Topic no. 6: Production and its Costs

Question 1

What are the 2 time frames?

Answer 1

Short run: Period of time so short that there is at least one fixed input.

Long run: Period of time so long that all inputs are variable,

Question 2

What are the key features of the time frames?

Answer 2

Short run: (2 types of inputs)
a) variable input - Quantity can be changed during the period of time under consideration. [e.g. workers]
b) fixed input - Quantity cannot be changed during the period of time under consideration. [e.g. firm’s plant size]

Long run: No fixed input

Question 3

What are the 3 main product curves in the SR?

Answer 3

1. Total Product
2. Average Product
3. Marginal Product

(TAM)

Question 4

What is the total product curve?

Answer 4

The TP curve shows the output that is produced when additional units of variable input (VI) are added to the fixed input (FI).

** Shape of the TP curve/short run TP curve is affected by the Law of Diminishing returns.

Question 5

What is the Law of Diminishing returns?

Answer 5

Beyond some point the marginal product decreases as additional units of a variable factor are added to a fixed factor.

Question 6

What is marginal product?

Answer 6

Measures the change in total output resulting from the addition of an extra unit of variable input.

Graphically, MP = gradient of a tangent drawn to any point on the total output curve.

Formula:
MP = △TP/△VI
[e.g. △Total output/△No. of workers]

Slope of tangent = △ in vertical/△ in horizontal
(rise/run)
[e.g. △ in TP/△ in VI]

Question 7

1. If MP initially increases, as 1st unit of worker employed adds 10 bushels of wheat per day to output and 2nd unit of worker adds another 12 bushels of wheat per day to output. Between 1-2 workers, MP is rising. Why?
2. From 3-6 workers, each worker adds less & less to output. Why?
3. Total output is at its maximum at the 6th worker. Thereafter total output falls. Why?

Answer 7

1. Due to better combination of VI and FI.
   [Better usage of the FI]
2. Combination of VI to Fi is no longer optimal.
3. This occurs because there are too many VI and too little FI to work with.
   [For output to fall, MP must be negative. Which means that each subsequent worker employed does not add more to output but instead reduces the output produced.]

Question 8

What is Average Product?

Answer 8

Total output divided by number of VI used.

Shape: Like MP, AP increases, reaches a maximum, and then declines.

AP = TP/VI

Question 9

What is the relationship between MP & AP?

Answer 9

*** MP determines what happens to AP.

1. Both MP & AP have the same shape but do not overlap each other.
2. i) when MP > AP, it pulls AP up. (i.e. AP rises)
   ii) when MP < AP, it pulls AP down (i.e. AP falls)
   [It follows from (i) and (ii) that MP and AP are equal when AP is at its maximum.

Question 10

What is short run cost curves?

Answer 10

In the short run, a firm incurs both fixed and variable costs when it produces a good.

Question 11

What are the Short Run Total Cost Curves?

Answer 11

1. Total Fixed Costs (TFC)
2. Total Variable Costs (TVC)
3. Total Cost (TC)

Question 12

What is Total Fixed Costs?

Answer 12

Fixed costs are the costs of the firm’s fixed inputs.
[costs that do not vary as output varies and that must be paid even if output is zero]

*** TFC is a horizontal line.
[e.g. Rental paid for machine (wheat harvester), rental paid for factory]

TFC curve can shift up or down when the FI (e.g. factory size) changes.

Question 13

What is Total Variable Costs?

Answer 13

Costs of the firm’s variable inputs.
[costs that are zero when output is zero and vary as output varies.]

[e.g. utility costs & material costs]

*** TVC varies directly with the output level.

i.e. TVC increases/decreases when output increase/decrease because more/less VI are required.

i) TVC curve must start from the origin. No output = no TVC.
ii) As output increases, TVC increases. [TVC curve is positively sloped.]

Question 14

What is Total Cost?

Answer 14

Sum of total fixed cost and total variable cost at each level of output.

TC = TFC + TVC

*** Zero output -> TC = TFC since TVC is zero. Vertical gap between TC and TVC = TFC.

Question 15

What are the average costs of productions?
[Short Run Average Cost Curves]

Answer 15

1. Average Fixed Costs (AFC)
2. Average Variable Cost (AVC)
3. Average Total Cost (ATC)
4. Marginal Cost (MC)

Question 16

What is Average Fixed Cost?

Answer 16

Total fixed costs divided by quantity of output produced.

AFC decreases as output increases, given amount of fixed cost is spread over a bigger output.

Formula: AFC = TFC/Q
[fixed cost per unit of output]

Question 17

What is Average Variable Cost?

Answer 17

Total variable cost divide by the quantity of output produced.

Formula: AVC = TVC/Q
[Variable cost per unit of output]

*** U-shaped

Question 18

What is Average Total Cost?

Answer 18

Total cost divided by quantity of output produced.

Formula: ATC = TC/Q
ATC = AFC + AVC
[measures total cost per unit of output]

*** U-shaped
Shape of AFC and AVC combined.
Distance between ATC and AVC is AFC.

Question 19

What is the relationship between ATC and AVC?

Answer 19

i) ATC is always greater than AVC.
ii) Gap between ATC and AVC = AFC
iii) Gap between ATC and AVC gets smaller as output increases. AFC falls as output increases.

Question 20

What is Marginal Cost?

Answer 20

Change in total cost when one additional unit of output is produced.

Formula: MC = △TC/△Q or △TVC/△Q

*** MC curve mirror image of MP curve

[e.g. 1st w: $10 = 10 wheat, 2nd w: $10 = 12 wheat. (2nd wheat cheaper) MC of wheat gets cheaper as workers get more productive. MC at first decreases as output increases because of better combination of VI and FI. As output increases, MC increases because of law of diminishing returns (workers not as productive as before). MC curve is therefore U-shaped]

Question 21

What is the relationship between the Average and Marginal cost curves?

Answer 21

MC determines what happens to the AVC and ATC curves.

a) When MC < AVC or ATC, AVC & ATC will decrease.
b) When MC > AVC OR ATC, AVC & ATC will increase.
c) MC must = AVC and ATC at their respective minimums.

MC is related to AVC and ATC but MC is NOT related to AFC. MC is a variable cost while AFC is a fixed cost. VC does not affect FC, vice versa.

Question 22

How is Production in the Long Run?

Answer 22

Key points:
- There are no fixed costs in the long run.
- Firm can increase its scale of production by expanding all inputs, including something permanent as the factory size. [no constraints]
- All inputs are variable in the long run, no fixed input as firms can tear down and its factory size.
- All inputs can be changed, a firm in the LR can choose the best input combination. [Best input combination is the one that enables the firm to produce its output at the lowest cost.]
- Production in the long run is NOT affected by the Law of Diminishing returns but affected by concept of returns to scale which looks at what happens to output when ALL inputs are changed proportionately.

Question 23

What are the Long Run Average Cost Curve?

Answer 23

i) Increasing returns to scale / economies of scale. [cost of production drops]
ii) Decreasing returns to scale / economies of scale.
iii) Constant returns to scale.

Question 24

In the Long Run Average Cost Curve, what does increasing returns to scale means?

Answer 24

Initially, the firm experiences increasing returns to scale (or economies of scale)

[Double ALL inputs -> output more than doubles]

Question 25

What is economies of scale?

Answer 25

Economies of scale occurs when a firm’s output increases more than proportionately to the increase in ALL its inputs. It is accompanied by a decline in the long run average total cost.

Question 26

In the Long Run Average Cost Curve, what does decreasing returns to scale / diseconomies of scale means?

Answer 26

After a point, the firm experiences decreasing returns to scale (or diseconomies of scale).

Output increases less than proportionately to the increase in ALL its inputs. [e.g. double ALL inputs -> output less than doubles]

-> Firm becomes too big, red tapes and management problem arises. [due to inefficiency]

Question 27

In the Long Run Average Cost Curve, what does constant returns to scale means?

Answer 27

In between economies of scales, the firm experiences constant returns to scale.

Output increase proportionately with the increase in ALL inputs. [Doubles ALL inputs, output also doubles]

(When there is constant returns to scale -> productivity does not change -> therefore (average) cost will be constant.