Types of Cost, Revenue And Profit, Short-Run And Long-Run Production (Copy)
7.5.1 Short-Run Production Function
- Fixed Factors of Production:
- Inputs that cannot be changed in the short run (e.g., factory size, machinery).
- Variable Factors of Production:
- Inputs that can be changed in the short run (e.g., labour, raw materials).
- Total Product (TP):
- Total output produced by all units of variable factors employed.
- Average Product (AP):
- Output per unit of variable input.
- Formula:
AP = TP ÷ Quantity of variable input
- Marginal Product (MP):
- Additional output from employing one more unit of variable input.
- Formula:
MP = ΔTP ÷ ΔQuantity of variable input
- Law of Diminishing Returns (Law of Variable Proportions):
- As more units of a variable factor are added to fixed factors, marginal product eventually decreases.
- Initially, MP may rise due to specialization, then falls as overcrowding occurs.
7.5.2 Short-Run Cost Function
- Fixed Costs (FC):
- Costs that do not vary with output (e.g., rent, salaries).
- Variable Costs (VC):
- Costs that vary directly with output (e.g., raw materials).
- Total Cost (TC):
- Sum of fixed and variable costs.
- Formula:
TC = FC + VC
- Average Total Cost (ATC) / Average Cost (AC):
- Cost per unit of output.
- Formula:
ATC = TC ÷ Output
- Average Fixed Cost (AFC):
- Fixed cost per unit of output.
- AFC = FC ÷ Output
- Average Variable Cost (AVC):
- Variable cost per unit of output.
- AVC = VC ÷ Output
- Marginal Cost (MC):
- Additional cost of producing one more unit of output.
- MC = ΔTC ÷ ΔOutput
- Shapes of Curves:
- MC curve is U-shaped due to law of diminishing returns.
- AVC curve is U-shaped and lies below ATC.
- ATC curve is also U-shaped, approaching AFC + AVC.
- AFC curve decreases continuously as output increases (spreading fixed costs).
7.5.3 Long-Run Production Function
- No Fixed Factors:
- All factors of production are variable. Firm can adjust all inputs.
- Returns to Scale:
- How output changes when all inputs are increased proportionally.
- Types:
- Increasing Returns to Scale (IRS): Output increases by a greater proportion than inputs.
- Constant Returns to Scale (CRS): Output increases proportionally with inputs.
- Decreasing Returns to Scale (DRS): Output increases by a smaller proportion than inputs.
7.5.4 Long-Run Cost Function
- Long-Run Average Cost (LRAC) Curve:
- Envelope of all possible short-run average cost curves.
- Shape: U-shaped due to economies and diseconomies of scale.
- Minimum Efficient Scale (MES):
- Smallest level of output at which long-run average cost is minimized.
- Below MES, firm cannot fully exploit economies of scale.
7.5.5 Relationship Between Economies of Scale and Decreasing Average Costs
- Economies of Scale:
- Factors causing LRAC to fall as output increases, leading to decreasing average costs.
- Examples: technical, managerial, financial, marketing, purchasing economies.
- As output rises, the firm can lower average cost due to these economies.
7.5.6 Internal and External Economies of Scale
- Internal Economies of Scale:
- Cost savings within the firm as it grows larger.
- Types:
- Technical (better machinery)
- Managerial (specialised management)
- Financial (lower borrowing costs)
- Marketing (bulk buying)
- Risk-bearing (diversification)
- External Economies of Scale:
- Cost savings arising outside the firm due to industry growth.
- Examples:
- Improved infrastructure
- Skilled labour pool
- Supplier specialisation
7.5.7 Internal and External Diseconomies of Scale
- Internal Diseconomies of Scale:
- Cost increases within the firm as it becomes too large.
- Causes:
- Communication problems
- Management inefficiencies
- Worker alienation
- External Diseconomies of Scale:
- Cost increases due to industry-wide factors.
- Examples:
- Traffic congestion
- Resource shortages
- Increased competition for inputs
7.5.8 Definition and Calculation of Revenue: Total, Average and Marginal Revenue
- Total Revenue (TR):
- Total income from sales of output.
- TR = Price × Quantity sold
- Average Revenue (AR):
- Revenue per unit sold.
- AR = TR ÷ Quantity sold = Price
- Marginal Revenue (MR):
- Additional revenue from selling one more unit.
- MR = ΔTR ÷ ΔQuantity
7.5.9 Definition of Normal, Subnormal and Supernormal Profit
- Normal Profit:
- Minimum profit necessary to keep a firm in business.
- Occurs when total revenue equals total costs (including opportunity costs).
- Economic profit = 0.
- Subnormal Profit (Loss):
- Total costs exceed total revenue.
- Firm incurs losses, may exit industry if sustained.
- Supernormal Profit:
- Total revenue exceeds total costs.
- Economic profit > 0.
7.5.10 Calculation of Supernormal and Subnormal Profit
- Supernormal Profit:
- Supernormal Profit = Total Revenue – Total Costs (including normal profit)
- Or: Supernormal Profit = (AR – AC) × Quantity
- Subnormal Profit (Loss):
- Subnormal Profit = Total Revenue – Total Costs (negative value)
- Or: Subnormal Profit = (AR – AC) × Quantity < 0
Diagrams
Diagram 1: Short-Run Production — Total, Average, and Marginal Product
Output
↑
| TP
| /
| / ______
| /
| /
| AP / /
| / /
| / /
| MP / /
|__________________________→ Variable Input
- TP increases, AP and MP initially rise then fall (due to diminishing returns).
Diagram 2: Short-Run Cost Curves (U-shaped MC, AVC, ATC, AFC)
Cost
↑
| MC
| /
| /
| /
| /
|___/__________________ AC
|
| AVC
| ____ AFC
|_________________________→ Output
Diagram 3: Long-Run Average Cost Curve and Returns to Scale
Cost
↑
| LRAC
| / ______
| /
| /
|___/___________________→ Output
- Downward slope: Economies of scale
- Flat bottom: Constant returns to scale (MES)
- Upward slope: Diseconomies of scale
Diagram 4: Revenue Curves in Perfect Competition
Revenue
↑
| TR
| /
| /
| /
| /
| /_________→ Output
| AR = MR = Price (horizontal line)
Diagram 5: Profit Calculation Area
Price/Cost
↑
| AR=Price
| _________
| | | Supernormal Profit Area
| | |
|_|_________|
| AC
|__________________→ Quantity