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1.3 Theory of the Firm (HL ONLY) Part I
Sub-topic
Production and costs
Production in the
short run: the law of
diminishing returns
HL Core – Assessment Objectives
AO2 – Distinguish between the short run and long run in the context of production.
Long run is the planning stage in which all factors of production are variable apart
from technology; short run is in the production stage in which at least one factor of
production is fixed.
AO1 – Define total product, average product and marginal product, and construct
diagrams to show their relationship.
Total product is the total output that a firm produces using its fixed and variable
factors in a given period of time. Average product is the output produced on average,
by each unit of the variable factor (AP=TP/V). Marginal product is the extra output
produced by using an extra unit of the variable factor (MP=∆TP/∆V).
AO3 – Explain the law of diminishing returns.
*NOTE: You must be able to calculate total, average and marginal product from a set
of data and/or diagrams.
Costs of production:
economic costs
Costs of production
in the short run
As labor increases marginal returns increase (see diagram above showing relationship
between Total, Average and Marginal product in the long run). However, after a
certain point marginal returns diminish because there is so much labor that production
becomes inefficient. If labor continues to increase there will be negative marginal
returns.
Economic costs are the opportunity cost of all resources employed by the firm
(including entrepreneurship).
AO2 – Distinguish between explicit costs and implicit costs as the two components of
economic costs.
Explicit costs are factors of production purchased from others and not already owned
by the firm. Implicit costs are factors of production already owned by the firm. One
must consider the opportunity costs of both explicit and implicit costs. Even if one is
not paying for factors of production as with explicit costs, the firm could close down if
it is not covering the opportunity cost of implicit costs (it could be making more money
in another business).
AO3 – Explain the distinction between the short run and the long run, with reference
to fixed factors and variable factors.
In the short run, at least one variable is fixed. In the long run, all factors are variable
except the state of technology.
AO2 – Distinguish between total costs, marginal costs and average costs.
Total costs are the sums of fixed (total costs of all fixed assets that a firm uses in a
given time) and variable costs (total costs of all variable assets a firm uses in a given
time). Marginal costs are the costs of producing one extra unit of output. Average
costs are the costs per unit output.
AO3 – Draw diagrams illustrating the relationship between marginal costs and
average costs, and explain the connection with production in the short run.
The marginal cost has to intersect
the average cost at its lowest point.
While the marginal cost is below the
average cost, the average cost will
continue to decrease. When the
marginal cost increases above the
average cost, however, average cost
too will increase, so that is why
marginal cost equals average cost at
its lowest point.
AO3 – Explain the relationship
between the product curves
(average product and marginal product) and the cost curves (average variable cost
and marginal cost), with reference to the law of diminishing returns.
(See diagram above) To start with, as output increases average cost decreases as does
marginal output. After a point, however, due to diminishing marginal returns, both the
marginal and average cost increases.
(See diagram left) Similarly, due to
diminishing returns, after a point,
increasing the input will only cause
output per unit input to decrease
instead of rising. This will cause
marginal product to drop. However,
it is only when marginal product is
less that average product that
average product will also start to
drop. Hence, the marginal product
intersects the average product at its
highest point.
Production in the
long run: returns to
scale
Costs of production
in the long run
*NOTE: You must be able to calculate total fixed costs, total variable costs, total costs,
average fixed costs, average variable costs, average total costs and marginal costs
from a set of data and/or diagrams.
AO2 – Distinguish between increasing returns to scale, decreasing returns to scale
and constant returns to scale.
In the long run, as output per
period increases, cost per unit
output decreases due to
economies of scale (e.g.
benefits of specialization). As
a result of the decrease in
average cost, there are
increasing returns to scale.
However, due to diminishing
returns, after a certain point
cost per unit output does not
decrease but remains the
same and there are constant returns to scale. If output per period continues to
increase there can be decreasing returns to scale due to diseconomies of scale (e.g.
strained control and communication).
AO1 – Outline the relationship between short-run average costs and long-run average
costs.
The LRAC (Long Run
Average Cost) curve is Ushaped because of
economies and
diseconomies of scale. The
SRAC (Short Rune Average
Cost) curve is U-shaped
due to the law of
diminishing returns. In the
short run (the production
stage) costs increase as
output increases because
at least one fixed factor of
production restrains
further growth. In the long run (the planning stage) all factors of production are
variable, apart from technology, so production can move to a new short-term curve.
Once production begins the firm is again stuck on the new short-term curve. In the
next wave of planning, however, the firm can again increase all factors, apart from
technology, and move to a new point on the LRAC curve.
AO3 – Explain, using a diagram, the reason for the shape of the long-run average total
cost curve.
As output per period
increases, cost per unit
output decreases due
to economies of scale.
After a certain point,
due to diseconomies of
scale, there are only
constant returns to
scale and eventually
cost per unit actually
starts increasing with
rising output.
AO2 – Describe factors giving rise to economies of scale.
There are a number of factors giving rise to economies of scale. Economies of scale are
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. Economies of scale lead
to the firm experiencing increasing return to scale There are both internal and external
economies of scale.
Internal economies of scale are the reduced costs brought to a single firm from being
large. Internal economies of scale include:
Specialization:
In large firms, there can be specialized managers who have individual areas of
expertise, such as production, finance or marketing and can therefore be more
efficient.
Division of labor:
Breaking down the production process into small activities that workers can perform
repeatedly and efficiently allows unit costs to be reduced (e.g. assembly lines).
Bulk buying:
As firms increase in scale they are often able to negotiate discounts with suppliers that
they would not have received when they were smaller, the cost of their inputs is then
reduced, which in turn reduces the costs of production.
Financial economies:
Large firms can raise financial capital more cheaply because banks tend to charge
lower interest rates to larger firms, since the larger firms are considered to be less of a
risk than the smaller firms, and are less likely to fail to repay their loans.
Transport economies:
Large firms making bulk orders may be charged less for delivery costs than smaller
firms. Also, as firms grow they may be able to have their own vehicles, which will cost
less because of not having to pay other firms, who will include a profit margin.
Large machines:
A large firm can have its own large machinery and would not have to pay other firms,
who will include a profit margin, thereby reducing unit costs of production.
Promotion economies:
Since the costs of promotion tend not to increase in the same proportion as output,
the cost of promotion per unit output falls, as a firm gets larger.
External economies of scale are the benefits of the concentration of firms in an
industry (e.g. technical firms in Silicon Valley). For instance, due to the concentration
of firms special courses are offered in university in and near the area so that there is a
talented labor force for firms to pick from.
AO2 – Describe factors giving rise to diseconomies of scale.
Factors giving rise to diseconomies of scale include problems of coordination and
communication (it is difficult to maintain control over a large organization, also
decision making can take longer and everyone’s points of view may not be taken into
consideration) and alienation and identity loss (workers may feel that they are an
insignificantly small part of the organization as a whole and receive no individual
recognition for their work – this could cause a lack of motivation and staff morale). An
external diseconomy of scale is that with more firms there is more demand and costs
of labor and supplies rise.
Revenues
Total revenue,
average revenue and
marginal revenue
AO2 – Distinguish between total revenue, average revenue and marginal revenue.
Total revenue (TR) is the total amount of money that a firm receives from selling a
certain amount of a good or service in a given time period (TR = pq). Average revenue
(AR) is the revenue that a firm receives per unit of its sales (AR = TR/q = pq/q = p).
Marginal revenue (MR) is the extra revenue a firm gains when it sells one more unit of
a product in a given time period (MR = ∆TR/∆q).
AO4 – Illustrate, using diagrams, the relationship between total revenue, average
revenue and marginal revenue.
As previously states, AR is equal to price and so it falls as output increases, since the
price has to be lowered in order to sell more products. This is shown in the diagram
above where the demand curve is labeled as AR. MR also falls as output increases but
twice as steeply as AR and also goes below the x-axis. This relationship holds for all
downward sloping AR curves and the MR curves relating to them. MR is below AR
because in order to sell more products the firm has to lower the price of the products
being sold – losing revenue on the ones that could have been sold at a higher price in
order to get the revenue from the extra sales. For TR, extra units are being sold so TR
rises; however, in order to do this the price has to be lowered. As a result, for a normal
downward sloping demand curve TR rises at first but eventually starts to fall due to
lowered prices.
NOTE: You must be able to calculate total revenue, average revenue and marginal
revenue from a set of data and/or diagrams.
Profit
Economic profit
(sometimes known
as supernormal
profit or abnormal
profit) and normal
profit (zero
economic profit
occurring at the
break- even point)
Economic profit is the case where total revenue exceeds economic cost.
Normal profit is the amount of revenue needed to cover the costs of employing selfowned resources (implicit costs, including entrepreneurship).
Economic profit is profit over and above normal profit, and that the firm earns normal
profit when economic profit is zero.
Loss is negative economic profit arising when total revenue is less than total cost.
AO3 – Explain why a firm will continue to operate even when it earns zero economic
profit.
A firm will continue to operate because it may able to cover its average variable costs.
This is the most important because if it cannot cover these costs in the short run, it will
have to shut down in the short run.
NOTE: You must be able to calculate different profit levels from a set of data and/or
diagrams.
Goals of the Firm
Profit maximization
Alternative goals of
firms
The goal of profit maximization is where the difference between total revenue and
total cost is maximized or where marginal revenue equals marginal cost.
AO2 – Describe alternative goals of firms, including revenue maximization, growth
maximization, satisficing, and corporate social responsibility.
Revenue maximization is the measuring of success by the amount of revenue a firm
makes. If this is the case then they may attempt to maximize their sales revenue by
producing where the marginal revenue is zero. They will actually produce above the
profit maximizing level of output (MC=MR).
Growth maximization is targeting growth in the short run, rather than profits, in order
to gain a large market share and then dominate the market in the long run. Growth
may be measured in many different ways, such as the quantity of sales, sales revenue,
employment or the percentage of market share.
Satisficing is when firms work hard enough to cover the opportunity costs, so to a
satisfactory level, rather than maximization. This allows them to pursue other goals.
In general people who do not actually own these firms run them (e.g. shareholders
who are not involved in running the company and are therefore managed by
employed non-owners).
Corporate Social Responsibility is where a business includes the “public interest in its
decision making”. It adopts an ethical code that accepts responsibility for the impact
of its activities on areas such as the workforce, consumers, the local community and
the environment.