Topic 12: Production & Cost

• Theory of supply: Production and Cost
• Economic resources provide for our economic wants, including land for which the reward is rent, factors of production such as labour for which the reward is wages/salaries, capital for which the reward is interest, and entrepreneur/enterprise for which the reward is profit.
• The production function is the relationship between the maximum amount of output a firm can produce and various quantities of inputs, represented by the equation Q = f (L,K).
• In the short run, a firm can increase output by using more variable factor such as labour and raw material.
• In the long run, a firm can build more factories or purchase new machinery and can enter the industry and existing firm may leave the industry.
• Where the MC and AVC intersect is the minimum point of production.
• If the market price which is the firm’s marginal revenue curve falls below the AVC the firm will shutdown and supply becomes zero.
• If the firm produces below the AVC it simply cannot cover its variable cost and therefore must shutdown.
• The MC curve is the firm’s supply curve because it represents the change in costs as more output is produced.
• In the short run, MC represents the change in costs as more output is produced.
• The firm will supply anywhere above the AVC as it can cover its unit cost and will shut down anywhere below the AVC as it cannot cover its cost per unit.
• The firm will begin production where the marginal cost meets the AVC.
• A fixed input is one that remains constant over the period of production, that is, it does not vary with the level of output produced, such as land and capital (machines, buildings, heavy equipment).
• A variable input is one that is directly related to the level of output produced, such as labour, raw material, electricity and oil.
• Marginal physical product (MPP) refers to the addition to output from hiring one more unit of factor of production, calculated as MPP= ∆TPP/∆ Q or Marginal Product = Change in Output/ Change in Input.
• The extra cost of producing an additional unit of a good is known as marginal cost.
• The extra revenue gained from producing an extra unit of a product is known as marginal revenue.
• Each short run average cost curve corresponds to a particular amount of factor that is fixed in the short run.
• All cost are variable in the long run.
• The LRAC curve can be drawn from a number of short run average cost curves.
• External economies of scale occur when new large firms enter an industry to process waste, provide technical support, and offer better transportation facilities.
• Diseconomies of scale occur when a business grows so large that the costs per unit increase due to management and administration problems, lack of cooperation, higher factor prices, and more.
• The long run average cost (LRAC) curve is drawn based on the assumption that there is an infinite number of choices of plant sizes as determined by short run average cost curves such as SAC1, SAC2, SAC3…………………….
• Internal economies of scale include technical efficiency, marketing efficiency, and risk bearing.
• An envelope curve is a LRAC curve drawn from the tangency of a series of short run average cost curves.
• Larger businesses can purchase materials in larger quantities, which can bring them per-unit cost advantages smaller businesses are unable to achieve due to their lack of output and cash.
• The LRAC curve shows the least cost combination of producing any particular quantity of output.
• The LRAC curve is 'U' shaped which implies that the expanding firm will eventually experience diseconomies of scale.
• In the long run, there is no fixed cost.
• The minimum efficiency of scale is the cost of producing one extra unit of output assuming that all factors are variable.
• Constant Return to Scale means LRMC = LRAC - constant.
• Changes in fixed cost affect both AC and MC causing them to shift upwards, increasing cost.
• The Short-run Supply Curve (SRSC) is the portion of the MC that lies above the AVC as the market price increases supply increases.
• The relationship between total, fixed and variable cost is represented by the average fixed curve which is u-shaped due to the law of diminishing returns.
• A firm operating one factory can build more in the long run if it experiences economies of scale.
• External economies of scale are economies of scale which are gained when a number of firms in one industry achieve cost savings due to expansion taking place in the industry as a whole.
• Long-run Marginal cost (LRMC) is the relationship between LRMC and LRAC studied in the context of laws of return.
• Increasing returns to scale occur when output increases more than proportionately to the increase in inputs.
• Changes in variable cost affect both AC and MC causing them to shift upwards, increasing cost.
• There are three possible returns to scale scenarios: Increasing return to scale, Decreasing return to scale, and Constant return to scale.