Types Of Costs, Revenue And Profit, Short Run And Long Run Production

Question 1

Isoquant

Answer 1

A curve showing the possible combinations of two factors of production that can be used to produce the same level of output.

Question 2

Total product

Answer 2

Total output of a firm.

Question 3

Marginal product

Answer 3

The change in output arising from the use of an additional factor of production.

Question 4

Marginal product

Answer 4

Change in total output ➗ Change in factor of production

Question 5

Average product

Answer 5

Total output ➗ Number of labour employed

Question 6

Short run production function

Answer 6

A graph that shows the maximum possible output from a given set of factor inputs.

Shows the relationship between quantity of factor inputs used and total product obtained.

Question 7

Graph of short run production function

Answer 7

X-axis: Number of workers
Y-axis: Output of goods

Label ‘Total product curve’ at the end of the curve

The curve reflects diminishing returns whereby as labour increases, the amount of additional output gets smaller.

Analysis of graph:
1. Output increases.
2. After a certain point, total output starts to diminish.
3. This is due to limited resources available. The firm hires more workers, quality of workers depreciate, leads to decrease in total production.

Question 8

Diminishing returns / Law of variable proportions

Answer 8

1. Law of diminishing returns, also referred to as the law of diminishing marginal returns, states that in a production process, as one input variable is increased, there will be a point at which the marginal per unit output will start to decrease, holding all other factors constant.
   > When the output from an additional unit of input leads to fall in marginal product.
   > Adding more labour can increase output but these comes a point where the marginal return will fall and might even be negative.
2. Diminishing returns to labour occurs when the marginal product of labour starts to fall.
   > meaning total output will be increasing at a decreasing rate
   > as productivity falls, the marginal cost of production will increase
3. This law only applies in the short un as in the long run, all factors are variable.

Question 9

What cause marginal products to fall?

Answer 9

1. Beyond a certain point, new workers will not have as much capital equipment to work with so it becomes diluted among a large workforce (less capital per worker).
2. Based on the table,
   > Initially, marginal product is rising, example, the 4th worker adds 26 to output and the 5th worker adds 28.
   > Marginal product then starts to fall. After the 6th worker, diminishing returns sets in, as the MP declines.
   > The 7th worker supplies 26 units and the 8th worker just added 20 units. At this point, production demonstrates diminishing returns.

Question 10

Firm

Answer 10

1. Firm is a business that hires factors of production in order to produce goods and services.
   > They organise factors of production to produce output.

Question 11

Fixed costs

Answer 11

Factors of production that cannot be changed in the short run.
> Costs that are independent of oitput in the short run.
> Costs that do not vary with the level of output.
> Can be drawn as a horizontal straight line.
> Examples: rent, offices, computers, machinery.

Question 12

Variable costs

Answer 12

1. Costs that can vary.
   > Costs that vary directly with output.
   > When production increases, so do variable costs.
   > All costs are variable in the long run.
   > Examples: raw materials or component costs, electricity, packaging and shipping.

Question 13

Short run cost function

Answer 13

X-axis: Output
Y-axis: Cost

TFC: horizontal straight line above 0
TVC: inverted ‘S’ curve start from 0
TC: inverted ‘S’ curve start from TFC

TC and TVC curves are parallel because the vertical distance between the two is the constant TFC.

Question 14

Total cost (TC)

Answer 14

Total fixed cost (TFC) ➕ Total variable cost (TVC)

Question 15

Average total cost (ATC)

Answer 15

Total cost ➗ Output

> ATC shows the cost per unit of any chosen output
Increased output will raise total costs hence ATC increases

Question 16

Average fixed costs (AFC)

Answer 16

Total fixed cost ➗ Output

Question 17

Average variable costs (AVC)

Answer 17

Total variable cost ➗ Output

Question 18

Marginal cost (MC)

Answer 18

Change in total cost ➗ Change in output

> The law of diminishing returns implies that marginal costs will rise as output increases
Diminishing marginal returns will cause marginal and average variable costs to rise

Question 19

Graph of short run cost production

Answer 19

X-axis: Output
Y-axis: Cost, $

ATC: U-shaped
> Due to interaction between AFC and AVC
> ATC = AFC + AVC

AFC: downward sloping curve at the bottom of all lines
> As output rises, AFC falls because TFC is spread over an increasing number of units

AVC: U-shaped below ATC, from far apart getting closer to ATC
> AVC is rising due to diminishing returns
> Eventually, this outweigh the effect of falling AFC, causing ATC to rise

MC: always cross AVC and ATC at their lowest point
> This is known as optimum output which is the most efficient output where unit cost is lowest
> When MC is below ATC, ATC will be falling, vice versa
> At this point, the firm is productive efficient in the short run, but most productive efficient does not mean most profitable.

Question 20

Long run production function

Answer 20

Factor A ➗ Price of factor A =
Factor B ➗ Price of factor B =
Factor C ➗ Price of factor C

Question 21

Graph of long run production curve

Answer 21

> derive from isoquant map

X-axis: Labour
Y-axi: Capital

> If a firm is using relatively less capital and labour as output increases, the firm is achieving increasing returns to scale.

Question 22

Returns to scale

Answer 22

1. Increasing returns to scale
   > Output increases at a proportionately faster rate than increase in factor inputs
2. Decreasing returns to scale
   > Factor input increases at a proportionately faster rate than increase in output

Question 23

Graph of returns to scale

Answer 23

X-axis: Input X
Y-axis: Output Y

Constant returns: Upward sloping straight line start from 0
Decreasing returns: Downward C-curve
Increasing returns: Upward C-curve

Question 24

Isocosts

Answer 24

1. Lines of constant relative costs for the factors of production.
2. Each isocost curve represents the different combinations of two inputs that a firm can buy for a given sum of money at the given price of each input
3. To set the output to produce, firms will be looking at most economically efficient or least cost process (productive efficient).
   > This can be obtained by connecting isoquants and isocosts.
   > The tangent point between isoquant and isocost gives the lowest-cost combination of inputs for firms to employ.
   > Each isocost has an identical shape.
   > Joining all the tangent points gives a long run production function.
4. In practice,
   > It is often difficult for producers to determine their isoquants as they do not have data or the experience.
   > It is assumed that in the long run, it is relatively easy to switch between factors of production.
   > Some producers may be reluctant to switch between capital and labour due to social obligation.

Question 25

Long run cost function

Answer 25

1. LRAC curve shows the least cost combination of production of any particular quantity.
   > Shape derived from a series of SRAC.
   > LRAC is a curve that is tangent to each SRAC.
   > Although LRAC shows the lowest possible average cost for each level of output, the firm is not necessarily producing at minimum point of each of its SRAC.

Question 26

Minimum efficient scale + Economies of scale

Answer 26

1. A firm is producing at its optimum output in the short run and lowest unit cost in the long run has maximised its efficiency.
2. This is known as the minimum efficient scale.
   > Firms take advantage of economies of scale.
3. Graph of economies of scale using LRAC
   X-axis: Output
   Y-axis: Unit cost
   LRAC curve
   In the middle, the line is minimum efficient scale of production (MES)
   Economies of scale on the left
   Diseconomies of scale on the right
4. Shape of LRAC can be explained by economies and diseconomies of scale.
   > Economies of scale
   » Benefits gained from falling LRAC as scale of output increases.
   » Occur when average cost (AC) decreases as a firm increases its output by increasing its size or scale.
   » Can only accrue in the long run.
   » Two types of economies of scale
   A. Internal economies of scale
   > Benefits that arise to firms as a result of its decision to produce on a larger scale.
   > If increase in output is proportional to the increase in input, the firm is experiencing constant returns to scale (minimum efficient scale of production). LRAC will be horizontal.
   > Internal economies of scale are associated with the expansion of a single firm.
   > Seven types of internal economies of scale
   » Technical economies
   » Purchasing economies
   » Marketing economies
   » Managerial economies
   » Financial economies
   » Technological economies
   » Risk-bearing economies
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   B. External economies of scale
   > Costs savings accruing to all firms in an industry as scale increases.
   > Benefits to all firms as an industry grows and develops.
   > Not directly controlled by firms.
   > Examples: availability of a pool of skilled labour, general expansion in the economic activities provide better infrastructures (road), technology.
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   > Diseconomies of scale
   » LRAC increases as the scale of output increases.
   » Most likely source of diseconomies of scale lies in the problems of management coordination of large complex organisations and the effect that size and poor communication have on the morale of the workforce.
   > Another example of diseconomies of scale is where workers may feel a lack of motivation due to the repetitive nature of the work.
   > Two types of diseconomies of scale
   A. Internal diseconomies of scale
   > Excessive concentration of economic activities in a narrow geographical location.
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   B. External diseconomies of scale
   > Traffic congestion which increases distribution costs
   > Land shortages and therefore rising fixed costs
   > Shortages of skilled labour and therefore rising variable costs

Question 27

Limitations of economies of scale

Answer 27

1. When a firm expands its output too much and leads to rising unit cost, firms begin to experience diseconomies of scale.
   > Examples: problems with coordinating large organisations, traffic congestion, land shortages that lead to increase in fixed cost, shortages of skilled labour increase variable cost.

Question 28

Revenue

Answer 28

1. Income generated from the sale of goods and services in a market.
2. Total revenue for the firm = Total expenditure from the consumer
3. Total revenue (TR) = Price (P) ✖️ Quantity (Q)

Question 29

Average revenue

Answer 29

1. Total revenue (TR) ➗ Output (Q)
2. As output increases, the average revenue (AR) curve slopes downwards.
   > Hence, AR curve is also the firm’s demand curve.
   > To increase sales (Q), firms need to lower price (P) (law of demand).

Question 30

Marginal revenue

Answer 30

1. The additional revenue received by a firm if it sells an additional unit of output.
2. Change in total revenue ➗ One extra unit output

Question 31

Revenue curve

Answer 31

X-axis: Quantity
Y-axis: Price

D=AR
MR - downwards sloping, more stiff than D=AR
TR: start from 0 and bend downwards

1. Because firms can only sell more by reducing price, it follows that value for MR will always be lower than AR.

Question 32

Fully competitive market

Answer 32

1. Firm has no control over the price of its goods.
2. The firm is a price taker.
3. The firm’s demand curve will be horizontal and its revenue will depend entirely on the amount of goods sold.
4. D = AR = MR

Question 33

Monopoly market

Answer 33

1. The firm is a price maker.
2. If the firm chooses to increase output, the price will fall. If it decides to reduce output, the price is expected to increase.
3. As output changes, so do price and revenue.
4. The extent of the change in revenue will depend on the price elasticity of demand.
5. Marginal revenue will always be below average revenue since the firm can only sell more goods by reducing prices.

Question 34

Profit

Answer 34

1. Difference between total revenue and total cost.
   > Profit = TR - TC
2. Profit measures the return to risk when committing scarce resources to a market or industry.
3. A firm will make the most profit (maximum profit) when the difference between total revenue and total cost is greatest.

Question 35

Three stages of profit

Answer 35

1. Normal profit is the cost of production that is sufficient for a firm to keep operating in a particular industry.
   > Rate of return that a firm needs to remain in business.
   > Represents the opportunity cost of the risk of being in business.
   > A firm in a perfectly competitive market requires normal profit to stay in the market. This is therefore the opportunity cost if a firm takes up the best alternative.
   > When TR = TC, the entrepreneur is earning normal profit.
   » Economic profit is zero (0).
2. Abnormal profit (supernormal profit) is the profit that is earned above normal profit.
   > This is what motivates firms to take risks.
   > Supernormal profit = Total profit - Normal profit
   > Earned when TR > TC.
   » Economic profit is positive.
   > Where supernormal profits are being earned, this is a signal for more firms to enter a market.
3. Subnormal profit is when the profit that is earned by a firm is less then normal profit,
   > If a firm is making subnormal profit, then it may decide to withdraw from the market in the long run.
   > In the short run, a firm may choose to remain in business even if it is not covering its opportunity cost, provided its revenue are covering its variable costs.
   > It is better off remaining in business and paying its fixed cost debt then exiting the market and lose out all the fixed cost.