4.1.4 Production, costs and revenue

Question 1

Outline Production

Answer 1

Production converts inputs, such as the services of factors of production from capital
and labour, into a final output. This will satisfy consumer needs and wants.

Question 2

Outline Productivity

Answer 2

Productivity is calculated by output per worker per period of timer. Being more productive means the same input, such as the number of workers, produces more output, over the same period of time. Being less productive requires a larger input to produce the same quantity of output. Productivity can be increased by training workers or using more advanced capital machinery.
Being more productive also lowers average costs per unit of output

Question 3

Define specialisation

Answer 3

Specialisation occurs when each worker is completes a specific task in a production process. The concept was famously stated by Adam Smith, who showed how, through the division of labour, worker productivity can increase. Firms can then take advantage of increased efficiency and lower average costs of production.

Question 4

Outline Adam Smith view on Specialisation

Answer 4

Smith essentially said that by dividing the production of pins into 18 different tasks,
the output of pins could increase significantly. Each worker specialises and output
increases. Specialisation can be achieved by individuals, businesses, regions of countries or countries themselves.

Question 5

Outline the advantages of Specialisation

Answer 5

Higher output and potentially higher quality, since production focusses on what people and businesses are best at.
o There could be a greater variety of goods and services produced.
o There are more opportunities for economies of scale, so the size of the market increases.
o There is more competition and this gives an incentive for firms to lower their costs, which helps to keep prices down.

Question 6

Outline the disadvantages of specialisation

Answer 6

Work becomes repetitive, which could lower the motivation of workers, potentially affecting quality and productivity. Workers could become dissatisfied.
o There could be more structural unemployment, since skills might not be transferable, especially because workers have focussed on one task for so long.
o By producing a lot of one type of good through specialisation, variety could in fact decrease for consumers.
o There could be higher worker turnover for firms, which means employees become dissatisfied with their jobs and leave regularly.

Question 7

Outline Specialisation in the production of goods and services to trade

Answer 7

Countries can specialise in the production of certain goods. For example, Norway is
one of the world’s largest oil exporters. Countries trade to get the goods and services they are unable to produce.

Countries can exploit their comparative advantage in a good, which means they can
produce a good at a lower opportunity cost to another.

Question 8

Define comparative advantage

Answer 8

Comparative advantage is an economic principle that explains how trade can benefit two countries or entities even if one of them has an absolute advantage in producing all goods.

Question 9

Define Absolute advantage

Answer 9

Absolute advantage occurs when a country can produce more of a good with the
same factor inputs.

Question 10

Outline the advantages in specialisation in the production of goods and services to trade

Answer 10

Advantages:
o Greater world output, so there is a gain in economic welfare.
o Lower average costs, since the market becomes more competitive.
o There is an increased supply of goods to choose from.
o There is an outward shift in the PPF curve.

Question 11

Outline the disadvantages in specialisation in the production of goods and services to trade

Answer 11

o Less developed countries might use up their non-renewable resources too
quickly, so they might run out.
o Countries could become over-dependent on the export of one commodity, such as wheat. If there are poor weather conditions, or the price falls, then the economy would suffer.

Question 12

Define A medium of exchange as a function of money

Answer 12

A medium of exchange: without money, transactions were conducted through bartering. Goods and services were traded with other goods and services, but people did not always get exactly what they wanted or needed. The goods and services exchanged were not always of the same value, which also posed a problem. Exchange could only take place if there was a double coincidence of wants, i.e. both parties have to want the good the other party
offer. Using money eliminates this problem.

Question 13

Define A measure of value (unit of account) as a function of money

Answer 13

A measure of value (unit of account): Money provides a means to measure the relative values of different goods and services. For example, a piece of jewellery might be considered more valuable than a table because of the relative price, measured by money. Money also puts a value on labour.

Question 14

Define a store of value as a function of money

Answer 14

Money has to hold its value to be used for payment. It can be kept for a long time without expiring. However, the quantity of goods and services that can be bought with money fluctuates slightly with the forces of supply and demand.

Question 15

Define a method of deferred payment as a function of money

Answer 15

Money can allow for debts to be created. People can therefore pay for things without having money in the present, and can pay for it later. This relies on money storing its value.

Question 16

Outline the difference between the short run and long run

Answer 16

In the short run, the scale of production is fixed (there is at least one fixed cost). For
firms, the quantity of labour might be flexible, whilst the quantity of capital is fixed.

In the long run, the scale of production is flexible and can be changed. All costs are
variable.

Question 17

Outline the difference between marginal, average and total returns

Answer 17

The marginal return of a factor, such as labour, is the extra output derived per extra
unit of the factor employed. For labour, it is the extra output per unit of labour employed. For example, employing more staff in a small shop will make it
overcrowded and the extra output per unit of labour falls.

The average return of a factor is the output per unit of input. This is output per worker over a period of time. The total return of a factor is the total output produced by a number of units of factors (e.g. labour) over a period of time. The amount of capital is fixed.

Question 18

Outline the law of diminishing returns

Answer 18

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

Question 19

Outline the returns to scale

Answer 19

Returns to scale refers to the change in output of a firm after an increase in factor
inputs. Returns to scale increases when the output
increases by a greater proportion to the increase in inputs. For example, if input doubles, and output quadruples, there is said to be increasing returns to scale

Question 20

Outline Constant returns to scale

Answer 20

Constant returns to scale are when output increases by the same amount that input
increases by.

Question 21

Define Fixed Costs

Answer 21

Fixed costs are costs which do not vary with output. For example, rents, advertising
and capital goods are fixed costs. They are indirect.

Question 22

Define Variable costs

Answer 22

Variable costs change with output. They are direct costs. For example, the cost of
raw materials increases as output increases.

Question 23

Define total cost and How is total cost calculated

Answer 23

The total cost is the cost to produce a given level of output and is calculated by:

Total costs = total variable costs + total fixed costs

Question 24

Define Average costs and give equation

Answer 24

Average costs is the cost per unit and is calculated by:

Average costs = total costs / quantity produced

Question 25

Define Marginal cost of production

Answer 25

The marginal cost of production is the cost of producing one extra unit of output. According to the law of diminishing returns, after a point, marginal costs rise as
output increases.

Question 26

Outline the Short Run average total cost

Answer 26

The short run average total cost curve is U shaped due to diminishing returns. This is because the factors of production are fixed. At one point, employing more
resources will be less productive, which means the marginal output decreases per extra factor of production. Marginal costs start to increase.

Question 27

Give diagram for the Long run average cost and explain

Answer 27

Initially, average costs fall, since firms can take advantage of economies of scale. This means average costs are falling as output increases. After the optimum level of output, where average costs are at their lowest, average costs rise due to diseconomies of scale.

Question 28

How factor prices and productivity affect firms’ costs of production and
their choice of factor inputs

Answer 28

If factor inputs become more productive, firms can produce more output with a smaller input. This results in lower unit costs of production. As the average cost per unit of one factor input rises, such as labour, firms are likely to switch to cheaper (and generally more productive) factor inputs, such as capital.

Question 29

Define Internal economies of scale

Answer 29

These occur when a firm becomes larger. Average costs of production fall as output
increases.

Question 30

Give examples of internal economies of scale

Answer 30

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

Question 31

Outline External economies of scale

Answer 31

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

Question 32

Outline Diseconomies of scale

Answer 32

These occur when output passes a certain point and average costs start to increase
per extra unit of output produced.

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

Question 33

Outline the Long run average cost curve and explain

Answer 33

Initially, average costs fall, since firms can take advantage of economies of scale. This means average costs are falling as output increases. After the optimum level of output, where average costs are at their lowest, average costs rise due to diseconomies of scale. The point of lowest LRAC is the minimum efficient scale. This is where the optimum level of output is since costs are lowest, and the economies of scale of production have been fully utilised.

Question 34

Outline the relationship between returns to scale and economies or diseconomies of scale

Answer 34

Returns to scale increases when the output increases by a greater proportion to the
increase in inputs. For example, if input doubles, and output quadruples, there is said to be increasing returns to scale. This occurs where there are economies of scale and factor inputs become more productive.

If, on the other hand, a doubling of input leads to a 1.5 times increase in output, there are decreasing returns to scale. This is linked to diseconomies of scale, since it occurs when factor inputs become less productive.

Question 35

Describe and explain the L-Shaped LRAC Curve

Answer 35

The diagram above shows the relationship between the SRAC curve and the LRAC curve. The LRAC curve envelopes the SRAC curve, and it is always equal to or below the SRAC curve. The LRAC curve shifts when there are external economies of scale, i.e. when an industry grows. SRAC falls at first, and then rises, due to diminishing returns. In the long run, costs change due to economies and diseconomies of scale. If SRAC = LRAC, the firm operates where it can vary all factor inputs. The L-shape curve is a development in cost theory from the traditional U-shaped curve. It suggests that to begin with, costs per unit fall as output increases, due to
economies of scale. Even if there are diseconomies of scale within the firm, such as if managerial costs increase, they are offset by the economies of scale gained by technical or production factors. This means that in the long run, costs continue to fall, even if the pace of falling output costs slows (shown by the flat part of the curve).

Question 36

Define Profit

Answer 36

Profit is the difference between total revenue and total costs.

Question 37

Define Normal profits

Answer 37

Normal profit is the minimum reward required to keep entrepreneurs supplying their enterprise. It covers the opportunity cost of investing funds into the firm and not elsewhere. This is when total revenue = total costs (TR = TC). Normal profit is considered to be a cost, so it is included in the costs of production.

Question 38

Define supernormal profit

Answer 38

Supernormal profit (also called abnormal or economic profit) is
the profit above normal profit. This exceeds the value of opportunity cost of investing funds into the firm. This is when TR > TC.

Question 39

Outline the profit in a market economy

Answer 39

In a free market economy, profit is the reward that entrepreneurs yield when they
take risks and make investments.

An entrepreneur wants to avoid loss and gain profit, which makes them want to innovate, so they can reduce their production costs and improve the quality of their products. Entrepreneurs seek to maximise their profits.

Profits can be retained, so they are kept within the firm and not given to shareholders as dividends. This can be a source of finance for firms if they choose to make an investment. It helps them avoid the costs of interest payments if they
borrow money.

Profits can also act as a signal to firms and consumers. For example, in markets where firms make supernormal profits, there are likely to be new firms entering the market since the market seems profitable. This increases market supply and lowers the market price. This assumes the market is contestable and there are no (or low) barriers to entry.

Scarce economic resources generally flow where rewards to investment are higher. The factors of production are used in markets where the rate of return is higher.

Question 40

Define Invention

Answer 40

Invention is the process of creating a new product or a new way to make a product

Question 41

Define Innovation

Answer 41

Innovation is the act of improving or contributing to existing products.

Question 42

How can Technological change affect methods or production

Answer 42

Technological change can result in improvements in efficiency and productivity, which could lower costs of production for firms. The quality and quantity of goods and services produced might improve.

Technological change can lead to the development of new products, the development of new markets and may destroy existing markets. For example, the development of DVDs, then blu-rays, and now the rise of downloadable films, has
essentially destroyed the market for VHS video tapes.

Question 43

Outline the process of creative destruction

Answer 43

Schumpeter, an economist, proposed the idea of ‘creative destruction’. This is the
idea that new entrepreneurs are innovative, which challenges existing firms. The more productive firms then grow, whilst the least productive are forced to leave the market. This results in an expansion of the economy’s productive potential.

Question 44

Outline how Technological change can influence the structure of markets

Answer 44

Monopolies do not have an incentive to innovate, since they have no competition. This means they are often inefficient and their costs are higher than they could be.

Oligopolies tend to have more of an incentive to innovate, since they are earning
supernormal profits and are trying to get ahead of their competitors. This means
that technological change is quite fast in oligopolies.