Topic 6: Production and Costs

Question 1

What is a firm and what costs do they encounter?

Answer 1

firms: economic units formed by profit-seeking people, they employ resources to produce goods and services for sale

• help reduce transaction costs e.g. building a new house (one contract with Master builder versus dozens of contracts with electricians, plasterers, bricklayers etc) – more efficient, reduction in time taken, generally less expensive (especially in time and costs)
• the overriding goal of firms is to maximise profits
• ## Costs
• all resources have an opportunity cost
• types of costs:
  
  • explicit costs: opportunity cost of resources that take the form of a cash payment e.g. computers, equipment
  • implicit costs: the opportunity cost of a firm using its own resources (or those provided by its owners) without a corresponding cash payment e.g. opportunity cost of owner’s time (i.e. could be working for another firm earning a wage)

Question 2

Describe economic profit

Answer 2

accounting profit = total revenue – total costs

economic profit = total revenue – explicit costs – implicit costs

• economists also subtract those opportunity costs that don’t have an explicit monetary value, factoring in the next best alternative

π = TR – TC

profit = total revenue – total cost

• π = 0, firms are happy in this situation or in best alternative
• π = + ve, firms doing very well and very happy in this situation
• π = - ve, economic loss (not necessarily accounting loss), firms not employing itself (and its resources) in the most optimal manner

Question 3

Define elements of the production process

Answer 3

production theory: looks at the relation between output and the inputs necessary for production of that output

Inputs (factors of production)

• land
• capital
• labour
• entrepreneurship (profit)
• by convention, economists focus on labour (L) and capital (k)
• short run*: at least one of the factors of production are fixed (typically capital as difficult to increase stock quickly), varies widely between firms and industries
• long run*: all factors of production are variable

Question 4

Describe the law of diminishing marginal returns

Answer 4

• in the short run, with one input fixed (K) and one variable (L), we can plot how Total Product/Output (TP) changes as we add more of the variable input (L)
• important assumption is that labour is homogeneous (i.e. have the same skills)

marginal product (MP): the extra output produced when the variable factor is increased by one unit

• the law of diminishing returns explains what happens to output when we add units of input to production
• holding k constant, output will at first ↑ by increasing amounts as labour is added (increasing returns)
• after some point, adding more labour will still ↑ output, but by smaller and smaller amounts (diminishing returns).

• the diminishing returns is a law because as long as one of the factors of production is fixed, output must eventually increase by smaller and smaller amounts when added to the fixed factor

Question 5

Describe returns to scale

Answer 5

• in the long run, all factors of production can be changed.
• returns to scale*: the long-run relation between a given % change in inputs and the resulting % change in output.
• constant returns to scale: if you double all inputs, output doubles.
• increasing returns to scale: if you double all inputs, output more than doubles.
• decreasing returns to scale: if you double all inputs, output increases by less than double.
• the law of diminishing returns occurs in the short run due to the constraints of the fixed factor, returns to scale cannot occur because of the constraints of the fixed factor, because there are no fixed factors.

Question 6

What are the types of production costs?

Answer 6

variable costs: do vary with quantity of output produced e.g. labour in general

fixed costs: do not vary with quantity of output produced, constant e.g. capital

total costs (TC) = total fixed costs (TFC) + total variable costs (TVC)

average total cost (ATC) =

average fixed cost (AFC) =

average variable cost (AVC) =

Question 7

Describe costs in the short run

Answer 7

Marginal cost

def.: the increase in total cost caused by an extra unit of production, helps to answer how much does it cost to produce an additional unit of output?

• these are equivalent because by definition, the extra costs can only be variable costs

Modelling short run costs

• assumption in the model is that labour is homogenous (workers have same skills = same wage)
• minimum MC is not necessarily optimal point to operate at – firms aim to maximise profits hence firms always operate where MC is decreasing (where extra revenue still exceeds extra costs)
• no need to plot AFC as the distance between ATC and AVC is by definition equal to AFC (ATC – AVC = AFC)
• AFC downward sloping while ATC and AVC are upward sloping
• AVC and ATC get closer together as output increases because AFC get smaller
• relationship between MC and AC:
  
  • MC = cost of producing next unit of a good
  • ATC = cost of producing each unit of a good
  • when MC < ATC, drags ATC down
  • when MC > ATC, drags ATC up
  • when MC = ATC, MC cuts ATC and AVC at minimum points

Question 8

Describe the stages of diminshing returns to scale

Answer 8

Stage I:

• falling MC =
• initially as each successive worker adds more to output than the previous worker ( increases), then the cost of this worker (w) is spread over more and more units of output, hence MC is decreasing

Stage II:

• rising MC =

once diminishing returns set in, each worker is adding less and less to output ( decreasing) and the wage is spread over fewer units of output

Question 9

Describe costs in the long run

Answer 9

• no fixed costs, firms plan in the long run, but produce in the short run i.e. once firms have decided on their scale of plant etc, they are again in the short run, because that scale of plant is fixed

Long run average cost (LAC)

def.: indicates the lowest average cost of production at each rate of output when the firm’s size is allowed to vary

• LAC can be thought of as an envelope of all short run ATC curves (SATC) with no variable costs
• x = minimum point on the LAC represents the minimum efficient scale i.e. over the entire range of production possibilities, this is the one that minimises average costs
• economies of scale*: forces that cause a ↓ in average costs as the scale of operation ↑ in the long run
• diseconomies of scale*: forces that cause an ↑ in average costs as the scale of operation ↑ in the long run, firms attempt to avoid this
• as LAC curve slop increases, it represents the structure of the organisation becoming more inefficient i.e. bureaucratic complexity and blurred lines of communications as firms get extremely large
• differs from diminishing marginal returns, diminishing returns sets in as more of the variable factor is added to a fixed factor. In the long run no factors are fixed, and so LAC is rising for some other reason