A2 cost theory week 1 (IB customised) week 1

Cost Theory : 

Cost Theory A2 Micro Part 1

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Learning Objectives

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Long run and Short run When we talk about production costs we have to distinguish between short run and long run When a firm is producing some of its factors of production will be fixed in the short run The firm will not be able to quickly increase the quantity of them that it has In the short run a firm that makes furniture will only have a limited amount of factory space In the long run it could plan to build another factory but in the short term it has to make do with what it has Often the fixed factor is some element of capital or land It could also be a a type of highly skilled labour such as a specialist machine worker If a firm wants to produce more in the short run it can only apply more units of its variable factors to the fixed factors while it plans ahead Short run – the period of time in which at least one factor of production is fixed. All production takes place in the short run Long run – the 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

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Long run and short run The length of the short run for the firm will be determined by the time it takes to increase the quantity of the fixed factor The furniture factory’s short run may be as long as it takes to build another factory (perhaps a year) A small firm involved in gardening’s fixed factor may be the number of lawn mowers it has Its short run will be the time it takes to order and take delivery of a new lawn mower which may only be a week The firm is in the long-run when it is planning (all the factors of production are variable) As soon as it makes the change the firm is once again in the short run but with a different number of fixed factors Once again the only way they can increase output is by applying more units of variable factors

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Consider the following scenario A small firm sets up a plant making teddy bears The firm has a small production unit Two bear making machines and two operators There is one manager that owns the firm who carries out all non-production activities The is an unlimited amount of materials needed to make the bears What are the fixed factors? Factory Machines Operators What are the variable factors? Materials

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Consider the following scenario There is an increase in demand for the bears and the firm decides to satisfy this demand with the existing factors What will the firm do? Work overtime The increase in demand persists and so the firm now decides to expand the production unit, bring in 2 more machines and employ 2 more workers The planning takes place in which time period? Long run What time period is the firm in once the changes to the plant have taken place and the firm is producing again? Short run What are the fixed factors now? Factory; Machines; Operators

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Total, average and marginal product A firm has four machines (fixed factors) and increases its output by using more operators to work the machines (variable factors) Make a note of the AP and MP definitions and then complete the table on the next slide Once you have completed the table you need to plot 2 graphs The total product curve (total product on the Y axis and quantity of variable factor on the X axis) Scale on y axis 0, 50, 100, 150 Scale on x axis 1, 2, 3, 4, 5……8 The AP and MP curve (same axes but scale will be different) Plot the MP on the mid points just as you drew the table e.g. you would plot 10 between 0 and 1 Scale on Y axis 0, 10, 20, 30 Scale on X axis 1, 2, 3, 4,.. to 8 Now look at the curves and think about what we can deduce Average product (AP) – the output produced, on average, by each unit of variable factor Marginal product (MP) – the extra output that is produced by using an extra unit of the variable factor

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Quantity of Labour (V) Total product (TP) Average Product (AP) Marginal Product (MP) 0 0 10 1 10 10 15 2 25 12.5 20 3 45 4 70 5 90 6 105 7 115 8 120

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The Tennis Ball Game Now plot your AP and MP curves What is happening? What is your product? What are you fixed factors? What are your variable factors?

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Total, average and marginal product Watch the mjm foodie video Producer Theory

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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 units 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

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Diminishing Marginal Returns Watch Econ concepts in 60 seconds video

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Economic costs / profit Watch the mjm foodie video Accounting vs Economics Profit

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Time for you to do some work!! A small firm has been operating for one year. During the year they have Paid £40,000 in wages and salaries Paid £100,000 for raw materials Used their own small factory that could have been rented out for £90,000 Used £40,000 worth of electricity and services Received £450,000 in total revenue In addition The firm uses its own machinery which has reduced in value by £20,000 because of wear and tear and now has a second hand value of £70,000 The owner gave up another job with another firm where he would have been paid £70,000 The owner has invested £60,000 of his own money into the business (the rate of interest during the year has been 5%) In light of the facts above: Calculate and explain the profits/losses made by the firm from the point of view of An accountant and An economist

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Time for you to do some work!! A small firm has been operating for one year. During the year they have Paid £40,000 in wages and salaries Paid £100,000 for raw materials Used their own small factory that could have been rented out for £90,000 Used £ 40,000 worth of electricity and services Received £ 450,000 in total revenue In addition The firm uses its own machinery which has reduced in value by £20,000 because of wear and tear and now has a second hand value of £ 70,000 The owner gave up another job with another firm where he would have been paid £ 70,000 The owner has invested £ 60,000 of his own money into the business (the rate of interest during the year has been 5%) Accountant profit = 450 – (40 + 100 + 40) = 270k Economist’s profit = 270k – 70 – 70 – (60 x 5%) = 127k Blue = implicit costs Purple = explicit costs

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Short run costs Firm’s have many different costs when producing whatever good or service they provide We need to understand the different types and where they originate There are 3 main types Fixed Variable Marginal

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Short run fixed costs Fixed costs (in the short run) are costs of production that do not vary as output changes It makes no difference how much the factory makes the fixed costs will be the same e.g. payment for buildings, rent, salaries (not wages), depreciation, machinery etc Fixed costs have to be paid for regardless of whether the firm produces nothing or works 24 hours Fixed costs are never zero Drawn as a horizontal line If there are high fixed to variable costs there is an opportunity for economies of scale because the fixed costs are spread over the output to give average fixed costs and these will reduce as output increases

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Variable costs Variable costs are costs of production that vary with output the more that is produced the more the variable costs Examples - raw materials, power, labour When there is no output the variable costs are zero We add the variable costs to the fixed costs to get the total costs ( TC) Average variable costs ( AVC ) are the total variable costs divided by the amount of output

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Cost Activity Using the same scenario that we used to create the MP and AP curves we are going to work out the costs and plot the curves (on excel) We are going to assume that there are 4 machines that cost $100 each per week (fixed costs) Each worker costs $200 per week (variable costs) For this scenario there are no other costs

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Fill in the spreadsheet and then use excel to create the curves Use 2 separate diagrams and include the following on each TFC,TVC, TC and AFC, AVC, ATC, ATC, MC Output should be on the x axis and costs on the y axis

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What do you notice about the TC curve? The TC curve is just the TVC curve shifted up by the fixed cost amount

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What do you notice about the marginal cost curve? It cuts through the ATC and the AVC at their lowest points (always!!)

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Average total costs (ATC) / Marginal Costs ATC is the total cost divided by the number of units produced These will decline as the fixed costs are spread over more unit It will then increase as the growth in variable costs is greater than the fall in fixed costs Marginal costs are the cost of producing one extra unit of output The average fixed costs fall as output rises The fall is very rapid as the fixed cost is spread over more units This will reduce the cost of producing the extra unit The falling AFC pull the marginal cost curve down But..the firm will be taking on more labour At some point the falling fixed costs will be unable to compensate for the increased labour costs Marginal costs will start to increase

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Note that the MC intersects the AC curve at the lowest point of the AC curve Extra units of labour raise marginal product (increasing returns) Extra units of labour reduce marginal product (decreasing returns) Whenever the marginal cost is below the average total costs then the average must be falling Even if the MC is increasing if it is less than the AC it will mean that AC are falling. When the MC is higher than the AC the AC will start to rise

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Note that the MC intersects the AC curve at the lowest point of the AC curve Extra units of labour raise marginal product (increasing returns) Extra units of labour reduce marginal product (decreasing returns) If there is a room full of people that are all 2m tall the average height will be 2m. If someone else comes into the room (the marginal person) that is 1.5m tall the average will fall (because they are lower than the average). If the next marginal person is 1.8m the average will still fall (still lower than the average). It is only when the next marginal person who is 2.2m tall that the average starts to increase (because the marginal person is taller than the average).

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Note that the MC intersects the AC curve at the lowest point of the AC curve So many graphs!! Which ones do we really need to know? Watch mjmfoodie video

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These are the curves you need to remember

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Watch Pajholden’s video on costs http://www.youtube.com/watch?v=jNL9PNfrKZI

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Long Run Costs This diagram shows what happens in theory in the long run (in the planning stage) The LRAC is an envelope curve (it envelops an infinite number of short run average cost curves) Any point on the SRAC curve that is tangential to the LRAC is the lowest possible cost of producing the output (in the short run)

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Long Run Costs Say a firm is operating at C3 on SRAC1 Demand increases and the firm wants to produce q2 They can employ more variable factors and move along the SRAC They are producing even more cheaply The firm knows that it can produce this output even more cheaply if it alters all of its factors of production They will plan to make the change and move onto SRAC2 They will now be producing Q2 at C2 (an even lower cost), again at the lowest point on the SRAC2 because it is tangential to the LRAC

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Long Run Costs The whole LRAC curve is made up of an infinite number of single points from SRAC curves These curves represent all of the possible combinations of fixed and variable factors that could be used to produce different levels of output The LRAC is the boundary between unit cost levels that are attainable and those that are unattainable If possible the firm would wish to produce different output levels at points on the LRAC curve in order to minimise their cost per unit of output This may not always be possible in the short run

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Long Run Costs When the long run average costs are falling as output increases we say that the firm is experiencing increasing returns to scale This means that a given percentage increase in all factors of production will lead to a greater percentage increase in output When the LRAC are constant as output increases we call it constant returns to scale This means that a given percentage increase in all factors of production will lead to the same percentage increase in output When the LRAC are increasing with increased output we call it decreasing returns to scale This means that a given percentage increase in all factors of production will lead to a lower percentage increase in output thus increasing long run average costs Don’t confuse this with the law of diminishing returns; that is always the short run. This is the long run

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Long Run Costs There are two factors that make long run average costs increase or decrease Economies of scale and Diseconomies of scale There are a number of different economies of scale Specialisation – as the firm grows managers can concentrate on areas that they specialise in e.g. finance, marketing etc and become more efficient Division of Labour – breaking the production process down into small jobs and sometimes replacing people with machinery Bulk buying – getting discount for buying larger supplies Financial economies – getting a better rate of interest on loans because the company is less of a risk Transport economies – have their own transport fleet Large machines – when a firm is small they may not be able to afford large machinery and may have to hire it but as they grow they can buy it Promotional economies – the costs of promotion do not tend to increase in the same proportion as output – the cost of promotion per unit of output falls Economies of scale – 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

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Long Run Costs There are 2 main diseconomies of scale Control and communication problems – as firms grow the management will find it harder to control and coordinate the activities of the firm This may lead to inefficiency and increases in unit costs of production Alienation and loss of identity – as firms grow workers and managers may begin to feel that they are only a very small part of the organisation They may be less motivated and therefore work less hard and become less productive All of these economies and diseconomies of scale relate to the unit cost decreases or increases that may be encountered by a single firm – they are internal economies and diseconomies of scale When the whole industry size increases and it effects the unit costs these are known as external economies and diseconomies of scale Growth of industry leads to local universities with courses related to the industry – graduates will leave ready trained so there is less cost to the firms Rapid growth of the industry may lead to more competition for raw materials, capital and qualified labour which forces up the pries of these factors Diseconomies of scale – any increases 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

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Final note on cost theory Short run cost curves are U shaped because of the hypothesis of diminishing returns Long run cost curves are U shaped because of the existence of economies and diseconomies of scale In reality, economists have not yet found evidence of a firm becoming so large that the diseconomies of scale start to outweigh the economies of scale in the long run Actual long run cost curves may be drawn like this

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Time for you to do some work!! The British political economist Thomas Malthus (1766-1834) argued that because cultivatable land is in fixed supply, food production is subject to the law of diminishing returns and cannot keep pace with population growth. Technological improvements and international trade have meant that his gloomy predictions of famine and drought have largely been avoided, certainly for industrialised countries like the UK. Now that the world has more than 6 billion people, predicted to rise to 9 billion by 2050, there is a worry once again that diminishing returns will set in. Some estimates suggest that the worlds undernourished could soon number over a billion people. Genetically modified (GM) crops are seen by some experts as providing a way around the problem of diminishing returns. Supporters of GM technology claim that by developing crops that are resistant to disease, drought, salty soil and flooding, more land can be cultivated and existing farmland used more efficiently. The result is improved agricultural productivity. They also claim that private goods like rice and tomatoes can be turned into merit goods by being modified to contain vaccines or cures for diseases. Explain what is meant by .diminishing returns ( Extract B , line 2-3) and analyse why the introduction of GM crops could help farmers to increase their productivity in the long run. (10 marks) ECN3 June10