3) Production, costs & revenue

• Division of labour

  occurs where the production process is broken down into many separate tasks.
• It is preferable to have production based on specialisation of individuals and firms
• Benefits of higher productivity:

  • Lower average costs
  • Higher profits
  • Higher real wages
  • Growth in the economy
• Costs are expenses faced by a business that must be recouped if a profit is to be made
• Fixed costs DO NOT change in relation to output

  eg. Rent
• Variable costs DO change in relation to output

  eg. Raw materials
• Economies of Scale

  where an increase in the scale of production leads to a reduction in a firms average total costs.
• Internal Economies of Scale

  1. Marketing EOS
  2. Bulk buying
  3. technical EOS
  4. Managerial EOS
  5. Financial EOS
  6. Risk bearing EOS
  7. Network EOS
• diseconomies of scale

  occur when an increase in scale of production leads to an increase in average total costs of a firm because productive efficiency decreases.
• diseconomies of scale may arise from:

  • break down in communications
  • lack of coordination
  • break down in control / monitoring systems
  • a sense of alienation and loss of motivation in workers
• internal economies of scale

  the advantages a firm gains due to an increase in its size
• external economies of scale

  the advantages a firm gains due to growth in the size of the industry in which it operates in.
• What is normal profit?

  The minimum profit required to keep a firm in operation

  It covers the opportunity cost of investing funds into the firm and nowhere else

  This is where total revenue = total costs
• profit

  total revenue - total cost
• production

  the process that coverts factor inputs into outputs
• short run production

  occurs when a firm adds variable factors of production to a fixed factor of production
• long run production

  occurs when a firm changes the scale of all factors of production
• The law of diminishing returns

  In the short run when variable factors of producation are added to a stock of fixed factors of production total/mariginal product will intially rise and then fall
• Marginal product= change in total prodcut/ change in quantity of workers
• average product=total product/ quantity of workers
• average fixed costs= total fixed costs/ quantity
• total fixed costs= total variable costs + fixed costs - variable costs
• specialisation

  Organising labour and resources to a certain type of producation to limited number of goods instead of a wide variety to create a comparitive advantage for an economy
• marginal return


  the output from adding an additional unit of input
• Diminishing Returns and Productivity


  • As output increases, marginal costs rise and average fixed costs fall.
  • Initially, the effect of falling average fixed costs outweighs the increasing marginal costs. So average total costs fall.
  • This benefit diminishes over time, as average total costs rise.

  
• short run average total cost curve


  U shaped due to diminishing returns

  • This is because the factors of production are fixed. At one point, employing more resources will be less productive
  • which means the marginal output decreases per extra factor of production.
  • Marginal costs start to increase.
• LRAC shows


  how average costs change with output when all factors of production are variable.
• Diminishing marginal return is 


  the concept that the more of something you add, the lower the impact of each additional unit, assuming all else is fixed.
• Financial economies of scale


  • Larger firms are viewed by financial institutions (like banks) as less risky (less likely to go bankrupt) relative to smaller firms.
  • Banks are therefore willing to lend money at a cheaper rate as they can be more certain that the money will be repaid.
• Marginal revenue

  • This is the additional revenue gained from selling the last output unit.
• normal profit


  • When total revenue is equal to total cost, a firm is said to be generating normal profit.
  • In the long run, normal profit is the minimum a firm can be making to be sustainable.
  • In a perfectly competitive industry, firms can only make normal profit.
• Supernormal profit


  • When total revenue exceeds total costs, a firm is said to be generating supernormal profits.
  • The existence of supernormal profits signals to firms that they should enter the market.
  • Their ability to do this depends on the barriers to entry and level of contestability.
• Short run profits


  • In the long run, a firm must make at least normal profits.
  • But in the short run, at least one factor of production is fixed.
  • If the firm makes enough revenue to cover its variable costs, and begin to pay off its fixed costs, operations can continue.
  • The shut down point is the revenue where a firm just covers its variable costs. Below this point the firm will cease production immediately.
• when is a firm profit maximising


  when MC = MR
• Explain the difference between normal and supernormal profits.


  • Normal profit is when total revenue = total cost. In the long run, normal profit is the minimum a firm can be making to be sustainable.
  • Supernormal profit is when total revenue exceeds total costs. The existence of supernormal profits signals to firms that they should enter the market.
• Why don't firms always shut down when they start to make losses?


  In the long-run, firms will always shut down if they cannot make normal profits. However, in the short-run, firms may continue to produce.

  • A firm in the short-run has assets that take time to liquidate and contracts which need to be fulfilled.
  • If production covers the average variable cost, that is to say, the cost of producing each unit, then they should continue production.
  • The firm can use the revenue from production to start paying off the fixed costs, otherwise production only increases debt.
• specialisation


  different firms/factors of production concentrating on the production of different goods and/or services