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Economics summary IB year 2
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Chapter 6.6.1 The short-run theory of production
The cost of producing any level of output will depend on the amount of inputs used and
the price the firm must pay for them.
Short- and long-run changes in production
If a firm wants to increase production, it will take time to acquire a greater quantity of
certain inputs. If a firm wants to increase output relatively quickly, it will only be able to
increase the quantity of certain inputs, but it will have to work with its existing buildings
and machinery. A fixed factor is an input that cannot be increased within a given time
period. A variable factor is one that can.
We also distinguish short-run and long-run. Short-run is a time period during which at
least one factor of production is fixed. Output can be increased only by using more
variable factors. The long-run is a time period long enough for all inputs to be varied. The
actual length of the short- and long-run will differ.
The law of diminishing returns
Production in the short-run is subject to diminishing returns. When one or more factors
are held fixed, there will come a point beyond which the extra output from additional
units of the variable factor will diminish.
When a variable factor is added to a fixed factor, the total output that results it called the
total physical product (TPP). The relation between inputs and output is shown in a
production function. The production function gives the relationship between quantities of
physical inputs and quantities of output of goods. A firm is technically efficient when the
firm is producing as much output as is technologically possible given the quantity of
factor inputs it is using. All the points along the total physical product are technically
efficient. Any point below is technically inefficient.
In reality, total output from any given combination of inputs may be lower than the
production function indicates because of inefficient management and methods of
production. The level of production is also assumed to be constant. If there is
technological progress, the whole production function would change.
Average physical product
This is output (TPP) per unit of the variable factor. APP = TPP/Q
Marginal physical product
This is the extra output produced by employing one more unit of the variable factor.
MPP = change in TPP/change in Q
6.2 Costs in the short run
When measuring costs, economists use opportunity costs. This is the cost of any activity
measured in terms of the sacrifice made in doing it/the value of the best alternative.
Factors now owned by the firm (explicit costs)
The opportunity cost of using factors not already owned by the firm is simply the price
that the firm has to pay for them. These costs are called explicit costs because they
involve direct payment of money by firms.
Factors already owned by the firm (implicit costs)
When the firm already owns factors, it does not have to pay money to use them. Their
opportunity costs are implicit costs. They are equal to what the factors could earn for the
,firm in some alternative use, either within or hired out to some other firm. Implicit costs
are less visible than explicit costs.
Examples of explicit costs are;
Buildings; the opportunity cost of using them in production for a year is the
highest rent that could have been earned by letting them out to another firm.
The owner could have earned a specific amount working for someone else. This is
the opportunity cost of the owner’s time running the business.
The opportunity costs of any decision in production are the implicit and explicit costs that
are relevant to that particular decision. By relevant we mean the costs that are incurred if
the firm chose one particular course of action. If a different decision is taken, these costs
would be avoided.
Some costs remain unaffected by whatever decision a firm makes; sunk costs. A sunk
cost often exists when a firm has paid for a factor of production in the past and that
factor of production no longer has value in any alternative uses. For example, a machine
purchased that is highly specialized. If this machine has no value to any other firms and
has no scrap value, the opportunity cost of using it is zero. No matter what decision the
firm makes in the future, the money used to purchase the machine – historic cost – is
irrelevant. Not using that machine will not bring the money back. In such a case, if the
output from the machine is worth more than the cost of all the other inputs involved, the
firm might as well use the machine. However, before the purchase the opportunity cost of
the machine was the money paid for it. Only after the purchase it became a sunk cost.
Costs and inputs
A firm’s cost of production depend on the factors of production it uses. The more factors
used, the greater the costs. This relationship depends on 2 elements;
The productivity of the factors; the greater their productivity, the smaller will be
the quantity of them required to produce a given level of output and hence the
lower the cost of that output.
The price of the factors; the higher their price, the higher the cost of production.
In the short-run, some factors are fixed in supply. Their total costs, therefore, are fixed in
the sense that they do not vary with output. Rent on land is a fixed cost. It is the firm no
matter how much the firm produces.
The total cost of using variable factors does vary with output. The cost of raw materials is
a variable cost. The more that is produced, the more raw-materials are used and
therefore the higher is their cost.
Total cost
The total cost (TC) of production is the sum of the total variable costs (TVC) and total
fixed costs (TFC) of production. TC = TVC + TFC
Total fixed costs do not vary with output and therefore it is a straight line.
With zero output, no variable factors will be used; TVC = 0. Therefore, the curve starts
from the origin. After this the line follows the curve of diminishing returns.
Average and marginal costs
Average cost (AC) is cost per unit of production. AC = TC/Q
Like total cost, average cost can also be divided in fixed and variable. Average costs
equals average fixed costs plus average variable costs. AC = AFC + AVC
Marginal cost (MC) is the extra cost of producing one more unit; the rise in total cost per
one unit rise in output. The shape of the MC curve follows from the law of diminishing
returns. As more of the variable factor is used, extra units of output cost less than
,previous units. MC rises as MPP falls. Additional units of output cost more and more to
produce, since they require ever-increasing amounts of the variable factor.
Average fixed costs (AFC) falls continuously as output rises, since total fixed costs are
being spread over a greater and greater output.
As long as new units of output cost less than the average, their production must pull the
average down. If MC is less than AC, AC must be falling. If new units cost more than the
average, their production must drive the average up. That is, if MC is greater than AC, AC
must be rising.
6.3 The long-run theory of production
In the long-run, all factors of production are variable. There is time to build a new factory
or purchase new machinery. In the long-run there are several decisions that a firm has to
make; decisions about the scale and location of its operations and what techniques of
production it should use. These decisions affect the costs of production. To scale mean
that all inputs increase by the same proportion.
If a firm were to double all of its inputs, would it double its output? There are 3 possible
situations;
1. Increasing returns to scale
This is where a given percentage increase in inputs leads to a larger percentage
increase in output.
2. Constant returns to scale
This is where a given percentage increase in inputs leads to the same percentage
increase in output.
3. Decreasing returns to scale
This is where a given percentage increase in input leads to a smaller percentage
increase in output.
Economies of scale
Economies of scale are experienced if costs per unit of output fall as the scale of
production increases. This can be achieved by increasing production and lowering costs.
This happens because costs are spread over a larger number of goods.
There are several reasons why firms are likely to experience economies of scale;
Specialization and division of labor
In large-scale plants workers can often do simple, repetitive jobs. With this
specialization and division of labor less training is needed. Workers can become
efficient in their job, especially with long production runs. There is less time lost in
workers switching from one operation to another.
Indivisibilities
Some inputs are of minimum size; they are indivisible. Some machines are only
economical for firms above a certain size.
The container principle
Any capital equipment that contains things tends to cost less per unit of output
the larger its size. The reason has to do with the relationship between a
container’s volume and its surface area. A container’s cost depends largely on the
materials used to build it and hence roughly on its surface area. Its output largely
depends on its volume. Large containers have a bigger volume relative to surface
area than do small containers.
Greater efficiency of large machines
Large machines may be more efficient in the sense that more output can be
gained for a given amount of inputs. Also, a large machine may make more
efficient use of raw materials.
, By-products
There may be sufficient waste products to enable some by-product(s) to be made.
Multi-stage production
A large factory may be able to take a product through several stages in its
manufacture. This saves costs and time in moving the semi-finished product from
one firm or factory to another. These are examples of plant economies of scale.
They are due to an individual factory or workplace or machine being large. They
are economies of scale that are associated with the firm being large perhaps with
many factories.
Organizational economies
With a large firm, individual plans can specialize in particular functions. Often a
merger between two firms can save money by rationalizing their activities.
Spreading overheads
Some expenditures are economic only when the firm is large. This is another form
of indivisibilities, only this time at the level of the firm rather than the plant. The
greater the output, the more these overhead costs are spread.
Financial economies
Large firms are often able to obtain finance at lower interest rates than small
firms, since they are seen as to be lower risk. They can buy in bulk for example.
Economies of scope
Often a firm is large because it produces a range of products. This can result in
each product being produced more cheaply than if it was produced in a single-
product firm. The reasons for these economies of scope is that various overhead
costs etc. can be shared among the products.
Diseconomies of scale
When firms get beyond a certain size, costs per unit of output may start to increase.
There are several reasons for such diseconomies of scale;
Management problems and co-ordination may increase as the firm becomes larger
and more complex, and as lines of communication get longer.
Workers may feel alienated if their jobs are boring and repetitive and they feel
that they are a small part of the organization.
Industrial relations may deteriorate as a result of these factors and also as a result
of the more complex interrelationships between different categories of worker.
Production-line processes and the complex interdependencies of mass production
can lead to great disruption if there are hold-ups in any part of the firm.
Location
In the long-run, a firm can move locations. The location affects the cost of production.
Transport costs will also be an important influence on a firm’s location. Ideally a firm is as
near as possible to both its raw materials and the market for its finished product. If these
2 are in different locations, they will locate somewhere between the two. In general, raw
materials are more expensive to transport than the finished product thus the firm should
be located as near as possible to these raw materials. If the finished product is more
expensive to transport, it probably will be located as near as possible to its market.
As an industry grows, this can lead to external economies of scale for its member firms.
This is where a firm benefits from the whole industry being large. The industry’s
infrastructure are the facilities, support services, skills and extra experience that can be
shared by the members of an industry. The member firms of an industry might
experience external diseconomies of scale. As an industry grows larger, this may create a
growing shortage of specific raw materials or skilled labor. This will push up prices and
therefore costs.
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