1 The Theory of Production Production in the Short Run (SR)

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The Theory of Production

Production in the Short Run (SR)

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Connector

• Covered in Economics AS is the make up of a firm’s costs, total costs, fixed costs and variable costs.

– These are the costs to the individual firm that it incurs as a result of production.

• Write down the definition of the above terms

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Lesson Objectives

Revise definitions and knowledge of costs from AS

Learn the differences between fixed, variable and

marginal costs Understand the shape of the average and marginal cost

curves Understand the theory that explains the short run Appreciate that different sized firms have different levels

of productive efficiency

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The Big Picture

• In this lesson we will start our advanced study of microeconomics by building on your knowledge from AS.

• We will look at the costs of production faced by the

individual firm and we will analyse them in more depth

than you experienced at AS.• We will look at marginal and average costs and

revenues and use numerical examples to explain firms’ behaviour.

• You will become aware of the diagrammatic presentation of costs curves which we use at A2 and the effect of time on the firms’ costs in terms of short-run.

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Big Picture

• To arrive at the learning outcomes you will do the following:

• Listen to teacher demonstrations on PPP• Draw graphs• watch VIDEO • ‘Stretch and challenge’ Questions• Group work• Independent work• Class discussion• Short presentation• Debate economic issues• Demonstration on the board• Pair marking• Advise on examiner’s tip

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Lesson Outcome

Understand the difference between the short and long run and the theories that underpin them

Be able to use short-run (SR) and long-run (LR) concepts to answer questions

Be able to explain the relationship between average and

marginal costs both in words and graphically

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Key Terms

• Total costs• Fixed costs• Variable costs• Short run • Long run• Marginal Product• Average product• Increasing marginal returns• Diminishing marginal returns• Law of diminishing marginal

returns

• Optimum output• Productive efficiency• Depreciation• Semi-variable costs• Average fixed cost• Average variable cost• Average total cost• Marginal cost

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• Assume a fictional firm that has been set up to produce reproduction furniture and has hired a factory unit and machinery in order to carry out production.

• Initially the firm has incurred some fixed costs in terms of the factory unit and the machinery

• The owners of these will expect to be paid for their use from the outset, even though production has not yet started.

• Economists study costs over different time periods. These are the short run and the long run.

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• As the firm commences production of furniture we assume that it is in a short-run situation – where at least one factor

remains fixed, – for example, the size of

the premises.

• To increase its output it will take on extra workers and as it does so it will find, up to a point, – that each worker will add

more to the total output than the previous workers.

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• In table 1.1, the marginal product of worker no. 3 is 9 units, – whereas the marginal

product of worker no. 4 is 12 units.

• This is referred to as increasing marginal returns – where increasing the amount of the variable factor increases output more than proportionately.

Production in the Short Run

This has nothing to do with the quality of the workers as we are assuming they are all equally capable

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• As the firm grows and orders increase it will continue to employ more workers and purchase more raw materials.

• However, there will come a point – where the premises cannot accommodate extra

workers – and their presence will reduce the output of the

existing workers.


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• From Table 1.1, marginal product rises up to five workers

– each successive worker adds more output than the previous worker.

• But with worker number 6 MP begins to fall.

• However, average product rises and as the MP is above the AP it pulls the average up.

• Employment of the 7th worker only adds 3 units of output

– as the fixed factors (the size of the factory unit and the number of machine) are now overloaded

– as there are too many variable factors for the size of the fixed factor.


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• In the short run the firm can only change its rate of output by combining more or less of the variable factors with the fixed factor and the table indicates that:

Initially there are increasing marginal returns to the variable factor so that output rises more than proportionately to the increase in the variable input

Subsequently the firm experiences diminishing marginal returns to the variable input as the increase in output is less than proportional to the increase in labour input.

• This sequence of events occurs because the plant is of a fixed size and must eventually become overloaded.

• This is referred to as the law of diminishing returns.

• This is the ‘law’ that economists use to explain the short run


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• Figure 1.1 illustrates both diminishing and increasing short-run costs where the average total cost curve (ATC) is at its lowest point with the employment of 6 workers.

• This is known as the optimum output, the point where the firm has achieved the lowest cost combination between fixed and variable factors.

• This is also the point of productive efficiency in the short run as the firm is operating at the minimum average cost.

Production in the Short RunTable 1.1 indicates the amount produced, the pattern of costs can be inferred from it.

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• If the firm decides to increase its output and needs to employ extra workers, beyond six workers it will face increasing costs and will no longer be productively efficient.


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• Figure 1.2 indicates the revenues of the firm (output X price) and average revenue will be at maximum at an output of 60 units where six worker are employed.

• If the firm produces more output its average revenue start to fall.

• In the short run we have encountered a number of costs: fixed, variable and marginal.


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How do marginal returns affect marginal costs?

Diagrammatically, the link between marginal returns (or marginal product)

and marginal costs isshown in Figure 3.2 below.

• This question provides the opportunity to distinguish between a production function and a cost

• function, and also between marginal product and marginal costs. In the answer to Question 2, a

• firm’s short-run production function was:• Q = f(K–, L)• Taking this one stage further, the marginal returns or marginal product

(MPL) of labour can be• written as:• MPL = ΔQ/ΔL• In a similar way, the firm’s short-run cost function is:• C = f(Q)• and marginal costs of production (MC) are:• MC = ΔC/ΔQ• Diagrammatically, the link between marginal returns (or marginal product)

and marginal costs is shown in Figure 3.2 below.

• To start with, as it employs labour, the firm benefits from the increasing marginal productivity of labour. This is shown by the rising section of the MP curve in the upper panel of Figure 3.2. Extra workers add more to total output than previous workers employed, but the wage cost of employing an extra worker remains the same. As a result, the total cost of producing output rises at a slower rate than output itself, and this causes the marginal cost (MC) of producing an extra unit of output to fall. The increasing marginal productivity of labour (shown by the positive slope of the marginal product curve in the upper panel of Figure 3.2) thus causes marginal cost (in the lower panel) to fall.

• However, once the law of diminishing marginal productivity sets in, marginal cost rises with output. The wage cost of employing an extra worker is still the same, but each extra worker is now less productive than the previous worker who joined the labour force. The total cost of production rises faster than output, so the marginal cost of producing output also rises.

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Fixed Costs

• In the short run, because at least one factor of production is fixed, output can be increased only by adding more variable factors

• Hence we make a distinction between fixed and variable costs

Understanding Short Run Costs

Short run costsFixed CostsVariable CostsAC, MC and AVC

Fixed factor inputs

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Fixed costs• Fixed costs will not vary with output in the short run and they

are sometimes called overhead or indirect costs.

• They are looked upon as contractual, that is, enforceable in a court of law, and usually consist of payments of on building and machinery.

• Fixed costs have to be paid whether the firm produces nothing or runs the plant 24 hours per day, and as a result, in a cost table fixed costs will be shown even when the firm is not producing any output, for example, £180 at zero output in Table 1.2.

• In addition to those mentioned, typical example of fixed costs are rents, salaries of permanent employees and depreciation.


Examples of fixed costs for this business? (Speedferries)

Fixed Costs

• Fixed costs

– These do not vary directly with the level of output i.e. they are treated as independent of production

– Examples of fixed costs include the rental costs of buildings, the costs of leasing or purchasing capital equipment such as plant and machinery, the costs of full-time contracted salaried staff, the costs of meeting interest payments on loans, the depreciation of fixed capital (due solely to age) and also the costs of business insurance

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Fixed Cost Curves

Costs

Output

Total Fixed Cost

Fixed costs (FC) are totally independent of output and must be paid out evenif the production stops. Capital intensive industries with a high ratio of fixed to variablecosts offer scope for economies of scale AFC = Fixed Costs (FC) / Output (Q).

Fixed Cost Curves

Costs

Output

Total Fixed Cost

Average Fixed Cost

Average fixed costs must fall continuously as output increases because fixed costs are being spread over a higher level of production. In industries where the ratio of fixed to variable costs is extremely high, there is great scope for a business to exploit lower fixed costs per unit if it can produce at a big enough size

AFC = Fixed Costs (FC) / Output (Q).

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Variable costs

• In contrast with fixed costs, variable costs vary directly with output.

Increasing output will require an increase in such things as raw materials, power and labour.

• The variable costs of a firm are zero when there is no output, and increase

and decrease as output rises and falls.

• When the firm is closed due to, – for example, in a holiday period, variable costs will be zero as production is not

taking place.

• Variable costs are sometimes called unit-level costs as they vary with the number of units produced.


When the firm is closed due to, for example, in a holiday period, variable costs will be zero as production is not taking place.

When the firm is closed due to, for example, in a holiday period, variable costs will be zero as production is not taking place.

Variable Costs

• Variable costs are business costs that vary directly with output

• Examples of variable costs include the costs of intermediate raw materials and other components, the wages of part-time staff or employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs due to wear and tear.

• Total variable cost rises as output increases

• Average variable cost (AVC) = total variable costs (TVC) /output (Q)

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Semi-variable costs

• These are costs which have both a fixed cost and variable cost element.

– An electricity bill may include elements that are fixed (such as the fixed or standing, charge for supplying the service)

– And elements that are variable (such as the amount of electricity used by machinery during the production process).


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• Figure 1.3 shows the total cost curves for a particular firm.

• Fixed costs remains at £180 over the range of output produced while costs increase as output increases.

• The addition of fixed and variable costs gives the total cost.

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• The first three columns of the table indicate the total costs

• the second three columns are average costs

• the last column shows the marginal cost, which is the cost of producing the extra unit of output.


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• Total costs comprise total fixed costs and total variable costs.

• Average fixed cost (AFC) can be found by dividing the total fixed costs by the number produced, and diminishes quite rapidly as the cost is spread over an increasing number of units.

• Thus the AFC of unit 2 is TFC (180)÷ 2 = 90 whereas by the time output has increased to nine units AFC has fallen to 20.


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• In contrast, average variable cost (AVC), – TVC divided by the

number product

• AVC increases as output increases (as variable costs increase with output).

• Thus the AVC of unit 1 is 15 but has increased to 190 by unit 9.


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• Average total cost (ATC) is total cost divided by the number produced

• ATC declines as the fixed cost is spread over more units but then increases as the growth in variable costs is greater than the fall in fixed costs.

• For unit 1 ATC is 195, falling to 120 for unit 4 but then rising as output increases and reaches 210 by unit 9.


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Marginal cost (MC) is the amount added to the total cost of production by the next unit of output – the cost of producing one more unit.

•The marginal cost is calculated by taking the total cost and deducting the total cost of the previous unit

– for example, the total cost of producing six units is £828; the total cost of producing five units is £645.

•The MC is therefore the difference between them, £183, and the actual cost of producing the sixth unit. .


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The marginal cost is calculated by taking the total cost and deducting the total cost of the previous unit

The marginal cost is calculated by taking the total cost and deducting the total cost of the previous unit

Marginal Cost (MC)• Marginal cost is the change in total costs from increasing

output by one extra unit.

• The marginal cost of an extra unit of output is linked with

the marginal productivity of labour– If marginal product is falling, assuming the cost of

employing extra units of labour is constant the extra costs of these units of output will rise

– There is an inverse relationship between marginal product and marginal cost.

The law of diminishing returns implies that the marginal cost of production willrise as output increases. Eventually, rising marginal cost will lead to a rise in average total cost. This happens when the rise in AVC is greater than the fall in AFC as output (Q) increases

The Marginal Cost Curve

Costs

Output

Marginal Cost (MC)

The law of diminishing returns implies that the marginal cost of production will rise as output increases. Eventually, rising marginal cost will lead to a rise in average total cost

The law of diminishing returns implies that the marginal cost of production will rise as output increases. Eventually, rising marginal cost will lead to a rise in average total cost

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An increase in marginal costs

Costs

Output

MC1

MC2

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Production in the Short RunThis information can be produced in

diagrammatic form and figure 1.4 shows three average cost curve: total,

variable and fixed, as well as the marginal cost curve.

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• The average fixed costs fall as output rises

– and in the table the fall is from £180 to £20 over nine units of output.

• The fall is very rapid as the fixed cost is spread over more units and this will reduce the cost of producing the extra unit.

• The falling average fixed costs pull the marginal cost curve downwards as the costs of producing each unit will fall.

• But the firm will be taking on labour and, after some point, the falling fixed cost will be unable to compensate for the increased labour cost and marginal cost will begin to increase.


The marginal cost is shown as cutting the average costs at their lowest point and you need to understand this relationship.The marginal cost is shown as cutting the average costs at their lowest point and you need to understand this relationship.

The relationship between average and marginal costs

Costs

Output

Average Variable Cost

Marginal Cost

Marginal cost always cuts the average variable cost curve at the bottom of the AVC curve – this is always the case!Marginal cost always cuts the average variable cost curve at the bottom of the AVC curve – this is always the case!

Production in the Short RunThe relationship between average and marginal costs

• Imagine that the average mark for essays is 15.

• In the next essay, the marginal essay, students get 10 marks – this will put the average down.

• In the essay after this, students get 18 marks which will pull their average up. The relationship can be expressed as follows and can be clearly seen in figure1.1

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In order the appreciate the relationship, students should consider the problem from the prospective of range of essay marks.

The relationship between average and marginal costs

– If the marginal cost is below the average cost curve then it will pull the average cost curve down and the average cost will be falling.

– If the marginal cost is above the average cost then it will pull the average cost up

– The marginal cost will cut the average cost at its lowest point.

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An Increase in Variable Costs

Costs

Output

Average Variable Cost

MC1

MC2

AVC2

A rise in variable costs causes an upwards shift in marginal and average variable cost – e.g. brought about by a rise in the market price of factors of production used in the production process (for example a rise in commodity prices)

A rise in variable costs causes an upwards shift in marginal and average variable cost – e.g. brought about by a rise in the market price of factors of production used in the production process (for example a rise in commodity prices)

Family of short run cost curves

Costs

Output

AVC

MC ATC

Short run costs of production - If a marginal cost is below average cost then average must be falling. Even if MC is rising, AC falls if MC <AC. For this reason, MC curve intersects the AC curve at the lowest point of the AC curve

Short run costs of production - If a marginal cost is below average cost then average must be falling. Even if MC is rising, AC falls if MC <AC. For this reason, MC curve intersects the AC curve at the lowest point of the AC curve

A change (fall) in fixed costs

Costs

Output

AVC

MC ATC1

ATC2

A change in fixed costs has no effect at all on variable costs of production. This means that only the average total cost curve shifts. In the example shown in the diagram we see the effect of a fall in fixed costs, e.g. the result of a decrease in interest rates on business loans, or a fall in the rate of capital depreciation or business administration costs

A change in fixed costs has no effect at all on variable costs of production. This means that only the average total cost curve shifts. In the example shown in the diagram we see the effect of a fall in fixed costs, e.g. the result of a decrease in interest rates on business loans, or a fall in the rate of capital depreciation or business administration costs

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Answers1)

2. Initially, both average total costs and marginal costs fall. This is because average fixed costs fall quickly as they are spread over more units, which makes the average total cost also fall. The marginal costs also fall for the same reason. However, as the firm’s variable costs increase as more output is produced, the rate at which the average fixed costs fall will be outweighed by the increasing variable costs, and so marginal costs will start to rise.

3. Marginal cost equals average total cost when average total costs are at their lowest. Average total cost is equal to average fixed cost plus average variable cost. When marginal cost is below average cost then the average cost is falling; when marginal cost is above average cost then average cost is rising. Marginal cost cuts all of the average costs at their lowest point.

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Activity

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Answers

a) Average costs of generating electricity by nuclear methods have been lower. Fixed costs associated with nuclear are high. External costs associated with nuclear are generally lower. Data shows nuclear power costs 3.2euros per kWh, compared to an average cost for gas of 3.65 and coal of 4.19.

b) Define minimum efficient scale. Show MES on a diagram. Firms benefit from producing at the MES because lower costs are likely to lead to higher profits. Consumers may benefit because lower costs often translate into lower prices, thus increasing consumer surplus. Firms need to ensure however that they don’t surpass the MES, and end up with rising LRATC. Additionally, consumers may not benefit if firms don’t pass on the cost reductions in terms of lower prices.

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c) Define diminishing returns.

Explain what is meant by the short-run.

Explain that diminishing returns are caused by increasing the level of output by using more labour, whilst maintaining other fixed factors of production; thus in the short-run diminishing returns are not eliminated by increasing output. Use LRATC/SRATC envelope curve.

Explain what is meant by the long-run. Explain how firms can eliminate diminishing returns by increasing the scale of production in order to increase output i.e. increasing the amount of capital, and not just increasing the amount of labour.

Comment that increasing capital is not necessarily easy, owing to finance constraints, planning permissions, legal barriers (e.g. prevention of monopoly power, patents etc) and so firms cannot guarantee that they can eliminate diminishing returns.

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a) Define total costs (i.e. fixed plus variable).

Factors affecting fixed costs could include: salary demands of permanent employees (e.g. public sector workers demanding wage increases in line with inflation), rent prices (dependent on area of country etc.).

Factors affecting variable costs could be: price of fuel (more expensive in winter as demand increases, more expensive if there’s uncertainty in the Middle East etc), changes to the National Minimum Wage affecting non-salaried employees, cost of raw materials (e.g. price of gelatine increased following BSE outbreaks).

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b) Explain what is meant by average cost (use diagram).

Reasons for firms having similar costs: often face the same changes in variable costs (i.e. they buy the same raw

materials); we might expect production to take place in similarly-sized industrial units.

Reasons why they might not face similar costs: products are often differentiated (e.g. costs will be very different for a small

company making small batches of cars compared to say, Ford, or boutique chocolate shops may focus on high-quality handmade chocolates which is very different to Cadbury’s mass production approach).

firms may operate in different countries where wages are different (e.g. many European companies relocated production to China);

well-established firms can negotiate good bulk-purchasing discounts on raw materials, or carry out sound negotiations in the futures markets

the internal structure of companies may be different, leading to different levels of morale (workers with low morale are likely to produce less, leading to higher average costs)

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Past Exam Questions

• Jan 2010• Explain the concept of ‘minimum efficient scale’ (Extract

E, line 30) and analyse its implications for the structure of, and barriers to entry to, the motor manufacturing industry. (10 marks)

• June 2010• Explain what is meant by ‘diminishing returns’ (Extract

B, line 2-3) and analyse why the introduction of GM crops could help farmers to increase their productivity in the long run. (10 marks)

Documents

1 The Theory of Production Production in the Short Run (SR)