Introduction to Economics - LEC 4 (Technology, Production and Costs) PDF

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Introduction to EconomicsLecture 4Technology, Production and CostsTo better understand the concept of supply, it is important to examine firms’ costs of production, and how costs relate to output decisions. Over a short time period, these supply decisions are limited by the size of the firm (some pr...

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Introduction to Economics Lecture 4

Technology, Production and Costs To better understand the concept of supply, it is important to examine firms’ costs of production, and how costs relate to output decisions. Over a short time period, these supply decisions are limited by the size of the firm (some production factors are fixed). However, in the long run, the decision includes whether or not the firm should expand in size. This topic explains a whole family of production and cost curves using graphical illustration. Learning Objectives:

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Define technology and give examples of technological change Understand the nature of production in the short run Explain the reason behind the shape of the total product curve in short run Explain the reasons behind increasing marginal returns and diminishing marginal returns in production Understand the relationship between the marginal product of labour and average product of labour Understand the various measures of costs, distinguishing between short-run and longrun time periods Understand the reasons behind the shape of cost curves Understand the nature of production in the long run and why the Long run average cost curve is called the 'planning curve'.

Some Economic Definitions: Firm: -

An organization that comes into being when a person or a group of people decides to produce a good or service to meet a perceived demand.

Technology: -

The processes a firm uses to turn inputs into outputs of goods and services

Technological Change: -

A change in the ability of a firm to produce a given level of output with a given quantity of inputs

Production Function: -

The relationship between the inputs employed by the firm and the maximum output it can produce with those inputs

The Behaviour of Profit Maximising Firms: -

All firms must make several basic decisions to achieve what we assume to be their primary objective — maximum profits

Short-Run VS. Long-Run: -

Economists distinguish between the short-run and the long-run

Distinguishing between either depends on the business and what it is selling: e.g. Selling Coffee from a cart – Long run may be 2 months e.g. Car manufacturer (FORD) – Long run may be 10 years

Fixed and Variable Inputs: Fixed Input: -

Any resource where the quantity used cannot change during a specific period of time

Variable Input: -

Any resource for which the quantity used can change during a specific period of time

The Total Product and Marginal Product of Labour:

Diminishing Marginal Returns (Marginal Product of Labour MP L) Marginal Product and the Law of Diminishing Returns: Marginal Product: -

The additional output that can be produced by adding one more unit of a specific input, CETERIS PARIBUS

Law of Diminishing (Marginal) Returns: -

The principle that, at some point, adding more of a variable input, such as labour, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline.

Shape of the Marginal Product Curve: Increasing Marginal Returns: -

Arises from increased specialisations & division of labour as the first few workers are hired

Decreasing Marginal Returns: -

More and more workers are using the same equipment and work area, so while the total number of copies still increases as the 4th & 5th worker is hired, the rate of increase is slowing

Law of Diminishing Returns: -

Diminishing returns always apply in the short run, and in the short run every firm will face diminishing returns. This means that every firm finds it progressively more difficult to increase its output as it approaches capacity production

Marginal Product and Average Product:

DIVIDE QUANTITY OF COPIES

Relationship between Marginal and Average Product:

QUANTITY OF WORKERS

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If the marginal is above the average, the average increases.

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If the marginal is below the average, the average falls.

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The marginal is equal to the average, when the latter is at its maximum.

Shifting Short-Run Production Curves: •

If the technology improves, and/or the fixed resources increase, it is likely the total output curve rises.

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For each worker employed, more output can be produced.

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It is likely this will also result in higher marginal and average product curves. Productivity rises.

Costs: Cost theory is the relationship between output and costs Explicit Costs (Money Changes Hands): -

A cost that involves spending money E.g. Resources employed by a firm that takes the form of cash payments On the accounting statement

Implicit Costs (No Money Changing Hands): -

Next best option’s value A firm’s opportunity cost of using its own resources or those provided by its owners Without a corresponding cash payment Not on the accounting statement

Accounting Profit VS. Economic Profit: Accounting Profit is: -

Total Revenue (Price x Quantity Sold) – (Minus) Total Explicit Costs = Accounting PROFIT

Economic Profit is: -

Total Revenue – (Minus) Total Opportunity Costs

Total Opportunity Costs is: -

Explicit costs + Implicit Costs

EXAMPLE:

= Economic Profit

Short Run Costs: Fixed Costs (TFC): -

The cost of fixed inputs Fixed costs do not vary with output and are sometimes called overhead costs E.g. Capital

Variable Costs (TVC): -

The cost of variable input Variable costs depends on the number of units of output produced E.g. Wages, Raw materials etc.

Total Costs (TC): -

The sum of Fixed cost and Variable Costs o TC = TFC + TVC

Average Total Cost (ATC): -

Total costs divided by the quantity of output produced Per unit cost of Production

LINKED: Quantity + Cost

Marginal Costs: -

The change in a firm’s total cost from producing one more unit of a good or service

Relationship between Average and Marginal Cost:

As Margin INCREASES, Average also INCREASES As Margin DECREASES, Average also DECREASES

Short Run Costs (Continued): -

AVERAGE FIXED COST: o Fixed cost / Quantity of Output Produced AVERAGE VARIABLE COST: o Variable cost / Quantity of Output Produced Average total cost = ATC = TC/Q Average fixed cost = AFC = TFC/Q

GENERAL FORMULA: ATC = AFC + AVC

Average variable cost = AVC = TVC/Q

Relationship Between Cost Curves:

Relationships between MC, ATC, AVC and AFC •

The MC, ATC and AVC curves are all U-shaped, and the marginal cost curve intersects the average variable cost and average total cost curves at their minimum points.

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As output increases, AFC gets smaller and smaller.

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As output increases, the difference between average total cost, and average variable cost decreases.

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ATC and AVC gets closer and closer because the difference between them is AFC, as the graph represents AFC is decreasing. And so that is why the gap become becomes smaller

Long-Run Production Costs: •

In the long run, the quantity of all inputs can be adjusted:  build a larger factory  expand onto new land  hire new staff.

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The long run allows greater planning for the expected level of production

To examine long run costs, we need to examine the costs relating to all the possible plant sizes from which firms can select:

The curve traces the lowest cost per unit at which a firm can produce any level of output (when the firm is in a position to build any desired plant size)

Shape of Long Run Average Cost Curve: •

Economies of Scale: when a firm’s long-run average costs fall as it increases output.

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Constant returns to scale: when a firm’s long-run average costs remain unchanged as it increases output.

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Diseconomies of scale: when a firm’s long-run average costs rise as it increases output.

Shape of Long Run Average Cost Curve: Economies of scale Reasons: The division of labour and the use of specialisation are increased More efficient use of capital equipment. Bulk buying leading to cheaper inputs. Spreading fixed costs. Financial economies (E.g. Negotiating Lower Interest rate)

Constant Returns to Scale Reasons: When Long Run Average Cost (LRAC) does not change as the firm increases output

Diseconomies of scale Reasons: More Bureaucracy Increased barrier to communication Management difficulties (lack of coordination)...