply and price determination
6 Analysis of perfectly competitive markets
7 Analysis of monopoly markets
8 Analysis of monopolistically competitive markets
9 Oligopoly
10 Managerial objectives and the firm
11 Understanding competitive strategy
12 Understanding pricing strategies
13 Understanding the market for labour
14 Understanding the market for capital
15 Understanding the market for natural resources
16 Government and business
17 Business and economic forecasting
18 Business economics - a checklist for managers

OHT 0.2
Contents
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
CHAPTER 1
Business economics: an overview
Microeconomic Environment
deals with the operation of the firm in its immediate market
involves determination of prices, revenues, costs,
employment, etc

Macroeconomic Environment
deals with the general economic conditions of the larger
economy of which each firm forms a part.
involves the impact of political, legal and economic
decisions, both nationally and internationally.
OHT 1.1
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 1.2
Figure 1.1 The business environment
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Learning outcomes

This chapter will help you to:

Understand the core terms and concepts used in
business economics.

Appreciate the nature of a firms production
decisions with respect to what to produce, how
to produce and for whom to produce.

Employ economic reasoning when making
choices in the use of resources and to recognise
the importance of diminishing returns.

OHT 1.3A
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Comprehend the nature of marginal analysis in
the context of business and consumer
decisions.

Recognise the different objectives which
different firms may pursue and the consequent
impact on price and output decisions.

Distinguish between the short run and long run
in business economics.

Understand the nature of different competitive
structures in market economies ranging from
perfectly competitive to monopoly situations.

OHT 1.3B
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Analyse the external environment and internal
capabilities of a firm using core techniques in
business economics and thereby understand the
forces shaping the firms competitive
environment.

Appreciate the choice of generic strategies
facing firms in terms of cost leadership,
differentiation and focus options.


OHT 1.3C
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Resource allocation.

Opportunity cost.

Diminishing marginal returns.

Marginal analysis.

Business objectives.

Basic concepts in business economics
There are a number of basic concepts which lie at the heart
of business economics and managerial [Link]
most important of these are the following:
OHT 1.4A
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.

Time dimension.

Economic efficiency and equity.

Risk and uncertainty.

Externalities.

Discounting.

Property rights.

OHT 1.4B
Basic concepts in business economics

J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Resource allocation

Economics is concerned with the efficient allocation of scarce
resources. When purchasing raw materials,employing labour
and undertaking investment decisions,the manager is involved
in resource [Link] need to be made at three
levels, namely:
What goods and services to produce with the available
resources,

How to combine the available resources to produce
different types of goods and services;and

For whom the different goods and services are to be
supplied.
OHT 1.5
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 1.6
Figure 1.2 The production decision
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The opportunity cost of any activity is what we give up
when we make a [Link] other words,it is the loss of the
opportunity to pursue the most attractive alternative given
the same time and resources.

A production possibility curve shows the maximum output
of two goods or services that can be produced given the
current level of resources available and assuming
maximum efficiency in production.

The concept of diminishing marginal returns refers to the
situation whereby as we apply more of one input
([Link]) to another input ([Link] or land),then after
some point the resulting increase in output becomes
smaller and smaller.
OHT 1.7
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 1.8
Figure 1.3 Production possibility curve
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Marginal utility is the amount by which consumer well-being
or total utility changes when the consumption of a good or
service changes by one unit.

Marginal product is the amount by which total product
changes due to a one unit change in the amount of input
used.

Marginal revenue is the change in total revenue which
results from increasing the quantity sold by one unit.

Marginal cost is the change in total cost which results from
increasing the quantity produced by one unit.
OHT 1.9
Marginal Analysis
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Profit maximisation

The achievement of personal goals,involving personal
security and reward,status, degree of discretionary
power,etc.

Growth targets for the company in terms of scale of
output,market share,geographical market,annual
extension of physical capacity,size of departments or
size of the labour force,etc.

Maximisation of sales revenue.

Pursuit of the interests of all stakeholders including
employees,customers,suppliers, [Link] well as
shareholders.
Business Objectives
OHT 1.10
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The short run represents the operating period of
the business in which at least one factor of
production is fixed in supply.

The long run represents the planning horizon for
the business in which all factors of production may
be varied.
Time dimension
OHT 1.11
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The concept of discounting is concerned with the fact that
costs and benefits arising in future years are worth less to us
than costs and benefits arising today.

Discounting formula

NPV =


where NPV is the net present value of the cash flow over the
life of the project, S is the future sum, r is the rate of interest
or discount rate, and t the number of years elapsing before
the future sum is received.
Discounting
OHT 1.12
( )

+
t
t
r
S
1
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The competitive environment & market
structure
Perfectly competitive markets.

Monopolistically competitive markets.

Oligopolistic competition.

Monopoly.
OHT 1.13
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Defining the nature of the market

The number and size distribution of the buyers
and sellers in the market.

The degree of product differentiation that
exists.

The severity of the barriers to entry and exit
that face potential new entrants to the market.
OHT 1.14
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 1.15
Figure 1.4 Characteristics of markets
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Porter Five Forces Model

The bargaining power of buyers how much leverage buyers
have in determining the price.

The bargaining power of (input) suppliers the competition
among suppliers which determines the price of inputs to the
firm.

The threat from potential new entrants into the market the
degree of market contestability or the extent to which firms
are able to enter the market and contest for consumers.

The threat from substitute products or services e.g. mobile
telephones for fixed-line services.

The degree of competition (rivalry)in the market.
OHT 1.16
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 1.17
Figure 1.5 Forces shaping the competitive environment
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Cost positioning of the firm


Cost leadership.

Differentiation.

Focus.
OHT 1.18
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 1.19
Figure 1.6 Strategy and the competitive environment - an overview
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Key learning points

Microeconomics deals with the operation of the firm in
its immediate market, involving the determination of its
prices, revenues,costs and input employment levels.

Macroeconomics is concerned with the interactions in
the economy as a whole of which each firm forms a part.

Resource allocation is concerned with decisions
regarding what, how , and for whom to [Link] a
market economy the price mechanism is the major
determinant of these decisions.
OHT 1.20A
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The opportunity cost of any activity is the loss of the
opportunity to pursue the most attractive alternative
given the same resources.

A production possibility curve shows the maximum
output that can be produced given the current level of
resources available and assuming maximum efficiency
in production.

Diminishing marginal returns refers to the situation
whereby,as we apply more of one input to a fixed
amount of another input,then after some point the
resulting increase in output becomes smaller and
smaller.

OHT 1.20B
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Marginal analysis reminds us that most choices involve relatively
small (incremental)increases or decreases in production (or
consumption).

The short run represents the operating period of the business in
which at least one factor of production is fixed in supply.

The long run represents the planning horizon of the business in
which all factors of production may be varied in order to alter the
scale of production.

Externalities represent wider outcomes of the market mechanism
and arise when some of the benefits or costs of consuming a good
or service spill over to others.

Key learning points
OHT 1.20C
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The concept of discounting is concerned with the fact that costs
and benefits arising in future years are worth less to us than costs
and benefits arising today.

Property rights are the rights to own,benefit from and transfer
assets (tangible or intangible)in market economies

Perfectly competitive markets are made up of numerous small
sellers each offering identical products with complete freedom of
entry and exit. Each firm is a price-taker rather than a price-
maker

In monopolistically competitive markets there are many sellers
but there is also some degree of product [Link] form
of market structure is also sometimes referred to as imperfectly
competitive.

Key learning points

OHT 1.20D
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Oligopolistic competition arises where there exists a small
number of relatively large firms which are constantly aware of
each others actions and reactions regarding price and non-price
competition.

A monopoly exists where the market is supplied by one firm
producing a product for which there is no close substitute. A
monopolist, therefore, tends to be a price-maker, in that the firm
is able to set a price in the face of little or no competition. In
practice, the term monopoly is often applied also to markets that
are dominated by one firm.

Porter Five Forces Model describes the competitive
environment as being determined by the power of buyers, the
power of suppliers, the threat from potential new entrants, the
threat from substitutes and the degree of rivalry in the market.
Key learning points

OHT 1.20E
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The external environment of business is determined by
changes in political, economic, social and technological
factors, [Link] influences.

A SWOT analysis involves consideration of a firms internal
strengths and weaknesses in the context of the opportunities
and threats which it faces.

Generic strategies refer to the choice between pursuing a
market strategy based on cost leadership, differentiation or
focus .
Key learning points

OHT 1.20F
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The market demand curve.
Utility and the demand curve.
Consumer surplus.
The determinants of demand.
The classification of goods.
Concepts of elasticity.
The relationship between price elasticity and
sales revenue.
CHAPTER 2.
The analysis of consumer demand
OHT 2.1
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
This chapter will help you to:
Understand why changes in price affect consumer demand and, in
particular, why demand curves are normally downward sloping, i.e.
the law of demand.

Understand why demand curves may shift in response to changes
in various factors, other than price, which impact upon demand
(known as the conditions of demand).

Analyse the nature of the relationship between marginal utility and
the demand curve for any product or service.

Appreciate the meaning and importance of consumer surplus in the
context of pricing strategies.
Learning outcomes

OHT 2.2A
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.

Interpret the relative importance of income and
substitution effects on demand when the price of a
good or service changes.

Classify goods and services according to how demand
responds to changes in price and income, giving rise
to the terms normal, inferior, Giffen and Veblen goods
or services.

Calculate price, cross-price and income elasticities of
demand and interpret the significance of the results.

Appreciate the relationship between price elasticity,
marginal revenue and total revenue arising from the
sale of goods or services.
OHT 2.2B
Learning outcomes

J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
A consumers demand curve relates the amount
the consumer is willing to buy to each conceivable
price for the product.

The market demand curve for a good or service is
derived by summing the individual demand curves
of consumers horizontally for any given price.
The market demand curve
OHT 2.3
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.4
Figure 2.1 Derivation of the market demand curve
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
In general there is a central law of demand, which
states that there is an inverse relationship
between the price of a good and the quantity
demanded assuming all other factors that might
influence demand are held constant .
The law of demand
OHT 2.5
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.6
Figure 2.2 Linear and non-linear demand relationships
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Consumer equilibrium



where
MU =marginal utility
P =price
a ,b ,...,z =various goods and services consumed
The term utility describes the pleasure, satisfaction or
benefit derived by a person from the consumption of goods
or services.

Marginal utility is the addition to total utility as a consumer
purchases each extra unit of a good or service.

Utility and the demand curve
OHT 2.7
z
z
b
b
a
a
P
MU
P
MU
P
MU
= = ...
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.8
Marginal utility and water shortages
Consumer surplus
Consumer surplus is the excess of the price which a person would
be willing to pay rather than go without the good, over that which he
or she actually does pay.
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Determinants of demand
The own price of the good itself (P
0
).

The price of substitute goods (P
s
).

The price of complementary goods (P
c
).

The level of advertising expenditure on the
product in question, a , as well as on
complementary and substitute products, b,...,
z (denoted A
a,b,..z
).

The level and distribution of consumers
disposable incomes (Y
d
),[Link] after
state direct taxes and benefits.
OHT 2.9A
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Wealth effects (W )caused by, for example, stock
market booms, rising house prices, windfall gains,etc.

Changes in consumers tastes and preferences (T ).

The cost and availability of credit (C ).

Consumers expectations concerning future price
rises and availability of the product (E ).

Changes in population (POP),if we are examining the
total market demand.

Demand function
OHT 2.9B
Determinants of demand
( ) POP E C T W Y A P P P f Q
d z b a c s d
, , , , , , , , ,
... , 0
=
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.10
Figure 2.3 Shift in the demand curve
When the own price of a product changes, the outcome is a movement along the
demand curve and when any other determinants of demand change, there will
be a shift of the demand curve (either to the left, showing a fall in the quantity
demanded, or to the right, showing a rise) depending on the nature of the
change.
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.11
Figure 2.4 Examples of changes in the conditions of demand (demand curves
DD refer to the good in question)
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Normal products.

Inferior products.

Giffen products.

Veblen products.
Classification of products
OHT 2.12
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Normal products
Goods and services may be classified as normal productsif the quantity
demanded rises as incomes rise and falls as incomes fall.

Inferior products
Certain products are classified as inferior because the demand for them falls as
incomes rise (and vice versa).

Giffen products
A special case of the inferior product arises when,as price rises ,more of the
good in question is bought resulting seemingly in an upward sloping demand
curve,contrary to the normal law of demand.

Veblen products
It has been suggested that luxury typeproducts also display perverse price
demand relationships,though for different reasons to that of the Giffen
products [Link] are sometimes referred to as Veblen products,
OHT 2.13
Classification of products
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Price elasticity of [Link] measures the responsiveness of
quantity demanded of a product to changes in its own price. For
example,if the price of alcohol increases,what happens to the quantity of
alcohol demanded?

Cross-price elasticity of [Link] measures the responsiveness of
quantity demanded to changes in the prices of other goods (both
complements and substitutes).For example,if the price of one brand of
coffee rises,what happens to the demand for another coffee brand?Or,if
the price of petrol falls,what happens to the demand for cars?

Income elasticity of [Link] measures the responsiveness of
demand to a change in the income of [Link] example,if incomes
are rising,on average, by $50 per month,what will happen to the demand
for housing?

Coefficient of elasticity = Percentage change in quantity demanded
Percentage change in the relevant variable

OHT 2.14
Concepts of elasticity
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Price elasticity of demand

E d = Percentage change in quantity demanded
Percentage change in the price of the product

Two different types of price elasticity (E d )can be
calculated,as follows:
Arc elasticity of demand.
Point elasticity of demand.

OHT 2.15
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.12
Figure 2.5 Arc elasticity of demand
Arc elasticity of demand



( ) ( )
( ) ( )
1 2 1 2
1 2 1 2
2
1
/
2
1
/
P P P P
Q Q Q Q
+
+
( )
( )
( )
( )
1 2
1 2
1 2
1 2
Q Q
P P
x
P P
Q Q
+
+

=
Arc E
d
=
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Point elasticity of demand


OHT 2.17
( )
( )
( )
( )
1
1
1 2
1 2
1 1 2
1 1 2
/
/
Q
P
x
P P
Q Q
P P P
Q Q Q
E
d

=
Point
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Products with a price elasticity of demand
of less than 1 are said to have a relatively
inelastic demand with respect to price
they are said to be price inelastic .

Products with a price elasticity of demand
greater than 1 are said to have a relatively
elastic demand they are said to be price
elastic .

Products with a price elasticity of demand
exactly equal to 1 are said to have a unit
(or unitary)elasticity of demand.
OHT 2.18
Degrees of elasticity
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.19
Figure 2.6 Degrees of elasticity of demand
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Cross-price elasticity of demand

Cross-price E
d
= Percentage change in the demand for A
Percentage change in the price of B

The terminology regarding the degree of cross-price
elasticity (ignoring the sign)is the same as for price
elasticity,namely:

1 =unit cross-price elasticity.
Less than 1 =inelastic cross-price elasticity.
Greater than 1 =elastic cross-price elasticity.

OHT 2.20
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Income elasticity of demand

Income E
d
= Percentage change in demand
Percentage change in real income

Inferior goods
These are goods of which consumers buy less when real
incomes [Link] value of income elasticity is,
therefore,[Link] might be potatoes,
unbranded clothing,cheap package holidays,etc.

Normal goods
These are the most common goods with demand
generally rising as real income rises. They can
themselves be further subdivided into two categories:

OHT 2.21A
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Necessities .These are goods and services which exhibit
a positive income elasticity of demand,though the value
will tend to be less than 1. Articles such as basic
foodstuffs and ordinary day-to-day clothing fall into this
[Link] will purchase a certain amount of
these goods at very low levels of income,but they will
tend for any given percentage increase in real income to
increase their spending on the goods by a smaller
proportion.

Luxuries . At very low income levels,nothing will be
spent on these but,once a certain threshold income level
is reached,the proportionate rise in demand for luxury
goods is greater than the proportionate rise in real
income,[Link] holidays,dining out and DVD players.

OHT 2.21B
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.22
Figure 2.7 Demand and total revenue
The relationship between price elasticity
and sales revenue
Total revenue = price x quantity sold
TR = P x Q
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Price elasticity and total revenue

With a price inelastic demand:
(a)an increase in price causes a reduction in
quantity demanded,but total revenue increases;

(b)a fall in price causes an increase in quantity
demanded,but total revenue earned declines.
With a price elastic demand:
(a)an increase in price causes such a large fall in
quantity demanded that total revenue falls;

(b)a reduction in price causes such a large increase
in the quantity demanded that the total revenue
rises.
OHT 2.23
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Marginal revenue
Marginal revenue (MR) is defined as the change in (A)
total revenue (TR) as a firm sells one more or one less
unit of its output (Q ).

MR =

Average revenue (AR)is the total revenue (TR) divided by
output (Q )or the revenue earned on average for each unit
sold.

AR =
OHT 2.24
Q
TR
A
A
Q
TR
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.25

Figure 2.8 Elasticity, marginal revenue and total revenue
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.

Marginal revenue falls as output rises. Since the demand curve
slopes downwards, the addition to total revenue from producing
and selling extra units declines.

Average revenue exceeds marginal revenue. When the demand
curve is downward sloping,the marginal revenue from selling one
more unit falls faster than the average revenue from selling the
total output.

The marginal revenue curve declines at twice the rate of the
demand (average revenue)curve. Hence, the marginal revenue
curve cuts the horizontal axis at a point midway between the origin
and point C in Figure 2.8.A proof of this mathematical relationship
is given in Appendix 2.2 at the end of the chapter.
OHT 2.26A
Elasticity, marginal revenue and total revenue - key
relationships
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
When total revenue is increasing,marginal revenue is
positive. This results from the fact that demand is elastic
between points A and B on the demand curve DD in Figure
2.8.

When total revenue is falling,marginal revenue is
negative.A negative marginal revenue results from demand
being inelastic between points B and C in Figure 2.8.

Total revenue is maximised when marginal revenue is
zero which occurs when the price elasticity is
[Link],further attempts to increase total revenue
by lowering price below P *will fail because the sales
volume will not increase sufficiently to compensate for the
price fall.
Elasticity, marginal revenue and total revenue -
key relationships

OHT 2.26B
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
A demand curve relates the amount that consumers are
willing to buy to each conceivable price for the product.

In general, the law of demand states that there is an
inverse relationship between the price of a good and the
quantity demanded,assuming all other factors that might
influence demand are held constant ([Link] paribus ).

Utility theory helps explain why consumers buy more of
something the lower its price.
Key learning points

OHT 2.27A
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Marginal utility is the addition to total utility as a consumer
purchases each extra unit of a good or service.

The law of diminishing marginal utility is concerned with
the tendency for marginal utility to fall as more units of a
good or service are consumed at any given time.

Consumer equilibrium describes how consumers
maximise their total utility by distributing expenditure so
that the ratio of marginal utilities for all the goods and
services they consume,at any given time, is equal to their
relative prices.

Consumer surplus is reflected by the excess of the price
which a person would be willing to pay rather than go
without the good,over that which he or she actually
does pay.
OHT 2.27B
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
When the own price of a good changes,the outcome is a
movement along the demand curve and when any other
determinant or condition of demand changes, there will be a shift
of the demand curve .

The impact of a change in price on quantity demanded is made up
of two distinct effects:an income effect and a substitution
effect. The income effect arises from the fact that as the own
price of a good falls,consumers are in effect better off and hence
able to buy more of the [Link] substitution effect reflects the
fact that as the price falls, the product becomes relatively cheaper
than alternatives and hence there will be a tendency for
consumers to substitute more of it for other goods.

Goods and services are classified as normal products if the
quantity demanded rises as (real)incomes and falls as incomes
fall.
OHT 2.27C
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
In contrast, goods and services are classified as inferior
products if the quantity demanded falls (rises)as incomes
rise (fall).

A Giffen product is a special case of an inferior product and
has what appears to be an upward sloping demand
curve,contrary to the normal law of demand,because the
income effect outweighs the substitution effect.

A Veblen product also has seemingly an upward sloping
demand curve because of snob effects, [Link] is demanded
because it is expensive and therefore exclusive. Many luxury
products fit into this category.
OHT 2.27D
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.

The (own) price elasticity of demand for a product may be
defined in general terms as:

E
d
= Percentage change in quantity demanded
Percentage change in the price of the product

The value of E
d
may be calculated on the basis of a
movement along a section of the demand curve,giving rise
to a value of the arc elasticity .This is expressed on the
basis of the average quantity and average price,as follows:

Arc E
d

OHT 2.27E
( )
( )
( )
( )
1 2
1 2
1 2
1 2
Q Q
P P
x
P P
Q Q
+
+

J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
For very small price changes,elasticity may be calculated with
reference to a single point on the demand curve,giving rise to a
value of the point elasticity ,as follows:

Point E
d
=

Products with a price elasticity of demand of less than 1 (in
absolute terms)are said to have a relatively inelastic demand
with respect to price hey are said to be price inelastic .In this
case,total sales revenue will tend to rise (fall)as price rises
(falls).

Products with a price elasticity of demand greater than 1 (in
absolute terms)are said to have a relatively elastic demand
they are said to be price elastic. In this case,total sales
revenue will tend to fall (rise)as price rises (falls).

OHT 2.27F
( )
( )
1
1
1 2
1 2
Q
P
x
P P
Q Q

J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Products with a price elasticity of demand equal to 1 (in
absolute terms)are said to have a unit or unitary elasticity of
demand. In this case, total sales revenue will remain
unchanged as price rises or falls.

The value of price elasticity of demand can range from infinity
(in absolute terms)to 0. A product with a perfectly inelastic
demand will have a value of E
d
equal to 0 at every price,while
a product with a perfectly elastic demand will have a value of
E
d
equal to infinity at a particular price.

Cross-price elasticity of demand indicates the
responsiveness of the demand for one product to changes in
the prices of other goods and services and may be calculated
as:

Cross-price E
d
= Percentage change in the demand for A
Percentage change in the price of B
OHT 2.27G
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Substitutes will tend to have a positive value for cross-price
E
d
,while complements will tend to have a negative value.

Income elasticity of demand measures the responsiveness
of quantity demanded with respect to (real) income variations
as follows:

Income E
d
= Percentage change in quantity demanded
Percentage change in real income
Necessities exhibit a positive income elasticity of demand
though the value will tend to be less than 1. In contrast,
luxuries will tend to have an income elasticity of demand
greater than 1.

Marginal revenue is defined as the incremental change in
total revenue and is usually measured as a firm sells one more
or one less unit of its output.
OHT 2.27H
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The marginal revenue curve declines at twice the rate of the
demand (average revenue)curve.

When total revenue is increasing (decreasing),marginal revenue
is positive (negative)such that total revenue is maximised
when marginal revenue is zero .This occurs when the price
elasticity of demand is equal to 1.

An indifference curve shows all combinations of two goods or
services that yield the same level of utility or satisfaction so that
the consumer is indifferent between each combination.

The slope of the budget line is determined by the relative
prices of the two goods or services and the position of the line
by the consumer income.

OHT 2.27I
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Together, the indifference curve mapping and the
budget line determine the combination of the goods or
services that the consumer will choose to buy.
Indifference curve analysis can be used to show the
income and substitution effects of a price change.
OHT 2.27J
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A2.28
Figure A2.1 A typical indifference curve
Appendix 2.1 Indifference curve analysis
The meaning of indifference curves
An indifference curve details all combinations of two goods or
services that yield the same level of utility or satisfaction.
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A2.29
Figure A2.2 An indifference curve map
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A2.30
Figure A2.3 The budget constraint
The budget constraint
Budget constraint
P
x
Q
x
+ P
y
Q
y
sm
The slope of the budget line is determined by the relative prices of the two goods
and the position of the line by the consumers income.
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A2.31
Figure A2.4 Illustrating the effects of price and income changes
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A2.32
Figure A2.5 Utility maximisation with a budget constraint
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A2.33
Figure A2.6 Substitution and income effects of a price change for a normal good
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A2.34
Figure A2.7 Income and substitution effects for an inferior good
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.

Proof that the marginal revenue curve declines at twice the rate of
the demand curve

The equation of a linear demand relationship is:

P = a - bQ (2.1)

Total revenue (TR) = P x Q

Total revenue (TR) = (a - bQ) x Q (substituting for P = a - bQ)

Total revenue (TR) = aQ - bQ
2














OHT 2.35A
Appendix 2.2 Marginal revenue and the demand
curve
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 2.35B
Appendix 2.2 Marginal revenue and the demand curve
( )
Q
bQ aQ
o
o
2

Marginal revenue (MR) is defined as the change in total revenue with

respect to a unit change in sales. In terms of differential calculus:


Q
TR
Q
TR
MR
o
o
=
A
A
=
= a - 2bQ 2.2)

(substituting for TR = aQ - bQ
2
)
=
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The production function.
Variable costs versus fixed costs.
Production decisions in the short run and long run.
Diminishing returns in production.
The relationship between production and costs.
Maximising profit and the production decision.
Economies and diseconomies of scale.
Economies of scope.
Organising production.
The experience curve.
Product and process innovation.
The relationship between short-run and long-run costs.
Optimal scale and X-inefficiency.
The importance of information and knowledge.
CHAPTER 3.
The Analysis of production costs
3.1

OHT 3.1

J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
This chapter will help you to:
Understand the relationship between the firms factor inputs,
its outputs and its costs of production in the short-run and
long-run.
Differentiate between total, average and marginal costs of
production and how these costs affect output decisions and
profitablity.
Determine the level of output which maximises profit for any
given cost structure and demand conditions.
Distinguish between variable and fixed costs of production and
their role in determining when a firm should shut down
production.
Appreciate the meaning of diminishing returns in the context of
short-run production decisions.
Learning outcomes
OHT 3.2A
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Learning outcomes
Understand the nature of external and internal economies of
scale as the size of a business alters.
Appreciate the significance of innovation in sustaining a
firms competitive advantage over the long run.
Distinguish between scale inefficiencies in production and
inefficiencies that result from the poor management of
resources (i.e. X-inefficiency).
Realise the growing importance of information and
knowledge in business decision-making as factors of
production in their own right.
OHT 3.2B
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Production function

The production function is a mathematical expression which
relates the quantity of all inputs to the quantity of outputs,
assuming that managers employ all inputs efficiently. In general
terms the production function for any firm may be expressed as
follows:
Q = F (I
1
, I
2
, I
3
,,I
n
)
Cost function
C = F(Q,p
1
,p
2
,p
3,
,p
n
)
where the cost, C, is expressed as a function of the quantity of
output, Q, and the prices p
1
, p
2
, p
3
,,p
n
of the corresponding
inputs I
1
,I
2
,I
3
,,I
n
.
OHT 3.3
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Total fixed costs (TFC)are fixed at all levels of output.

Total variable costs (TVC)and,therefore,total costs (TC)rise as
output increases.

Average fixed costs (AFC)decline continuously as the fixed costs
are distributed across more and more output,until at very large output
levels they may be [Link] AFC curve is a rectangular
hyperbola,[Link] area under the curve remains constant as output
changes.

Average variable costs (AVC)may fall initially but after a certain
level of output they begin to [Link] occurs because of what
economists term the law of diminishing returns ,mentioned in Chapter
1 and discussed more fully [Link] is, of course,possible for average
variable costs to rise continuously as output expands, while in some
businesses there may be a large output range over which they are
constant.
OHT 3.4A
Variable costs versus fixed costs
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Average total costs (ATC),being the
combination of AFC and AVC, tend to decline
initially and then rise after a certain level of
output (Q )is reached. Average total cost is
often referred to by accountants as the unit cost
.It is also often simply referred to as the
average cost .

Summary
TC =TFC +TVC
AVC =TVC/Q
AFC =TFC/Q
ATC =AFC +AVC =TC/Q
OHT 3.4B
Variable costs versus fixed costs
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.5

Figure 3.1 Total and average costs of production
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The short run is the time period during which
the amount of at least one input is fixed in
supply ([Link] amount of capital equipment
installed or in some organisations the number
of personnel employed) but the other inputs
can be altered.

The long run represents a sufficient length of
time for management to be able to vary all
inputs into the production process.
Production decisions in the short run and long run
OHT 3.6
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The law of diminishing (marginal)returns

In the short run,when one or more factors of
production are held fixed, there will come a point
beyond which the additional output from using extra
units of the variable input(s)will diminish.

TPP is the total output when labour is applied to
capital.
APP is the total output or physical product divided by
the number of units of labour employed.
MPP is the addition to total physical product as each
extra unit of labour is employed.

OHT 3.7
Diminishing returns in production
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.8
Figure 3.2 Diminishing returns
Table 3.1 Example of the law of diminishing returns
(1)
Units of
capital input
(2)
Units of
labour input
(n)
(3)
Total
physical product
(TPP)
(4)
Average physical
product of labour
(APP) = (3) (2)
(5)
Marginal physical
product of labour
(MPP)
10
10
10
10
10
10
1
2
3
4
5
6
8
20
35
40
42
43
8
10
11.7
10
8.4
7.2
8 (8-0)
12 (20-8)
15 (35-20)
5 (40-35)
2 (42-40)
1 (43-42)
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Marginal cost
The change in total costs of production as output is changed
incrementally is referred to as the marginal cost .Given a total cost
function,it is technically the first derivative that is, the slope of the
total cost curve at each level of output (insert equation) ).Where the
total cost curve is linear,the marginal cost is a constant,and it is
easier to refer to the marginal cost of output.

Incremental cost
The incremental cost per unit is the total change in costs caused by
the output increment (this is equal to the sum of the marginal costs
over the increment in output), divided by the change in [Link]
other words,incremental cost equals the averagemarginal cost
over the range of outputs.
The relationship between production and
costs
OHT 3.9
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Table 3.2 Deriving cost data from product data
(1)
Cost of capital
employed
$

(2)
Cost of labour
employed
$

(3)
Total cost
=(1)+(2)
$

(4)
Total output
(5)
Average cost
per unit = (3) (4)
$

100
100
100
100
100
100
10
20
30
40
50
60
110
120
130
140
150
160


8
20
35
40
42
43
13.7
6.0
3.7
3.5
3.6
3.7
OHT 3.10
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.11
Figure 3.3 Marginal cost and output
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.12
Figure 3.4 Constant marginal costs
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Table 3.3 Cost of production: a worked example
Variable
cost
($)
VC
(2)
Fixed
cost
($)
FC
(3)

Total
cost
($)
TC
(4) = (2) + (3)
Marginal
cost
($)
MC
(5)

Average
variable cost
($)
AVC
(6) = (2)/(3)
Average
fixed cost
($)
AVC
(7) = (3)/(1)
Average
total cost
($)
ATC (8) = (4)/(1)
= (6) + (7)
Quantity
of output
(units)
Q
(1)
0
1
2
3
4
5
6
7
8
9
0
20
30
36
40
48
60
80
112
156

48
48
48
48
48
48
48
48
48
48
48
68
78
84
88
96
108
128
160
204
20
10
6
4
8
12
20
32
44
-
20
15
12
10
9.6
10
11.4
14
17.3
-
48
24
16
12
9.6
8
6.9
6
5.3
-
68
39
28
22
19.2
18
18.3
20
22.6
OHT 3.13
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.14
Figure 3.5 Worked example of short-run cost curves
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The profit maximisation rule

Profits are maximised where marginal cost (MC)equals
marginal revenue (MR). It is possible that over the
firms full potential range of outputs there are two points
where MC =MR (in Figure 3.6 the two points are shown
at X and at output q *). Producing at point X would not
profit maximise because outputs up to X are produced
where MC > MR. Technically,profits are maximised
where MC =MR and the MC curve is rising (not
falling),as at q *output in Figure 3.6.
OHT 3.15
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.16
Figure 3.6 Profit-maximising output
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Normal profit is the minimum profit which must be earned to ensure
that a firm will continue to supply the existing good or service. In
incorporated firms it is equivalent to the cost of capital, namely the
interest charges on loan capital plus the return to equity investors
that must be paid if creditors and investors are to put their capital
into the firm. In non-corporate enterprises (sole traders and
partnerships)this is the profit that ensures that a sufficient number
of people are prepared to invest, organise production and
undertake risks in an industry (including the return to risky
entrepreneurship). The normal profit will differ from industry to
industry,according to the degree of risk involved. Costs of
production, in an economic as opposed to an accounting sense,
include an allowance for normal profit.

Supernormal profit is any profit earned above normal profit and is a
form of economic rent (see pp.143 and 308).
OHT 3.17
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.18
Figure 3.7 The production decision
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Constant returns to [Link] arises when
the volume of output increases in the same
proportion to the volume of inputs.

Increasing returns to [Link] arises
where the volume of output rises more
quickly than the volume of inputs.

Decreasing returns to [Link] arises
where the volume of output rises less quickly
than the volume of inputs.
Economies and diseconomies of scale
OHT 3.19
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Labour.
Investment.
Procurement.
Research and development.
Capital.
Diversification.
Product promotion.
Transport and distribution.
By-products.

OHT 3.20
Internal economies of scale
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Labour force.

Suppliers.

Social infrastructure.
External economies of scale
OHT 3.21
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Management

Labour

Other inputs

External diseconomies of scale
Internal diseconomies of scale
OHT 3.22
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.23
Figure 3.8 The long-run average cost curve
Long-run average costs
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.24
E-commerce and costs of production
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Sharing common inputs over a range of its
activities.

Jointly promoting its range of products and
services;or

Jointly distributing its range of products and
services.
Economies of scope
OHT 3.25
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.26
Figure 3.9 Organisational structures
Organising production
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.27
Figure 3.10 The impact of improved technology on long-run production costs
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.28
Figure 3.11 The experience curve
The experience curve
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.29
Figure 3.12 The virtuous circle
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.30
Figure 3.13 Benefits from increasing the scale of production
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.31
Figure 3.14 Long-run average total cost curve
The relationship between short-run and long-
run costs
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.32
Figure 3.15 The L-shaped long-run average total cost curve
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.33
Figure 3.16 The production cost gap

Optimal scale and x-inefficiency
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.34
Economies of scale of large goods vehicles
Large goods vehicles: an example of economies of
scale
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The production function is a mathematical
expression which relates the quantity of all inputs
to the quantity of outputs.
Total physical product (TPP)is the total output
from the factors of production employed.
Average physical product (APP)is the TPP
divided by the number of units of the variable
factor of production employed.
Marginal physical product (MPP)is the change in
TPP when an additional unit of the variable factor
of production is employed.
Fixed costs are costs of production which do not
vary as output changes.
OHT 3.35A
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Variable costs are costs of production which do vary
with output.

Average total cost (ATC) is total cost divided by output
(TC/Q ) and is made up of average fixed cost (AFC) plus
average variable cost (AVC),where AFC =TFC/Q and
AVC =TVC/Q .TFC is total fixed cost;TVC is total
variable cost;and Q is output.

The law of diminishing (marginal)returns states
that,in the short run,when one or more factors of
production are held fixed,there will come a point beyond
which the additional output from using extra units of the
variable input(s)will diminish.

The output at which average costs are at their lowest is
known as the technically optimum output .
OHT 3.35B
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Marginal costs (MC),defined as the additional costs
incurred when producing a very small increment or one more
unit of output,will only depend on changes in variable costs
in the short run because fixed costs are unaltered as output
changes. In the long run, however, marginal costs reflect
changes in the total costs of production since all inputs are
variable.

The marginal cost curve will always be below (above)the
average cost curve when average costs are falling (rising).

Profits are maximised at the level of output where marginal
cost equals marginal revenue and when marginal costs are
rising.

Economists include a normal profit in costs.
OHT 3.35C
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Normal profit is defined as the minimum profit which must be
earned in order to ensure that a firm will continue to supply the
existing good or service.

Normal profit is earned when price is set equal to average total
cost.

Supernormal profit is earned when price is set above average
total cost.

The shut-down point in the short-run exists when price has fallen
below average variable [Link] the long run a profit-maximising
firm must cover its average total costs if it is to remain in business.

Constant returns to scale arise when the volume of output
increases in the same proportion to the volume of inputs.
OHT 3.35D
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Increasing and decreasing returns to scale arise when the
volume of output rises more quickly or less quickly,
respectively,than the volume of inputs.
The existence of increasing and decreasing returns to scale is
explained by the presence of both internal and external
economies and diseconomies of scale ,which relate to the
behaviour of long-run production as the scale of output changes.
Decreasing ,constant and increasing cost production relate
to what happens to the costs of production as the scale of
production is changed.
The minimum efficient scale (MES)represents the technical
optimum scale of production for the firm,corresponding to
minimum unit costs over the long run.
OHT3.35E
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Economies of scope exist where a range of goods use
joint inputs,promotion or distribution resulting in a
reduction in the long-run average costs of production.
Static cost reductions tend to occur in the short run and
are associated with improving existing production
methods.
Dynamic efficiency gains are more clearly associated
with new developments in product and production
processes over time.
The experience (learning)curve relates to declining unit
costs of production over time as the cumulative volume of
output rises.
Innovation occurs within firms in the form of both products
and processes. Product innovation involves the
introduction of new goods and services;while process
innovation is concerned with improving the existing
methods by which outputs are produced so as to lower the
costs of production.
OHT 3.35F
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
X-inefficiency indicates the extent to which the costs of
production are above the minimum average cost due to
waste and organisational slack given the existing scale of
production.
The envelope curve shows how total costs of production
change as output continues to rise over the long [Link]
represents the envelope of all possible short-run average
total cost curves relating to different scales of production
and is appropriate where there are no significant
indivisibilitiesin the capital stock.
Information and knowledge are of growing importance as
factors of production in their own right in the new
information-led or weightless economy.
OHT 3.36G
Key learning points
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Key Learning Points
Appendix 3.1 (see p. 95)

An isoquant curve shows in graphical form different
combinations of factor inputs that can be used to
produce a given quantity of a product.

An isoquant map is a collection of ranked isoquant
curves that shows in graphical form a firms increasing
output when moving outward from the origin using
larger quantities of factor inputs.
OHT 3.35H
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The marginal rate of technical substitution
(MRTS)is the ratio of the marginal physical product of
two inputs in the production process;[Link] amount by
which it is possible to reduce one factor input and
maintain a given level of output by substituting one
extra unit of the other factor input. In notation form:




An isocost line shows the combination of two inputs
which can be purchased for the same total money
outlay.

OHT 3.35I
Key Learning Points

( )
K
L
kforL
MP
MP
MRTS =
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
An optimal combination of inputs in the production
process takes place when the ratio of the marginal
products of the factor inputs is equal to the ratio of the
input prices; i.e.






OHT 3.35J
Key Learning Points

( ) ( )
K
L
K
L
P
P
MP
MP
=
Or, alternatively
K
K
L
L
P
MP
P
MP
=
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The key task facing the firm is to determine the specific
combination of capital and labour which should be
selected in order:

either to maximise output for a given production cost;
or to minimise production cost subject to a given output.

The task of determining the optimal combination of inputs
introduces a number of important concepts including:



Isoquant curves and isoquant maps.
The marginal rate of technical substitution.
Isocost lines.

Appendix 3.1 Isoquants, isocosts and the
optimal combination of inputs
OHT 3.36
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A3.37
Figure A3.1 Isoquant curve for a given level of production
Isoquant curves and isoquant maps
An isoquant curve shows in graphical form the different combinations of factor
inputs (such as capital and labour) that can be used to produce a given quantity of
a product per time period with a given state of technology
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 3.38
Figure A3.2 Isoquant map for different levels of production
An isoquant map is a collection of ranked isoquant curves that shows
in graphical form a firms increasing output per time period when
moving outward from the origin using larger quantities of two factor
inputs (such as capital and labour).
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
The marginal rate of technical substitution (MRTS )is the
ratio of the marginal physical products (MP)of two inputs
in the production process;[Link] amount by which it is
possible to reduce one factor input ([Link])and
maintain a given level of output by substituting an extra
unit of the other factor input ([Link]).



The marginal rate of technical substitution
OHT3.39
( )
Capital
Labour
Labour Capitalfor
MP
MP
MRTS =
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A3.40
Figure A3.3 Isocost line
Isocost lines
The isocost line shows the combination of the two inputs
(capital and labour) which can be purchased for the same total
money outlay.
C = P
K
K+P
L
L
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Maximising output for a given production cost

Principle : to maximise output subject to a given total cost of
production and given input prices for capital and labour, the firm
must purchase inputs in quantities such that the marginal rate of
technical substitution of capital for labour (MRTS
K for L
) is equal to
the ratio of the price of labour to the price of capital (P L /P K ).
OHT 3.41
Optimal combination of inputs
( ) ( )
K
L
K
KforL
P
P
MP
MP
MRTS
L
= =
K
K
L
L
P
MP
P
MP
=
The optimality condition can be reorganised as:
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A3.42
Figure A3.4 Maximising output for a given cost
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
Optimal combination of inputs
Minimising cost subject to a given output
( ) ( )
K
L
K
L
KforL
P
P
MP
MP
MRTS = =
Or, alternatively




K
K
L
L
P
MP
P
MP
=
OHT A3.43
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT A3.44
Figure A3.5 Minimising cost for a given output