Production, Costs, and Revenue

The four functions of money

A medium of exchange

A measure of value

A store of value

A method of deferred payment

Marginal returns

The extra output gained from one extra unit of input

Total returns

The overall output obtained from a given level of input

Average returns

The total output / the total input

(A measure of efficiency or productivity)

The Law of Diminishing Marginal Returns (+ diagram) (short run)

As more of a variable factor of production (e.g. labour) is added to fixed factors (e.g. capital):

• initially there will be an increase in productivity

• then there will be a decrease in productivity

Returns to scale (long run)

How changing the quantity of inputs affects the quantity of outputs (i.e. does increasing the inputs give a larger than proportional return in quantity of output)

Fixed costs

Costs that do not change as the level of output changes (e.g. salaries)

Variable costs

Costs that vary directly with output (e.g. raw material costs)
All costs are variable in the long run.

Total costs

The sum of fixed and variable costs

Short run cost curve

AFC (the difference between AC and AVC) decreases as quantity increases.

Marginal costs decrease initially as additional workers are added and marginal product is rising.

Diminishing returns begin when the MC starts to increase.

MC crosses AVC and AC at their lowest points.

Economies of scale

As a firm increases its scale of output, average costs continue to decrease, helping larger firms achieve lower costs of production.

Diseconomies of scale

As a firm continues to increase its scale of output, it will reach a point where average costs begin to increase.

Types of internal economies of scale (within the firm)

Financial - larger firms receive lower interest rates lowering AC.

Managerial - Larger firms can employ specialist managers who are more efficient.

Marketing - Large firms spread the cost of advertising over a larger number of sales.

Purchasing - Occurs when large firms buy raw materials in greater volumes and receive a bulk discount.

Technical - Machinery operates at a higher level of capacity, spreading the cost of the machinery over more units.

Risk bearing - when a firm is able to spread the risk of failure over more products.

External economies of scale (when there is an increase in the size of the industry)

Geographic cluster - ancillary firms move closer to major manufacturers, cutting costs and generating more business.

Transport links - lower transport costs of labour and goods.

Skilled labour - the larger the pool of skilled labour (due to a geographic cluster), the lower the cost of the labour.

Favourable legislation - governments support certain industries to achieve wider objectives.

Types of diseconomies of scale

Management - when managers work more in the their own interest than in the interest of the firm.

Communication - When a firm has multiple layers of management - slow comms.

Geographical - widespread firm leads to logistical and communication challenges.

Increasing and decreasing returns to scale

Each new SRAC curve represents growth (e.g. a new factory)

Marginal Revenue

The extra revenue received from the sale of an additional unit of output.

AR, MR and TR in a perfectly competitive market

The firm is a price taker at P1.

AR, MR and TR in imperfect competition

The firm is a price maker

In order to sell and additional unit of output, the price (AR) must be lowered.

The gradient of the MR is twice as steep as the AR.

TR is maximised when MR = 0

Explicit costs

Costs that have to be paid.

Implicit costs

The opportunity costs of production.

Normal and Supernormal Profit

Normal - when TR = TC, or breakeven

Supernormal - when TR > TC

The role’s of profit in a market economy

• Incentive for innovation and entrepreneurship

• Allocation of resources

• Competition

• Economic growth

• Wealth creation

How is profit an incentive for innovation and entrepreneurship?

Profit serves as the reward for taking a risk to start a business/ develop new products/services.

Encourages innovation leading to economic growth and improved living standards.

How does profit allocate resources?

Serves as a signal for resource allocation.

When a business is earning profit it signals that there is consumer demand for those products, leading to more resources being allocated to that area.

How does profit drive competition?

Profit serves as a measure of business success and efficiency.

Firms always strive to maximise profit.

This benefits consumers as they experience better products at lower prices.

How does profit drive economic growth?

Profit is reinvested into expanding operations, research and development, and hiring more workers.

This stimulates economic growth, creates jobs, and generates technological advancements.

How does profit create wealth?

Profits are reinvested or distributed to shareholders as dividends or to employees as bonuses. This creates wealth for those parties.