CIE​ ​Economics​ ​A-level

Topic​ ​2:​ Price System and the

Microeconomy
c) Types of cost, revenue and profit, short-
run and long-run production
Notes

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Short-run production function

Fixed and variable factors of production

In the short run, the scale of production is fixed (there is at least one fixed cost). For
firms, the quantity of labour might be flexible, whilst the quantity of capital is fixed.
In the long run, the scale of production is flexible and can be changed. All costs are
variable.

Total product, average product and marginal product

The marginal product of a factor, such as labour, is the extra output derived per
extra unit of the factor employed. For labour, it is the extra output per unit of labour
employed. For example, employing more staff in a small shop will make it
overcrowded and the extra output per unit of labour falls.
The average product of a factor is the output per unit of input. This is output per
worker over a period of time.
The total product of a factor is the total output produced by a number of units of
factors (e.g. labour) over a period of time. The amount of capital is fixed.

The law of diminishing returns

Diminishing returns only occur in the short run.

The variable factor could be increased in the short run. For example, firms might
employ more labour. Over time, the labour will become less productive, so the
marginal return of the labour falls. An extra unit of labour adds less to the total
output than the unit of labour before.
Therefore, total output still rises, but it increases at a slower rate.
This is linked to how productive labour is.
The law assumes that firms have fixed factor resources in the short run and that the
state of technology remains constant. However, the rise of things like out-sourcing
means that firms can cut their costs and their production can be flexible.

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Marginal cost and average cost

Average (total) costs (ATC) = total costs / quantity produced. ATC = AVC + AFC. This
is the cost per unit of output produced.
Average fixed costs (AFC) = total fixed costs/quantity.
Average variable costs (AVC) = total variable costs/quantity.

Marginal costs are how much it costs to produce one extra unit of output. It is
calculated by ∆TC÷∆Q.

Short-run cost function

Total costs are how much it costs to produce a given level of output. An increase in
output results in an increase in total costs. Total costs = total variable costs + total
fixed costs

Total fixed cost:

In the short run, at least one factor of production cannot change. This means there
are some fixed costs. Fixed costs do not vary with output. For example, rents,
advertising and capital goods are fixed costs. They are indirect costs.

Total variable cost:

In the long run, all factor inputs can change. This means all costs are variable. For
example, the production process might move to a new factory or premises, which is
not possible in the short run. Variable costs change with output. They are direct
costs. For example, the cost of raw materials increases as output increases.

Explanation of shape of Short-Run Average Cost (SRAC)

The measure of the short run varies with industry. There is no standard. For
example, the short run for the pharmaceutical industry is likely to be significantly
longer than the short run for the retail industry. In the short run, there are some
fixed costs. In the long run, all costs are variable. In the very long run, the state of
technology can change, such as electronics.
The law of diminishing marginal productivity states that adding more units of a
variable input to a fixed input, increases output at first. However, after a certain
number of inputs are added, the marginal increase of output becomes constant.

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Then, when there is an even greater input, the marginal increase in output starts to
fall.
In other words, at some point in the production process, adding more inputs leads to
a fall in marginal output.
This could be due to labour becoming less efficient and less productive, for example.
At this point, total costs start to increase.

On the diagram, the red parts show diminishing returns, where the cost of
production starts to rise with increased output.
Marginal costs rise with increasing diminishing returns.

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The diagram above shows cost curves. MC, ATC and AVC rise with diminishing
returns. AFC falls with increasing output.
The lowest points on the curves, as shown by the yellow highlighted circles, are the
points where diminishing marginal productivity sets in. Before this, average costs are
falling. After this, average costs are rising.
The MC curve cuts through the lowest points on the ATC and AVC curves.

Long-run production function

Returns to scale
Returns to scale refers to the change in output of a firm after an increase in factor
inputs.
Returns to scale increases when the output increases by a greater proportion to the
increase in inputs. For example, if input doubles, and output quadruples, there is
said to be increasing returns to scale.
If, on the other hand, a doubling of input leads to a 1.5 times increase in output,
there are decreasing returns to scale. This is linked to diseconomies of scale, since it
occurs when the firm becomes less productive.
Constant returns to scale are when output increases by the same amount that input
increases by.

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Long-Run Average Cost (LRAC)

The LRAC curve is shown in the diagram below. The point of lowest LRAC is the
minimum efficient scale. This is where the optimum level of output is since costs are
lowest.

If fixed costs are high, average costs are lowered as output increases. When
diseconomies of scale set in, average costs increase. This is shown on the long run
average cost curve because economies of scale are only applicable in the long run.
Initially, average costs fall, since firms can take advantage of economies of scale.
This means average costs are falling as output increases.
After the optimum level of output, where average costs are at their lowest, average
costs rise due to diseconomies of scale.
The point of lowest LRAC is the minimum efficient scale. This is where the optimum
level of output is since costs are lowest, and the economies of scale of production
have been fully utilised.

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Internal economies of scale:

These occur when a firm becomes larger. Average costs of production fall as output
increases.
Examples of internal economies of scale can be remembered with the mnemonic
Really Fun Mums Try Making Pies

Risk-bearing: When a firm becomes larger, they can expand their production range.
Therefore, they can spread the cost of uncertainty. If one part is not successful, they
have other parts to fall back on.
Financial: Banks are willing to lend loans more cheaply to larger firms, because they
are deemed less risky. Therefore, larger firms can take advantage of cheaper credit.
Managerial: Larger firms are more able to specialise and divide their labour. They
can employ specialist managers and supervisors, which lowers average costs.
Technological: Larger firms can afford to invest in more advanced and productive
machinery and capital, which will lower their average costs.
Marketing: Larger firms can divide their marketing budgets across larger outputs, so
the average cost of advertising per unit is less than that of a smaller firm.
Purchasing: Larger firms can bulk-buy, which means each unit will cost them less. For
example, supermarkets have more buying power from farmers than corner shops, so
they can negotiate better deals.

There are also network economies of scale. These are gained from the expansion of
ecommerce. Large online shops, such as eBay, can add extra goods and customers at
a very low cost, but the revenue gained from this will be significantly larger.

External economies of scale:

These occur within the industry.

For example, local roads might be improved, so transport costs for the local
industries will fall.
Also, there might be more training facilities or more research and development,
which will also lower average costs for firms in the local area.

Diseconomies of scale:

These occur when output passes a certain point and average costs start to increase
per extra unit of output produced.
Examples include:
Control: It becomes harder to monitor how productive the workforce is, as the firm
becomes larger.

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Coordination: It is harder and complicated to coordination every worker, when there
are thousands of employees.
Communication: Workers may start to feel alienated and excluded as the firm
grows. This could lead to falls in productivity and increases in average costs, as they
lose their motivation.

The relationship between returns to scale and economies or diseconomies of scale

Returns to scale increases when the output increases by a greater proportion to the
increase in inputs. For example, if input doubles, and output quadruples, there is
said to be increasing returns to scale. This occurs where there are economies of scale
and factor inputs become more productive.
If, on the other hand, a doubling of input leads to a 1.5 times increase in output,
there are decreasing returns to scale. This is linked to diseconomies of scale, since it
occurs when factor inputs become less productive.

Revenue: total, average and marginal

Total revenue (TR) is calculated by price times quantity sold. This is the revenue
received from the sale of a given level of output.

Average revenue (AR) is the average receipt per unit. This is calculated by TR /
quantity sold. In other words, this is the price each unit is sold for.

Marginal revenue is the extra revenue earned from the sale of one extra unit.
It is the difference between total revenue at different levels of output.

Profit: normal and abnormal

Profit is the difference between total revenue and total costs.

Normal profit: Normal profit is the minimum reward required to keep entrepreneurs
supplying their enterprise. It covers the opportunity cost of investing funds into the
firm and not elsewhere. This is when total revenue = total costs (TR = TC). Normal
profit is considered to be a cost, so it is included in the costs of production.
Supernormal profit: Supernormal profit (also called abnormal or economic profit) is
the profit above normal profit. This exceeds the value of opportunity cost of
investing funds into the firm. This is when TR > TC.

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