Chapter 6 Flashcards
Theory of the firm
Assumes that the first aim is to maximise profit.
Fixed factor
An input that cannot be increased in supply within a given time period.
Variable factors
An input that can be increased in supply within a given time period.
Short run
The period of time over which at least one factor is fixed.
The actual length of the short run will differ from firm to firm and industry to industry. It is not a fixed period of time.
Long run
The period of time long enough for all factors to be varied.
The law of diminishing returns
When one or more factors are held fixed, there will come a point beyond which the extra output from additional units of the variable factor will diminish.
Short-run productions
Production in the short-run is subject to diminishing returns
Technical efficiency
The firm is producing as much output as is technologically possible given the quantity of factor inputs it is using.
Average physical product
Total output (TTP) per unit of the variable factor in question
APP = TPP/Q
Marginal physical product
The extra output gained by the employment of one more unit of the variable factor.
MPP = ΔTPP/ ΔQ
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.
When measuring costs, economists always use the concept of opportunity cost
Cost measured in terms of the value of the best alternative forgone.
explicit costs
Factors not owned by the firm
The payments to outside suppliers of inputs. They involve direct payment of money by firms.
implicit costs
Factors already owned by the firm:
costs that do not involve a direct payment of money to a third party, but which nevertheless involve a sacrifice of some alternative.
Sunk costs
Costs that cannot be recouped.
Examples include specialised machinery or the costs of an advertising campaign.
Remember that the cost of a machine was not always a sunk cost. Before its purchase, the opportunity cost of buying the machine was the money paid for it.
You should not base your decision on sunk costs.
Historic costs
the original amount the firm paid for factors it now owns.
A firm’s costs of production will depend on the factors of production it used. The more it uses, the greater its costs be.
This relationship depends on two elements:
The productivity of the factors. The greater the physical productivity, the smaller will be the quantity of them required to produce a given level of output, and hence the lower will be the costs of that output.
The price of the factors. The higher the price, the higher the costs of production.
The total cost (TC) = TVC + TFC
TVC= total variable costs. Vary with the amount of output produced.
TFC= total fixed costs. Do not vary with the amount of output produced.
Average cost (AC) is cost per unit of production
AC = TC/Q, AC = AFC + AVC
Average fixed costs (AFC)
AFC = TFC/Q
Average variable cost (AVC):
AVC = TVC/Q
Marginal cost (MC)
The extra cost of producing one more unit.
Three possible situations when increasing inputs
Increasing returns to scale.
Constant returns to scale.
Decreasing returns to scale.
Increasing returns to scale.
This is where a given percentage increase in inputs leads to a larger percentage increase in output.
Constant returns to scale
This is where a given percentage increase in inputs leads to the same percentage increase in output.
Decreasing returns to scale.
This is where a given percentage increase in inputs leads to a smaller percentage increase in output.
“to scale”
all inputs increase by the same proportion.
Increasing and decreasing returns to scale are therefore quite different from increasing diminishing returns to a variable factor.
economies of scale
When increasing the scale of production leads to a lower cost per unit of output.
Reasons why firms are likely to experience economies of scale
Specialisation and division of labour.
Indivisibilities
The ‘container principle’
Greater efficiency
By-products
Multi-stage production
Specialisation and division of labour.
Because of this, less training is needed, workers can become highly efficient, less time is lost in workers switching from one operation to another, and supervision is easier.
Indivisibilities
The impossibility of dividing a factor into smaller units. The problem of indivisibilities is made worse when different machines, each of which is part of the production process, are of a different size.
The ‘container principle’
Any capital equipment that contains things 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. A container’s cost depends largely on the materials used to build it and hence roughly on its surface area. Its output depends largely on its volume.
Greater efficiency
of large machines.
By-products
There may be sufficient waste products to enable some by-product(s) to be made.
Multi-stage production
A large factory may be able to take a product through several stages in its manufacture. This saves time and cost in moving semi-manufactures products from one firm to another.
These are plant economies of scale = economies of scale that arise because of the large size of a factory.
There are other economies of scale:
Organisational economies.
Spreading overheads
Financial economies.
Economies of scope
Organisational economies.
Often after a merger between two firms, savings can be made by rationalising their activities in this way. Rationalisation = the reorganising of production (often after a merger) so as to cut out waste and duplication and generally to reduce costs.
Spreading overheads
The greater the firm’s output, the more these overhead costs are spread. Overheads = costs arising from the general running of an organisation, and only indirectly related to the level of output.
Financial economies.
Large firms are often able to obtain finance at lower interest rates than small firm, since they are seen by banks to be lower risk.
Economies of scope
when increasing the range of products produced by a firm reduces the cost of producing each one
Diseconomies of scale
where costs per unit of output increase as the scale of production increases.
Reasons for diseconomies of scale
