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WS 2a: Year 2 Microeconomics Theme 3: 3.3.2 Costs

Anderton Unit 44 p 242-; unit 45 p252

3.3 Costs: This section will support students in exploring theories of the firm. Students are required to be able to calculate
and understand the relationships between different costs. An appreciation of the short and long run is essential here.
Economies and diseconomies of scale should be covered.

Part One: 3.3.2 Cost (Short run)

a) Formulae to calculate and understand the relationship between:
 Total cost
 Total fixed cost
 Total variable cost
 Average (total) cost
 Average fixed cost
 Average variable cost
 Marginal cost
b) Derivation of short-run cost curves from the assumption of diminishing marginal productivity
c) Relationship between short-run and long-run average cost curves

Important distinction: Cost is not the same as Price!

Costs are the monetary value of all the inputs used to produce the output (the amount spent on making the output).
Reminder: In economics, a firm’s cost of production must include all costs so Economists include opportunity cost in the cost of production.

Price is what the output is sold for (it is the average revenue). AR = P= TR/Q = (P x Q) /Q.

Anderton Chapter 43: Short run and long run in Production

In this section, you will learn about:

 The distinction between the short run and the long run
 The law of diminishing productivity/returns
 The distinction between fixed and variable costs
 Calculating total, average and marginal costs
 Drawing diagrams for total, average and marginal costs
 Diminishing marginal productivity/ the law of diminishing marginal returns

Short-Run Long- Run

Plant size is fixed so output the firm can only The long run is associated with a change in the
increase its output by adding more factors that scale of production.
are variable.
Hence, we consider both fixed and variable costs. In the long run all costs are variable.
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Fixed costs, FC, (also called overhead or indirect cost):

Costs that are independent of output in the short run. FC have to be paid even when output is zero.
E.g. rent, insurance, interest on loans.

A change in fixed costs has no effect on marginal costs – more on this later

Variable Costs, VC, (also called prime cost or direct cost):

Costs that vary directly with output in the short run (they increases as output increases and decrease when output
decreases.
E.g. popcorn, in-flight meals, raw materials.

When output is zero, variable cost will be zero but as production increases, variable cost will rise.
As marginal cost is the additional cost of one additional unit, a change in variable costs will affect marginal cost.

Note some costs are semi-fixed/semi-variable:

A semi-fixed cost is a cost that contains both fixed and variable elements
The fixed element of the cost will be incurred repeatedly over time, while the variable element will only be incurred as a function of activity
volume.
Example: The monthly bill for a phone, where the recipient pays a fixed fee for phone usage, as well as a variable fee if the user exceeds a
certain amount of data usage, calls, or texts.

In the short run at least one____________________________________________________________________________________,

whereas in the long run all factors of production are variable.

For example, in the short run firms it is difficult for firms to respond to increases in demand through expansion. This is due to the large
amount of money and time it takes to buy land. Therefore, we assume that this factor is usually fixed in the short run.

However in the long run, firms are likely to have the time to build new buildings and expand, meaning that land is now variable.

Please note: The short-run and long run in Economics do not refer to a specific length of time.
The actual time involved varies from firm to firm and market to market. The SR for a window cleaning business is different from the SR for
a car manufacturer.

Types of costs in the short run

Type Explanation/calculation
Total cost (TC) Total fixed cost + Total variable cost = TFC + TVC
Total variable costs (TVC) Average variable cost x quantity = AVC x Q
Average total cost (ATC) (usually just Total cost ÷ quantity = TC/Q
AC)
Average fixed cost (AFC) Total fixed cost ÷ quantity = TFC/Q
Average variable cost (AVC) Total variable cost ÷ quantity = TVC/Q
Marginal cost (MC) The increase in total cost resulting from increasing the level of output by one unit (or the
additional cost of selling one extra unit)
Change in total cost ÷ change in quantity = ∆TC/∆Q
(mathematically MC is all the AVC added together)
Average total and variable costs measure the average costs of producing some quantity of output. Marginal cost is different. Marginal cost
is the additional cost of producing one more unit of output. Therefore, it is not the cost per unit of all units being produced, but only the
next one (or next few).

MC calculation start with from 1 to 2 MC =

Output Total cost Marginal cost
£ £

1 10, 500

2 11,000

3 11,500

5 12,500
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Students need to learn:

a) Formulae to calculate and understand the relationship between:

AC/DC example- Please complete the table

Output Variable cost Fixed Cost Total Cost Marginal Cost AVC AFC ATC
$ $ $ $ $ $ $
0 0 10
1 10
2 17
3 25
4 40
5 60
6 110

Task: 4. Costs: the different types

The relationship between average cost and marginal cost:

 Marginal cost (MC) is the extra cost incurred when one extra unit of output is produced.
 Average product (AC) is the total cost per unit of output.
 When the MC is smaller the AC, the AC decreases. This is because when the extra unit of output is cheaper than
the average cost then the AC is pulled down.
 Similarly, when the MC is greater than the AC, the AC is pulled up.

Marginal cost: It is important to note that marginal cost is derived solely from variable costs, and not fixed costs and are
subject to diminishing returns in the short run.

Complete Q3 on Page 244; use the table below:

Output TFC TVC TC AFC AVC AC MC
£ £ £ £ £ £ £
0 40 0 0 0

1 6

2 11

3 15

4 60

5 66

.
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Diminishing Marginal Productivity. (P238-239)

The relationship between product curves and short run cost curves: The Law of Marginal Diminishing Returns (DMR)

Production in the Short Run, Specification- 3.3.2 Costs:

b) Derivation of short-run cost curves from the assumption of diminishing marginal productivity

The short run is a time period when the time period during which at least one factor of production is fixed (therefore, it is
the period of time over which a firm’s plant size is fixed).

Diminishing Marginal Productivity

Diminishing marginal productivity is the understanding that, in the short run, using variable additional inputs will generally
increase output. However, there comes a point where adding more of the variable input will result in smaller increases in
the output, and there is another point where using even more input will lead to a decrease in output.

Therefore, diminishing marginal productivity is the concept that using increasing amount of some variable input during the
production period while holding other inputs constant (fixed inputs) will eventually lead to decreasing productivity.

Example of diminishing marginal productivity

 In the short run, a film production company decides to make more films.
 It employs more labour, the variable factor, but has fixed capital, cameras, and studios.
 Initially resources are used more efficiently: The firm benefits from improvements in productivity as underutilised
cameras and studios are used; they also benefit from specialisation of labour.
 This leads to a rise in marginal and total output and a fall in marginal cost as each extra workers adds more to total
output than the previous one.
 However, as it makes more films and adds more and more labour to the fixed stock of capital and studios, it studios
are likely to becomes overcrowded so each additional worker adds less to output than the previous one.
 If they continue to add workers, they will not be able to move so output will fall to zero.

In the short run, As more and more of There will come a point when each additional
because at least one the variable factor is worker contributes less to total output than the
factor of production is added to the fixed previous one so marginal productivity will diminish
fixed. factors. and so average and marginal cost will rise.

The basic assumptions of the law of diminishing marginal productivity can help with evaluation:
 It is a short run concept, will the outcome hold in the long run when firms could benefit from economies of scale?
 It assumes the variable factor/labour is homogenous (has identical skills/ability).
 It assumes technology remains unchanged. Rising productivity of labour, capital and/or land may offset it
 Other: A business may have factories/plant in different low-cost locations – raising output to meet changing
demand but still at a low marginal cost.

Diminishing marginal productivity:

Marginal product (MP) also called marginal physical product (MPP) is:
The additional (extra) output as a result of employing one more worker.
MP = ∆ In Output = ∆Q
∆ In Labour ∆ L
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Task: Question 1 p 239

Q b: Product curves – complete the table

Capital Labour Total product Average product Marginal product

MP=∆TP/∆Variable factor

10 1 8

10 2 24

10 3 42

10 4 60

10 5 70

10 6 72

There are three rules relating to the relationship:

1. If marginal is above the average, the average must rise.
2. If marginal is below the average, the average must fall
3. If the marginal equals the average, the average is constant.

If the total weekly pay of 4 individuals in a room is £4000, average pay is £1000
 A fifth individual (marginal one) earning £800 (less than the original average) enters the room, what happens to the
average? It falls to £960
 A sixth individual (marginal one) earning £1800 (more than the average) enters the room, what happens to the
average? It rises to £1100

The relationship between marginal product (MP) and marginal cost (MC)

Economics help example: Small Cafe

 Assume a constant wage rate of £10, then an extra worker costs MC= £10.
 Total Product (TP) This is the total output produced by workers
 Marginal Product (MP) this is the output produced by an extra worker.

Number of workers Total output Output of the Total cost Marginal cost
(Total product) additional worker TC MC
Marginal product: £ £
MP= ∆TP/∆Q)
0 0 0 0 0
1 2 10
2 6 20
3 12 30
4 20 40
5 30 50
6 38 60
7 43 70
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The relationship between marginal product (MP) curves and marginal cost (MC) curves: Although diminishing returns are
a physical measure of output, they can be expressed in terms of costs

MP and MC are mirror images of each other:

 When MP is increasing, MC is falling
 When MP is decreasing, MC is falling
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Task: Question 1 p 239

Q b: Product curves – complete the table (a)

Capital Labour Total product Average product Marginal product

MP=∆TP/∆Variable factor

10 1

10 2

10 3

10 4

10 5

10 6
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Diagrams of Short Run Cost Curves

A) Using total cost curves:

Complete the table and, on graph paper, draw the three curves
Outpu TFC TVC TC
t £ £ £
Q
0
0
10
1
12 16 28
2
33
3
28 40
4
40
5
60 72
6
 Given that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line on the cost graph.
 Total variable costs: The total variable cost (TVC) starts at zero and the curve slopes up at an accelerating rate, reflecting the law of
diminishing marginal productivity.
 Total costs: The total cost (TC) curve is found by adding total fixed and total variable costs (so cannot start at zero). Its position
reflects the amount of fixed costs, and its gradient reflects variable costs.
 TC and TVC should be parallel as fixed cost do not vary with output
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B) Using short-run average cost curves:

Short run Average total cost: SRATC = TC/Q. The short run average cost curve is U shaped because as output increases AC tend to fall
because each extra unit is ‘carrying’ a smaller element of fixed cost and initially as more resources are employed, they can be used more
efficiently due to specialisation. However, after a certain point as output continues to increase, AC may start to rise again because of the
law of diminishing marginal productivity

Marginal cost curve. MC = ∆TC/∆Q. Marginal cost is the cost of producing one extra unit of output. It can be found by calculating the
change in total cost when output is increased by one unit.
It is important to note that marginal cost is derived solely from variable costs, and not fixed costs
The MC curve is shaped as a tick/J shaped always and intersects the AC curve form below at its lowest point.
Why at the lowest point of the AC curve?
 IF MC< AC then AC falls
 If MC>AC then AC rises
 MC curve always cuts the AC curve at its lowest point.
Why?
 A group of 3 students earn an average of £60.
 A fourth student, a marginal one joins. If this student earns less than £60 e.g. £40, what happens to average earnings? Fall to
£55
 If he/she earns more than £60, e.g. £80, what happens to average earnings? Rise to £65
 When the average is neither rising nor falling, MC must equal AC.

Average fixed costs: AFC= TFC/Q. The AFC curve must fall continuously as output increases because total fixed costs are being spread
over a higher level of production; so the average fixed cost curve must fall always slopes downwards to the right with AFC approaching
zero at very high levels of output, but never quite equalling zero.

The average variable cost: AVC = TVC/Q. The AVC curve will at first slope down from left to right, then reach a minimum point, and rise
again because of diminishing returns

The Law of Diminishing Marginal Productivity: states as more of a variable input is added to an existing fixed input, after some point the
additional output from the additional input will fall. Although diminishing returns are a physical measure of output, they can be
expressed in terms of costs. This is because, In order to continue to raise output by a given amount increasingly more units of the variable
factor(s) need to be employed – hence a rising MC (and AC)

Task: SR Costs Q4 p 244

Workers Total TFC TVC TC AFC AVC ATC MC

Physical £ £ £
Product

1 20 200 50 250 12.25

2 45 4.44

3 60 150 2.50

4 70 2.86

Capital employed, also known as funds employed. It is the value of all the assets employed in a business
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SRAC and MC
 SRAC = TC/Q = (TFC +TVC)/Q = AFC + AVC
 MC = ∆TC/∆Q

When average cost is falling, what we can say definitely is only that the marginal cost will be below it but the marginal cost
itself may be either rising or falling

 The MC curve is : J/U shaped (also because of diminishing returns)

 The MC curve always intersects the AC curve at its lowest point.

IF MC< AC then AC falls

If MC>AC then AC rises
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MC curve always cuts the AC curve at its lowest point.

SRAC, MC, AFC and AVC curves
 SRAC = TC/Q = (TFC +TVC)/Q = AFC + AVC
 AFC = TFC/Q
 AVC = TVC/Q
 MC = ∆TC/∆Q

The short-run marginal cost (MC) curve will at first decline and then will go up at some point, and will intersect
 The average total cost and average variable cost curves at their minimum points.
 The average variable cost (AVC) curve will go down (but will not be as steep as the marginal cost), and then go
up. This will not go up as fast as the marginal cost curve. The gap between the average total and average variable
cost is always getting smaller because the average fixed cost must always getting smaller as output increases.
 The average fixed cost (AFC) curve will decline as additional units are produced, and continue to decline.
 The average total cost (ATC) curve initially will decline as fixed costs are spread over a larger number of units, but
will go up as marginal costs increase due to the law of diminishing return
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Effects of an increase in fixed costs

Using all the curves

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An increase in fixed costs, in an essay

Fixed costs do not __________________________________ directly with __________________________________

.

A change in fixed cost will have no impact on _______________________________ and

_________________________________________.

SRAC = _____________________________ + _____________________________________

Therefore, a change in fixed costs will only have an effect on the __________________________ curve and the
_______________________________ curve.
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The Effects of an Increase in Variable Costs

Variable costs_______________ directly with ____________________.

A change in variable cost will have no impact on _______________________.

However, a change in variable cost will have an impact on ______________________ curve and
_____________________________________curve.

Therefore, a change in variable costs will shift ________________ curves.

1_________________________, 2____________________________ and 3___________________________

Why does a change in AVC affect MC?

MC is the cost of producing one more unit and so relates to variable not fixed costs.
This is because fixed costs do not change with output
Increase in AVC using all the curves
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Increase in AVC in an essay

Quick question:

If a firm’s fixed costs increase by 20 per cent, marginal costs will increase by:
A zero
B 10%
C 20%
D 100%
E 200%
Explain your choice:
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A firm, which prints greetings, cards records its short run costs. It observes that the average cost per card decreases as
more are produced, although the marginal cost is rising. It follows that (1)
A there are economies of scale
B the law of diminishing returns has not yet set in
C the fixed costs are zero
D marginal costs rise whenever average costs fall
E marginal costs are below average cost

Short run cost curves summary:

In the short run of shape of both MP and MC curves are influenced by the law of marginal diminishing productivity (also
called the law of marginal diminishing returns) the curves are in effect mirror images of each other.

The marginal cost curve in the lower panel has a

distinctive U-shape, with marginal cost falling,
reaching a minimum, and then rising.

The falling portion of the marginal product curve is

the result of increasing marginal returns.

The rising portion is attributable to diminishing

marginal returns

Task: 6. Short-run costs

New terms, add to your glossary and diagram bank

 Normal profit  Total product (TP)  Total costs (TC) and Average
 Short run  Average product (AP) cost (ATC) and why the short
 Long run  Marginal product (MP) run AC curve is U shaped
 Difference between cost and  The relationship between  Total variable cost (TVC) and
price average and marginal Average variable cost (AVC)
 Marginal diminishing returns/  Marginal cost, why the MC
diminishing marginal curve is J shaped and why it cuts
productivity. the AC curve at its lowest point
 Fixed costs, variable costs and  Total fixed cost (FC) and
semi-variable costs Average fixed cost (AFC); why
the AFC falls

Diagrams/Curves:
Total product (TP) Total cost (TC)
Average product (AP) Total variable cost (TVC)
Marginal product (MP) Total fixed cost (TFC)

Average total cost (AC)

Average variable cost (AVC)
Average fixed costs (AFC)
Marginal cost (MC)

Changes in FC or VC using average cost curves

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The Long-Run Average Cost Curve LRAC

Economies and Diseconomies of Scale
3.3.3, Anderton p 246-247

3.3.3 Economies and diseconomies of scale

a) Students are required to understand types of economies and diseconomies of scale – for example, financial,
technical, managerial, marketing, purchasing and risk-bearing – and be able to explain these using examples.
Students should be able to understand these as a long-run concept.
b) An understanding of the minimum efficient scale is also required. Students should draw long-run average cost
curves to show economies and diseconomies of scale as well as being able to identify the minimum efficient
scale.
c) Students should consider the distinction between internal and external economies of scale.

3.3.2 Students should also appreciate the relationship between short-run and long-run average cost curves.

Both the short run average costs curve (SRAC) and the long run average cost curve (LRAC) are usually drawn U-shaped but
for different reasons.
 SRAC: Because of specialisation and diminishing returns
 LRAC: because of economies and diseconomies of scale

 The long run is the period of time when all factors of production are variable

 Therefore, the long run is the period of time when all costs are variable/no costs are fixed in the long run.

 The long run depends on the specifics of the firm in question—it is not a precise period of time. If you have a
one-year lease on your factory, then the long run is any period longer than a year, since after a year you are no
longer bound by the lease.
 A firm can build new factories and purchase new machinery, or it can close existing facilities

 In planning for the long run, the firm will compare all alternative methods of combining inputs to produce
outputs (for a given level of technology).

The firm will search for the production technology that allows it to produce the desired level of output at the lowest cost.
After all, lower costs lead to higher profits—at least if total revenues remain unchanged. Moreover, each firm must fear
that if it does not seek out the lowest-cost methods of production, then it may lose sales to competitor firms that find a
way to produce and sell for less.
Once a firm has determined the least costly production technology, it can consider the optimal scale of production, or
quantity of output to produce for the given technology.
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Shape of the long run average cost curve (LRAC)

A typical LRAC: Internal economies and diseconomies of scale: In the long run all factors of production are variable so
the firm is able to change the scale of its operation. In long run, a firm will not have fixed cost curves, total or average. It
will only have average and marginal cost curves.
The long run average cost curve is a boundary. It represents the minimum level of average costs attainable; at any given
level of output.

 Increasing returns to scale – When the % change in output > % change in inputs E.g. a 30% rise in factor inputs leads
to a 50% rise in output so the long run AC fall
 Constant ant returns to scale When the % change in output = % change in inputs E.g. when a 10% increase in all
factor inputs leads to a 10% rise in total output Long run average total cost will be constant
 Decreasing returns to scale: When the % change in output < % change in inputs E.g. when a 60% rise in factor inputs
raises output by only 20% Long run average total cost will be rising .
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Internal and external economies of scale (EOS): The result of the long run expansion of the firm
itself

External economies and diseconomies of scale (EOS): The result of the long run expansion of the
industry of which the firm is a member. Most firms can benefit, helps explain the growth of many
cities.
Agglomeration economies are the benefits that come when firms and people locate near one
another together in cities and industrial clusters.
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External economies and diseconomies of scale (EOS): The result of the long run expansion of the
industry of which the firm is a member

External EOS
 Good supply networks (cluster effect)
 Supply of skilled workers.
 Infrastructure built specifically for the industry.
 Improved transport links.

External Dis-EOS
 Competition for resources.
 Congestion

External EOS and External Dis-EOS cause the LRAC to shift.

Other factor causing the LRAC to shift

 Improvements in technology increase dynamic efficiency and can cause it to shift downwards.
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In long run, a firm will not have fixed cost curves, total or average. It will only have average and
marginal cost curves.
Long-run marginal cost: LRMC = ∆ LTC
∆Q
The LRMC cuts the LRAC at its lowest point.

Tasks
1) In 2016, the insurance group Esure undertook a demerger with its GoCompare price comparison website. (a) The
most likely reason for this demerger was to: (1)
A benefit from external economies of scale
B benefit from internal economies of scale
C focus more on its core business
D increase its market share

2) Following the demerger, GoCompare announced in 2017 a profit of £17.5 million, up 21.5% on 2016. Total
revenue in 2017 was £75.8 million, up 4.1% on 2016.
(Source: adapted from https://www.insuranceage.co.uk/insurer/3107496/ profits-up-at-go-compare)

Calculate, using the information provided, the total costs of GoCompare in 2016. (4)
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MES, Minimum Efficient Scale: The minimum efficient scale is the first/lowest level of output at which average costs are
minimised, all internal EOS have been exploited
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The nature of production/technology relative to demand will determine the MES. MES can be at a relatively low output.
 The Minimum efficient scale (MES) corresponds to the lowest output range at which the minimum possible
average cost can be achieved in the long run average; it is also known as an output range over which a business
achieves productive efficiency.
 MES is not a usually a single output level – more likely, the MES is a range of outputs where the firm achieves
constant returns to scale and has reached the lowest feasible cost per unit.
 Industries with very high capital costs (e.g. water supply) have a very large MES.

From Short run cost curves to long run cost curves – p 249
The Envelope Curve

In the long run all factors of production are variable so the firm is able to change the scale of its operation.
A short run average costs curve (SRAC) shows the minimum cost per unit for different levels of output with a given fixed
factor.
When a firm expands, it moves onto a new lower SRAC, it is experiencing internal economies of scale.
The LRAC is constructed form a series of short run average total cost curves associated with a series of different output
levels.
Therefore, the LRAC is effectively an “envelope” that contains all possible short-run average total cost (ATC) curves for the
firm.
The short-run ATC curves represent different scales of plant that cannot be changed in the short run. They are all above the
LRAC because firms have less flexibility in the short run and costs are higher. Each tangency point is the cost-minimizing
point for that level of output.

Extension material:
Will the envelope curve be tangential to the bottom of each of the short-run average cost curves?
No. At the tangency points, the two curves must have the same slope. Thus if the envelope curve is downward sloping, so
too must the short-run average cost curve be downward sloping at the tangency point.
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Examination Technique- Analysis

Simple reference to “For example, purchasing / financial EOS lead to lower AC” IS NOT ANALYSIS until there is some
explanation of how and why average costs fall as a result of an increase in scale.

Examples:
Purchasing EOS arise with larger scale cinemas having more customers and therefore buying food and drink in greater bulk.
This buying power results in lower average costs as the cinemas are able to gain discounts.
As a result, although total cost rises, long run average cost falls.

Managerial EOS occur with larger companies being able to employ specialist managers, for example HR and accountants.
Such specialists are likely to increase total staff costs but will also will allow the firms to benefit from lower AC’s in the long
run.
This is because specialists should be more productive, they can improve quality, make fewer mistakes and increase
production in a given time frame.
Therefore, higher labour total costs can often be more than offset by improved productivity and quality thereby lowering
long run AC’s

7. Long-run costs and economies of scale

New terms, add to your glossary and diagram bank

 Long run  Financial, EOS
 Internal economies of scale  Technical EOS
 External economies of scale  Managerial EOS
 Internal diseconomies of scale  Marketing EOS
 External diseconomies of scale  Purchasing EOS
 Minimum efficient scale (MES)  Risk-bearing EOS (link to conglomerate
mergers)

Diagrams/Curves:
Long run average cost curve and marginal cost curve
Minimum efficient scale (MES).
Effect of external economies and diseconomies of scale on the LRAC
The link between short run ACs and the long run AC (the envelope curve)

Notes: http://moniquelowesib.weebly.com/economies-and-diseconomies-of-scale.html

There are also two main categories of diseconomies of scale, internal diseconomies of scale and external diseconomies of scale.

Internal economies of scale are those that are within the organisation's control and occur within the firm:

Purchasing:
 Large firms can buy in bulk, which means lower unit costs. Firstly, suppliers will be able to produce in large quantities and thus lower
their own average costs. Secondly, suppliers will offer greater discounts in order to guarantee a contract with a large customer.
 Specialist purchasing departures or specialist buyers can be employed, allowing the firm to research and negotiate the best
purchases.

Financial:
 Lenders and prospective investors may see large firms as a better risk, making it easier to such firms to obtain finance.
 Interest charges may be lower because they present a lower risk to providers of capital.
 Successful organisations can use their own retained profit, thus avoiding the need to pay interest, although there is an opportunity
cost involved in doing this. Retained profits are the major source of capital, once a business has been set up.
 Specialist accountants can be employed to ensure that the company organises its finances efficiently.
 New issues of shares will be easier to sell in a large, well-established company.

Technical:
 Modern equipment can be installed which will improve efficiency. This should lower unit costs and improve the quality and reliability
of the product or service.
 Improved production techniques allow for division or specialisation of labour to be implemented, increasing efficiency.
 Mass production or flow techniques can be employed in order to improve the productivity.
 Highly trained technicians can be employed in order to improve the reliability of the production process.
 Large-scale transportation can reduce distribution costs per unit.
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Marketing:
 Advertising in the most popular forms of media, leading to lower advertising costs per thousand customers reached.
 Utilising agencies with specialist marketing skills.
 Investment in marketing research, to minimise the risks involved and build a profile of prospective customers.
 The ability to build successful, widely recognised brands.

Managerial/Administrative:
 Large firms can purchase computer systems to improve efficiency.
 They are able to employ specialist staff and introduce coordinated administrative systems.
 Communication systems can be improved through new technology
.
Risk-bearing:
 Large firms can diversify through takeovers into other business areas in order to reduce risks of a narrow concentration.
 Investment in research and development should produce a wider range of products, hence spreading risks.
 Large firms can afford to take greater risks in new product development than a smaller firm with a limited product range.

Social and welfare:

 Large firms are able to provide social facilities for workers.
 They can improve working conditions and introduce new processes to reduce monotony and increase scope for employee
responsibility.
 The introduction of welfare facilities and benefits, such as health care and pension provision, becomes possible.
 These facilities will improve morale and loyalty, lower labour turnover and improve motivation, consequently increasing productivity
and lowering unit costs

Internal diseconomies of scale can be experienced by organisations when they grow, leading to a lowering of efficiency and higher unit
costs of production.

Communication and Coordination diseconomies:

 Where production on a very large scale becomes difficult to organise as effectively as smaller scale production.
 The size of the company can cause communications problems, leading to mistakes
 Large organisations become less flexible and innovative and may not continue to meet the changing needs of their customers.

Excessive bureaucracy: As organisations grow, the number of levels of management increases and this may slow down decision-making
and add to the costs of production.

Motivation problems:
 The size of the company can cause communications problems and lower morale. These factors identified can cause lower
productivity and industrial relations problems.
 Large firms may experience inefficiencies related to the principal-agent problem. This problem is caused because the size and
complexity of most large firms means that their owners often have to delegate decision making to appointed managers, which can
lead to inefficiencies. For example, the owners of a large chain of clothes retailers will have to employ managers for each store, and
delegate some of the jobs to managers but they may not necessarily make decisions in the best interest of the owners. For example,
a store manager may employ the most attractive sales assistant rather than the most productive one (economics on line)
 X-inefficiency: As firms, growing in size, if there is a lack of competition and regulation, they may waste resources as well as pay
excessively high prices for resources (they are able to pass on higher prices and their demand is relatively PED inelastic)

External economies of scale

- A pool of skilled labour: The development of the computer industry along the 'M4 corridor' has encouraged more firms into the area, as a
workforce with the required skills has become established there.
- Specialised training: Local colleges and training providers tend to gear their courses to the local needs, further enhancing the
attractiveness of the area.
- Infrastructure: Local councils or agencies will strive to provide facilities such as roads and amenities that support the needs of the local
community.
- Suppliers: Suppliers and end-users will be attracted to an area specialising in the provision of certain products, as this is likely to be their
least-cost location. This will improve the efficiency of existing companies in that area.
- Reputation: Some area, such as Silicon Valley retain a reputation that will assist in the marketing of the product.
- Specialist facilities: science parks have developed alongside universities, benefiting from the research skills available.

External diseconomies of scale

- Congestion: The concentration of firms in an area will increase travelling times and expenses. Where delivery times are an essential
factor, this may reduce the competitiveness of an organisation.
- Shortages of resources: In particular, the cost of land and labour with the relevant skills will be inflated by competition amongst firms to
acquire these resources.
- Pollution: The social costs created in these areas may be considered excessive by firms who place a high value on their impact on society.
Local councils may impose additional costs on firms in order to alleviate this problem.

Economies of scope: the unit cost to produce a product will decline as the variety of products increases. That is, a firm can gain efficiencies
from producing a wider variety of products.

How well can you answer the following questions?

 26

Very well OK Not at all

Production
1. What is the economic definition of the short run?
2. Draw a total product curve
3. Draw a marginal product curve
4. What is the law of diminishing marginal productivity?
5. Why does diminishing marginal productivity only apply in the short
run?

Costs
1. What is the difference between accounting costs and economic
costs?
2. What is the difference between fixed and variables costs? (use
examples e.g. related to a coffee chain)
3. What is total cost?
4. How is total cost calculated?
5. Draw a typical TC curve
6. How is total variable cost calculated?
7. Draw a typical TVC curve
8. How is average (total) cost calculated?
9. Draw a typical AC curve
10. How is average fixed cost calculated?
11. Draw typical AFC curve
12. How is average variable cost calculated?
13. Draw an AVC curve
14. Why are short run costs different from long run costs?
http://oer2go.org/mods/en-boundless/www.boundless.com/econ
omics/textbooks/boundless-economics-textbook/production-9/
production-cost-64/short-run-and-long-run-costs-242-12340/
index.html
15. Illustrate the relationship between short run average costs and
long run average cost (The envelope curve)

Economies and Diseconomies of Scale- Long run (The car

manufacturing industry is good for both internal and external economies
of scale, as are the airline industry and on-line retailers)
1. What is an economy of scale?
2. What is a diseconomy scale?
3. Explain each of the 6 types of economy/diseconomy of scale
4. Give an example of each of the 6 types of economies of scale?
5. What is minimum efficient scale?
6. Illustrate economies of scale, diseconomies of scale, constant
returns to scale and minimum efficient scale
7. What is the difference between internal and external economies of
scale?

Profits and Costs: Glossary of terms and diagrams.

 27

 Normal profit  Total costs (TC)  Economies of scale

 Supernormal  Fixed cost (FC)  Risk bearing
profit  Variable cost (VC)  Managerial
 Loss  Average total costs (ATC usually  Financial
only AC)  Purchasing
 Short run  Average fixed costs (AFC)  Technical
 Long run  Average variable costs (AVC)  Marketing
 Marginal cost (MC)  Diseconomies of scale:
 Marginal diminishing returns  Example 1
returns/productivity (DMR)  Example 2
 Marginal product (MP)  External economies of scale
 Example 1
 Example 2
 External diseconomies of scale:
 Example 1
 Example 2
 Increasing returns to scale
 Constant returns to scale
 Decreasing returns to scale

The relationship between average and marginal:

If marginal is above average then average must_____________________________
If marginal is below average then average must_____________________________
If marginal is equal to average then average must_____________________________

Diagrams
 Marginal product curve (MP Short run: Long run:
curve)  SRAC with an explanation of  LRAC with explanation of it
 Total cost, total fixe cost and its shape shape
total variable cost curves  ATC, AVC, AFC and MC  AC and MC (together)
(together) (together)  MES
 A rise in AFC  Effect of benefits of external
 A rise in AVC economies of scale on LRAC

From short run to long run:

 The envelope curve

4. Costs: the different types

 28

1. Fill in the missing words

In Economics, costs are different to the standard costs we might consider in everyday life
as the economic costs of an activity include both the accounting cost and ____________
cost. A firm faces two distinct types of economic cost, costs that change directly with
output which are called ______________ and might be costs such as _______________, and
costs which do not vary with output called ______________, and might be costs such as
______________. In the short-run, when at least one _________ ___ _______ is fixed, a firm
must pay its ____________ costs regardless of its level of production but in the long run,
when _____________ factors of production are fully variable, then all costs will vary with
output. The addition of both fixed and variable costs gives the ______________ cost. Some
of these costs might be high capital start up costs and these costs act as a __________ ___
___________ to an industry. If these entry costs cannot be recovered by a firm when they
leave the industry then they are classified as _______________. Choose the words from:
total, variable costs, opportunity, barrier to entry, fixed costs, fixed,
electricity, rent, sunk costs, all, factor of production
2. Are the following fixed or variable costs?
2.1 Workers’ wages.
2.2 Depreciation of capital due to its age.
2.3 Costs of buying cotton.
2.4 Wear and tear of machinery due to its use.
2.5 The repayments on a loan used to purchase land.
2.6 The salary of a company director on a five year contract.
2.7 The cost of providing free tea and coffee to workers.
3. Multiple choice
Question Possible answers Ke
y
A Of less than one year.
B When all inputs are variable.
3. The short run is a
1 time period C When there is at least one fixed input and one
variable input.
D When all inputs are fixed.
A Only the scale of the factory is fixed.
3. B All inputs are fixed.
In the long run
2 C A firm only pays accounting costs.
D All inputs can be varied.
3. Which of the A Costs of advertising a new product.
3 following is most B Costs of leasing an airplane.
likely to be a sunk
cost? C Costs of buying electricity.
D Costs of paying wages to staff.
 29

Outp Total Total variable cost Average total cost

ut Cost (£) (£)
(£)
With reference to
the table, answer 0 500
the following
1 510
questions:
2 518
3 525
3. Calculate the total fixed and variable costs for the
4 above firm.

Calculate the average total cost of producing each unit

3.
of output. Is the fall in average costs mainly due to a
5
fall in fixed or variable costs?

6. Short-run costs 1. State the concept defined in each of the situations below:

1.1 The change in the total cost of producing one additional unit of output.
______________________________

1.2 If increasing quantities of a variable factor are applied to a given quantity of

a fixed factor, the marginal product of the variable factor will eventually
decrease. ______________________________________________________

1.3 The change in total output when one additional variable factor input is
added. __________________________

1.4 The cost per unit – total costs divided by quantity of output.
______________________________________

1.5 The period of time over which the inputs of some factors cannot be varied.
___________________________

2. Complete the missing values in the table, label the curves and identify for both the level of
labour input where diminishing marginal returns sets in:
 30

Unit Total Margi Avera

s of Produ nal ge
labo ct Produ Produ
ur ct ct

0 0 - -

1 10

2 22

3 17

4 48

5 11

6 60

7 3

3. Multiple choice

Question Possible answers Key

A Diminishing marginal utility.

The marginal cost
3. curve slopes B Diminishing marginal returns.
1 upwards because
of C Technological inefficiency.
D Economic inefficiency.
A Be falling faster than average cost.
When average B Must be less than average cost.
3. cost is falling,
2 marginal cost C May be either greater, equal to, or above
must marginal cost.
D Not be falling.
A The total product is at a maximum.
B The marginal product of the variable factors
The minimum is at a maximum.
3. marginal cost
3 occurs at the C The factors are combined in their best
output where possible proportions.
D The average product of the variable factors
is at a maximum.
 31

LONG RUN COSTS

1. Fill in the missing words:

In the long-run all costs are _______________ as _____________ factors of production

are also variable. The long-run average cost curve is thus explained by

economies and diseconomies of scale. If these changes in long-run average cost

occur only within an individual firm then they are called __________________

economies of scale but if they are cost savings which affect the whole industry

then they are called __________________ economies of scale. Choose words

from: external, internal, variable, all

2. Define the following terms and match them to the arrows on the two
diagrams below

2.1 Internal economies of scale:

______________________________________________________________

2.2 Internal diseconomies of scale:

____________________________________________________________

2.3 Minimum efficient scale:

_________________________________________________________________

2.4 External economies of scale:

______________________________________________________________
 32

3. Define or identify the economies of scale below:

3.1 Larger firms can employ specialist managers and so increase productivity:
_____________________________

3.2 Purchasing economy of scale:

_____________________________________________________________
__________________________________________________________________________

3.3 Larger firms can borrow at lower cost due to greater assets and lower risk of
default. ___________________

3.4 Marketing economy of scale:

_____________________________________________________________
__________________________________________________________________________

3.5 Larger firms can develop a wider customer base and range of products to
spread risk and minimise the impact of a slowdown in any one market.
_______________________________________________________
4. Multiple choice

Question Possible answers Answ

er

A it persistently produces on the upward-

sloping part of its short-run average total
cost curve.
A firm will want
B it persistently produces on the downward-
4. to increase the
sloping part of its short-run average total
1 scale of its plant
cost curve.
if
C it is producing below capacity.

D marginal cost is below average total cost.

4. The long-run A Is the short run average total cost curve

2 average cost with the lowest cost.
curve
B Traces the minimum points on all the
short run average cost curves for each
 33

scale of plant.

C Traces the minimum short run average

total cost for each output.

D Will always fall as output increases.