Costs, revenues and profits Flashcards
The short run production function
This is a model that represents how the volume of output changes as factor inputs are increased.
A number of assumptions are made…
- The firm uses only two factors of production, labour (L) and capital (K).
- K is fixed in the short run, but variable in the long-run.
- L is variable in both the short and long run.
Average output
This is total output per variable input.
Total output/inputs = Average output
Marginal output
The additional output that an additional input adds to total output.
Change in total output/change in inputs = marginal output
Short-run production function
This summarises the most technically efficient combinations of inputs to produce output. There are three phases of the DIAGRAM.
- Increasing marginal returns, as the firm employs more workers they can become more specialised, boosting marginal productivity.
- Diminishing marginal returns, as the firm employs more workers they begin to get into each others way, benefits of specialisation are maximised. Marginal productivity falls.
- Negative marginal returns, workers now prevent each other from working efectively and they get into each others way to the extent in which productivity of existing workers fall, this means there is negaitve marginal productivity.
Productivity definition
Measures output per unit of input
Relationship between the marginal product curve and the average product curve
- Both curves rise and then begin to fall, the average output begins to fall when it is intersected by the marginal output curve. Diminishing marginal returns/productivity takes place when the marginal product/output curve begins to fall.
The average product curve lages the marginal product curve.
Law of diminishing returns
At a certain point, employing an additional factor of production causes a relatively smaller increase in output.
Total short run FIXED costs
These are costs that do not vary with input, they are independant of output and are strictly a short run Phenomen.
E.G Rent
Total short run variable costs
Costs which vary with output, if output is 0 than the variable costs will also be 0. This include wages.
Total short run costs
TFC + TVC = TC
Explain the shape of the Average Fixed Cost curve
TFC/Q = AFC
- Continuosly sloping downwards for all levels of output.
- Decreasing at a slowing rate
- As output rises the TFC remains constant so the AFC approaches 0 as Q rises, but never meets it.
Explain the shave of the AVC curve
- AVC falls and then rises as output increases, U shaped.
- This is because the Marginal Cost curve fall and then rises. As MC falls it is below the AVC and do it drags down the AVC, but as MC rises it eventually rises above the AVC, causing the AVC to subsequently rise.
- MC falls initially as output rises because of increasing marginal productivity of the factor inputs, driven by specialisation.
- MC turns and begins to rise due to diminshing marginal productivity of inputs (MP falls).
Explain the shape of the ATC curve
ATC = AFC + AVC
- Initially AFC and AVC fall as output rises, as ATC is the sum of AVC and ATC, it too will fall.
- AVC rises at a certain point, but AFC continues to fall, the decrease in AFC is larger than the increase in AVC, so the ATC continues to fall.
- Because AVC rises at an increasing rate and AFC falls at a decreasing rate the ATC will eventually begin to rise (AVC becomes the more dominant factor determing the ATC shape)
Long run cost curve
In the long run all factor inputs can be varied, in the short run factor inputs are fixed.
This means that in the long-run the firm can produce on any of its short run cost curves, inputs are not fixed, the firm can vary inputs and therefore operate on a different short run cost curve.
The long run cost curve is therefore serived from a combination of short run cost curves.
Internal economies of scale
As a firm increases its sale of production in the long run by varying its capital stock, the firm is able to move onto previouslt inaccessible short run average cost curves. As capital stock is increasing the SRATCs are falling. This is economies of scale.
Any factor which drives down long-run average costs as output increases.
Examples of economies of scale
- Purchasing
- Managerial
- Technical
- Financial
- Risk bearing
Examples of economies of scale - Purchasing
As a firm scales up production it will purchase more inputs in order to facilitate this increased production. The firm might be able to access discounts on its inputs by buying them in bulk. This means its total costs rise by less than its output rises by. Dragging down LRATC.
Examples of economies of scale - Managerial
Larger firms have the revenue to justify hiring more managers than smaller firms, this allows for them to take on more specialised roles, this therefore should boost productivity of the teams they manage, as they can have a more narrow focus and develop a more detailed knowledge on the field. Total output rises by more than the increased cost from hiring more managers, reducing long run average costs.
Examples of economies of scale - Technical
Larger firms are able to spend more on capital and technology allwoing them to access better quality machinery and tech than smaller firms who cannot justify the expense. This boosts productivity, raising total output by more than the decreased cost of this new technology, decreasing LRATC.
Examples of economies of scale - Financial
Large buisnesses which produce more output are likely to have greater stock of assets to borrow against, this means firms producing at a large scale might be able to access credit at a lower interest rate than smaller firms. Therefore firms producing at a larger scale with have lower borrowing costs.
Examples of economies of scale - Risk bearing
Larger firms are able to take greater business risks than smaller firms, due to more reliable revenue firms and more assets. Firms can take more risks in developing cost saving techniques, such as new production methods than smaller firms. This drives down long run average costs for firms producing on a larger scale
Examples of diseconomies of scale
- Workers in large organisations might feel insignifcant and less motivated so productivity falls and costs rise.
- Management issues arise when a firm becomes too large, teams may grow in size and become difficult to manager, coordination issues between different layers of manegement.
- If firms grow too large they may attract the attention of government regulators, introducing regulatory framework will increase their costs.
External economies of scale
- As the industry grows, there might be more technological progress so all the firms can benefit and reduce costs.
- Skilled labour, as industries grow more people train for that sector, meaning productivity for firms rise.
- CLustering effect, as industry gorws, supply clusters will develop which may push costs down.
- Government support for growing sector.
External diseconomies of scale
- As a industry grows this places additional competition on factor resources, raw materials, pushing up their prices and therefore costs for firms rise. EVAL depends on PES of factor market.
- Issues with clustering, local strain on ifastructure might emerge. Industry growth might put a strain on local rental markets.
- Large industries might require more regulation to protect the rest of the economy from spill over effects.
