1.5 Theory of the Firm Syllabus items - Production and costs

6. Large Machines:

A large firm can have its own large machinery and would not have to pay other firms, who will include a profit margin, thereby reducing unit costs of production.

3. Bulk buying:

As firms increase in scale they are often able to negotiate discounts with suppliers that they would not have received when they were smaller, the cost of their inputs is then reduced, which in turn reduces the costs of production.

Average costs:

Average costs: These are costs per unit of output. We use three measures: Average fixed cost (AFC): AFC is the fixed cost per unit of output. It is calculated by the equation - AFC = TFC/q , where q is the level of output. Because TFC is a constant, AFC always falls as output increases. Average variable cost (AVC): AVC is the variable cost per unit of output. It is calculated by the equation AVC = TVC/q , where q is the level of output. AVC tends to fall as output increases, and then to start to rise again as the output continues to increase. This is explained by the hypothesis of eventually diminishing average returns. As more of the variable factors are applied to the fixed factors, the output per unit of the variable factor eventually falls, and so the cost per unit of output eventually begins to rise. Average total cost (ATC): ATC is the total cost per unit of output. It is equal to AFC plus AVC. It is calculated by the equation ATC = TC/q , where q is the level of output. As with AVC, ATC tends to fall as output increases, and then to start to rise again as the output continues to increase.

2. Division of labor:

Breaking down the production process into small activities that workers can perform repeatedly and efficiently allows unit costs to be reduced (e.g. assembly lines).

43b. Distinguish between explicit costs and implicit costs as the two components of economic costs.

Explicit costs are any costs to a firm that involve the direct payment of money. Implicit costs are the earnings that a firm could have had if it had employed its factors in another use or if it had hired out or sold them to another firm. Explicit cost + Implicit cost = economic cost.

46d. Describe factors giving rise to diseconomies of scale, including problems of coordination and communication.

Factors giving rise to diseconomies of scale include problems of coordination and communication (it is difficult to maintain control over a large organization, also decision making can take longer and everyone's points of view may not be taken into consideration) and alienation and identity loss (workers may feel that they are an insignificantly small part of the organization as a whole and receive no individual recognition for their work - this could cause a lack of motivation and staff morale). An external diseconomy of scale is that with more firms there is more demand and costs of labor and supplies rise.

1.Specialization:

In large firms, there can be specialized managers who have individual areas of expertise, such as production, finance or marketing and can therefore be more efficient.

45a. Distinguish between increasing returns to scale, decreasing returns to scale and constant returns to scale.

In the long run, as output per period increases, cost per unit output decreases due to economies of scale (e.g. benefits of specialization). As a result of the decrease in average cost, there are increasing returns to scale. However, due to diminishing returns, after a certain point cost per unit output does not decrease but remains the same and there are constant returns to scale. If output per period continues to increase there can be decreasing returns to scale due to diseconomies of scale (e.g. strained control and communication).

42d. Calculate total, average and marginal product from a set of data and/or diagrams.

It is important to recognise the relationship between the ATC, AVC, and MC curves. Quite simply, the MC curve cuts the AVC and ATC curves at their lowest points. This is a mathematical relationship. AFC falls as output increases and, since it is the difference between ATC and AVC, the vertical gap between ATC and AVC gets smaller as output grows.

4. Financial economies:

Large firms can raise financial capital more cheaply because banks tend to charge lower interest rates to larger firms, since the larger firms are considered to be less of a risk than the smaller firms, and are less likely to fail to repay their loans.

5. Transport economies:

Large firms making bulk orders may be charged less for delivery costs than smaller firms. Also, as firms grow they may be able to have their own vehicles, which will cost less because of not having to pay other firms, who will include a profit margin.

44a. Explain the distinction between the short run and the long run, with reference to fixed factors and variable factors.

Long run costs have no fixed factors of production, while short run costs have fixed factors and variables that impact production. The main difference between long run and short run costs is that there are no fixed factors in the long run; there are both fixed and variable factors in the short run. In the long run the general price level, contractual wages, and expectations adjust fully to the state of the economy. In the short run these variables do not always adjust due to the condensed time period. In order to be successful a firm must set realistic long run cost expectations. How the short run costs are handled determines whether the firm will meet its future production and financial goals.

Marginal cost:

Marginal cost (MC): MC is the increase in total cost of producing an extra unit of output. It is calculated by the equation: MC = ∆TC/∆q , where ∆TC is the change in total cost and ∆ q is the change in the level of output. MC tends to fall as output increases, and then to start to rise again as the output continues to increase. This is explained by the hypothesis of eventually diminishing marginal returns. As more of the variable factors are applied to the fixed factors, the extra output from each additional unit of the variable factor added eventually falls, and so the extra cost per unit of output eventually begins to rise.

46b. Explain, using a diagram, the reason for the shape of the long-run average total cost curve.

Short-run cost curves are U-shaped because of the hypothesis of diminishing returns. The existence of eventually diminishing average returns explains the shape of the short-run average variable cost curve and the existence of eventually diminishing marginal returns explains the shape of the short-run marginal cost curve. Long-run cost curves are U-shaped, in theory, because of the existence of economies and diseconomies of scale.

7. Promotion economies:

Since the costs of promotion tend not to increase in the same proportion as output, the cost of promotion per unit output falls, as a firm gets larger.

46a. Outline the relationship between short-run average costs and long-run average costs.

The LRAC (Long Run Average Cost) curve is U-shaped because of economies and diseconomies of scale. The SRAC (Short Run Average Cost) curve is U-shaped due to the law of diminishing returns. In the short run (the production stage) costs increase as output increases because at least one fixed factor of production restrains further growth. In the long run (the planning stage) all factors of production are variable, apart from technology, so production can move to a new short-term curve. Once production begins the firm is again stuck on the new short-term curve. In the next wave of planning, however, the firm can again increase all factors, apart from technology, and move to a new point on the LRAC curve.

43a. Explain the meaning of economic costs.

The economic cost of producing a good is the opportunity cost of the firms production. Remember that opportunity cost is the next best alternative foregone when an economic decision is made. In this case it is the opportunity cost of the factors of production (resources) that have been used in producing the good or service.

42c. Explain the law of diminishing returns.

The hypothesis of eventually diminishing marginal returns: As extra units of a variable factor are added to a given quantity of a fixed factor, the output from each additional unit of the variable factor will eventually diminish. The hypothesis of eventually diminishing average returns: As extra of a variable factor are added to a given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish. The two hypothesis look at the same relationship from different angles. The whole concept is really a matter of common sense. Whether we measure it from the amount added by the extra variable factor (marginal product) of the amount added per unit of the variable factor (average product), logic tells us that inefficiency must eventually begin to occur.

44c. Draw diagrams illustrating the relationship between marginal costs and average costs, and explain the connection with production in the short run.

The marginal cost has to intersect the average cost at its lowest point. While the marginal cost is below the average cost, the average cost will continue to decrease. When the marginal cost increases above the average cost, however, average cost too will increase, so that is why marginal cost equals average cost at its lowest point.

42a. Distinguish between the short run and long run in the context of production.

The short run is that period of time in which at least one factor of production is fixed. All production takes place in the short run. The long run is that period of time in which all factors of production are variable, but the state of technology is fixed. All planning takes place in the long run.

46c. Describe factors giving rise to economies of scale, including specialization, efficiency, marketing and indivisibilities.

There are a number of factors giving rise to economies of scale. Economies of scale are any decreases in long-run average costs that come about when a firm alters all of its factors of production in order to increase its scale of output. Economies of scale lead to the firm experiencing increasing return to scale There are both internal and external economies of scale. External economies of scale are the benefits of the concentration of firms in an industry (e.g. technical firms in Silicon Valley). For instance, due to the concentration of firms special courses are offered in university in and near the area so that there is a talented labor force for firms to pick from. Internal economies of scale are the reduced costs brought to a single firm from being large. Internal economies of scale include:

44b. Distinguish between total costs, marginal costs and average costs.

This graph is a cost curve that shows the average total cost, marginal cost, and marginal revenue. The curves show how each cost changes with an increase in product price and quantity produced. When the average cost declines, the marginal cost is less than the average cost.

Total costs:

Total costs: Total costs are the complete costs of producing output. We use three measures: Total fixed cost (TFC): TFC is the total cost of the fixed assets that a firm uses in a given time period, TFC is a constant amount. It is the same whether the firm produces one unit or one hundred units. Total variable cost (TVC): TVC is the total cost of the variable assets that a firm uses in a given time period. TVC increases as the firm uses more of the variable factor. TVC is equal to the number of variable factors times the cost of each variable factor. Total cost (TC): TC is the total cost of all the fixed and variable factors used to produce a certain output. It is equal to TFC plus TVC.

42b. Define total product, average product and marginal product, and construct diagrams to show their relationship.

Total product (TP) is the total output that a firm produces, using its fixed and variable factors in a given time period. As we have already said, output in the short run can only be increased by applying more units of the variable factors to the fixed factors. Average (AP) is the output that is produced, on average, by each unit of the variable factor. AP=TP/V, where TP is the total output produced and V is the number of units of the variable factor employed. Marginal product (MP) is the extra output that is produced by using an extra unit of the variable factor. MP= △TP/△V, Where △TP is the change in total output and △V is the change in the number of units of the variable factor employed.