Subject

Assignment No.
Discipline
Term
Submitted By
Examination Roll No.

Economics
01
M.B.A. (Executive)
III
Samiullah Khan
056

Q.1: Write a brief note of factors of production?

Factors of production are the resources that are used to produce goods and services:
1. Natural resources:
The things created by acts of nature such as land, water, mineral, oil and gas deposits, renewable
and nonrenewable resources.
2. Labor:
The human effort, physical and mental, used by workers in the production of goods and services.
3. Physical capital.
All the machines, buildings, equipment, roads and other objects made by human beings to
produce goods and services.
4. Human capital:
The knowledge and skills acquired by a worker through education and experience.
5. Entrepreneurship:
The effort to coordinate the production and sale of goods and services. Entrepreneurs take risk
and commit time and money to a business without any guarantee of profit.
THE PRODUCTION POSSIBILITIES FRONTIER (PPF)
The PPF curve shows the possible combinations of goods and services available to an economy,
given that all productive resources are fully and efficiently employed.
When the economy is at point i, resources are not fully employed and/or they are not used
efficiently. Point g is desirable because it yields more of both goods, but not attainable given the

amount of resources available. Point d is one of the possible combinations of goods produced
when resources are fully and efficiently employed.

SCARCITY AND THE PPF

To increase the amount of farm goods by 10 tons, we must sacrifice 100 tons of factory goods.
The PPF curve is bowed out because resources are not perfectly adaptable to the production of
the two goods. As we increase the production of one good, we sacrifice progressively more of the
other.

SHIFTING THE PPF CURVE

To increase the production of one good without decreasing the production of the other, the PPF
curve must shift outward. The PPF curve shifts outward as a result of an increase in the
economys resources OR a technological innovation that increases the output obtained from a
given amount of resources. From point d, an additional 200 tons of factory goods or 20 tons of
farm goods are now possible (or any combination in between).

Q.2: Write Economics in its historical background?

Economics is the science that deals with the production, allocation, and use of goods and
services. It is important to study how resources can best be distributed to meet the needs of the
greatest number of people. As we are more connected globally to one another, the study of
economics becomes extremely important. While there are many subdivisions in the study of
economics, two major ones are macroeconomics and microeconomics. Macroeconomics is the
study of the entire system of economics. Microeconomics is the study of how the systems affect
one business or parts of the economic system.

History of Economics
The first writings on the subject of economics occurred in early Greek times as Plato, in The
Republic, and Aristotle wrote on the topic. Later such Romans as Cicero and Virgil also wrote
about economics.
In medieval times the system of feudalism dominated. With feudalism, there was a strict class
system consisting of nobles, clergy and the peasants. In the system, the king owned almost all the
land and under him were a series of nobles that had land holdings of various sizes. On these
landholdings were series of manors. These were akin to large farming tracts in which the
peasants or serfs worked the land in exchange for protection by the nobles.
Later the system of mercantilism predominated. It was an economic system of the major trading
nations during the 16th, 17th, and 18th centuries, based on the idea that national wealth and
power were best served by increasing exports and collecting precious metals in return.
Manufacturing and commerce became more important in this system.
In the mid eighteenth century, the Industrial Revolution ushered in an era in which machines
rather than tools were used in the factory system. More workers were employed in factories in
urban areas rather than on farms. The Industrial Revolution was fueled by great gains in
technology and invention. This also made farms more efficient, although fewer people were
working the farms. During this time the idea of "laissez faire" became popular. This means that
economies work best without lots of rules and regulations from the government. This philosophy
of economics is a strong factor in capitalism, which favors private ownership.
In the nineteenth century, there was reaction to the "laissez-faire" thinking of the eighteenth
century due to the writings of Thomas Malthus. He felt that population would always advance
faster than the science and technology needed to support such population growth. David Ricardo
later stated that wages tend to settle at a poor or subsistence level for most workers. John Stuart
Mill provided the backdrop for socialism with his theories that supported farm cooperatives and
labor unions, less competition. These theories were brought to a high point by Karl Marx who
attacked the capitalistic, "laissez-faire" theories of competition and instead favored socialisms,
marked more government control and state rather than private ownership of property.

Another important idea at this time was the change in how items are valued. While formerly an
item's value stayed the same according to what the item was, now the worth of an item was
determined by how many people wanted the item and how great the supply of the item was. This
was the beginning of the laws of supply and demand.
In the first half of the twentieth century, John Maynard Keynes wrote about business cycles when the economy is doing well and when it is in a slump. His theories led to governments
seeking to put more controls on the economy to prevent wide swings.
After World War II, emphasis was placed on the analysis of economic growth and development
using more sophisticated technological tools.
In recent years, economic theory has been broadly separated into two major fields:
macroeconomics, which studies entire economic systems; and microeconomics, which observes
the workings of the market on an individual or group within an economic system. In the later
twentieth century such ideas as supply side economics which states that a healthy econonomy is
very necessary for the health of the nation and Milton Friedman's ideas that the money supply is
the most important influence on the economy were favored.
In the twenty-first century, the rapid changes and growth in technology have spawned the term
"Information Age" in which knowledge and information have become important commodities.

Q.3: Briefly explain the Price Elasticity of Demand?

The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate of
response of quantity demanded due to a price change. The formula for the Price Elasticity of
Demand (PEoD) is:
PEoD = (% Change in Quantity Demanded)/(% Change in Price)

Calculating the Price Elasticity of Demand

You may be asked the question "Given the following data, calculate the price elasticity of
demand when the price changes from $9.00 to $10.00" Using the chart on the bottom of the
page, I'll walk you through answering this question.
First we'll need to find the data we need. We know that the original price is $9 and the new price
is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the
quantity demanded when the price is $9 is 150 and when the price is $10 is 110. Since we're
going from $9 to $10, we have QDemand(OLD)=150 and QDemand(NEW)=110, where
"QDemand" is short for "Quantity Demanded". So we have:
Price(OLD)=9
Price(NEW)=10
QDemand(OLD)=150
QDemand(NEW)=110
To calculate the price elasticity, we need to know what the percentage change in quantity demand
is and what the percentage change in price is. It's best to calculate these one at a time.

Calculating the Percentage Change in Quantity Demanded

The formula used to calculate the percentage change in quantity demanded is:
[QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
By filling in the values we wrote down, we get:
[110 - 150] / 150 = (-40/150) = -0.2667
We note that % Change in Quantity Demanded = -0.2667 (We leave this in decimal terms. In
percentage terms this would be -26.67%). Now we need to calculate the percentage change in
price.

Calculating the Percentage Change in Price

Similar to before, the formula used to calculate the percentage change in price is:
[Price(NEW) - Price(OLD)] / Price(OLD)
By filling in the values we wrote down, we get:
[10 - 9] / 9 = (1/9) = 0.1111
We have both the percentage change in quantity demand and the percentage change in price, so
we can calculate the price elasticity of demand.

Final Step of Calculating the Price Elasticity of Demand

We go back to our formula of:
PEoD = (% Change in Quantity Demanded)/(% Change in Price)
We can now fill in the two percentages in this equation using the figures we calculated earlier.
PEoD = (-0.2667)/(0.1111) = -2.4005
When we analyze price elasticities we're concerned with their absolute value, so we ignore the
negative value. We conclude that the price elasticity of demand when the price increases from $9
to $10 is 2.4005.

How Do We Interpret the Price Elasticity of Demand?

A good economist is not just interested in calculating numbers. The number is a means to an end;
in the case of price elasticity of demand it is used to see how sensitive the demand for a good is
to a price change. The higher the price elasticity, the more sensitive consumers are to price
changes. A very high price elasticity suggests that when the price of a good goes up, consumers
will buy a great deal less of it and when the price of that good goes down, consumers will buy a
great deal more. A very low price elasticity implies just the opposite, that changes in price have
little influence on demand.

Often an assignment or a test will ask you a follow up question such as "Is the good price elastic
or inelastic between $9 and $10". To answer that question, you use the following rule of thumb:

If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes)

If PEoD = 1 then Demand is Unit Elastic

If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)

Recall that we always ignore the negative sign when analyzing price elasticity, so PEoD is
always positive. In the case of our good, we calculated the price elasticity of demand to be
2.4005, so our good is price elastic and thus demand is very sensitive to price changes.

Q.4: Write a detailed note of Price Elasticity of Supply?

The Price Elasticity of Supply measures the rate of response of quantity demand due to a price
change. If you've already read The Price Elasticity of Demand and understand it, you may want
to just skim this section, as the calculations are similar. (Your course may use the more
complicated Arc Price Elasticity of Supply formula. If so you'll need to see the article on Arc
Elasticity) We calculate the Price Elasticity of Supply by the formula:
PEoS = (% Change in Quantity Supplied)/(% Change in Price)

Calculating the Price Elasticity of Supply

You may be asked "Given the following data, calculate the price elasticity of supply when the
price changes from $9.00 to $10.00" Using the chart on the bottom of the page, I'll walk you
through answering this question.

First we need to find the data we need. We know that the original price is $9 and the new price is
$10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the quantity
supplied (make sure to look at the supply data, not the demand data) when the price is $9 is 150
and when the price is $10 is 110. Since we're going from $9 to $10, we have
QSupply(OLD)=150 and QSupply(NEW)=210, where "QSupply" is short for "Quantity
Supplied". So we have:
Price(OLD)=9
Price(NEW)=10
QSupply(OLD)=150
QSupply(NEW)=210
To calculate the price elasticity, we need to know what the percentage change in quantity supply
is and what the percentage change in price is. It's best to calculate these one at a time.

Calculating the Percentage Change in Quantity Supply

The formula used to calculate the percentage change in quantity supplied is:
[QSupply(NEW) - QSupply(OLD)] / QSupply(OLD)
By filling in the values we wrote down, we get:
[210 - 150] / 150 = (60/150) = 0.4
So we note that % Change in Quantity Supplied = 0.4 (This is in decimal terms. In percentage
terms it would be 40%). Now we need to calculate the percentage change in price.

Calculating the Percentage Change in Price

Similar to before, the formula used to calculate the percentage change in price is:
[Price(NEW) - Price(OLD)] / Price(OLD)
By filling in the values we wrote down, we get:

[10 - 9] / 9 = (1/9) = 0.1111

We have both the percentage change in quantity supplied and the percentage change in price, so
we can calculate the price elasticity of supply.

Final Step of Calculating the Price Elasticity of Supply

We go back to our formula of:
PEoS = (% Change in Quantity Supplied)/(% Change in Price)
We now fill in the two percentages in this equation using the figures we calculated.
PEoD = (0.4)/(0.1111) = 3.6
When we analyze price elasticities we're concerned with the absolute value, but here that is not
an issue since we have a positive value. We conclude that the price elasticity of supply when the
price increases from $9 to $10 is 3.6.

How Do We Interpret the Price Elasticity of Supply?

The price elasticity of supply is used to see how sensitive the supply of a good is to a price
change. The higher the price elasticity, the more sensitive producers and sellers are to price
changes. A very high price elasticity suggests that when the price of a good goes up, sellers will
supply a great deal less of the good and when the price of that good goes down, sellers will
supply a great deal more. A very low price elasticity implies just the opposite, that changes in
price have little influence on supply.
Often you'll have the follow up question "Is the good price elastic or inelastic between $9 and
$10". To answer that, use the following rule of thumb:

If PEoS > 1 then Supply is Price Elastic (Supply is sensitive to price changes)

If PEoS = 1 then Supply is Unit Elastic

If PEoS < 1 then Supply is Price Inelastic (Supply is not sensitive to price changes)

Recall that we always ignore the negative sign when analyzing price elasticity, so PEoS is
always positive. In our case, we calculated the price elasticity of supply to be 3.6, so our good is
price elastic and thus supply is very sensitive to price changes.

Q.5: Write a detailed note of Theory of Costs?

Cost theory is related to production theory, they are often used together. However, the question is
usually how much to produce, as opposed to which inputs to use. That is, assume that we use
production theory to choose the optimal ratio of inputs (eg. 2 fewer engineers than technicians),
how much should we produce in order to minimize costs and/or maximize profits? We can also
learn a lot about what kinds of costs matter for decisions made by managers, and what kinds of
costs do not.
Opportunity Costs
In addition to accounting profit, managers must consider the cost of inputs supplied by the
owners (owners capital and labor).
Accounting Costs: Costs that would appear as costs in an accounting statement.
Opportunity Costs: The value of all inputs to a firms production in theirmost valuable
alternative use.
Fixed costs, variable costs, and sunk costs
Some inputs vary with the amount produced and others do not. The firms computer system and
accountants may be able to handle a large volume of sales without increasing the number of
computers or accountants, for example. Inputs that do not vary with the amount produced, like
accountants and computers, are called fixed inputs.
Most inputs are fixed only for a certain range of production. A medical office may be able to
handle many additional patients without adding and office assistant or extra phones.
The phones and office assistants are fixed inputs. But, if the number of extra patients is large
enough, the firm needs extra office staff.
Reasons for fixed costs:

1. Salaried workers. Salaried workers are a fixed input if the worker can work overtime without
additional compensation (doctors paid a fee for service are variable inputs, salaried medical staff
are fixed inputs).
2. Fixed hours at work. An hourly worker sometimes cannot be sent home early if not enough
work is available. Therefore, workers may not be busy and be able to handle extra work without
additional hours.
3. Time to adjust. Some inputs, like machines, take time to purchase and install. Conversely,
unskilled labor may be adjusted more quickly through overtime, temps, etc. Therefore, by
necessity the firm may only be able to vary production by increasing labor in the short run.
Total Variable Cost The total cost of all inputs that change with the amount produced (all
variable inputs).
Total fixed costs The total cost of all inputs that do not vary with the amount produced (all fixed
inputs).
Consider the Thompson machine company. The firm uses 5 machines to make machine parts.
Because of the time to adjust, machines are a fixed cost, while the number of workers varies with
the amount produced. Labor is a variable cost.
Sunk costs Are costs that have been incurred and cannot be reversed.
Any costs incurred in the past, or indeed any fixed cost for which payment must be made
regardless of the decision is irrelevant for any managerial decision. Suppose you hire an
executive with a $100,000 signing bonus, plus $200,000 salary. After hiring, you may find the
executive does not live up to expectations. However, if the executives marginal revenue product
is $200,001, the executive still generates $1 in profits relative to his salary and therefore should
be retained. But if his MRP is $199,999, the firm loses an extra $1 each year they keep him, so
he should be let go. The bonus is a sunk cost and does not affect the retention decision.
The principle of sunk costs is equivalent to the saying dont throw good money after bad.
Sometimes a decision can be made to recover part of a fixed cost. Perhaps one could sell a
factory and recover part of the fixed costs. Then only the difference is sunk. For example, if we
can sell a building for which we paid $500,000 for $300,000, then only $200,000 is sunk.
Sunk costs are perhaps one of the most psychologically difficult things to ignore. Examples:
1. Finance. Studies show investors let sunk costs enter their decision making. What price the
stock was purchased at is sunk and therefore irrelevant. What matters is only whether or not this

stock offers the best return for the risk. Yet, investors are reluctant to sell stocks whose price has
gone down.
2. Cut your losses? Consider the war in Afghanistan. We have sunk billions, but that should not
enter our decision about whether or not to stay.
3. Pricing in high rent districts. Consider restaurants in a high rent district (say an airport).
Should they take the rent into account when setting prices? No. In fact, prices are high not
because of the rent, but typically because of the lack of competitors.
II Short run costs
We use short run costs primarily to compute how much to produce while maximizing profits.
We use long run costs to answer questions like should the firm expand, contract, merge, etc.
Average Costs: Costs divided by output.
Marginal Costs: The cost of one additional unit of an input.
Here is the notation:
Type of Cost Total Cost equals Variable Costs Plus Fixed Costs
Total TC = TV C +TFC
Average ATC = TC
Q = AV C = TV C
Q +AFC = TFCQ
Marginal MC = dTC
dQ = _TC_Q
Properties of cost functions in the short run:
1. Total costs of increase with Q, the quantity produced.
2. Average Total costs decline with Q, but eventually rise. The fixed costs are spread over many
more units of production at high Q, reducing average costs. All of the extra workers required for
producing additional units when the factory is near capacity starts to increase average costs
eventually.
3. Marginal costs usually decline then increase, but must eventually increase. At first, producing
one additional unit is may cheaper than the last unit, due to specialization. However, eventually
diminishing returns sets in and the workers just get in each others way. Then a very large
number of additional workers might be needed to produce an additional unit. A Profit
maximization with perfect competition Let us suppose that you are a hypothetical manager of a

group of cruise ships. Using data from previous years, you estimate the short run cost function is
(we will see how to do this estimation below):
TC = 60 +Q220 (69)
Here Q is the number of cruises the ship takes (not the number of passengers). The cost of the
ship is $60 million, which is sunk. Notice in equation (69) that the cost of the ship does not
depend on the number of cruises the ship takes. Suppose further that each cruise generates
revenue of $3 million.
Maximize profits: max _ = TR TC = 3Q 60 Q2 (70)
Take the derivative to get the slope and set the slope equal to zero:
3 Q10= 0 ! Q = 30. (71)
Notice that the fixed costs have dropped out. The math agrees: fixed costs do not matter for our
decision. In general, to maximize profits we set marginal revenue (here $3) equal to marginal
costs (here Q/10).
MR = MC. (72)
In a competitive industry, firms have no ability to influence the price. Examples include market
makers in stock markets, commodities, and large food markets. For example, an individual
farmer may produce as much corn as desired and sell the corn on the commodities markets with
no change in price. Regardless of the amount produced by an individual firm, the price is
unchanged and MR = P. So in competitive industries, we set:
P = MC. (73)
The firm should produce one more unit if we can sell it for more than it costs to produce.
The firm makes profits in this case. In the next set of notes, we will do the case where firms have
pricing power.
The marginal revenue is the price of the cruise, equal to $3 million. We can see that marginal
revenue equals marginal costs somewhere between 30 and 35 cruises.1
Producing the 30th cruise gives us $3 of revenue, enough to cover the costs of producing the
30th cruise, which (using table 6) is approximately $2.75. However, the 35th cruise loses money.
The table estimates that cruise would cost $3.25, and since revenues are $3, the cruise would lose
an estimated $0.25 million.
The fixed costs are irrelevant here. When considering the fixed costs, the firm has negative
profits regardless of how many cruises the firm takes. The maximum profits occurs at 30 cruises:

_ = TR TC = 3 30 _60 + 302
20 _ = $15. (74)
We have already paid the fixed costs, so we might as well lose as little as possible.2
B Break Even Analysis
An important consideration when deciding whether to continue operations in a particular market,
expand into a market, or start a new business is a break even analysis. We can do a break even
analysis with a cost function.
In a break even analysis, the question is: how much profit is required to exactly pay off all fixed
costs? Alternatively, how much revenue is required to pay off the average variable costs and the
fixed costs:
_ = 0 = TR TC (75)
0 = P Q TFC TV C (76)
0 = P Q TFC AV C Q (77)
Q=
TFC
P AV C (78)
Here I have assumed linear total costs, so that average variable cost is constant. One could
assume (more realistically) that average variable costs depend on Q, and use a table to get the
break even point.
C Average Costs
Often average cost data is easy to get. It is relatively easy to measure total costs and the quantity
sold to get average costs. However, many managers then incorrectly base decisions on average
costs.
Consider the following data:
Typical Data Calculate this!
Gas Production (Q)
Total costs (TC)
Average Total costs (ATC)
Marginal Costs (MC)
For example, a gas refinery might produce different quantities monthly depending on variations
in the price of gas and demand. Suppose the price of gas is currently $68.

How much gas should be produced? Setting price equal to average cost (48 units) actually
produces a loss. We could try to minimize average costs, which occurs at 28 units. Still, this is
not the maximum profits. The maximum profits occurs when price equals marginal costs, about
32-34 units. The key is that given the first 3 columns, one can easily calculate the marginal costs
and calculate the profit maximizing quantity.
IV Long Run Costs
We use long run costs to decide scale issues, for example mergers, but also the optimal size of
our operations (e.g. optimal plant size). The long run is when all costs are variable.
In the long run, we can build any size factory we wish, based on anticipated demand, profits, and
other considerations. Once the plant is built, we move back to the short run as described above.
Therefore, it is important to forecast the anticipated demand. Too small a factory and marginal
costs will be high as the factory is stretched to over produce.
Conversely too large a factory results in large fixed costs (eg. air conditioning, or taxes).
Think of each short run average cost curve as a factory of different size. We build the factory,
and then operate within the short run average cost curve for the factory that is built. For each size
factory, average total costs are initially decreasing as the fixed costs are spread over more and
more units. Eventually, however, average total costs rise as the factory becomes over crowded.
Suppose we forecast demand at Qd on the graph. Then, from the graph, we create a small sized
factory, as that is the cheapest way to build Qd units.
Therefore, we must have that the long run average cost curve is tangent to the minimum of the
short run average cost curves.
B Deriving a long run average cost curve:
Example
Suppose we can build plants of three sizes:
Cost Type Plant Size
AV C Small Medium Large
Labor $3.70 $2.50 $1.10
Materials $1.80 $1.40 $0.90
Other $2.00 $2.60 $3.00
TFC $25,000 $75,000 $300,000
Capacity 50,000 100,000 200,000

What type of plant produces 100,000 units at the lowest long run average costs? We can build
either two small plants, 1 medium sized plant, or one large plant. The average costs of two small
plants are:
ATC = AV C + TFC
Q , (79)
ATC = $3.70 + $1.80 + $2.00 + $25,000 2100,000= $8. (80)
Here, the fixed cost of the small plant is multiplied by two since we need two plants. For a single
medium sized plant:
ATC = $2.50 + $1.40 + $2.60 + $75,000
100,000 = $7.25. (81)
The medium sized plant is cheaper. Although the factory is more expensive to build than two
small factories, it can produce units at lower average variable cost. A large plant has:
ATC = $1.10 + $0.90 + $3.00 + $300,000
100,000 = $8.00. (82)
The large plant can produce at a very low average variable cost of $5 per unit, but is just too
expensive to build.
So for Q = 100,000 units, we build a single, medium sized factory. The point on the long run
average cost curve for Q = 100,000 is LRAC = $7.25.
Suppose instead expected demand is Q = 200,000 units. We can build 1 large, two medium, or 4
small plants.
The cost of these options (per unit) are: $6.50, $7.25, and $8, respectively.
The large plant is the cheapest, and LRAC = $6.50 for Q = 200,000. We could also build 1
medium and two small factories, but then the costs would be an average of $7.25
and $8, which is still worse than a large plant.
Finally long run average costs are minimized when we dont have to build any small or medium
sized plants, at Q = 200,000, 400,000, and so on.
C Factors that affect long run average costs
Long run average costs may be decreasing and then increasing, but also may be strictly
decreasing. Here are some LRAC curves for some industries.
1. Nursing Homes have decreasing LRAC. Nursing homes have many fixed management costs.
Further, larger nursing homes are able to negotiate lower prices for many raw materials.

2. Cruise Ships have decreasing LRAC. Huge cruise ships have lower average costs than small
cruise ships, economizing on many services provided on the ships.
3. Hospitals have U-shaped LRAC. Cowing and Holtmann (1983) in fact found many hospitals
in New York should in the long run reduce both capital and physicians to lower average costs.
When the LRAC curve is decreasing, it is in the interest of the industry to consolidate.
A merger with another firm can increase the customer base but reduce the cost per unit, thus
increasing profits.
Reasons for decreasing long run average costs:
1. Specialization of labor. Producing more units requires more workers. Workers can then
specialize in different parts of the production process, and produce more units.
2. Indivisibilities. A firm may require one accountant, even if there is less than 40 hours of work
to do. But then the firm can increase units produced without increasing the size of the accounting
staff.
3. Pricing Power. Large firms buy in bulk and therefore negotiate lower prices for inputs.
Notice the reasons are similar to increasing returns to scale.
Reasons for increasing costs:
1. Regulation may exempt smaller firms.
2. Coordination and information problems. In a large firm, many individuals do not meaningfully
affect profits and thus have the wrong incentives. Smaller operations may know their customers
and production processes better.
With decreasing returns, spin-offs and divestments may be optimal.
A compromise is franchising. Nationalize just the parts for which increasing returns works.
D Long run competitive equilibrium
In the long run, firms can enter and exit the market, or grow or shrink in size. As long as
economic profits are positive, new entrants arrive as the industry gives higher profits than
alternatives. New entrants increases competition and pushes down the price until economic
profits are zero. Therefore, in the long run:
_ = TR TC = 0, (83)
P Q = TC, (84)
P = TC
Q = LRAC. (85)

Now at the firm level, we set P = LRMC. But since also P = LRAC, marginal and average costs
are equal in the long run. We can therefore minimize long run average costs and in the long run,
we will have P = LRMC = LRAC.
V Application of long run average costs: Banking mergers
Consider two banks. The first bank services Q = 15 customers and the second (smaller) bank
services Q = 5 customers. The long run average cost function in the industry is:
LRAC = 700 40Q + Q2 (86)
Price is constant at $300 dollars of revenue per customer.
Should these two firms merge? The size of the customer base (Q) which minimizes long run
average costs is:
min LRAC = 700 40Q + Q2 (87) 40 + 2Q = 0 ! Q = 20 (88)
Costs per unit fall until Q = 20. Thus these two firms can reduce costs by merging from two
firms of size Q = 15 and Q = 5) into one firm with Q = 20.
Profit per unit in each case are:
_ = 300 700 40Q + Q2_ = 400 + 40Q Q2 (89)
_ (Q = 15) = 400 + 40 15 152 = 25 (90)
_ (Q = 5) = 400 + 40 5 + 52 = 225 (91)
_ (Q = 20) = 400 + 40 20 202 = 0 (92)
Individually, the two banks lose money but together they have zero economic profits. At zero
economic profits, no incentive exists for firms to enter or exit the market (remember, _ here is
economic profits so zero here means that investing in this industry gives the same profits as
investing in the next best industry). The choice is essentially to merge and get bigger or exit the
market.
VI Measuring Cost Functions
We use the same procedure as with production functions: Obtain data on total costs and quantity
produced, and use Excel to fit the data. Both total cost and total quantity produced may appear to
be easier to obtain than input data. However, one must remember that costs represent opportunity
costs, which are not always straightforward.
Some additional issues:
A Choice of Cost Function
One choice is whether to use a linear, quadratic, or cubic function:

TC = a + bQ (93)
TC = a + bQ + cQ2 (94)
TC = a + bQ + cQ2 + dQ3 (95)
Under most circumstances, the linear cost function does a reasonable job over a narrow range of
Q (for example in the short run), but the quadratic and cubic terms must matter theoretically,
especially for a wider range of Q. A good strategy might therefore be to estimate the cubic or
quadratic.
If the t-stats are low for the quadratic and cubic terms, then predictions are likely to be unreliable
for Q that falls outside the data. This indicates using some caution before, for example,
committing to large mergers. The following graph illustrates the problem.
B Data issues
Some problems with the data that often need correcting:
1. Definition of cost: as mentioned earlier, we use opportunity costs not accounting costs.
2. Price level changes: Historical data is likely to be inaccurate if the price of some inputs or
outputs have changed dramatically.
3. What costs vary with output: Some costs have a very limited relationship with output.
For example, the number of professionals required may vary in some limited way with output. A
firm with $1 million in sales may have two accountants. The firm can obviously increase output
to some degree without needing more accountants (so the cost would be fixed). But for larger Q
additional accountants are needed (like a variable cost).

4. The cost data needs to match the output data. Often the cost of producing some output may be
accounted for in some other period.
5. The firms technology may change over time.
When estimating long run costs, it is usually preferable to use a cross section of firms across an
industry. An individual firm is unlikely to have changed size significantly enough to generate
data for a wide range of Q.

THE END