3. Production, costs and revenue

production converts inputs into...

production converts inputs into...

outputs

inputs are..

factors of production

outputs are...

goods and services

Productivity is...

how efficiently we use inputs to produce outputs

What is the short run?

a period of time during which at least one factor of production is fixed (e.g. land or capital)

What is the long run?

a period of time where it is possible for firms to vary all factors of production

What are the short-run costs firms face?

Fixed and Variable Costs

Fixed costs

cost that do not vary with output

Variable costs

costs that vary directly with output.

Example of fixed costs

rent (e.g. land), interest on loans, insurance costs etc.

Example of variable costs

raw materials and some labour costs if they are paid per unit of output produced

Total Costs =

Fixed Costs + Variable Costs

Average Fixed Cost (AFC) =

TFC / Q

Average Variable Cost (AVC) =

TVC / Q

Average Total Cost (ATC) =

TC / Q

Marginal revenue (MR)=

ΔTR/ ΔQ

The relationship between ATC and MC

If the marginal is below the average, the average falls and if the marginal is above the average the average rises

Total revenue is...

the total amount of money that a firm receives from selling a certain amount of a good or service in a given period of time.

Average revenue is...

the revenue a firm receives per unit of its sales.

Marginal revenue is...

the extra revenue that a firm gains when it sels one more unit of a product in a given time period.

labour productivity is…

the output per worker

capital productivity is…

output per unit of capital

productivity gap

the difference between labour productivity in the UK and in other developed economies

specialisation

a worker only performing one task or a narrow range of tasks. Also, different firms specialising in producing different goods or services.

division of labour

this concept goes hand in hand with specialisation. Different workers perform different tasks in the course of producing a good or service.

trade

the buying and selling of goods and services exchange

exchange

to give something in return for something else received. Money is a medium of exchange.

short run costs is…

a period of time during which at least one factor of production is fixed (for example land or capital) whereas in the long-run it is possible for firms to vary all factors of production.

fixed costs

These are costs that do not vary with output.

Total Costs =

Fixed Costs + Variable Costs

Average Fixed Costs (AFC) =

TFC / Q

Average Variable Costs (AVC) =

TVC / Q

Average Total Cost (ATC) =

TC / Q

Marginal Cost (MC) =

∆ TC / ∆Q

TR =

P x Q

Average Revenue

This is the revenue a firm receives per unit of its sales.

AR =

TR/Q or P

MR =

ΔTR/ΔQ

Relationship between MR and TR

When MR is positive and falling the TR is rising at a decreasing rate

When MR is a negative and falling the TR is falling

When the MR is zero, TR is a maximum

Economic Profits are…

the difference between total revenues and the total economic costs of production

In the long run…

all factors of production are variable and therefore all costs are variable

Economies of Scale

an increase in inputs leads to a % increase in output with the result that the long-run average cost falls

Constant Returns to Scale

an increase in inputs leads to same % increase in output with the result that the long-run average remain the same

Diseconomies of Scale

an increase in inputs leads to a smaller % increase in output with the result that the long-run average cost rises.

The minimum efficient scale is…

the scale of output where internal economies of scale have been fully exploited and the LRAC is at a minimum

If the MES is small relative to the total market size…

then a number of small firms can exist and be considered efficient

MES - Natural Monopoly

This is when the MES is extremely high compared to the market size and it is likely that only one firm can exist

Internal Economies of Scale

refer to cost savings made by an individual firm as they expand their scale of production. (They are only experienced by the individual firm who is expanding). They result in a movement along the LRAC curve.

External economies of scale

• occur outside a firm but within an industry - they arise from the growth of an industry.

• costs which are outside the control of a single firm and result of the growth of a specific industry.

Types of Internal economies of scale

• Technical economies of scale

• Managerial economies of scale

• Marketing/Purchasing economies of scale*

• Financial economies of scale

• Risk-bearing economies of scale

Technical economies of scale

• These are cost savings that result from changes in the production process as the firm grows in size.

• Large firms can employ the division of labour which increases productivity and lowers average costs.

• Large firms can employ specialist machines which can produce more in a given period of time and at lower cost.

Managerial economies of scale

A large firm can afford to employ specialist managers who can perform their tasks more efficiently.  For example an accounts manager, marketing specialist, production manager.  In a small form all these tasks may need to be performed by one person.

Marketing economies of scale

• These are cost savings that result from the ways in which firms buy materials and sell their products.

• A large firm can buy in bulk and therefore obtain goods at lower cost per unit.

• A large firm can afford to employ specialist buyers who can obtain goods at lower cost.

• A large firm can launch a very large advertising campaign because the cost per unit of the campaign is lower due to higher levels of output.

Financial economies of scale

• These are cost savings as a result of the way in which large firms raise money.

• A large firm may be able to sell shares on the stock exchange and this can be cheaper than borrowing money from a bank.

• A large firm has more buildings and machines to offer as security to the bank (collateral) so the banks are more likely to lend them money.

• A large firm can be less risky and therefore borrow money at lower rates of interest.

Risk-bearing economies of scale

• Large firms can overcome the risks associated with production in many ways and therefore maintain high levels of output which can reduce the costs per unit of output.

• Large firms buy from many suppliers so if one source of raw materials fails they have others to rely on.

• Large firms sell a variety of products, in a variety of markets (home and overseas) so if the demand falls for one product they have revenue from the others to rely on.

What are the benefits in terms of lowering average costs of the development of these specialist areas?

• Access to skilled labour - lowers training costs + this can come from other tech companies and/or the university.

• Research

• Transport Infrastructure

• Suppliers/Firms that provide services to the business will locate in the are which reduces the cost of accessing these services + the speed at which they are available

• Sharing of ideas - often workers move from one company to another and start to form networks in a particular area which facilitates the sharing of ideas.

How can a firm reduce the average costs of production as a result of producing a range of products ? (Like Amazon)

They have a huge output; risk-bearing

These business can use one finance, marketing, technology department. Can spread the costs over many different products. Even the packaging can be versatile.

Internal diseconomies of scale involve …

either technical constraints on the production process that the firm uses or organizational issues that increase costs or waste resources without any change to the physical production process.

External diseconomies of scale are…

costs which are outside the control of a single firm and result of the growth of a specific industry

An internal economy of scale measures …

a company's efficiency of production. That efficiency is attained as the company improves output when the average cost per product drops.