3 An introduction to

production, costs,
revenue and profit
The operation of markets, market
failure and the role of government
3.1
1.1 Production
The demandand
forproductivity
goods and services

This section will develop your knowledge and understanding of:

➔ how production converts inputs, such as raw materials, capital and labour, into final output
➔ the importance of the natural environment in sustaining economic activity
➔ the meaning of productivity, including labour productivity.

Link Production
Production involves turning inputs, such as raw materials, capital and
Production was introduced in labour, into final output.
1.1 “The nature and purpose of
economic activity” and the factors The inputs or economic resources (factors of production) are: land
of production were covered in 1.2 (natural resources); capital (human-made resources); labour (human
“Economic resources”. resources); and enterprise or the entrepreneur (the organiser or risk-
taker). These inputs are combined to create goods and services.
For example, a person decides to open a business selling furniture. As
an entrepreneur, they make the decisions about what to produce and
how to produce it. They take the risks involved and the resulting profit
or loss.
The entrepreneur may employ additional workers (labour). They will
need raw materials such as wood and somewhere to carry out their
business (land). The business will also need equipment, to cut and
shape the wood (capital).

Link The importance of the natural environment

Economic activity was introduced Provision of inputs
in 1.1 “The nature and purpose Economic activity is concerned with the production, distribution
of economic activity” and the and consumption of goods and services. The furniture business is
environment as a scarce resource an example of economic activity. The natural environment plays an
in 1.2 “Economic resources”. important part in sustaining economic activity. It provides inputs for
the productive process.
For example, the wood to make the furniture comes from the
environment. It may have been growing naturally or land may have
been set aside to plant trees, to provide wood to make furniture and
other wooden products. Trees needs the right growing conditions to
produce good-quality wood.
Other products of the environment include minerals, such as iron,
copper and diamonds, and agricultural products. Iron can be used to
make steel, which can be used in the building, medical and transport
industries. We rely on agricultural products for our food.

Productive activity as a source of potential

damage
As the world’s population and incomes have grown, so has the
demand for inputs. Although some resources are renewable, such as
sunlight and wind for energy, others are not. This may be because

64
 Production and productivity

once they are used, they cannot be replaced, such as coal and oil, or
because renewable resources are being used up more quickly than Link
they can be replaced. This applies to some fish in parts of the world. Renewable and non-renewable
Economic activity may damage the environment. Mining and resources were covered in 1.2
quarrying can cause pollution, both when the minerals are extracted “Economic resources”.
and also by leaving behind an unattractive landscape. However, in
some areas, old quarries have been filled with water to become nature
reserves, which can then be used for leisure.

Case study: Palm oil – good or bad?

To produce more palm oil, more of these trees have been
planted. This has resulted in cutting down forests that
are the homes of animals such as orangutans. Forests
help to keep the air clean and reduce soil erosion. With
forests being cleared, there is also a greater risk of fires
in the dry season. This can cause clouds of ash in some
areas, which then cause breathing problems. When the
palm trees grow too high, they are cut down for more to
be planted.
1 Around 0.25% of the world’s farmland is used to
grow palm trees to produce oil and 0.5% is used for
sunflowers. Use the information in the case study to
calculate how many times more oil is obtained in the
▲ Figure 3.1.1: Oil palm trees world from palm trees than sunflowers.
Palm oil has many uses including for cooking oil, washing 2 Identify two advantages and two disadvantages of
powder, soap and biofuel. With growing populations and producing more palm oil.
health concerns about substitute goods, the demand for 3 Draw a supply and demand diagram to show the effects
palm oil for food has doubled over the last 15 years. It is of an increase in the use of palm oil on the market for
also the most productive oil crop. The fruit from the oil palm soybeans used to produce oil.
tree produces 10 times as much oil as sunflowers and 11 4 Assess whether more should be done to control the
times more oil than soybean plants. Oil palms also need amount of land used for palm oil.
less fertiliser.

The meaning of productivity Activities

Productivity measures how much a unit of a factor of production
produces in a given time. Unlike production, productivity compares Choose another agricultural
the inputs to the output. It can therefore be used as a measure of product or raw material.
efficiency. Production is the total amount produced in a given time, 1 Find out which parts of the
regardless of the inputs that were used. world it is grown in or mined.
Labour productivity is how much a worker produces in a given 2 What are its uses?
time. For example, the production of a furniture business may be six 3 Has there been any damage to
tables in a week. If there are two full-time workers, the productivity the environment as a result?
of a worker/labour productivity is three tables a week. A year later,
perhaps due to more training or experience, the production rises
to eight tables a week. If the firm still has two workers, labour
productivity is four tables per worker per week. The workers are now
more productive than before.

65
3 An introduction to production, costs, revenue and profit

Productivity can also apply to other factors of production. For

Get it right example, it can be used as a measure of how much an area of land or
Do not confuse production with a piece of equipment can produce in a given time.
productivity. They are linked but
are not the same. Link
Productivity, including labour productivity, was introduced in 2.3 “The supply
of goods and services” and will be looked at again in 6.2 “Macroeconomic
indicators”, when considering data commonly used to measure the
performance of an economy.

Progress questions
1 How are production and the natural environment linked?
2 Explain the difference between production and productivity.

Case study: The amazing growth of maize

▲ Figure 3.1.2: Maize

The United States is the world’s largest maize producer, followed by China and
Brazil. In 1940, the average amount of maize produced per hectare (yield) in
the United States was 2 tonnes. In 1980, it was 5.7 tonnes per hectare and it is
now 10 tonnes per hectare.
1 Give two reasons why the yield of maize may have increased in this time.
2 What was the percentage increase in the yield of maize between 1940
and 1980?
3 If 39,000,000 hectares are used to grow maize in the United States, use
the current yield to calculate the production of maize.

66
 3.2 Specialisation, division of labour and
exchange
This section will develop your knowledge and understanding of:
➔ the benefits and costs of specialisation and division of labour
➔ why specialisation requires an efficient means of exchanging goods and services, including
the use of money as a medium of exchange.

Specialisation and division of labour

Specialisation is where different firms, regions, countries or factors
of production concentrate on the production of different goods or
services. This happens because different firms, regions, countries or
factors of production have different natural advantages or strengths.
For example, Chile produces approximately a third of the world’s
copper, and copper mining provides between 10% and 20% of the
country’s income. If minerals are not found in a country, it will need
to buy them from other countries. The landscape of Chile varies ▲ Figure 3.2.1: Adam Smith
from snow-topped mountains to dry deserts. Some regions, such as
Patagonia in the south and the Atacama Desert in the north, have
been very successful in promoting the natural beauty of their area and
have attracted increasing numbers of foreign tourists in recent years.
This has created more jobs and increased local incomes. Although Activity
Chile also produces other goods and services, some regions specialise
Adam Smith wrote about the
in copper mining and tourism.
impact of division of labour in a pin-
Firms and factors of production will also specialise. A firm may making factory in his 1776 book An
assemble cars or perhaps make a particular part for a car, such as car Inquiry into the Nature and Causes
tyres. Machines may be designed for a specific purpose and they have of the Wealth of Nations. Find out
replaced workers in many jobs in recent years, such as self-service tills how division of labour in the factory
in shops. increased productivity.
Division of labour is when a worker performs one task or a narrow
range of tasks as part of the production process. Instead of making
whole tables, a worker may specialise in making the legs for tables.
Get it right
Key terms Division of labour is the application
of specialisation to workers in the
Specialisation: where different firms, regions, countries or factors of
production process. Specialisation
production concentrate on the production of different goods or services.
is a general term and division
Division of labour: when a worker performs one task or a narrow range of of labour is an example of
tasks as part of the production process. specialisation.

Activities
1 Make a list of at least six different jobs in your school or college.
2 Choose another good or service and make a list of at least six different
jobs involved in supplying that good or service.

67
3 An introduction to production, costs, revenue and profit

Benefits and costs of specialisation and division

of labour
Benefits
Countries can take full advantage of their resources and focus on what
they do best. If specialisation occurs on a world basis, this increases the
size of the market for each producer. Any surplus goods can be sold to
other countries.
Firms and workers will “learn by doing” more quickly if they focus on
one or a narrow range of tasks. Training will take less time. If workers
are more skilled, this may lead to more pay, which may increase
motivation. It may also enable the use of specialist machinery.
Production should be quicker, increasing productivity. If more is
produced in a given time from a set amount of inputs, the cost of
producing each unit (average cost or unit cost) will fall. Producing
on a large scale may lead to even greater savings. This will enable
Key term firms to reduce prices for consumers. They may also benefit from a
Average cost or unit cost: the cost greater variety and quality of products.
of producing each unit, total cost If countries, regions, firms and factors of production concentrate on
divided by the number of units what they do best, then specialisation, including division of labour,
produced. will help to make the best use of the world’s scarce resources.

Link Activities
Average costs will be covered in 1 Find out which products your country specialises in.
3.3 “Costs of production” and 3.4 2 Why has your country focused on these products?
“Economies and diseconomies of
scale”.
Costs
Overspecialisation may cause problems. A country or region that
focuses on one or a few products for its income may have nothing else
to rely on, for example, if a natural resource runs out or its price falls.
Specialisation may lead to products being mass produced with less
variety available.
Specialisation leads to interdependence, where individuals or
Key term firms depend on each other. For example, if there is only one firm
Interdependence: when two producing a part needed in the next stage of the production process,
things, for example individuals or and there is a hold-up in its production, the firms involved later in the
firms, depend on each other. process will be unable to carry out their work until more parts become
available.
There is a human cost. Workers carrying out the same tasks all day
every day may become bored and boredom can result in a loss of job
satisfaction. This can also lead to mistakes and poorer-quality products.
Workers may take more time off (higher absenteeism) and stay in jobs
for shorter periods of time (higher labour turnover). Firms will then
have to spend more money recruiting and training new workers.
If a machine can be developed that can carry out the same task as
the workers, they may lose their job. They could have few skills to
offer in a different job. Countries, regions, firms and workers will be
vulnerable to changes in demand.

68
 Specialisation, division of labour and exchange

▼ Table 3.2.1: Summary of benefits and costs of division of labour

Benefits Costs
• Production is quicker • Workers may become bored
• Less training time is needed for • They may lack job satisfaction
workers • They have few skills to offer in
• Average cost is lower other jobs
• Consumers benefit from firms’ • They could be replaced by
reduced prices machines
• Firms are more able to use • There is less variety of products
specialist machinery • Interdependence can cause
• Resources are used efficiently problems

Case study: Division of labour – how far to go?

About 30 years ago, Volvo, the Swedish automotive
company, was one of a few firms experimenting with
organising their workers into teams, often in threes,
instead of having people working individually.
The teams could organise themselves how they wished, in
order to produce the target output for that session. Instead
of working all day, for example, on fitting the back lights
of the car, workers could work on all parts of the electrical
system. Workers could take breaks when they liked and
every team had its own workshop and sauna.
Now, teamwork is much more common. About 80% of the
world’s work is done by teams.
1 What are the advantages of an automotive company
▲ Figure 3.2.2: The result of teamwork
using teams instead of people working individually?
Economic theory suggests that division of labour will 2 What are the disadvantages of a business allocating
increase productivity and reduce average cost. However, work to teams instead of to individuals?
repetitive work that requires little skill is boring and can 3 Assess whether there should be more division of labour
lead to a lack of job satisfaction. or whether more work should be allocated to teams.

69
3 An introduction to production, costs, revenue and profit

The need for an efficient means of exchanging

goods and services
In early history, families and communities had to be self-sufficient.
Key terms They had to provide everything they needed. This meant that what
Self-sufficient: providing for your they had was very limited.
own needs. If different firms, regions, countries or factors of production
Barter: the exchange of goods concentrate on the production of different goods and/or services, there
and services for other goods and needs to be some way of obtaining the other goods and services they
services. need or want. This involves trading what has been produced.
Trading could involve barter, which is the exchange of goods
and services for other goods and services. This requires
a double coincidence of wants. You have to find someone who
has what you want and will accept what you have to trade. This is
difficult. There also needs to be a good transport and communication
system, for you to find the other person or firm and to be able to
exchange the products easily.
Over time, a medium of exchange developed. This is something not
wanted for itself but to be used as a way of obtaining other goods and
services. Money acts as a medium of exchange. We use it to buy what
we need and want, and to receive payment for what we sell. Without
an efficient means of exchanging goods and services, such as money,
specialisation could only take place to a very limited extent.

Key terms
Double coincidence of wants: having to find someone who has what you want
and will accept what you have to trade.
Medium of exchange: something not wanted for itself but to be used as a way
of obtaining other goods and services.

Progress questions
1 What is the difference between specialisation and division of labour?
2 Explain two advantages and two disadvantages of specialisation for a
country.
3 Explain two advantages and two disadvantages of division of labour.
4 What is necessary for specialisation to take place?

70
 3.3 Costs of production

This section will develop your knowledge and understanding of:

➔ the difference between the short run and the long run
➔ the difference between fixed and variable costs
➔ the difference between average and total costs.

The difference between the short run and the Link

long run
Time periods, including the
In Economics, there are two main time periods. In the short run, short run and the long run, were
at least one factor of production is fixed in supply. For example, a
introduced in 2.4 “Price elasticity of
business may have a certain amount of equipment in a limited work
supply”.
area. In the short run, it may only be possible to increase or decrease
production by changing the amount of labour.
In the long run, all factors of production are variable. It is possible to
change all the factors of production in response to changes in demand.
For example, another factory could be built and more equipment
bought to increase the capacity of the business.
The short run and long run are not set periods of time in terms of
weeks or years. They vary according to the product. For example, it
takes about six years after a rubber tree is planted before any latex
from it can be harvested. In this case, the short run is six years.

The difference between fixed and variable costs

Fixed costs
Fixed costs (FC) are (short-run) costs that do not change with
output. They must be paid even when there is no output. For
example, if the factory is closed for some reason, there will still be
some costs to pay. Fixed costs are sometimes known as overheads.
Fixed costs are associated with the fixed factors of production.
They include the rent of the factory or office, and interest on loans.
Average fixed costs (AFC) are the fixed costs per unit of output.
They are calculated by dividing the total fixed costs by the number of
units produced (Q).
AFC = FC
Q
For example, if fixed costs are $6,000 a month and 20 items are
produced in this time, the average fixed costs are $300.
Key terms
Although fixed costs stay the same in the short run, average fixed
Fixed costs: costs that do not
costs do not. The greater the output, the lower the average fixed costs
change with output.
because the fixed costs are spread over a greater number of units. For
example, if fixed costs are $6,000 a month and 50 items are produced, Average fixed costs: fixed costs per
the average fixed costs fall to $120. unit of output.
Figures 3.3.1 and 3.3.2 show the relationship between fixed costs
and average fixed costs. Fixed costs stay the same. If the fixed costs
are $6,000 a month, FC is a horizontal line at this amount. Average

71
3 An introduction to production, costs, revenue and profit

fixed costs fall as output increases, rapidly to start with and then more
gradually, as the fixed costs are spread over an increasing number of
units. Note the difference in scale on the vertical axes.

Cost Cost
($) ($)

6,000 FC 600
Quantitative skills
Do not confuse fixed costs and
300
average fixed costs. Fixed costs
stay the same for all output levels AFC
120
(in the short run). Average fixed
costs fall with output. O 10 20 30 40 50 Q O 10 20 30 40 50 Q

▲ Figure 3.3.1: Fixed costs (FC) ▲ Figure 3.3.2: Average fixed costs (AFC)

Activity Variable costs

Variable costs (VC) are costs that change with output. As output
What type of business is likely to
rises, so do variable costs. If the factory is closed, there will be no
have high fixed costs and why?
variable costs to pay.
Test your theory by finding out
more about this type of business. Variable costs are associated with the variable factors of production.
They include wages, raw materials and packaging costs. Average
variable costs (AVC) are the variable costs per unit of output. They
are calculated by dividing the total variable costs by the number of
units produced (Q).
AVC = VCQ
For example, if variable costs are €4,000 a month and 200 items are
Key terms produced in this time, the average variable costs are €20.
Variable costs: costs that change It is likely that average variable costs will fall as output increases but
with output – as output rises, so do after a certain point, they are likely to rise. In the long run, all costs
variable costs. are variable because all factors of production are variable.
Average variable costs: variable
costs per unit of output. Progress questions
1 What is the difference between the short run and the long run?
2 Give an example of:
i. a fixed cost
ii. a variable cost.
3 If the average fixed costs of producing 20 units are $500, what are the
total costs when output is zero?

Quantitative skills
As with supply and demand diagrams, when drawing cost and revenue
diagrams, the quantity is always put on the horizontal axis. The vertical axis
should be labelled cost, revenue, or cost and revenue, whichever is appropriate
for the curves drawn. Alternatively, a currency sign can be used, for example $.

72
 Costs of production

Case study: Sven’s TT bats (part one)

Table tennis is the most popular racquet sport. It is played 2 Use the information to draw:
throughout the world, particularly in Asia and Europe, and i. a graph of AFC and AVC
became an Olympic sport in Seoul, in 1988. ii. a graph of FC and VC.
Sven owns a business making table tennis bats. Table
3.3.1 lists the fixed and variable costs for different levels
of his firm’s output per month but some of the figures are
missing.
▼ Table 3.3.1: Fixed and variable costs of Sven’s TT bats, per
month
Output (units) FC (€) AFC (€) VC (€) AVC (€)
0
100 2,500
200 1,000 5 4,000 20
300 5,250
400 6,000
500 1,000 2 8,000

1 Copy and complete the table (apart from the two ▲ Figure 3.3.3: An Olympic sport
shaded boxes).

The difference between total and average costs Key term

Total costs
Total costs: all the costs of a
Short-run costs can be variable costs or fixed costs, depending on
business, fixed costs plus variable
whether or not they increase with output. The total costs (TC) of a
business relate to all costs and are therefore made up of the fixed costs
costs.
plus the variable costs.
TC = FC + VC
For example, in Table 3.3.1, the total costs of producing 200 units of
output per month are €5,000 (€1,000 + €4,000).
In the short run, as output increases, fixed costs stay the same but
variable costs increase, so total costs will also increase with output. In
the long run, when there are no fixed factors of production, all costs
are variable. For example, in the long run, if the firm increases output
it may need to rent a new factory, so rent increases.

Average costs
Average costs (AC) are the costs of producing each unit of output and
are sometimes called unit costs. They are calculated by dividing the
total costs by the number of units produced.
Link
AC = TCQ
Average costs were introduced
For example, in Table 3.3.1, the average costs of producing 200 units in 3.2 “Specialisation, division of
are €25 (€5,000 ÷ 200). labour and exchange”.

73
 3 An introduction to production, costs, revenue and profit

Average costs include both fixed and variable costs, so can also be
calculated as the average fixed costs plus the average variable costs.
AC = AFC + AVC
Again, using Table 3.3.1, the average costs of producing 200 units can
be calculated as €5 + €20 = €25.

Case study: Sven’s TT bats (part two)

Table 3.3.2 lists the total and average costs for different
output levels of Sven’s table tennis bat business. The
figures relate to possible outputs of bats per month but
again, some of the figures are missing.
▼ Table 3.3.2: Total and average costs of Sven’s TT bats, per
month
Output (units) TC (€) AC (€)
0
100
200 5,000 25
300 ▲ Figure 3.3.4: Table tennis bats
400 With the help of your completed table from the previous
500 case study (Table 3.3.1), calculate the missing figures
(apart from average costs for zero units).

A note on the shape of the average cost curves

Quantitative skills Both the short-run average cost (SRAC) curve and long-run average
You should be able to calculate cost (LRAC) curve may be U-shaped but for different reasons.
average and total costs.
Short run
In the short run, at least one factor of production is fixed in supply.
Short-run average costs are made up of average fixed costs and
average variable costs. In the short run, average fixed costs fall as
output increases because the fixed costs are spread over a greater
number of units.
Average variable costs are also likely to fall, as better use is made of the
fixed factors of production. Also, if labour is the variable factor, more
Cost division of labour can take place, helping an extra worker to add more
to output than the previous one. After an optimal point where there is
the ideal combination of the variable factor and fixed factors, average
SRAC variable cost will start to rise.
When there are fixed factors of production, extra workers will not be
able to keep increasing output at the same rate. Eventually, an extra
worker will add less to output than the existing average and average
variable costs will rise. If this is not offset by the fall in average fixed
q
costs, then average costs will also rise. The output where short-run
O Q
average costs is minimised is shown as q on Figure 3.3.5. This means
▲ Figure 3.3.5: A U-shaped SRAC curve that the SRAC curve is likely to be U-shaped.

74
 Costs of production

Link
The link between the law of diminishing returns and the shape of the SRAC
curve is explained in the A2 part of the course.

Long run
In the long run, all the factors of production are variable. A firm may
decide that a certain combination of land, labour and capital works
best. The firm can then increase the number of these combinations it
employs if demand increases. Again, it is likely, but not certain, that
the long-run average cost will fall initially as output increases but after
a certain point, average costs may rise. However, this depends on the
good or service being produced and the extent of the economies or
diseconomies of scale.

Link
There is more on the shape of the LRAC curve in 3.4 “Economies and
diseconomies of scale” and the relationship between the SRAC and LRAC
curves is covered in the A2 part of the course.

Progress questions
4 State two ways of calculating total costs.
5 If fixed costs are $10,000 and the average variable costs of producing
100 units are $120, calculate:
i. total costs
ii. average costs.

75
 3.4 Economies and diseconomies of scale

This section will develop your knowledge and understanding of:

➔ the difference between internal and external economies of scale
➔ reasons for diseconomies of scale
➔ the relationship between economies of scale, diseconomies of scale and the shape of the
long-run average cost curve.

The difference between internal and external

economies of scale
Economies of scale are a fall in long-run average costs due to the
Key terms growth of a firm or the industry in which it operates. This can be
Economies of scale: a fall in separated into internal and external economies of scale.
long-run average costs due to the Internal economies of scale are a fall in long-run average costs due
growth of a firm or industry. to the growth of the firm.
Internal economies of scale: a fall External economies of scale are a fall in long-run average costs due
in long-run average costs due to to the growth of the whole industry. All firms can benefit from the
the growth of a firm. growth of the industry, in the form of lower long-run average costs.
External economies of scale: a fall
in long-run average costs due to
the growth of an industry.

▲ Figure 3.4.1: An increase in the scale of production

Internal economies of scale

There are many reasons why a firm producing on a larger scale
could reduce its costs per unit. These relate to different aspects of the
business and can be classified under the following headings.
• Technical
• Marketing
• Financial
• Risk-bearing
• Managerial

76
 Economies and diseconomies of scale

Technical economies
Technical economies are lower average costs due to the production
Key term
process being carried out on a larger scale. Average costs fall Technical economies: a fall in
because more units are being produced. For example, some pieces average costs due to the production
of equipment have a large capacity, the capital is indivisible (not process being carried out on a
available in smaller sizes). If the firm produces more units, more larger scale.
effective use is made of the equipment, spreading its cost over more
units of output.
Some items of equipment and transport have a variety of sizes. Being
able to use larger pieces of equipment or transport may reduce average
costs. For example, an oil tanker that is twice the length, width and
height of another tanker holds eight times as much oil. A lorry with
twice the capacity of a smaller one does not need two drivers.
Producing larger quantities will enable the firm to take more
advantage of division of labour. As workers become more specialised,
their productivity should rise.

Marketing economies
Marketing economies are obtained by spreading the selling or buying
costs over more units of output. For example, making more of the
same product or a greater variety of products carrying the firm’s name
helps to reduce advertising costs per unit.
Larger firms buying raw materials or parts in large quantities may
be able to obtain these at cheaper prices than smaller firms. A bulk-
buying discount is even more likely if the firm buys a large proportion
of another firm’s output because this gives the buying firm a strong
bargaining position.

Financial economies
Financial economies arise because larger firms find it cheaper and easier
to finance growth. They may be able to negotiate a lower rate of interest
on a loan. This is partly because they have more assets, so are more
likely to be able to pay back the loan. Also, from the lender’s point of
view, it is cheaper to arrange a few large loans than many smaller loans,
so some of these savings can be passed on to the borrower.
Larger firms may also have more sources of funds. For example, they
may be able to obtain money by selling shares in the firm. They may
also be able to borrow from a wider variety of institutions.

Risk-bearing economies
Larger firms will find it easier to spread the risks and uncertainties of
trading. They may sell a wider variety of products than a smaller firm
and/or sell in more countries or regions. Increases and decreases in
demand are more likely to balance out, making total demand more
stable.
If a firm sells only one product in one country and demand for this
product falls, it is at more risk of going out of business. A fall in
demand is likely to raise the firm’s costs per unit as costs are now
spread across fewer units. It may also be less risky for a large firm with
many products to introduce a new one.

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3 An introduction to production, costs, revenue and profit

Managerial economies
Activity A large firm will be able to afford to employ specialist staff in different
Choose a local business. If it parts of the business. In smaller firms, the owner is likely to have a
doubles in size, how do you think wide range of responsibilities, such as managing the firm’s sales and
its average costs will be affected accounts. Employing an expert in a narrow role may help the firm run
and why? more efficiently, reducing average costs. A large firm may have its own
sales managers and accountants, for example.

External economies of scale

Most external economies of scale arise due to the localisation of
a growing industry. This means it is concentrated in one or a few
locations. Some of the ways that this could lead to lower average costs
for firms in the industry involve:
• labour
• suppliers of local services
• disintegration
• research and promotion of the industry.

Labour
Local colleges may run courses training people who work in that
industry, reducing the training costs of the firms.

Suppliers of related services

Firms that provide parts or services for the industry may locate nearby.
This will reduce transport costs and improve communication between
the different parts of the industry. For example, an area that specialises
in horse racing is likely to attract vets who are specialists in treating
horses.

Disintegration
Disintegration (or vertical disintegration) is where different parts of
a production process are carried out by different firms. For example,
to make woollen clothes, the wool has to go through a number of
processes including cleaning, spinning, weaving and finishing. If a
firm only carries out one process, it may operate on a larger scale and
be more likely to be able to use the most up-to-date equipment and
techniques, reducing the cost of that stage of the process.

Research and promotion of the industry

It is easier to organise cooperation between firms if they are in the
same area. This may include operating joint research facilities, or
promoting the industry to the public or government to improve its
position.

Key terms
Localisation: when an industry is concentrated in one or a few locations.
Disintegration: where different parts of a production process are carried out
by different firms.

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 Economies and diseconomies of scale

Case study: Silicon Valley

Silicon Valley is an area in California, USA, which has
become associated with innovation. Its name came from
the silicon used to make computer chips. It is home to
3 million people, whose income per head is among the
highest in the world.
There are about 2,000 technology companies located in
Silicon Valley, including Google and Apple. Many of the
firms are the leaders in their industries and as well as
software and social media businesses, the area contains
firms involved in lasers and robotics. It is also home to a
number of business support companies such as Hewlett-
Packard and Adobe.
▲ Figure 3.4.2: Silicon Valley – centre of innovation
There are many well-respected universities and colleges is a shortage of skilled workers. For example, the United
in the surrounding area. Many of the founders of the States cannot provide enough software engineers. Many
companies and their technical support staff were trained top engineers from other countries, especially from India
in local universities, including Stanford and the University and China, now work in the area and 38% of the people
of California at Berkeley. Since many of the founders in Silicon Valley were not born in the United States. Not
trained together, there is much more cooperation and surprisingly, with high demand and limited supply, the
support than in alternative locations. price of land and housing is also high.
Professional networks help to share information, and by 1 Is the case study mainly discussing economies and
working together on projects they can all benefit. Being diseconomies of scale that are internal or external?
close to suppliers, customers and research facilities gives
2 Identify at least two reasons why a high-tech firm
the firms several advantages.
may choose to locate in Silicon Valley.
However, one problem that has arisen from the rapid 3 Identify at least two reasons why average costs may
growth of the area and its attraction to so many firms be higher if a firm is located in Silicon Valley.

Diseconomies of scale
Key term
Diseconomies of scale are a rise in long-run average costs due to the
growth of a firm or industry. Again, this could be due to the growth of Diseconomies of scale: a rise in
the firm or the industry in which it operates. long-run average costs due to the
growth of a firm or industry.
Reasons for internal diseconomies of scale
On the technical side, operating with large-scale equipment can be a
problem if the equipment breaks down and there is a hold-up in the Get it right
production process. Economies and diseconomies of
The main reason for rising average costs as a firm grows is due to the scale are long-run concepts and
more complex management structure. This could lead to a number apply when all factors of production
of problems relating to: are variable.
• coordination
• communication
• workers’ morale.

79
3 An introduction to production, costs, revenue and profit

Coordination
Larger firms are likely to be split into a number of different
departments, for example sales and accounts. These have to be
coordinated and the managers will need to work together. Decision
making in larger firms is likely to be slower and the firm may not be
able to react as quickly if there is a change in the market.

Communication
As well as making decisions, managers must make sure that they are
carried out. This can be difficult and costly in big businesses because
there may be many layers of management. Communication is vital to
make sure that everyone knows what they should be doing and that
problems can be passed back. This can be time-consuming and involve
many meetings in large firms.

Workers’ morale
When a firm has hundreds or thousands of employees, it is difficult to
make everyone feel that what they do is valued. It may also take more
time to sort out problems. Consequently, workers may lack motivation
and there could be other labour issues in large firms.

Reasons for external diseconomies of scale

If the industry is growing, this could lead to shortages of certain types
of labour. Firms may have to offer higher pay to attract enough skilled
workers. If the growing industry is localised, this will also push up the
price of land in the area. Rises in the prices of factors of production
will raise the average costs of a firm.

Progress questions
1 What is the difference between internal and external economies of scale?
Link 2 Give an example of:
The shape of the LRAC curve i. a technical economy of scale
was introduced in 3.3 “Costs of ii. a marketing economy of scale.
production” where the U-shaped 3 Give an example of an external economy of scale.
SRAC curve was also explained. 4 Give two reasons why the growth of a firm may increase its average costs.

Economies of scale, diseconomies of scale and

the LRAC curve
Economies and diseconomies of scale affect long-run average costs as
the scale of production changes. The factors of production can change
in the same or different proportions in the long run. A firm may
believe that a certain combination of land, labour and capital works
best to minimise average cost or it may decide to change the ratio
between the different factors as it increases the scale of production.
Up to a point, increasing the scale of production may lead to lower
long-run average costs, as the firm is able to take advantage of
economies of scale. Bulk buying and employing specialists may lower
its costs per unit of output.

80
 Economies and diseconomies of scale

At some point, diseconomies of scale, perhaps due to problems of

coordinating a larger firm, may more than offset the economies of
scale. Average costs start to rise. In this case, the LRAC curve will be
U-shaped as in Figure 3.4.3.

Cost LRAC

c1 Economies Diseconomies
of scale of scale
c2

c3
c

O q1 q2 q q3 Q

▲ Figure 3.4.3: A U-shaped LRAC curve

Up to output q, as output increases, average costs fall. For example,

if the firm produces q1 units, its LRAC is c1. If output increases to q2,
LRAC falls to c2. The firm is benefiting from economies of scale. At q,
long-run average costs are minimised at c, the firm is productively
efficient. At outputs greater than q, average costs rise. For example,
if output increases to q3, LRAC rises to c3. The firm is experiencing
diseconomies of scale.
The shape of the LRAC curve depends on the good or service being Key term
produced and the extent of the economies or diseconomies of scale.
Some activities, particularly personal services such as hairdressing, Productive efficiency for a
may benefit less from economies of scale than, for example, car firm: where average costs are
manufacturing, where there are considerable technical economies minimised, the lowest point of the
of scale. In some cases, the LRAC curve may not be U-shaped as AC curve.
economies of scale continue to offset any diseconomies, as output
increases.

Link
Productive efficiency on a production possibility boundary was covered in 1.4
“Production possibility diagrams” and will be looked at again in the A2 part of
the course. Alternative shapes of the LRAC curve are covered in the A2 part of
the course.

Activity
Other than hairdressing and car manufacturing, choose two other examples of
production, one that has few economies of scale and another that has many.
Explain why this applies to each of your examples.

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 3.5 Average revenue, total revenue and profit

This section will develop your knowledge and understanding of:

➔ the difference between average and total revenue
➔ why the average revenue curve is the firm’s demand curve
➔ why profit is the difference between total revenue and total costs.

The difference between average and total

revenue
Total revenue (TR) is income from sales. It is calculated by adding
up all the money received from selling the firm’s goods and services.
If all the units are sold for the same price, then the total revenue
is calculated by multiplying the price (P) by the number of units
sold (Q).
TR = P × Q
For example, if 50 units are sold per day at a price of $15, the total
revenue per day is $15 × 50 = $750.
Average revenue (AR) is the revenue per unit sold. It is calculated by
Quantitative skills
dividing the total revenue by the number of units sold.
Why is average revenue the same
AR = TR
as price? Q
For example, if the total revenue is $750 and 50 units were sold, the
This is because AR = TR ÷ Q and
average revenue is $15. Average revenue is the same as price when all
since TR = P × Q, AR is also
the units are sold for the same price.
(P × Q) ÷ Q = P.

Key term Why the average revenue curve is the firm’s

demand curve
Average revenue: the revenue per
A demand curve shows the quantity consumers are able and willing to
unit sold, calculated by dividing
buy at a given price in a given time. Figure 3.5.1 shows how many of
the total revenue by the number of
a firm’s take-away meals are demanded per day at different prices.
units.
P ($)

Link 15

Total revenue was introduced 12

in 2.2 “Price, income and cross
elasticities of demand” and profit
in 2.3 “The supply of goods and D = AR
services”.

O 50 70 Q

▲ Figure 3.5.1: Demand (D) as the AR curve

If the price of a take-away meal is $15, 50 meals are sold in a day. The
total revenue is $750 and the average revenue is $15. If the price is

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 Average revenue, total revenue and profit

reduced to $12, 70 meals are sold in a day. Total revenue is now $840
and average revenue is $12. At each point on the demand curve, the
price and average revenue are the same. The demand curve shows the
average revenue for each quantity, so the demand curve is also the
average revenue curve.

Why profit is the difference between total

revenue and total costs
Total costs are everything the firm has to pay in connection with the
provision of its goods or services and total revenue is all the money it
receives for its goods or services. If the firm’s total revenue is greater
than its total costs, it has made a profit. This is what is left over from
its income after paying all its costs. If the total costs are greater than
the firm’s total revenue, it has made a loss.
Profit = TR – TC Quantitative skills
The profit per unit can be calculated by dividing the total profit by the (TR – TC) ÷ Q can also be written
number of units sold (Q). It may also be calculated as the difference (TR ÷ Q) – (TC ÷ Q), which is the
between average revenue and average cost. same as AR – AC. You should be
able to calculate average revenue,
Profit per unit = TR Q
– TC = AR – AC total revenue and profit.

Case study: Sven’s TT bats (part three)

After making table tennis bats for many years, Sven 1 Copy and complete the table.
decides to start making and selling table tennis balls. 2 What are the price and quantity where profit is
He researches the market, and Table 3.5.1 shows his estimated to be at its highest?
estimates of costs and revenue per month for four possible
outputs of boxes of balls at different prices. Some of the
figures are missing.
▼ Table 3.5.1: Costs, revenue and profit for boxes of table
tennis balls, per month
Quantity AC (€) AR (€) TC (€) TR (€) Profit (€)
100 5.50 6
200 1,000 1,150
300 4.80 1,650
400 1,900 200 ▲ Figure 3.5.2: Table tennis balls

Progress questions
1 What are two ways of calculating the profit per unit?
2 The AR curve is the same as which other curve?
3 If the average revenue for 20 units is $10 and TC is $250, will there be a
profit or loss and of how much?

83
3 An introduction to production, costs, revenue and profit

Exam-style questions
1 Which one of the following is a true statement about costs?
A Average cost is fixed costs plus variable costs.
B Average fixed costs do not change with output.
C Average variable costs may fall or rise with output.
D Total costs fall as output increases. (1 mark)
2 Specialisation is most likely to require
A a large number of firms.
B a medium of exchange.
C a system of barter.
D higher productivity. (1 mark)
3 Define “division of labour”. (3 marks)
4 The following table shows costs and revenue when 100 units are produced by a firm.
Quantity Average fixed Average variable Total revenue ($) Profit ($)
costs ($) costs ($)
100 6 ? 1300 200

You are advised to show your working for the calculations below.
(i) Calculate average fixed costs if output falls to 50 units. [2 marks]
(ii) Calculate average variable costs when 100 units are produced. [4 marks]
5 Analyse the likely effects on a firm’s long-run average costs of an increase in production. (12 marks)
6 Use the information in the case study on Silicon Valley (in 3.4 “Economies and diseconomies of
scale”) and your knowledge of economics to assess whether a government should intervene to help to
establish an expanding industry in a particular area. (20 marks)

Get it right
When provided with information about an industry, situation or recent
experience, using it to support your points will strengthen your arguments.

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