Chapter 4 Flashcards
Define fixed factors and variable factors.
Fixed factors: an input that cannot be increased within a given time period (e.g., buildings).
Variable factors: an input that can be increased in supply within a given time period (e.g., labour).
Define the short run and the long run.
The short run: a time period during which at least one factor of production is fixed. Output can be increased only by using more variable factors.
The long run: a time period long enough for all new inputs to be varied. Given long enough, a firm can build a second factory, install new machines, etc. The actual length of time will vary from firm to firm.
Explain the law of diminishing returns in relation to production in the short term.
Production in the short run is subject to the law of diminishing returns. When increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.
Explain the relationship between cost and output.
The more a firm produces, the more factors it must use and the greater its costs will be. This relationship is based on two elements:
1. the productivity of the factors: the greater their productivity, the smaller will be the number of them that is needed to produce a given level of output, and hence the lower the cost of that output.
2. the price of the factors: the higher their price, the higher will be the costs of production.
Define fixed costs and variable costs.
Fixed costs: do not vary with output (i.e., stay the same regardless of if a firm produces a lot or a little).
Variable factors: vary with output. E.g., The more that is produced, the more raw materials are used and therefore the higher their total cost. Total cost = total fixed cost + total variable cost.
Define average costs.
Average total cost is cost per unit of production = total cost/unit
Average cost can be broken down further = total fixed cost/unit + average variable cost/unit.
Marginal cost is the extra cost of producing one more unit: that is, the rise in total cost per one unit rise in output. Triangle sign means “a rise in”. ∆total cost/∆unit
Explain marginal cost curve.
Relates to the law of diminishing returns. Initially, extra units of output cost less than previous units. MC falls. Beyond a certain level of output, diminishing returns set in.
Thereafter, MC rises. Additional units of output cost more and more to produce because they require ever increasing amounts of the variable factor.
Explain average fixed cost curve.
This falls continuously as output rises, since total fixed costs are being spread over a greater and greater output.
Explain average (total) cost curve.
The shape of the AC curve depends on the shape of the MC curve. As long as new units of output cost less than the average, their production must pull the average cost down. That is, if MC is less than AC, AC must be falling. Likewise, if new units cost more than the average, their production must drive the average up.
That is, if MC is greater than AC, AC must be rising. Therefore, the MC curve crosses the AC curve at its minimum point.
Explain average variable cost curve.
Since AVC = AC - AFC, the AVC curve is simply the vertical difference between the AC and the AFC curves. Note that, as AFC gets less, the gap between AVC and AC narrows. Since all marginal costs are variable (by definition, there are no marginal fixed costs), the same relationship holds between MC and AVC as it did between MC and AC. That is, if MC is less than AVC, AVC must be falling, and if MC is greater than AVC, AVC must be rising. Therefore, as with the AC curve, the MC curve crosses the AVC curve at its minimum point.
List three universal rules about averages and marginals.
- If the marginal equals the average, the average will not change.
- If the marginal is above the average, the average will rise.
- If the marginal is below the average, the average will fall.
Define and explain three economies of scale.
Economics of scale = when increasing the scale of production leads to a lower cost per unit of output.
1. Constant returns to scale. This is where a given percentage increase in inputs will lead to the same percentage increase in output.
2. Increasing returns to scale. This is where a given percentage increase in inputs will lead to a larger percentage increase in output.
3. Decreasing returns to scale. This is where a given percentage increase in inputs will lead to a smaller percentage increase in output.
The words ‘to scale’ mean that all inputs increase by the same proportion. Decreasing returns to scale are therefore quite different from diminishing marginal returns (where only the variable factor increases).
List 6 reasons why firms are likely to experience economies of scale (plant economics of scale).
Plant economies of scale are due to the large size of an individual factory, workplace or machine.
1. Specialisation and division of labour. In large-scale plants workers can do more simple, repetitive jobs. With this specialisation and division of labour less training is needed; workers can become highly efficient in their particular job, especially with long production runs; less time is lost by workers switching from one operation to another; and supervision is easier.
2. Indivisibilities. Some inputs are of a minimum size: they are indivisible. E.g., machinery. Take the case of a combine harvester. A small-scale farmer could not make full use of one. They only become economical to use on farms above a certain size. The problem of indivisibilities is made worse when different machines, each of which is part of the production process, are of a different size.
3. The ‘container principle’. Any capital equipment that contains things (e.g. blast furnaces, oil tankers, pipes, vats) tends to cost less per unit of output the larger its size. The reason has to do with the relationship between a container’s volume and its surface area. Its output depends largely on its volume. Large containers have a bigger volume relative to surface area than small containers.
4. Greater efficiency of large machines. Large machines may be more efficient in the sense that more output can be gained for a given amount of inputs.
5. By-products. With production on a large scale, there may be sufficient waste products to enable a by-product to be made.
6. Multi-stage production. A large factory may be able to take a product through several stages in its manufacture. This saves time and cost incurred moving the semi-finished product from one firm or factory to another.
List 3 economies of scale associated with a firm being large (e.g., having many factories, offices or shops).
- Organisational economies. In a large firm, individual plants can specialise in particular functions. There can also be centralised administration of the firm.
- Spreading overheads. Some expenditures are only economic when the firm is large, such as research and development. This is another example of indivisibilities, only this time at the level of the firm rather than the plant. The greater the firm’s output, the more these overhead costs are spread.
- Financial economies. Large firms may be able to obtain finance at lower interest rates than small firms. They may be able to obtain certain inputs more cheaply by buying in bulk.
Define economies of scope.
Often a firm is large because it produces a range of products. This can result in each individual product being produced more cheaply than if it was produced in a single-product firm. The reasons for these economies of scope are that the various overhead costs and financial and organisational economies can be shared among the products.
Define diseconomies of scale and list 4 reasons why these occur.
When firms get beyond a certain size, costs per unit of output may start to increase.
1. Management problems of coordination may increase as the firm becomes larger.
2. Workers may feel ‘alienated’ if their jobs are boring and repetitive, and if they feel an insignificantly small part of a large organisation. Poor motivation may lead to shoddy work.
3. Industrial relations may deteriorate as a result of these factors and also as a result of the more complex inter-relationships between different categories of worker.
4. Production-line processes and the complex interdependencies of mass production can lead to great disruption if there are hold-ups in any one part of the firm.
Define external economies of scale.
Where a firm’s costs per unit of output decrease as the size of the whole industry grows.
As an industry grows, this can lead to external economies of scale for its member firms. This is where a firm, whatever its own individual size, benefits from the whole industry being large.
The member firms of a particular industry might, however, experience external diseconomies of scale. For example, as an industry grows larger, this may create a growing shortage of specific raw materials or skilled labour. This will push up their prices and hence the firms’ costs.
Explain long-run average cost.
Since there are no fixed factors in the long run, there are no long-run fixed costs. All costs, then, in the long run are variable costs.
Long-run average cost curves: These can take various shapes, but a typical one is saucer shape. It is often assumed that, as a firm expands, it will initially experience economies of scale and thus face a downward-sloping LRAC curve. After a point, however, all such economies will have been achieved and the curve will flatten out. Then, possibly after a period of constant LRAC, the firm will become so large that it will start to experience diseconomies of scale and thus a rising LRAC. At this stage, production and financial economies begin to be offset by the managerial problems of running a giant organisation. The effect of this is to give a saucer-shaped curve.
What are 3 assumptions behind the long-run average cost curve?
- Factor prices are given. If factor prices change, both short-run and long-run cost curves will shift. Thus, an increase in energy prices would shift the curves upward. However, factor prices might be different at different levels of output. For example, one of the economies of scale that many firms enjoy is the ability to obtain bulk discounts on raw materials and other supplies. In such cases the curve does not shift.
- The state of technology and factor quality are given. These are assumed to change only in the very long run. If a firm gains economies of scale, it is because it has been able to exploit existing technologies and make better use of the existing availability factors of production.
- Firms choose the least-cost combination of factors for each output. The assumption here is that firms operate efficiently: that they choose the cheapest possible way producing any level of output. If the firm did not operate efficiently, it would be producing at a point above the LRAC curve.
Define an envelope curve.
From the succession of short-run average cost curves we can construct a long-run average cost curve. This is known as an envelope curve because it envelops the short-run curves.
Define 4 different time periods for decision making.
- Very short run (immediate run). All factors are fixed. Output is fixed. The supply curve is vertical. On a day-to-day basis a firm may not be able to vary output at all.
- Short run. At least one factor is fixed in supply. More can be produced, but the firm will come up against the law of diminishing returns as it tries to do so.
- Long run. All factors are variable. The firm may experience constant, increasing or decreasing returns to scale. But although all factors can be increased or decreased, they are of a fixed quality.
- Very long run. All factors are variable, and their quality and hence productivity can change. Improvements in factor quality will reduce costs and thus shift the short-run and long-run cost curves downwards.
Just how long the ‘very long run’ is will vary from firm to firm. It will depend on how long it takes to develop new techniques, new skills or new work practices. It is important to realise that decisions for all four time periods can be made at the same time. They can make both short-run and long-run decisions today.
Which of the four time periods does economics focus on most?
Short run and long run. There is very little the firm can do in the very short run. And in the very long run, the firm will not be in the position to make precise calculations on how to increase productivity.
Define total revenue.
Total revenue is the firm’s total earnings per period (P) of time from the sale of a particular amount of output (Q). TR = P x Q
Define average revenue.
Average revenue is the amount that the firm earns per unit sold. TR (amount earned) / Q (x amount of units).