IB Ch7 - Costs Revenues and Profit

8/8/2019 IB Ch7 - Costs Revenues and Profit

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What are COSTS?

COSTS OF PRODUCTION: These are thecosts to the individual firm that it incurs asa result of production; Total costs

Fixed costs

Variable costs


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The Theory of ProductionKey Terms 1

Total Costs Fixed costs + variable costs

Fixed Costs Costs of production that do not vary as output changes

Variable Costs Costs of production which vary with output Short Run

Period of time during which fixed costs and the scale ofproduction remain constant

Long Run Period of time during which all factors become variable and thescale of production can change

Marginal Product The output added by the extra worker or unit of a factor


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Adding more of theVARIABLE FACTOR when there are FIXED factors

(In SR)

1

2


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Adding more of theVARIABLE FACTOR when there are FIXED factors

(In SR)

AP

1

ClassTaskusingtable1.1addintheMPP

curve


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The relationship between APP and MPP (In SR)

Table 1.1.1

1


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The relationship betweenAVERAGE, MARGINAL &TOTAL Physical Product

(in SR)

AP

APP &MPP

Number of workers

MP

TP

TPP

1

ClassTaskusingtable

1.1.1toadddetail

2

3


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Increasing marginal returns Where the addition of an extra variable factor adds more to output that

the previous variable factor

Average product The total product divided by the number of workers

Law of diminishing marginal returns Where increasing amounts of a variable factor are added to a fixedfactor and the amount added to total product by each additional unit ofthe variable factor eventually decreases

Optimal output The ideal combination of fixed and variable factors to produce the

lowest average cost

Productive efficiency When a firm operates at minimum average total cost, producing the

maximum possible output from inputs into the production process

Depreciation In relation to fixed assets, all fall in the value of an asset during its

working life


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FIXED, VARIABLE & SEMI-VARIABLE(in SR)

TotalCosts

Output

ClassTaskcompletethediagramto

includeFC,VCandTC


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Semi-variable costs

Costs which have both a fixed and variable element e.g. landlinetelephone usage

Average fixed costs

TFC/Q Average total costs

TC/Q

Marginal costs

The cost of the extra unit of output


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Costsin more detail (SR)Table 1.2


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Increasing and decreasing SHORT RUN COSTS

AC

Costs

Output

MC

1

2

ClassTaskUsetable1.2tocompletethediagram


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MC, AC,AVC &AFC (in SR)

Costs s

Quantity

ClassTaskUsetable1.2tocompletethedi

agram


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http://news.bbc.co.uk/2/hi/business/8062844.stm | 22nd May 2009

Questions for thought

1) How does a weak GBP affect

costs for UK businesses?

2) Are all firms affected by risingfuel costs in the same way?

3) How can firms protect

themselves from thefluctuations in commodity andcurrency prices?
http://news.bbc.co.uk/2/hi/business/8062844.stmhttp://news.bbc.co.uk/2/hi/business/8062844.stm


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Task The shape of costs


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Production in the LR

In the LR all factors become variable and hence firmscan overcome diminishing returns by increasing theSCALE of production.

However as the firm continues to increase output thendiminishing returns will creep in again and the firm mustlook to increase its scale once more.

Each size of operation forms a SRAC (or SRATC) curveeach with its own optimal size of operation.

In practice firms may choose or be unable to move to anew SRAC and may over work a fixed factor e.g. existingfactory size is too small but the owners do not have thefunds to build a new one or the increase in output is onlyexpected to be temporary

All planning takes place in the long run


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Relationship between SR & LR AC

ClassTaskcompletethe

diagramtoshowaseriesof

SRACandtheeventual

LRAC

Costs s

Quantity

SRAC1SRAC2


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Which factory size would you choose if yourfirm needed to produce 100 units?

Costs s

Quantity

SRAC1SRAC2

100

SRAC3

175

What about

175 units?

What will

influence your

decision?


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The Theory of Production (LR)Key Terms 4

Increasing returns to scale

Where an increase in factor inputs leads to a more proportionateincrease in outputs

Decreasing returns to scale

Where an increase in factor inputs leads to a less than

proportionate increase in factor outputs Constant returns to scale

Where an increase in factor inputs leads to a proportionateincrease in factor outputs.

Minimum efficient scale (MES)

This corresponds to the point at which average costs reach theirlowest point for the first time, i.e. the lowest number of units afirm needs to produce to fully utilise all available economies ofscale


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What shape & why?

Cos

ts

s

Quantity

LRAC2

MES

Costss

Quantity

LRAC4

MES

Costss

Quantity

LRAC3

Cos

ts

s

Quantity

LRAC1

MES


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The Minimum Efficient Scale (MES)

The MES corresponds to thelowest point on the LRAC (orLRATC)

MES defined as the firstpoint at which all possibleeconomies of scale are fullyutilized

There is unlikely to be onepoint rather a range ofoutputs which are all

productively efficient During the range firms are

said to be experiencingconstant returns to scale

Costss

Quantity

LRAC4

MES


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Economies of Scale

Defined:Are any decrease in LRAC that comeabout when a firm alters all of its factors of

production - Increasing returns to scale

Specialisation Division of labour

Bulk buying

Financial economies

Transport economies

Large machines

Promotional economies


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Diseconomies of scale

Define: Any increase in LRAC when a firmalters all of its factors of production decreasing returns to scale

Control and management problems

Alienation and loss of identity

In reality there is little evidence to suggest

that firms actually suffer fromdiseconomies of scale


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External Factors

Economies of scale Local universities specialise due to high

concentration of firms

Diseconomies of scale

Increase in size of industry pushes up theprice of raw materials


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Revenue Theory

Total revenue TR=PQ

Average revenue AR=TR/Q

Marginal revenue MR=TR / Q


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Revenue Curves and Output

1. AR remains constant as Q increases PED = AR (D) horizontal

Firms are price takers1. AR falls as Q increases PED <

AR (D) downward sloping Firms have some influence over P&Q Price makers


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When PED =TR

Where P=5

5

1

TR

Q

35

7


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P

Q

ClassTaskUsetable7.4tocompletethediagram

The relationship between D, AR, MR, TR & PED for a

downward sloping linear demand curve


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Review of Revenue

When PED > 1 firms revenue increases ifP falls

When PED < 1 firms revenue increases ifP increases

When PED = 1 firms revenue stays thesame as P changes, revenue is alreadymaximised


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Profit Theory

The economist versus the accountant Accountant: Profit = TR TC

Economist: Profit = TR TC but;

Where TC = FC + VC + Opportunity Cost An accountant may deduce that a firm is making a

profit whereas an economist may conclude that theyare making a loss

3 scenarios to consider; The shut down price

The break even price

The profit maximising level of output


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The Shut Down Price

Firms often continue to produce even if they are makinga loss During the six months to September 2009, the company (BA)

suffered a 292m ($485m) loss. BBC, 9 th Nov 2009

Firms may even shut down for a period and then re-openlater on 1,700 jobs to go asCorus mothballs plantBBC, 4th Dec 2009

Jobs axed at Ford, Nearly a hundred jobs are being cut at Fordsplant in Dagenham as a result of the economic downturn The

company has introduced 14 "non production days" until thenew year in its stamping departments. It'll mean 520 staffcould have to work 3 day weeks. BBC Nov 2008

An ice cream shop shuts for winterand then reopens when theweather improves


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Why are they still in business?


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The Shut Down Price

The shut down price is the level of pricethat enables a firm to cover its variablecosts in the SR, i.e. it is the price where

P=AVC. If price does not cover AVC, thenthe firm will shut down in the SR


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Q (Units)

ClassTaskcompletethe

diagram

The Shut Down Price (ATC, AVC and MC)

Pric

eand

Cost


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Breaking Even

In the long run firms are able to cover ATC

Remember ATC includes OC and isdifferent for an economists and anaccountant

If the price does not cover all costs in theLR the firm will shut down and stay shut


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Where does the firm opperate?

Assumption: Firms seek tomaximise profit

A firm will continue to produce untilMC=MR why?

What if the MC curve crossed the

MR curve twice? A firm should produce at the level of

Q where MC cuts MR from below

Remember that the MC cuts the ACat its lowest point

Priceand

Cost($)

Output

Output


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Q (Units)

ClassTaskcompletethediagramto

showafirmmaximising

profitsinthe

productionoftelevisionsets

Pric

eand

Cost


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Q (Units)

ClassTaskCompar

efirmsmakingaprofit,making

alossandbreakingeven(normalprofit):HINTshiftthe

AC

Pric

eand

Cost


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Alternatives to Profit Max

Revenue Maximisation (MR=0)

Sales (Volume) Maximisation (AR=AC)

Employment Environment

Satisficing

Ideas Board 1


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Ideas Board 1

Documents

IB Ch7 - Costs Revenues and Profit