ECONOMICS OF STRATEGY – SUMMARY
ECONOMICS PRIMER - BASIC PRINCIPLES
The law of demand says that, all other things being the same, the lower the price of a product, the more of it
consumers will purchase.
COSTS
COST FUNCTIONS
The total cost function (TC(Q)) represents the relationship between a firm’s total costs, denoted by TC, and the
total amount it produces in a given time period, denoted by Q. If the firm is producing as efficiently as it knows
how, then the total cost function must slope upward: the only way to achieve more output is to use more
factors of production, which will raise total costs.
Variable costs, such as direct labour and commissions to salespeople, increase as output increases. Fixed costs,
such as general and administrative expenses and property taxes, remain constant as output increases.
The line dividing fixed and variable costs is often fuzzy. Some costs (maintenance or advertising and
promotional expenses) may have both fixed and variable components. Other costs may be semifixed:
fixed over certain ranges of output but variable over other ranges.
When we say that a cost is fixed, we mean that it is invariant to the firm’s output. It does not mean
that it cannot be affected by other dimensions of the firm’s operations or decisions the firm might
make.
Whether costs are fixed or variable depends on the time period in which decisions regarding output
are contemplated.
The average cost function describes how the firm’s average or per-unit-of-output costs vary with the amount of
𝑇𝐶(𝑄)
output it produces. AC(Q) = . When total costs are directly proportional to output: TC(Q) = cQ, then
𝑄
average cost would be a constant.
When average cost decreases as output increases, there are economies of scale.
When average cost increases as output increases, there are diseconomies of scale.
When average cost remains unchanged with respect to output, we have constant returns to scale.
Output level Q’ is the smallest level of output at which economies of scale are exhausted and is thus known as
the minimum efficient scale.
𝑇𝐶(𝑄+ ∆𝑄)−𝑇𝐶(𝑄)
Marginal cost refers to the rate of change of total cost with respect to output. MC(Q) =
∆𝑄
.
Marginal cost often depends on the total volume of output. Average cost is generally different from marginal
cost. The exception is when total costs vary in direct proportion to output, TC(Q) = cQ
𝑐(𝑄+ ∆𝑄)−𝑐𝑄
MC(Q) = ∆𝑄
= c (is also average cost).
When average cost is a decreasing function of output, marginal cost is less than average cost.
When average cost neither increases nor decreases in output, because it is either constant or at a
minimum point, marginal cost is equal to average cost.
When average cost is an increasing function of output, marginal cost is greater than average cost.
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ECONOMICS PRIMER - BASIC PRINCIPLES
The law of demand says that, all other things being the same, the lower the price of a product, the more of it
consumers will purchase.
COSTS
COST FUNCTIONS
The total cost function (TC(Q)) represents the relationship between a firm’s total costs, denoted by TC, and the
total amount it produces in a given time period, denoted by Q. If the firm is producing as efficiently as it knows
how, then the total cost function must slope upward: the only way to achieve more output is to use more
factors of production, which will raise total costs.
Variable costs, such as direct labour and commissions to salespeople, increase as output increases. Fixed costs,
such as general and administrative expenses and property taxes, remain constant as output increases.
The line dividing fixed and variable costs is often fuzzy. Some costs (maintenance or advertising and
promotional expenses) may have both fixed and variable components. Other costs may be semifixed:
fixed over certain ranges of output but variable over other ranges.
When we say that a cost is fixed, we mean that it is invariant to the firm’s output. It does not mean
that it cannot be affected by other dimensions of the firm’s operations or decisions the firm might
make.
Whether costs are fixed or variable depends on the time period in which decisions regarding output
are contemplated.
The average cost function describes how the firm’s average or per-unit-of-output costs vary with the amount of
𝑇𝐶(𝑄)
output it produces. AC(Q) = . When total costs are directly proportional to output: TC(Q) = cQ, then
𝑄
average cost would be a constant.
When average cost decreases as output increases, there are economies of scale.
When average cost increases as output increases, there are diseconomies of scale.
When average cost remains unchanged with respect to output, we have constant returns to scale.
Output level Q’ is the smallest level of output at which economies of scale are exhausted and is thus known as
the minimum efficient scale.
𝑇𝐶(𝑄+ ∆𝑄)−𝑇𝐶(𝑄)
Marginal cost refers to the rate of change of total cost with respect to output. MC(Q) =
∆𝑄
.
Marginal cost often depends on the total volume of output. Average cost is generally different from marginal
cost. The exception is when total costs vary in direct proportion to output, TC(Q) = cQ
𝑐(𝑄+ ∆𝑄)−𝑐𝑄
MC(Q) = ∆𝑄
= c (is also average cost).
When average cost is a decreasing function of output, marginal cost is less than average cost.
When average cost neither increases nor decreases in output, because it is either constant or at a
minimum point, marginal cost is equal to average cost.
When average cost is an increasing function of output, marginal cost is greater than average cost.
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