Scholarship Economics – Comprehensive Notes

turn these into key notes and graphs: Micro concepts with graphs:

• marginal utility and demand ✓✓

• diminishing returns and supply

• elasticity of demand ✓✓

• elasticity of supply ✓✓

• market structures (excluding perfect competition and monopoly)

• role of prices and profits in determining resource allocation.

Diminishing returns and supply:

• Law of diminishing returns

• Types of costs of firms – TC, AC, VC, FC,MC

• Short run and long run

• Economies of scale.

Costs

• Fixed costs are costs that do not vary with output [ short run situation]

• Variable costs are costs that change as output increases / decreases

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• Businesses aiming to make profits need to have an indication of the marginal cost of supplying extra output. They can make higher profits providing the marginal cost is less than the marginal revenue.

• If the marginal cost of increasing output is low, then a firm might benefit from expanding their production because it will lead to a fall in the average (or unit) cost of supply.

• Many firms engaged in mass production do not change their output in single units. They might produce “batches” of extra output e.g. by adding more shifts to their factory production.

Law of diminishing returns

• In the Short Run some inputs are fixed while others can be varied

• To increase output, a firm must increase the variable inputs

• Initially a firm may benefit from more efficient combinations of fixed and variable resources – increasing returns

• Eventually as firms increase production, the fixed inputs will become scarce in relation to the variable input. As the additional variable inputs have less access to the fixed inputs the extra output will begin to decrease – diminishing returns

• Example: in a bakery with 1 oven, increasing the number of bakers will mean each new baker has less access to the oven, and will be able to contribute less extra bread

Diminishing returns cost and supply

• As additional inputs cost the same, but contribute less extra output, the cost of that extra output (Marginal Cost MC) will increase

• Firms will supply up to the output where P=MC, but not beyond it as they would incur a loss

• If price increases, the firm will be able to increase production as the higher price will cover the higher MC, until the output where P=MC is reached. This underlies the Law of Supply

Diminishing returns

The law of diminishing returns states that where additional units of a variable input are added to a fixed amount of another input, the additional output, or marginal product, will eventually fall.

Diminishing marginal returns mean that the marginal product of a variable factor is declining. Output is still increasing as the variable factor is increased, but it is increasing by smaller and smaller amounts.

Total Product (TP) or (Q), Average Product (AP) &Marginal Product (MP)

• Total Product (TP)is the total output produced

• Marginal Product of labour is the additional output that one additional unit of labour produces.

• Average Product is the amount produced by each unit of variable factor in this case labour.

•

• In the example, the cement mixer is the fixed factor and even though more bricklayers are hired, the firm will find that it is progressively more difficult to increase its output as it approaches capacity production ( at 4 bricklayers).

•

Production and costs

Setting up a business is not an easy task. Whether you want to make laptops, bracelets or bread, there are some key decisions you need to make as an entrepreneur: what are you going to produce? How much of it? How many people will you employ? How much is it going to cost you?

Similar issues of production and costs take place in a classroom. If your school pays your best teacher to teach a class of only 3 students, it is wasting money: output (the number of students learning Economics) could be increased e.g. to 10 and the lesson would still be good! However, with 25 students, the teacher is being overburdened and each student will learn proportionately less. Should the school pay for a second teacher and form another class? These are very similar questions to those you will encounter in this section.

Production and output

Let’s start from the concepts of output (or product) in the short run.

Important

The short run in microeconomics is defined as the period of time when at least one of the factors of production (land, labour, capital, entrepreneurship) is fixed.

Imagine that you have a small bakery. On your own, you manage to bake 100 loaves of bread per day – your total output (TO). You would however be able to bake more, had it not been for the fact that you also have to sell them and do the dishes. You therefore decide to hire your friend Adam. Adam is very charismatic and friendly, and you therefore let him do the selling. Now, you are in fact able to bake and sell 250 loaves of bread every day. Your average output (AO) is 125. The dishes are still yours to do though, and you therefore decide to hire Beatrice, another friend. Because the three of you divide the chores between yourselves so as to maximise efficiency, you are able to bake 500 loaves of bread per day!

Feeling the need to increase output even further, you hire a third friend to help you with the baking. Output now increases to 600 loaves of bread per day. The marginal output (MO) of your third friend is 100. You realise that you and your friend run in each other's way every now and then - after all, it is a rather small bakery. When you hire yet another friend, output increases to 650, and when you hire another person still, you, in fact, find that this person has to remain in the corner the whole day so as not to block anyone else.

The situation you are experiencing in your bakery can be shown on the following table:

Number of workers Total Output Marginal Output Average Output

(per worker)

0 0 0 0

1 100 100 - 0 = 100 100 / 1 = 100

2 250 250 - 100 = 150 250 / 2 = 125

3 500 500 - 250 = 250 500 / 3 = 167

4 600 600 - 500 = 100 600 / 4 = 150

5 650 650 - 600 = 50 650 / 5 = 130

6 650 650 - 650 = 0 650 / 6 = 108

The law of diminishing marginal returns

What you experience in your bakery is the law of diminishing marginal returns. While you can add more employees, the fact that one of the factors of production is fixed, in this case capital (i.e. the size of the shop), means that you will experience a drop in marginal output. That is, you will experience a drop in the output added by the extra worker, as we move from 3 to 4 workers.

It is at this point that marginal output starts to decrease: the factors of production are no longer in perfect proportions to each other, and the result is that we do not make full use of each worker's capacity. In order to do so, we need to change another factor of production as well (e.g. capital: if we expand our shop so that workers do not step on each other’s feet!).

The data from our bakery example has also been plotted in the diagram to the right. An important point to remember when drawing these diagrams is that Average Output (AO) will continue to increase when MO>AO. Only when MO<AO will average output start to fall. It follows then that the MO curve always cuts the AO curve at the latter's point of inflexion (i.e. at the highest point of AO).

So, to sum up:

Important

· Average output is the total output divided by the number of workers employed.

· Marginal output is the extra output that an additional worker produces. The MO curve intersects the AO curve at its highest point.

· The law of diminishing marginal returns says that as a firm adds more and more units of a variable factor (e.g. labour) to a fixed factor (e.g. capital) in the short run, there is a point beyond which the total output will continue to rise but at a diminishing rate (i.e. the marginal output begins to decline).

Different types of costs

We can use the same example as above in order to better understand how costs work. You are still in the bakery, and you have figured out that you should hire 4 workers to produce efficiently. You are now interested in costs. The rent you pay to the landlord is a fixed cost (FC): it is always the same for example, $200, every week.

Important

Fixed costs are costs that are independent of the number of units produced.

In addition to fixed costs, you have to pay for other bills as they come through: electricity bills, flour for the bread, wages paid to the staff who works in the bakery etc. These are variable costs (VC). Variable costs increase as your production increases.

Revisiting the table of costs from the section above, For example, if you double the production of bread from 250 to 500 loaves of bread, your VC will increase from $ 150 to $ 200. However, when you try to increase production from 500 to 600 loaves of bread, your VC would go up from $ 200 to $ 400. This is because your old oven is not big enough to bake 600 loafs and it needs to be fixed constantly by the technician.

Important

Variable costs are costs that change with the number of units produced.

The sum of fixed and variable costs at each level of output gives you the total cost (TC = FC + VC). When we divide the total cost by the quantity produced, we find the average total cost (ATC) for producing X loaves of bread.

Finally, we want to know what the cost of producing an extra loaf of bread is. You can simply calculate this by seeing how much is your total cost going up for every extra loaf you make. For example, when you increase production from 100 to 250 loaves (150 more), your total cost goes up by 50. Hence the cost of producing an extra loaf of bread is $50/150 = $ 0.33. This is the marginal cost (MC).

The costs of your bakery can be written in a table to summarise our example as follows:

Output, q (loaves of bread) Fixed Cost, FC ($) Variable Cost, VC ($) Total Cost, TC ($) [FC + VC] Average Cost ($) [TC / q] Marginal Cost ($)

0 200 0 200 - -

100 200 100 300 3 1

250 200 150 350 1.40 0.3

500 200 200 400 0.80 0.20

600 200 400 600 1 2

650 200 700 900 1.40 6

We can plot the following diagrams to represent cost curves in the short run.

In the first one, we show how total cost is the sum of variable costs and fixed costs. As in our example, variable costs increase at a slower rate as production increases, but then start increasing at a faster rate again. This will happen when you make more bread from the same oven, but then it will break down very often if it never rests! Because total costs are the sum of fixed and variable costs, they will follow the same pattern: grow slowly up to $ 400, and then increase rapidly beyond that cost.

In the second diagram, we plot average and marginal cost curves from our example. We now know from the table above that the MC represents the cost of producing an additional unit. Thus our initial cost per loaf of bread is $ 1. However, when we manage our workers and our oven more efficiently, we can lower the cost of producing bread to $0.2 per loaf. However, when we try to produce more, each additional loaf will start becoming more expensive to make – even as high as $ 6!

Another important point to remember when drawing these diagrams is that ATC will continue to decrease when MC < ATC. But when MC > ATC average costs will begin to rise. It follows then that the MC curve always cuts the ATC curve at the lowest point!

You will have realised that the cost curves mirror the output curves, for a simple reason: it is, again, because of the law of diminishing returns! We saw that bread per worker starts decreasing when diminishing returns kicks in. Then it is only logical that costs per loaf of bread should also start rising beyond a certain point. The rise in costs per unit of output is, in our case, a consequence of overusing our oven.

Economies and diseconomies of scale

However, the law of diminishing returns only applies in the short run, when a factor of production is fixed. We can now see what happens in the long-run.

Important

The long-run is defined as the period of time when all factors of production are variable.

The definition tells us that in the long run we can overcome diminishing returns, for example by buying a new oven. This way, the average output per unit of input will continue to rise as output rises. This also means then that the average cost will fall as total output increases. When this happens, we are enjoying economies of scale in our bakery.

Important

Economies of scale is defined as the long run decrease in average total cost when total output increases. It is explained by increasing returns to scale – when the percentage increase in output is greater than the percentage increase in all inputs.

Economies of scale is yet another very important economic concept. It is one of the main reasons why firms wish to grow and expand production. This is, partly because the fixed costs are distributed over a greater output and partly because of increasing returns to scale. For example, rather than having one worker in the bakery producing 100 loaves of bread, two workers can produce 250 loaves of bread in the same shop; likewise, we can produce 500 loaves in our oven, instead of 250, using the same amount of energy.

In general, the most common reasons for economies of scale to occur are:

· Specialisation – workers learn a specific task and perform it more efficiently; if you only have to focus on placing fresh loaves in the window of your shop, you will become very good at it.

· Efficiency – machines are used at their full potential; we should fill up our oven before turning it on.

· Marketing – brands are established and customers become loyal; the more people appreciate your bakery, the more they will tell their friends how good it is. Without having to change production styles, we can sell more with a bit of marketing.

· Indivisibilities – large plants can only work if large volumes of output are produced; while this is not the case of our bakery, there are many examples of indivisibilities in bigger factories: would you set up a factory only to produce 2 cars per day? No, because the process of car production is indivisible from large-scale production processes.

It is however also possible that a firm might experience diseconomies of scale, i.e. that average total cost increases as output increases. This is the case of our bakery too. Look at the cost table again. As we increase production from 600 to 650 loaves, total costs rise sharply to $ 900. This may occur due to a lack of coordination between workers in the bakery: there is so much to do, that you and your friends start panicking! Also, communication may become difficult as too many customers are placing their orders for bread. Some of your workers could feel frustrated by the whole situations and start working less efficiently.

Important

We say that diseconomies of scale take place because of decreasing returns to scale – when the percentage increase in output is less than the percentage increase in all inputs.

Short-run vs. Long-run distinction

When comparing and discussing short-run and long-run costs in an exam situation, it is often very useful to make use of the diagrams below.

The first diagram shows the standard short-run situation one more time: average cost (in red) first declines and then starts rising again because of diminishing returns. Marginal cost (in blue) also declines as we increase production, but then starts rising and cuts the ATC curve at its lowest point.

The second diagram shows that there are a number of short-run average cost curves (SRAC1, SRAC2 etc) on the single long-run average cost curve (LRAC). In the short-run, at least one factor of production is fixed (e.g. capital, so we can't expand our shop, or we can’t buy a new oven).

As soon as we change the factor of production that was previously fixed, we move on to a new short-run average cost curve - that is, when we change a previously fixed factor of production, we start another short run! When we do this, long-run average cost will first fall (economies of scale) and, after reaching a minimum point, will start to rise again (diseconomies of scale).

Be Aware

You should now be able to distinguish between the law of diminishing returns (which models the shape of the cost curves in the short run) and economies/diseconomies of scale (which model the shape of the cost curves in the long-run).

What you should know

· The short run is defined as the period of time when at least one of the factors of production is fixed.

· Total cost is the sum of total fixed costs and total variable costs.

· Average cost is total cost divided by output.

· Marginal cost is the cost of an additional unit of output. The MC curve intersects the AC curve at its lowest point.

· The long run is defined as the period of time when all factors of production are variable.

· Firms experience economies of scale due to increasing returns – that is, as production increases, average cost decreases as firms gain efficiency.

· However, after a certain level of output, diseconomies of scale kick in – the more it is produced, the higher the average cost, because certain inefficiencies (e.g. coordination) cannot be overcome.

· This behaviour is shown by the U-shaped curve of the short-run average cost.

Law of diminishing returns: additional units of variable input added to fixed amount of another input, the additional output will fall

Short run concept: when at least one input in production process is fixed. All short run production is subjected to law of diminishing return

Long run: all factors of production are variable, needed for firm or industry to increase fixed factors of production

Economies of scale: when firms increases use of fixed factors, output increase proportionately higher rate than the increase in cost per unit - the firm receives increased output per unit of input

Diseconomies of scale: cause large firms to produce goods and services at increase per unit cost - the firm could be so large that makes it hard to manage, resulting in lost opportunities, lacks competition so not incentive to improve efficiency

Explanation

The central theme in SR costs is productive efficiency. The AC fall at first and then rise in accordance to diminishing returns. Optimum productive efficiency exists when AC is at the lowest point.

In the LR all factors of production can be adjusted and increase output at a proportionately higher rate than costs.

The SRAC curves show how additional (fixed)factors lift the constraints of the SR, and assuming any and all additional capital is variable in the long run, there is an infinite array of SRAC curves.

The SR curves are enveloped by the LR curve or the LR curve is made up of the tangential points of an infinite array of SRAC curves.

1. For what reasons might internal economies of scale exist?

2. Using diagrams, explain carefully the difference between diminishing returns and diseconomies of scale.

3. Why is AC used as a measure of productive efficiency? Why not MC?

• When fixed costs increase less than output, then LRAC falls. Spreading administrative and marketing costs, bulk-buying benefits, financial benefits, division of labour, specialisation, etc are examples of how internal economies of scale is achieved.

Diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. Economies of scale refers to the long-run average cost curve where all inputs are being allowed to increase together.

Answer 3

• Average costs show how well all factors of production are being used – both fixed and variable. Marginal costs only show the cost of producing the last unit.

• Profit maximisation,

• Standard economic theory of firm assumes rational producer behaviour. Firms are guided by goal of PROFIT MAXIMISATION

• The objective of profit maximisation is to make the difference between revenues and costs as large as possible so as to make profit as large as possible.

Total Revenue – Total Costs = Profit.

Profit maximization (Revenue is greater than costs)

A firm will produce at the point (or profit maximisation point) where MC = MR.

There are many advantages of firms trying to maximise profits. First, maximum profits mean that the owners or shareholders get the most back on their original investment. It is entrepreneurs that are rewarded with profits. Second, firms can use these profits to fund research and development, thereby securing a place in the market. Third, maximising profits is a very clear goal for employees and managers, targets can be set and wages can be tied to profits as an extra incentive.

•

• Revenue Maximisation,

• A firm which attempt to sell at a price which achieves the greatest sales revenue. Sales are pushed up to the point where MR = 0. The output is set higher than under profit maximisation.

The revenue maximising the level of output is found at the point where the marginal revenue cuts the x-axis or where MR = 0.

• Sales maximisation,

MR=0

A business might also aim to maximise sales revenue rather than profits because it wishes to deter the profitable entry of new firms / rivals into an industry

If a firm decides to aim to maximise sales revenue rather than profits, one consequence can be a reduction in the price of the firm’s shares since operating profit is likely to be lower

• means achieving the highest possible sales volume, without making a loss. To the right of Q, the firm will make a loss, and to the left of Q sales are not maximised. AC=AR

•

• Sales maximisation is used to build up market Share.

• Firms may use loss leaders or specials (selling at or below cost) to attract customers who purchase other full-priced goods eg. Supermarkets and Cinemas.

• Increased market share may prevent potential competitors entering market or even eliminate existing ones.

• Changes in output allow economics of scale to be used. Also they may allow different – more efficient business structures, techniques and use of capital goods not economical efficient at lower levels of output.

• Creates brand awareness – particularly important for new entrants in a market. Firms wanting to gain more sales and therefore gain more brand loyalty compared to its competitors.

AC=AR

•

• Satisficing,

• being satisfied with a lower level of profits as the goal is not about profit.

- could be for self development

• pursue of an individual’s business / passion

• satisfaction of providing a good which the producer feels society will benefit

• A pure profit may upset the stakeholders in the community.

• Corporate social responsibility (CSR)

• Many firms are increasingly recognizing that the pursuit of self-interest does not necessarily need to exclude social engagement. For instance reducing pollution, supporting human rights, avoiding investments in politically-oppressive regimes, making donations to charities, etc.

• firms should and will take the responsibility to look after their local community and the environment

• Pursuing corporate social responsibility may involve making some less cost-effective decisions such as choosing more expensive, but more environmentally friendly equipment, installing devices that will reduce carbon emissions, and have a mind on how wasteful their business is.

• Profit maximisation,

• Standard economic theory of firm assumes rational producer behaviour. Firms are guided by goal of PROFIT MAXIMISATION

• The objective of profit maximisation is to make the difference between revenues and costs as large as possible so as to make profit as large as possible.

Total Revenue – Total Costs = Profit.

Profit maximization (Revenue is greater than costs)

A firm will produce at the point (or profit maximisation point) where MC = MR.

•

• Revenue Maximisation,

• A firm which attempt to sell at a price which achieves the greatest sales revenue. Sales are pushed up to the point where MR = 0. The output is set higher than under profit maximisation.

The revenue maximising the level of output is found at the point where the marginal revenue cuts the x-axis or where MR = 0.

• Sales maximisation,

MR=0

A business might also aim to maximise sales revenue rather than profits because it wishes to deter the profitable entry of new firms / rivals into an industry

If a firm decides to aim to maximise sales revenue rather than profits, one consequence can be a reduction in the price of the firm’s shares since operating profit is likely to be lower

• means achieving the highest possible sales volume, without making a loss. To the right of Q, the firm will make a loss, and to the left of Q sales are not maximised. AC=AR

•

• Sales maximisation is used to build up market Share.

• Firms may use loss leaders or specials (selling at or below cost) to attract customers who purchase other full-priced goods eg. Supermarkets and Cinemas.

• Increased market share may prevent potential competitors entering market or even eliminate existing ones.

• Creates brand awareness – particularly important for new entrants in a market. Firms wanting to gain more sales and therefore gain more brand loyalty compared to its competitors.

AC=AR

•

• Satisficing,

• being satisfied with a lower level of profits as the goal is not about profit.

- could be for self development

• pursue of an individual’s business / passion

• satisfaction of providing a good which the producer feels society will benefit

• A pure profit may upset the stakeholders in the community.

• Corporate social responsibility (CSR)

• firms should and will take the responsibility to look after their local community and the environment