Day 8

Production: Production is a process in which raw materials are converted into semi finished and finished goods
with the help of other factors of production (labour, capital and owner). Business can choose between Capitals
intensive or labour intensive production methods according to its requirement and resources available.
Measuring the costs of production: Costs are defined as those expenses faced by a business in the process of
supplying goods and services to consumers. In the short run (where there are fixed and variable factors of
production) we make a distinction between fixed and variable costs. Examples of each are given below.

SHORT RUN COSTS OF PRODUCTION

TOTAL COSTS (TC) = TOTAL FIXED COST (TFC) + TOTAL VARIABLE COSTS (TVC)

FIXED COSTS: Fixed costs relate to the fixed factors of production and do not vary directly with the level of
output. (I.e. they are exogenous of the level of production in the short run). Good examples to use are rent of
buildings, leasing of capital equipment, the annual uniform business rate charged by local authorities, the costs of
full-time contracted salaried staff, interest rates on loans, the depreciation of fixed capital (due to age) and the costs
of business insurance.

Total fixed costs (TFC) remain constant as output increases. Average fixed cost (AFC) = Total Fixed Costs (TFC) /
Output (Q) Average fixed costs will fall continuously with output because the total fixed costs are being spread
over a higher level of production causing the average cost to fall.

Examples of fixed costs: Rent of buildings, leasing of plant and equipment, local business rates, the costs of
salaried staff, interest rates on loans, depreciation of capital (due to age) and insurance premiums. 

Average fixed cost (AFC) = TFC / OUTPUT

An increase in fixed costs has no effect at all on the variable costs of production. This means that only the average
total cost curve shifts. There is no change at all on the marginal cost curve leading to no change in the profit
maximising price and output of a business.

Average fixed costs will fall continuously with output because the total fixed costs are being spread over a higher
level of production causing the average cost to fall. Average fixed costs falls as output increases. A business can
"spread their over head costs" by increasing output in the short run. Average fixed cost will never be zero if there
are positive total fixed costs

VARIABLE COSTS: These are costs that vary directly with output since more variable units are required to
increase output. Examples are the costs of essential raw materials and components, the wages of part-time staff or
employees paid by the hour, the costs of electricity and gas and 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) AVC depends on the cost of employing
variable factors compared to the average productivity of these factors (usually labour productivity). If additional
units of labour can be hired at a constant cost there will be an inverse relationship between average product and
average variable cost. Therefore, when average product is maximized, AVC will be minimized.

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Marginal costs of production: Marginal costs are defined as the change in total costs resulting from a one unit
change in output. They are the variable costs associated with increasing output in the short run. A change in
marginal costs might come about for example because of a change in the prices of essential raw materials or an
increase in the wage rate paid to part-time employees.

Practice MCQS

1 The central area of a country produces tea for which it has an ideal climate. The coastal area produces coconuts
because its climate is different.

Assuming there is no change in market conditions, what will happen if this country subsequently produces only tea in
both areas?

A It will increase its costs of production.

B It will increase the productivity of its land.
C It will increase its total income.
D It will make the best use of its resources.

2 What is likely to be found when there are many small firms in an industry?

A There are few barriers to entry.

B There is high expenditure on research developments.
C Products are distributed to widely dispersed markets.
D Very large capital costs are needed to establish a firm.

3 A firm producing instant coffee previously paid for the disposal of the waste. It now sells the waste to be made
into garden fertiliser.

Which cost to the firm has not changed?

A average cost
B fixed cost
C total cost
D variable cost

4 In 2003 Hewlett-Packard, a major computer company, announced that its profits had fallen below the level predicted.

What might have caused this?

A increased advertising costs that greatly improved sales

B low prices that made the company’s product competitive
C new technology that reduced costs
D reduced sales and low prices

5 Ericsson is the world’s leading maker of mobile phone machinery. It announced that it had won a major contract to
supply a Chinese phone company, China Mobile, with machinery. Ericsson also announced that it would become more
efficient by reducing its workforce.

How would economists classify these changes for the two companies?

Ericsson China Mobile

A decreased average variable cost decreased fixed cost

B decreased average variable cost increased fixed cost
C increased fixed cost decreased average variable cost
D decreased fixed cost decreased average variable cost

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 6 Which cost incurred by a firm manufacturing shirts is a variable cost?

A buildings insurance
B interest on bank loans
C raw materials
D rent on property

7 Fifty people are employed in a business to produce 10 000 units per week.

The weekly costs are:

$
hire of machinery 230
power 200
raw materials 1000
wages per employee 40

What are the variable costs for the week?

A $1200 B $1430 C $1470 D $3200

8 The table shows the units of factors of production that a firm needs to employ for two different levels of output.

land labour capital output

5 2 4 10
10 4 8 300

What is the firm experiencing?

A constant returns to scale

B economies of scale
C external diseconomies of scale
D external economies

9 What is happening when a firm is experiencing diseconomies of scale?

A It has rising long-run average costs.

B It is operating in the short run.
C Its fixed costs are less than variable costs.
D Its output is increasing faster than its inputs.

10 In 2005, world oil prices increased significantly.

What effect would an increase in oil prices have on a firm that transports products for other firms?

A average fixed costs would increase

B profits would increase
C total fixed costs would increase
D variable costs would increase
 

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Day 9

Production in the short-run

The short run is a period of time when there is at least one fixed factor of production i.e. some factor inputs that
cannot be altered. This is usually fixed capital such as machinery and the amount of factory space
available. Output increases when more units of variable factors (labour and raw materials) are added to fixed
factors. Hence in the short run a firm will have fixed and variable costs of production. Total cost = fixed cost +
variable cost.

THE LAW OF DIMINISHING MARGINAL RETURNS

The law of diminishing returns states that as we add more units of the variable input (i.e. labour) to fixed amounts
of land and capital the change in total output will first raise, then fall. Diminishing returns to labour occurs when
marginal product starts to fall. This means that total output will increase at a decreasing rate when more workers
are employed.

The behavior of marginal product is linked directly to the productivity of each additional worker. At low levels of
employment the fixed factors of production, land, and capital are under-utilizeds. This means that each additional
worker will be have plenty of capital to use and, as a result, marginal product will rise. However, beyond a certain
point the fixed factors of production become scarcer and new workers will not have much capital to work with.
Indeed, eventually the workers will start to get in each other's way. As a result, the productivity of each additional
worker falls. As the labour input increases, so the capital per worker ratio declines and this can negatively affect
overall productivity.

Evaluation: Criticisms of the Law of Diminishing Returns the law of diminishing returns lies at the heart of
standard neo-classical production and cost theory. Underlying the idea is the assumption that a business operates in
the short run with fixed factor resources and given, constant technology. This concept may hold true for many
small and medium sized businesses that have little access to additional resources in the short-run production
process.
However the development of the global economy, and the ability of transnational corporations to source their
inputs from more than one economy and engage in rapid transfers of technology and other information, makes the
concept less relevant to the real world. This is worth mentioning in exam answers. In many industries as a business
expands, it is more likely to experience increasing returns rather than diminishing returns. This has important
implications for production costs and in particular the potential for a firm to exploit economies of size

Total output (also known as total product) is the output of a good or service generated by using factor inputs.
Total output is maximised when marginal product = zero (i.e. when adding extra units of labour adds nothing to
total output)

The behavior of marginal product is linked directly to the productivity of each additional worker. At low levels
of employment the fixed factors of production are under-utilised so each additional worker will be more
productive than the last. Marginal product will be high and average product will be rising. However, eventually the
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fixed factors of production become scarcer and the productivity of each additional worker will fall. This is when
we experience diminishing returns.

Consider this example: Extra units of labour are added to a fixed amount of capital and total output of good X
(measured in units per day) is shown in the table below.
Labour Input Total Output Marginal Product
(workers per day) (units per day) (units)
1 5 5
2 12 7
3 22 10
4 30 8
5 36 6
6 38 2

Marginal product at first rises but with the 4th worker, the marginal output declines to 8 units per day. From the
4th worker onwards we experience diminishing returns. Total output is still rising but at a decreasing rate.

Diminishing returns

The law of diminishing returns states that as we add more units of a variable input (i.e. labour) to fixed amounts of
land and capital, the change in total output will at first rise and then fall. Diminishing returns to labour occurs when
marginal product starts to fall. This means that total output will increase at a decreasing rate when more workers
are employed. Eventually a decline in marginal product leads to a fall in average product.

What happens to marginal product is linked directly to the productivity of each extra worker employed. At low
levels of labour input the fixed factors of production, land and capital tend to be under-utilised which means that
each additional worker will be have plenty of capital to use and, as a result, marginal product may rise.

Beyond a certain point the fixed factors of production become scarcer and new workers will not have as much
capital to work with (the capital input becomes diluted among a larger workforce). Indeed, eventually workers may
start to get in each other’s way. As a result, the productivity of each additional worker falls.

Evaluation: Criticisms of the Law of Diminishing Returns

The law of diminishing returns lies at the heart of mainstream production and cost theory which continued to
dominate textbooks! Underlying the idea is an assumption that a business operates in the short run with fixed factor
resources and given, constant technology. This concept may hold true for many small and medium sized businesses
that have little access to additional resources in the short-run production process.

However the process of globalization , and the ability of transnational corporations to source their inputs from
more than one economy and engage in rapid transfers of technology and other information, makes the concept of
diminishing returns less relevant to the real world of business. In many industries as a business expands, it is more
likely to experience increasing returns rather than diminishing returns. After all, why should a multinational
business spend huge sums on research and development and investment in new capital machinery and an
expanding labour force if a business cannot extract increasing from these extra inputs?

The argument that increasing returns to scale are now a more persuasive feature of the production process across
many industries and market has important implications for production costs and in particular the potential for a
firm to exploit economies of size and scope. This has important implications for many industries – for example the
nature of production in the pharmaceutical market or the returns to scale in the global production of computer
games consoles.

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Day 10

Business revenue and turnover

Revenue is the income generated from the output produced by firms and then sold in goods markets. It is also
known as sales turnover. The revenue the firm can create depends on the strength of demand for the products
they are supplying - in other words how much output can be sold at a given price.

TOTAL REVENUE = Price per unit x Quantity sold (TR = p x q)

AVERAGE REVENUE = PRICE = Total revenue divided by output - the average revenue curve for a business is
the same as their demand curve.

MARGINAL REVENUE = the change in total revenue as a result of selling one extra unit of output.

TOTAL REVENUE is maximized when marginal revenue = zero

Profit and sales revenue maximization using total cost and total revenue curves

One way of showing the differences in output that can come from different business objectives is to use total
revenue and total cost curves. If we assume that a business faces a downward sloping demand curve, the total
revenue curve will rise at a decreasing rate until marginal revenue = zero. The shape of the total cost curve depends
on what happens to marginal cost, if we assume that diminishing returns occurs in the short run, then the total cost
will eventually start to rise at an increasing rate. The profit maximising output occurs at the greatest vertical
distance between the TR and TC curves. However, revenue maximization occurs at a higher output level.

Shareholders might decide that a minimum level of profitability is required – so we might include in our analysis
the effect of such a constraint on the output choice. This is shown in the diagram below

Setting prices
Pricing is vital to business decision-making in markets and price decisions are also important to the government
when it wants to control the rate of inflation.

Price setting power

Not all firms have the ability to set their own market price. In perfectly competitive markets firms are said to be
price takers. They control only a very small percentage of total market supply and produce an output identical to
that of other sellers in the market. Each firm is assumed to be a price-taker. The ruling market price is determined
by the interaction of market demand and supply.
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Firms in imperfect competition can choose the price or output that they want - although they are constrained by
the demand curve. 
Monopolists may choose to price at an output which maximizes profits (see below) although a range of other
objectives are possible.

Pricing rules

Profit maximization: price and output where marginal revenue = marginal cost
Break-even pricing: price and output where average revenue = average total cost
Revenue maximization: price and output where marginal revenue = zero (this is also the price where the elasticity
of demand equals unity)
Price discrimination: when a firm charges different prices to different sub-groups of consumers for the same good
and service for reasons related to the willingness of the consumer to pay for a particular product. 

Measuring profit

Profit = the difference between total revenue and total cost

Profit per unit = AR - ATC

A firm adds to profits if marginal revenue from selling an extra unit is greater than the marginal cost of production

Break-even output occurs when AR=ATC ( TR=TC)

Revenue maximization is when MR = zero

TYPES OF PROFIT

In economics there is no unique definition of profit!

NORMAL PROFITS - are defined as the minimum level of profit required to keep the factors of production in
their current use in the long run. Normal profits are included in the ATC curve, thus if the firm covers its ATC it is
making normal profits.
ABNORMAL PROFIT - is any profit in excess of normal profit. Also known as supernormal profit or economic
profit. When firms are enjoying abnormal profits in an industry there is an incentive for other producers to enter
the industry to try to acquire some of this profit for themselves.

SUB-NORMAL PROFIT - is any profit less than normal profit. In the long run a firm will leave an industry if it
continues to make only sub-normal profits. Also called an economic loss.

Practice MCQs

1 A firm bottles 10 000 bottles of cola a week. Its fixed costs are $1000 a week. Its variable costs
are $0.50 a bottle. Each bottle of cola is sold for $1. What is the profit per bottle of cola?

A $0.40 B $0.50 C $0.60 D $0.90

2 Which statement is correct?

A Average revenue is total revenue divided by output.

B Fixed cost is total cost plus variable cost.
C Total cost is variable cost multiplied by fixed cost.
D Total revenue is fixed revenue minus variable revenue.

3 What is a firm seeking profit maximisation trying to achieve?

A the fastest rate of profit growth

B the highest level of profit per unit produced
C the highest level of total profit
D the lowest level of total cost
4 What is not equal to the average revenue?

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 A the price of each unit
B the profit from each unit
C the revenue from each unit
D the total revenue divided by output

5 A firm’s average revenue is $10. It sells 2000 units.

What is the firm’s total revenue and the price of the product?

Total revenue ($) Price ($)

A 10 10
B 2 000 200
C 20 000 10
D 20 000 200

6 What is most likely to increase a firm’s profits?

A government controls on its prices

B grants for the purchase of new machines
C an increase in the wages paid to its workers
D rising costs of its raw materials

7 A business aims to maximise profits.

To do this, it will have to

A maximise sales revenue.

B maximise the difference between sales revenue and production costs.
C minimise production costs.
D minimise the difference between actual production and maximum production.

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