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IB Diploma Economics:
Theory of the firm: Production and costs
Production in the short run
Inputs – factors of production – are used by all firms to make outputs – goods and services. Economists define the short-run as being a time period where at least one of the factors of production (land, labour, capital or enterprise) is fixed. This means, for example, that if a firm wishes to increase its output and produce more goods or services it could purchase additional capital goods (e.g., machinery) and/or employ additional labour reasonably quickly. However, purchasing additional land and/or building a new factory takes considerably longer. Thus, if even one of the factors of production (e.g., land) is fixed, then the firm is operating in the short run.
The long-run is a time period where each and every input could be changed – land can be purchased and new factories could be built. Thus, in the long-run a firm can produce as much output as it want by introducing additional resources into its production processes. All inputs are variable in the long run.
Total product, average product, and marginal product
We can now examine what happens to total product, average product and marginal product as additional units of labour are employed and capital remains fixed; i.e., in the short term.
Marginal product of Labour I
MARGINAL PRODUCT OF LABOUR II
Law of diminishing returns
Diminishing marginal returns
Given the production data in table 1, we can plot the Total Product, Average Product and Marginal Product curves. See Figure 1 below.
Law of diminishing returns
As additional units are of a variable input (such as labour; e.g., bakers) are added to at least one fixed input (such as capital; e.g., a bakery), the marginal product increases at first. So initially, each new baker added to the bakery produces successively more buns. However, there is a point where the addition of one more variable input does not produce as much as the previous variable unit. Marginal product will continue increasing up to a point, and from that point on, each new variable unit added to the production process will contribute less to TP than the previous unit.
For example, in our bakery, this point occurred with the introduction of the 5th baker. The 4th baker increase TP by 5000 buns (MP of the 4th baker = 5000), and the 5th baker increased TP by 4000 buns (MP of the 5th baker = 4000). And from there on, each new baker increased TP by successively less than her predecessor.
Thus, diminishing returns is the decrease in the marginal (incremental) output of a production process as the amount of a single factor of production (e.g., unit of labour) is incrementally increased, while the amounts of all other factors of production stay constant.
The law of diminishing returns states that in all productive processes, adding more of one factor of production, while holding all others constant ("ceteris paribus"), will at some point yield lower incremental per-unit returns. The law of diminishing returns does not imply that adding more of a factor will decrease the total production, a condition known as negative returns, though in fact this is common.
A common sort of example is adding more people to a job, or assembling a car on a factory floor. At some point, adding more workers causes problems such as workers getting in each other's way or frequently finding themselves waiting for access to a part. In all of these processes, producing one more unit of output per unit of time will eventually cost increasingly more, due to inputs being used less and less effectively.
The law of diminishing returns is a fundamental principle of economics, and it plays a central role in production theory.
Worked example: Calculations
The meaning of economic cost
Essential statement: The opportunity cost of producing a good or service is its real economic cost of production. Resources are scarce and firms need to make decisions about what they will produce. To make good A, the firm must use resources which cannot then be used to make a good B, which would be the next best alternative. We can price the opportunity cost of the decision by valuing the gain to the firm that would have accrued had a firm’s resources been used to produce the good that was the next best alternative.
If we sum explicit and implicit costs, we have the true economic costs of production.
Explicit costs are those payments a firm will make to purchase or acquire the resources it needs for its production processes. The wages and salary it pays its employees, rent for its offices, legal fees and the purchase of IT equipment are all examples of explicit costs.
Implicit costs on the other hand is the opportunity cost of using the resources which the firm already owns and do not need to be purchased. A firm may own the land and its factory buildings, plant and equipment which are valued at $2 million. In this case the implicit cost of producing its goods would be the next best alternative use of that $2 million. $2 million in the bank would safely generate $100 000 at 5% interest.
Economic costs explained
Calculating Economic costs
Calculating economic costs
Example: Annabel is a financial whiz-kid earning $130 000 p.a. at a large trading bank. Next year she is going to quit her job to open her own consulting business. She has $300 000 (earning 5% interest) saved which she will invest in her business. She estimates that the costs of running her business (rent on offices, marketing, etc.) in the first year will be about $60 000. These are her explicit costs and these costs will be the only costs that appear in her income statement (profit and loss account) – i.e., expenses for accounting purposes.
However, economists know that there are very real implicit costs that an accountant will ignore when informing Annabel how her firm is performing. There are implicit costs to consider too. In addition to the $60 000 in expenses incurred by the firm in its first year. Annabel has lost $130 000 in salary she has forgone + $15 000 in annual investment income from her money in the bank.
Thus, the true economic cost of running her business each year is:
$130 000 salary forgone
+$15 000 investment income foregone
+$30 000 rent
+$5 000 electricity
+$10 000 marketing expenses
+$15 000 other general expenses
Economic costs = total opportunity costs:
$145 000 (implicit costs)
+$60 000 (explicit accounting costs)
Thus, Annabel’s new consultancy business would need to generate an income of $205 000 before it makes economic sense for her to undertake her new consultancy venture.
Short run costs
Economists define the short-run as being a time period where at least one of the factors of production (land, labour, capital or enterprise) is fixed.
Fixed costs: A fixed cost is a cost that does not vary in the short term, irrespective of changes in production or sales levels, or other measures of activity. A fixed cost is a basic operating expense of a business that cannot be avoided, such as a rent payment. The rent on a building will not change until the lease runs out or is re-negotiated, irrespective of the level of business activity within that building. The landlord of the rented building is not interested if the firm is producing 20 000 units or $80 000 units, she just wants her rent cheque each month. Even if there is zero output, fixed costs still need to be paid.
Examples of other fixed costs are insurance, depreciation, and property taxes. Fixed costs tend to be incurred on a regular basis, and so are considered periodic costs. The amount charged to expense tends to change little from period to period.
Fixed costs are a short-run phenomenon. In the long-run there are no fixed inputs into the production process; e.g., rental agreements will need renewing.
Variable costs: A variable cost is an expense that varies with a firm’s production output. Variable costs are those costs that vary depending on a company's production volume; they rise as production increases and fall as production decreases. For example, the costs of raw materials (such as steel and plastics) will rise for a car manufacturer such as Nissan as production increases, and falls when the production of cars decrease. To produce more cars Nissan buys more steel, and when it produces fewer cars, it purchases less steel.
Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output. Fixed costs and variable costs comprise total cost.
In the short-run total costs = fixed + variable costs. In the long-run, there are no fixed costs and a firm’s total costs = variable costs.
Costs of production
Fixed and variable costs
Marginal costs are the cost added by producing one additional unit of a good or service.
Marginal costs (MC) are informative because they tell us by how much the total costs increase when the firm produces one more unit of output. Marginal cost is calculated by finding the change in total costs that result from the additional unit of output.
For example, a bakery may have TC of $2000 per day for producing 200 cakes (TC200 = $2000). When it produces 201 cakes a day, its total costs increase to $2003 per day (TC201 = $2003). The change in TC from TC200 to TC201 is $3, and thus the MC of producing the additional cake is $3.
Further, fixed costs do not change as output changes so an additional unit of output does not affect fixed costs, thus marginal cost can also be calculated by finding the difference in TVC.
Cost curves explained
The law of diminishing returns and the relationship between cost and product curves
The shape of the cost curves is largely determined by the law of diminishing marginal returns. Law of diminishing returns: as additional units are of a variable input (such as labour; e.g., bakers) are added to at least one fixed input (such as capital; e.g., a bakery), the marginal product increases at first.
So initially, each new baker added to the bakery produces successively more buns. This means that the AVC per unit of output declines. The wages cost of each new baker are being divided between ever greater numbers of output and AVC decreases.
However, there is a point where the addition of one more variable input does not produce as much as the previous variable unit. Marginal product will continue increasing up to a point, and from that point on, each new variable unit added to the production process will contribute less to TP than the previous unit. Now MC begins to increase and AVC will begin to rise. Each additional variable unit added to the production process contributes less to TP than the previous one. Thus, the wage of the new baker is being divided by fewer and fewer units of output, and the average cost per bun begins to increase as each new baker contributes less buns to total output than the previous baker did.
Essential statement: When the additional output produced by an extra worker is the most it can be, then the extra labour cost of producing an additional unit of output is the least it can be (see figure, below).
Production costs in the long run
Constant returns to scale: Units of output (e.g., cakes) increase in the same proportion to that of all inputs (e.g., bakers) used in the production process. For example, if a bakery doubles the number of bakers then it would double the amount of cakes it produces each day.
Increasing returns to scale: Units of output (e.g., cakes) increase more than proportionally to that of all inputs (e.g., bakers) used in the production process. For example, if a bakery doubles the number of bakers then it would more than double the amount of cakes it produces each day.
Decreasing returns to scale: Units of output (e.g., cakes) increase less than proportionally to that of all inputs (e.g., bakers) used in the production process. For example, if a bakery doubles the number of bakers then it would increase the amount of cakes it produces each day by less than 100 per cent.
What are economies of scale?
Economies of scale explained
Economies of scale: Decreases in the average cost of production (falling LRAC) as firms increase the amount of output they produce by varying all of its inputs
Long run average costs
The relationship between short-run average costs and long-run average costs
Each of the four factors of production (land, labour, capital and enterprise) are variable in the long run. In the long run a firm can change the amount of capital it uses in its production processes; e.g., a firm can purchase more land, build new factories and purchase new plant and equipment to make its goods or services. Variable inputs such as additional workers (units of labour) can be added to the new capital that is now variable, and not fixed. As such, in the long run the law of diminishing returns cannot be applied, because as more variable units of labour are added, new units of capital can be added as well.
Long run production consists of a progression of short-run time periods where new units of labour are systematically added to fixed quantities of other factors (e.g., capital). Thus, in the long run, more and more bakers are added to more and more bakeries to increase the output units – cakes. In the short run diminishing returns hold true (see the red short run average costs curves above), but in the long term average production costs per unit can continue to decrease.
In the short run, firms in competitive markets are most profitable when average costs are at their lowest. So as short run production increases past a point where the short run average costs begin to rise, firms begin to invest more in capital goods and/or other fixed factors of production such as land and enterprise (e.g., research and development). New investment in additional units of capital (e.g., factories) allows firms to escape from the law of diminishing marginal returns as production increases (see figure above).
However, eventually long run costs will rise no matter how many additional units of capital or other factors of production are used to produce a good or service. Why? We go back to the central concept of scarcity in Economics. As more and more resources are used to make more and more goods. Then the increased demand for these resources pushes up the price of these resources in the resource market. For example, if a bakery continued to increase its output of cakes it would eventually pay more for the resources it uses to produce cakes. For example, at very high levels of production a bakery company would:
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