Chapter 3 - Buisness Economics
Production and Productivity
Production means manufacturing something in order to sell it
Production involves converting inputs (factors of production) into outputs
Productivity is the output per factor employed
Productivity is a way to measure how efficient a company or economy is
Productivity is defined as the output per input employed
If one company uses the same inputs but produce more outputs, this company is more productive
The main way companies use productivity is by calculating labour productivity
Labour productivity is the output produced per worker
This can be calculated by taking the overall output divided by the total number of workers
Labour productivity can be improved by introducing better training, more experience, improving technology or specialisation
Specialization
Division of labour is a type of specialisation where a task is split between into smaller tasks where workers are allocated to each task
Advantages of specialisation:
People can specialise in the things that they are best at which could lead to better quality and higher quantity of products being produced (increased labour productivity)
Specialisation helps firms achieve economies of scale
Specialisation allows production to become efficient, which helps tackle the issue of scarcity as resources are being used more efficiently, therefore more output can be produced per unit of input
Training costs are brought down as workers are only trained to do specific tasks
Disadvantages of specialisation:
Workers will start to get bored after doing the same task over and over, which could start strikes within the workforce
Counties can become less self-sufficient. For example if a country is specialised in producing cars, they would have to depend on another country to supply things like fuel. If the country has a fall out with the fuel supplier, this could cause issues like hyperinflation of the price of fuel or wars with the other country.
It can cause lack of flexibility, so if a worker has been trained to do a specific task, and then must move to another firm, the worker will not be able to transfer their skills effectively
The Costs of a Firm
A firm is any business organisation
An industry is all the firms providing similar goods or services
A market contains all the firms supplying a particular good or service and the firms or people buying it
Firms generate a revenue by selling their outputs
Producing this output uses factors of production
The profit a firm makes is its total revenue minus its total costs
In the long run, firms must make profit to survive
In economics, the cost of production also includes opportunity cost
The opportunity cost of a factor of production is the money that could have gone into the next best use. For example if you run a business, the opportunity cost for your labour would be the income that could've been earnt if you were doing other work
The short run is a period of time where at least one of a firm's factors of production is the fixed
The long run is a period of time where all the factors of production can be varied
In the short run, costs can be either fixed or variable
Fixed costs are costs that don't change with with the level of output - they must be paid whether a firm produces no outputs or 100 outputs
Variable costs are costs that do vary with the level of output so as output increases, so does the variable cost
In the long run, all costs are variable
Marginal cost is the cost of increasing output by one unit
Marginal cost is calculated by doing the change in total cost / change in quantity
The lowest average cost occurs when marginal cost equals average cost
Marginal cost initially decreases as output increases, but starts increasing due to the law of diminishing returns
When marginal cost is lower than the average cost, the average cost will be decreasing because every extra unit produced will decrease the average cost
When marginal cost is higher than average cost, the average cost will increase as every extra unit produced increases average cost
This means that average cost will be lowest at MC = AC, which is the point of productive efficiency
This is also the same pattern with average variable cost as marginal cost is made up from variable costs because fixed cost does not change
In the short run, AVC and AC curves form a U shape
Average fixed cost falls as output rises because total fixed cost is spread across the greater output
The Law of Diminishing Returns
When you increase a variable factor by one while the other factors stay fixed, the extra output is called the marginal product
Initially if you add more of a factor of production, the marginal product will increase, but at a certain point, marginal product will start to decrease with every unit of input increased due to the other fixed factors of production staying the same
This point is called the point of diminishing returns
The law of diminishing returns states that if one factor of production is increased while other factors stay fixed, eventually the marginal returns from the variable factor will begin to decrease
As marginal returns rise, marginal cost falls, and vice versa
Marginal cost will rise as marginal returns fall as you are getting less additional output from each unit of input, so the cost per unit of that output will be greater
Long Run Average Cost
When a firm changes all its factors of production, it is in the long run and can move onto another short run curve
The minimum possible average cost at each level of output is shown by a long run average cost curve
Average cost falls as output increases when a firm is experiencing economies of scale and increases when a firm is experiencing diseconomies of scale
Returns to Scale
Increasing returns to scale is when the increase of all the factor inputs leads to more than proportional increase in output
Constant returns to scale is when the increase of all the factor inputs leads to a proportional increase in output
Decreasing returns to scale is when the increase of all the factor inputs leads to less than proportional increase in output
When RTS increases , LRAC decreases
The Revenue of a Firm
Average revenue is equal to total revenue / quantity, which is also equal to price, therefore the average revenue and demand curve are the same
Marginal revenue is the extra revenue received as after selling the final outputs
On a downward sloping demand curve, TR is maximised when PED = -1, which is the midpoint of the demand curve
The midpoint of the AR curve is when MR is equal to 0
This is the point where additional sales reduce total revenue and marginal revenue becomes negative
Profit
In economics, there is two types of profit; normal profit and supernormal profit
Normal profit occurs when TR = TC
Supernormal profit occurs when TR > TC
Normal profit is an economic profit of zero as the company will still be making accounting profit to stay afloat, but as we take opportunity cost into account, TR will equal TC
Normal profit is the minimum level of profit needed to keep resources in their current use in the long run
If a firm can’t make normal profit, it will close in the long term, as its revenue is not covering all of its costs
The point where a firm's average revenue is lower than its average variable cost (on the diagram revenue will be lower than the point where MC = AVC) it would shut down
In the long run, if the firm's revenue is less than point of normal profit (on the diagram revenue will be lower than MC = ATC) it would shut down
If a firm’s revenue is between these two points, it should continue to produce in the short run
Profits are maximised when MC = MR
This is because if MR > MC, the firm should continue to increase output as revenue gained by increasing outputs is greater than the cost of producing it, so increasing outputs adds to the profit
If MC > MR, the firm should decrease the level of output as revenue gained by increasing outputs is less than the cost of producing it, so decreasing outputs adds to the profit
The Objectives of Firms
Profit maximisation is assumed to be the objective of a firm
A firm would want to maximise profits so it can reinvest the profit, so they can make use of financial economies of scale and to pay dividends
Revenue maximisation (MR = 0) is another objective of a firm where the firm tries to maximise its revenue and continue producing outputs past the point where profit is maximised
Reasons a firm might want to focus on revenue maximisation is so it can make use of economies of scale
Sales maximisation (AR = AC) is another objective which is done to increase market share or to keep other businesses out of the market
Profit satisficing is another objective where the firm sacrifice profits to satisfy as many key stakeholders as possible