Economic Principles: Production, Costs, Pricing and Competitive Strategies

This article explains the concepts of production, costs, pricing and competitive strategies in economics. It covers the short run and long run production, different types of costs, pricing strategies and competitive strategies. The article also includes mathematical models for profit maximizing output in the short run and long run.

Running head: ECONOMIC PRINCIPLES 1
Economic Principles
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ECONOMIC PRINCIPLES 2
Economic Principles
1. Long run and Short run Production
Creation of utility is referred to as production. There are factor inputs that are converted
into output (Rasmussen, 2011). The factor inputs include labor and capital as the dominant
resources used. The relationship that exists between the factor inputs and output can be
explained using a production function. Therefore, the process by which inputs are converted into
output is referred to as production.
The time a variable takes to be varied is what defines either the short run or long run.
Consequently, there is the short run and long run production (Horsley & Wrobel, 2016). In the
short run, the variables cannot be changed. In this case, the production function is short run since
at least one of the factors cannot be changed. In this way, all the inputs used in the production
cannot be varied. Hence, at least one-factor input is fixed in the short run.
On the other hand, in the long run, all the factors of production can be varied. It means
that all the resources like labor and capital can be changed. The reason is that a firm has a long
period to make decisions (Baumol & Blinder, 2012). In the long run, decisions to invest in a new
plant can be undertaken unlike in the short term where decisions involve the existing plant.
Costs. There are different costs involved in the production. According to Mankiw (2011),
Variable costs are dependent on the level of quantity produced. It means that changing the
amount would change the variable cost. Fixed costs are independent of the output. Changing the
quantity of production would leave the fixed costs unchanged. It means that variable costs are
long run because they can be altered while fixed costs are short-term since they cannot be
changed over time.

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Another type of cost is the total cost. The economic cost of production is the total cost
(TC). It involves the opportunity costs of each production factor. Hence, it consists of the cost of
the alternative chosen plus the benefit that the foregone opportunity would have provided if
chosen (Tragakes, 2011). The benefit foregone is the opportunity cost of production. In other
words, the accounting costs (variable plus fixed costs) plus opportunity cost yields the economic
cost.
Additionally, there is the average and marginal costs. Marginal cost is the change in total
cost following a unit change in quantity produced. It is the cost of producing an extra unit
(Samuelson & Nordhaus, 2010). For example the production cost of one car is $20000. The total
cost of making two cars is $25000. The marginal cost of producing the second car is $5000. On
the other hand, the average cost is the cost per unit. It is obtained by dividing the total cost with
the number of units produced. For example if the production cost of two cars is $50000, the
average costs is &25000. Another way would be to add up the average fixed cost and average
variable costs to obtain the average costs. The different costs of production influence the total
cost of production.

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Pricing Strategies. Firms have different pricing strategies. The dominant strategies are
the marginal cost pricing and cost-plus pricing (Govindarajan, 2009). In marginal cost pricing,
the price is set equal to the cost of producing an extra unit which is referred to marginal cost.
Mostly, the method is applicable in the competitive market. Under the cost-plus pricing, other
costs like the material cost and overhead costs are added to create a profit margin. The method is
often used in the monopoly market structure. The pricing strategies are significant to an
organization. Firms can use the pricing strategies to protect themselves from new entrants by
preventing them. Also, organizations can use pricing methods to obtain a new market share.
Moreover, companies use pricing strategies to maximize their profits.
Different factors influence the decision of the pricing strategy. The level of competition
is influential. Firms must be aware of the actions that their competitors could take. Failure to
consider their opponent’s actions would make them lose their competitive advantage. According
to Narula (2006), consumers are very selective when making their decisions. Rational consumers
would ensure that they maximize their benefits from their money. One would not buy an
expensive product that serves the same purpose with another cheaper product. Buyers prefer to
buy cheaper commodities. Again, buyers can easily make price comparisons from the internet
because of the increased use of technology. Therefore firms must be attentive and selective to the
pricing strategy they apply.
Competitive Strategies. Sustainable competitive strategies determines the success of a
business. Competitive strategies drives the firm’s profitability either above or below the industry
average. Firms with a solid competitive advantage maintain their profitability level above the
industry’s position. There are two major ways in which firms can be competitive which are cost
leadership and differentiation. Cost leadership dictates that firms should pursue economies of

ECONOMIC PRINCIPLES 5
scale and have appropriate technology. In addition, firms should have strategic location. For
example, nearness to the market and source of raw material to reduce on production cost leading
to increased profitability (Moore & Longenecker, 2008). In differentiation, firms seek to have a
unique product that has been tailored to meet customer’s demand. A firm would look at the
elements that buyers perceive to be important and work on their product to ensure that they meet
the demand of consumers. Hence, competitive strategies are vital for the success of an
organization.
2. Derivation of the cost functions
Fixed Costs (FC).Fixed costs are costs that are independent of output. The fixed cost
function can be obtained by subtracting the variable cost from the total costs as shown
TC = FC + VC
Given that C = 2000 + 5Q + 2Q3
VC = 5Q + 2Q3
FC = TC - VC
Therefore, FC = (Q = 2000 + 5Q + 2Q3) – (5Q + 2Q3)
FC = 2000
Variable Costs (VC). Variable costs are costs that are dependent on quantity produced.
The variable cost function can be obtained by subtracting fixed costs from total costs.
Given that C = 2000 + 5Q + 2Q3 and FC = 2000
VC = TC – FC
VC = (2000 + 5Q + 2Q3) – 2000
VC = 5Q + 2Q3
Average Cost (AC)

ECONOMIC PRINCIPLES 6
It is the cost per unit produced. It can be obtained by dividing the total cost with the units
produced.
Given that C = 2000 + 5Q + 2Q3 and the units produced are Q
It follows that, AC = (2000 + 5Q + 2Q3) ÷ Q
AC = 5 + 2000∕Q + 2Q2
Marginal Costs (MC). It is defined as the cost of producing an extra unit of output.
To obtain marginal cost curve, you differentiate the total cost curve with respect to Q.
C = 2000 + 5Q + 2Q3
Differentiating the total cost function, you obtain the marginal cost function:
MC = dC /dQ
MC = 5 + 6Q2
3. Model for profit maximizing output in the short run
Firms maximize their revenue where MR = MC (Hall & Lieberman, 2013). Where firms
maximize their revenue, the output is maximum. For example in the above graphical
representation, the maximizing Quantity is Q0. The level of output can be obtained using a
Output
Price
P0
Q0
MC = 5 + 6Q2
AC = 5 + 2000Q +2Q2
D = AR = P = MR= 100
Profit Maximizing Quantity

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mathematical model. Given that a firm maximizes output where MR = MC, in perfect
competition it would mean that P = MC. It is because of the elastic demand curve which gives
MR = P.
4. Meaning of the 0.5
The 0.5 is the output elasticities. It shows how the output changes with the change in inputs
which are capital and labor.
5. Maximum profit conditions in the short run and long run
In the short run, firms maximize profits where MR = MC. Firms maximize profits where MC
curve intersects the AC curve from below.
6. The short run
Using P = MC and given that P = 100, MC = 5 + 6Q2
100 = 5 + 6Q2
6Q2 = 95
Q2 = 15.83
Q = 3.98
In the long run
AC = 5 + 2000∕Q + 2Q2
At the minimum, you differentiate the AC curve to obtain,
dAC ∕dQ = -2000∕Q2 + 4Q
MC = 5 + 6Q2
Equating the two equations,
-2000∕Q2 + 4Q = 5 + 6Q2
Multiplying both sides by Q you get,

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5Q + 6Q3 = 2000 + 5Q + 2Q2
Collecting the like terms together,
4Q3 = 2000
Q = 12.6

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References
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Hall, R. E., & Lieberman, M. (2013). Economics: Principles & applications. Australia: South-
Western Cengage Learning.
Horsley, A., & Wrobel, A. J. (2016). The Short-Run Approach to Long-Run Equilibrium in
Competitive Markets: A General Theory with Application to Peak-Load Pricing with
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Mankiw, N. G. (2011). Essentials of economics. Cincinnati, Ohio: South-Western.
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