Costs Flashcards
Short run
The short run is when at least one factor of production is fixed.
Long run
The long run is when all factors are variable.
Fixed costs
Costs which do not vary with output e.g. rent and salaries
Variable costs
Costs which vary with output e.g. raw materials and wages
Total cost (TC)
Total cost = Total Variable Cost + Total Fixed Cost
TC = TVC + TFC
And finally, it’s important to remember that TFC and AFC are relevant in:
Factors are only fixed in the short run so Total Fixed Cost and Average Fixed Cost are only relevant in the short run.
Marginal cost
Marginal cost is the additional cost from selling one extra unit.
The law of diminishing marginal returns states that:
In the short run, as more factors are employed, the marginal returns from these factors will eventually decrease!
But as we continue adding factors, at some point productivity will decrease because of:
Diminishing marginal returns.
So in the short run, as quantity rises, and more factors are employed, if productivity increases and then decreases, marginal cost will:
Decrease and then increase
Why does MC decrease and then increase?
Marginal cost initially decreases because as output increases and more workers are hired, they can specialise, increasing productivity and decrease marginal cost.
But marginal cost will then increase because diminishing marginal returns will decrease productivity, increasing marginal cost.
Marginal cost (MC)
Marginal cost is the cost of selling an additional unit.
MC = ∆TC/∆Q
Diminishing marginal returns (or the law of diminishing marginal returns)
In the short run, as more factors are employed, the marginal returns from these factors will eventually decrease!
Explaining why the marginal cost (MC) curve goes down and then up
MC decreases because initially workers will specialise, increase productivity and decreasing marginal cost.
MC will then increase because diminishing marginal returns will set in, which will decrease productivity and increase marginal cost.
If MC is below AVC, AVC will:
decrease
Average Variable Cost formula
AVC = TVC/Q
MC & AVC relationship
When MC is below AVC, AVC will decrease
When MC is above AVC, AVC will increase
When MC = AVC, AVC is at its lowest
But these cost curves only apply in:
This will only apply in the short run because we have fixed costs (AFC) on our diagram - and fixed costs are only present in the short run. In the long run, all factors become variable.
So only as firms scale up and expand can they exploit technical economies of scale - when big firms invest in specialist capital to:
Specialist capital, like robot lettuce farmers, will increase productivity and decrease LRAC.
So we’ve now seen how as companies get bigger, they can exploit internal economies to:
Internal economies of scale only apply to long run average costs, because it’s only in the long run when firms can expand enough to take advantage of economies of scale. In the long run, internal economies of scale help a firm reduce their long run average costs.
Internal economies of scale
Internal economies of scale are when long run average costs fall as a firm’s quantity increases.
Types of internal economies of scale
(RMFPTM)
Richard’s Mum Flies Past The Moon
Risk-bearing economies
Managerial economies
Financial economies
Purchasing economies
Technical economies
Marketing economies
Risk-bearing economies
Bigger firms can use their big profits to diversify into new areas, reducing the cost of failure in one sector.
E.g. Virgin have diversified into 400 different areas.
Managerial economies
Bigger firms can afford to hire highly skilled specialist managers, increasing a firm’s productivity and decreasing their LR average costs!
E.g. Amazon hire specialist accounting, software and marketing managers.
Financial economies
Bigger firms are less risky, so they can secure cheaper loans, reducing their long run average costs.
E.g. Alibaba.com borrowed £3bn at a tiny 2% interest rate.
Purchasing economies
Bigger firms can bulk-buy and negotiate lower prices, reducing their long run average costs!
E.g. McDonald’s purchase thousands of tonnes of chicken breast at a very low average cost.
Technical economies
Bigger firms can invest in specialist capital, to increase a firm’s productivity and decrease their long run average costs.
E.g. Amazon’s warehouse robots and Kameoka’s robot lettuce farmers have massively increased productivity.
Marketing economies
Bigger firms can spread their marketing costs across many units, decreasing their long run average costs.
E.g. Guinness, Beats or Nike, who spend millions on marketing in total but just pennies on average, because their costs are so spread out.
And as employee motivation falls:
productivity falls, and long run average costs rise
when LRAC starts to rise like this, firms are experiencing
Internal diseconomies of scale.
Internal diseconomies of scale
Internal diseconomies of scale lead to a rise in long run average cost, as a firm expands.
Types of internal diseconomies of scale (ABC)
Alienation
Bureaucracy
Communication
Alienation
Workers feel alienated in very large firms, like they’re just another cog in the machine. This leads to demotivation, decreasing productivity, increase LRAC.
E.g. large call centres in India.
Bureaucracy
Bureaucracy is all the paperwork, managers, filing and secretaries that a firm has to pay for when it expands, increasing LRAC.
Communication
In big firms, employees may argue with each other and communication will be slow because big firms have so many layers. These factors will reduce productivity, increasing LRAC.
internal economies of scale
Internal economies of scale are when long run average cost falls, as a firm expands.
External economies of scale
External economies of scale will reduce long run average cost, as the industry expands.
- External economies of scale: lower recruitment costs
When an industry expands, lots of specialist workers will be move to that area to find work. This makes it easier to recruit workers, reducing a firm’s recruitment costs, decreasing their LRAC.
E.g. In Silicon valley, there are 60,000+ coders which reduces tech firms’ recruitment costs.
External economies of scale: knowledge transfers
When an industry expands, knowledge will be transferred between firms. This helps firms learn more effective new production techniques, decreasing their LRAC.
E.g. In LA’s film industry, the green screen technique was spread by knowledge transfer. Using green screens has reduced film producers’ long run average costs.
