Avarage Cost and Marginal Cost

7/27/2019 Avarage Cost and Marginal Cost

1/26


2/26


3/26


4/26

States the relationship between inputs and outputs

Inputs the factors of production classified as: Land all natural resources of the earth not just terra

firma!

Price paid to acquire land = Rent

Labour all physical and mental human effort involved inproduction

Price paid to labour = Wages

Capital buildings, machinery and equipment

not used for its own sake but for the contributionit makes to production

Price paid for capital = Interest


5/26

Inputs Process Output

Land

Labour

Capital

Product orservice

generated

value added


6/26

In the short run at least one factor fixed in supply but all

other factors capable of being changed Reflects ways in which firms respond to changes

in output (demand)

Can increase or decrease output using more or less of

some factors but some likely to be easier

to change than others

Increase in total capacity only possible

in the long run


7/26

In times of risingsales (demand)firms can increaselabour and capitalbut only up to acertain level theywill be limited bythe amount ofspace. In thisexample, land is

the fixed factorwhich cannot bealtered in the shortrun.


8/26

Analysis of Production Function:Short Run

If demand slows

down, the firm canreduce its variablefactors in thisexample it reducesits labour andcapital but again,land is the factorwhich stays fixed.


9/26

Analysis of Production Function:Short Run

If demand slows

down, the firm canreduce its variablefactors in thisexample, itreduces its labourand capital butagain, land is thefactor which staysfixed.


10/26

The long run is defined as the period of time taken to vary all factors

of production

By doing this, the firm is able to increase its total capacity notjust short term capacity

Associated with a change in the scale of production

The period of time varies according to the firm

and the industry

In electricity supply, the time taken to build new capacity could bemany years; for a market stall holder, the long run could be as

little as a few weeks or months!


11/26

Analysis of Production Function:Long Run

In the long run, the firm can change all its factors of production thusincreasing its total capacity. In this example it has doubled its capacity.


12/26

Mathematical representation

of the relationship:

Q = f (K, L, La)

Output (Q) is dependent upon the amount ofcapital (K), Land (L) and Labour (La) used


13/26


14/26

In buying factor inputs, the firmwill incur costs

Costs are classified as: Fixed costs costs that are not related directly to

production rent, rates, insurance costs, admincosts. They can change but not in relation tooutput

Variable Costs costs directly relatedto variations in output. Raw materials primarily


15/26

Total Cost -the sum of all costs incurredin production

TC = FC + VC

Average Cost the cost per unitof output

AC = TC/Output

Marginal Cost the cost of one more or

one fewer units of productionMC= TCn TCn-1 units


16/26


17/26


18/26

Short run Diminishing marginal returnsresults from adding successive quantities of

variable factors to a fixed factor

Long run Increases in capacity can lead toincreasing, decreasing or constant returns toscale


19/26


20/26

Total revenue the total amount receivedfrom selling a given output

TR = P x QAverage Revenue the average amount

received from selling each unitAR = TR / Q

Marginal revenue the amount receivedfrom selling one extra unit

of outputMR = TRn TRn-1 units


21/26


22/26

Profit = TR TC

The reward for enterprise

Profits help in the process of directing

resources to alternative uses in free markets Relating price to costs helps a firm to assess

profitability in production


23/26

Normal Profit the minimum amountrequired to keep a firm in its current line ofproduction

Abnormal or Supernormal profit profit

made over and above normal profit Abnormal profit may exist in situations where firms

have market power Abnormal profits may indicate the existence of

welfare losses

Could be taxed away without altering resourceallocation


24/26

Sub-normal Profit profit below normalprofit

Firms may not exit the market even if sub-normal

profits made if they are able to cover variable

costs

Cost of exit may be high

Sub-normal profit may be temporary (or

perceived as such!)


25/26

Assumption that firms aim to maximise profit

May not always hold true

there are other objectives

Profit maximising output would be where MC= MR


26/26

Why?Cost/Revenue

Output

MR

MR the additionto total revenue asa result ofproducing one

more unit ofoutput the pricereceived fromselling that extraunit.

MCMC The costof producingONE extra unit

of production

100

Assume output is at100 units. The MC ofproducing the 100thunit is 20.

The MR received from

selling that 100th unitis 150. The firm canadd the difference ofthe cost and therevenue received fromthat 100th unit to

profit (130)20

150

Totaladded

toprofit

If the firm decides toproduce one more unit the 101st the additionto total cost is now 18,the addition to total

revenue is 140

the firmwill add 128 to profit. it is worth expandingoutput.

101

18

140

Added tototalprofit

30

120

Addedto totalprofit

The process continuesfor each successiveunit produced.Provided the MC isless than the MR it

will be worthexpanding output asthe differencebetween the two isADDED to total profit

102

40

145

104103

Reducestotalprofit bythisamount

If the firm were toproduce the 104th unit,this last unit would costmore to produce than itearns in revenue (-105)this would reduce totalprofit and so would notbe worth producing.

The profit maximisingoutput is where MR =MC

Documents

Avarage Cost and Marginal Cost