Download Ch 7 Costs Revenues and profit

IB Economics
Costs, Revenues
and profit
(HL ONLY)
Ford has commenced production
on the all-new 2009 Ford Fiesta
at the Cologne assembly plant in
Germany, with other Ford
factories around the globe
gearing up to produce the
automaker’s latest small car
offering.
What are COSTS?
• COSTS OF PRODUCTION: These are the
costs to the individual firm that it incurs as
a result of production;
– Total costs
– Fixed costs
– Variable costs
The Theory of Production
Key Terms 1
• Total Costs
– Fixed costs + variable costs
• Fixed Costs
– Costs of production that do not vary as output changes
• Variable Costs
– Costs of production which vary with output
• Short Run
– Period of time during which fixed costs and the scale of
production remain constant
• Long Run
– Period of time during which all factors become variable and the
scale of production can change
• Marginal Product
– The output added by the extra worker or unit of a factor
Adding more of the
VARIABLE FACTOR when there are FIXED factors
(In SR)
1
2
Adding more of the
VARIABLE FACTOR when there are FIXED factors
(In SR)
1
AP
The relationship between APP and MPP (In SR)
Table 1.1.1
1
The relationship between
AVERAGE, MARGINAL & TOTAL Physical Product
(in SR)
APP &
MPP
TPP
3
TP
2
AP
1
Number of workers
MP
The Theory of Production
Key Terms 2
• Increasing marginal returns
– Where the addition of an extra variable factor adds more to output that
the previous variable factor
• Average product
– The total product divided by the number of workers
• Law of diminishing marginal returns
– Where increasing amounts of a variable factor are added to a fixed
factor and the amount added to total product by each additional unit of
the variable factor eventually decreases
• Optimal output
– The ideal combination of fixed and variable factors to produce the
lowest average cost
• Productive efficiency
– When a firm operates at minimum average total cost, producing the
maximum possible output from inputs into the production process
• Depreciation
– In relation to fixed assets, all fall in the value of an asset during its
working life
FIXED, VARIABLE & SEMI-VARIABLE
(in SR)
Total
Costs
Output
The Theory of Production
Key Terms 3
• Semi-variable costs
– Costs which have both a fixed and variable element e.g. landline
telephone usage
• Average fixed costs
– TFC/Q
• Average total costs
– TC/Q
• Marginal costs
– The cost of the extra unit of output
Costs in more detail (SR)
Table 1.2
Increasing and decreasing SHORT RUN COSTS
MC
Costs
AC
1
2
Output
MC, AC, AVC & AFC (in SR)
Costs £’s
Quantity
Questions for thought
1) How does a weak £GBP affect
costs for UK businesses?
2) Are all firms affected by rising
fuel costs in the same way?
3) How can firms protect
themselves from the
fluctuations in commodity and
currency prices?
http://news.bbc.co.uk/2/hi/business/8062844.stm | 22nd May 2009
Task – The shape of costs
Production in the LR
• In the LR all factors become variable and hence firms
can overcome diminishing returns by increasing the
SCALE of production.
• However as the firm continues to increase output then
diminishing returns will creep in again and the firm must
look to increase it’s scale once more.
• Each size of operation forms a SRAC (or SRATC) curve
each with it’s own optimal size of operation.
• In practice firms may choose or be unable to move to a
new SRAC and may over work a fixed factor e.g. existing
factory size is too small but the owners do not have the
funds to build a new one or the increase in output is only
expected to be temporary
• All planning takes place in the long run
Relationship between SR & LR AC
Costs £’s
SRAC1
SRAC2
Quantity
Which factory size would you choose if your
firm needed to produce 100 units?
Costs £’s
SRAC1
SRAC2
SRAC3
What about
175 units?
What will
influence your
decision?
100
175
Quantity
The Theory of Production (LR)
Key Terms 4
• Increasing returns to scale
– Where an increase in factor inputs leads to a more proportionate
increase in outputs
• Decreasing returns to scale
– Where an increase in factor inputs leads to a less than
proportionate increase in factor outputs
• Constant returns to scale
– Where an increase in factor inputs leads to a proportionate
increase in factor outputs.
• Minimum efficient scale (MES)
– This corresponds to the point at which average costs reach their
lowest point for the first time, i.e. the lowest number of units a
firm needs to produce to fully utilise all available economies of
scale
LRAC1
Costs £’s
Costs £’s
What shape & why?
LRAC2
MES
Quantity
Costs £’s
Costs £’s
MES
Quantity
LRAC4
LRAC3
Quantity
MES
Quantity
• The MES corresponds to the
lowest point on the LRAC (or
LRATC)
• MES defined as the first
point at which all possible
economies of scale are fully
utilized
• There is unlikely to be one
point rather a range of
outputs which are all
productively efficient
• During the range firms are
said to be experiencing
constant returns to scale
Costs £’s
The Minimum Efficient Scale (MES)
LRAC4
MES
Quantity
Economies of Scale
• Defined: Are any decrease in LRAC that come
about when a firm alters all of its factors of
production - Increasing returns to scale
–
–
–
–
–
–
–
Specialisation
Division of labour
Bulk buying
Financial economies
Transport economies
Large machines
Promotional economies
Diseconomies of scale
• Define: Any increase in LRAC when a firm
alters all of its factors of production –
decreasing returns to scale
– Control and management problems
– Alienation and loss of identity
• In reality there is little evidence to suggest
that firms actually suffer from
diseconomies of scale
External Factors
• Economies of scale
– Local universities specialise due to high
concentration of firms
• Diseconomies of scale
– Increase in size of industry pushes up the
price of raw materials
Example IB Question
• What are the distinctions between
decreasing returns to scale and
diminishing marginal returns? (10 marks)
Answer
 Essential to an understanding of this question is the
economist’s distinction between short run and long run.
 Decreasing returns to scale should be illustrated with a
Long Run Average Cost Curve, with the clear
understanding that it operates over a period in which all
factor inputs are variable.
 Diminishing returns should be illustrated with a numerical
or diagrammatic example which shows increasing
application of a variable factor to at least one fixed factor.
 Good answers might include short run average cost
curves on a climbing envelope curve.
 Allow up to [5 marks] if only one aspect of the question
is answered.
 10 Marks
Revenue Theory
• Total revenue
 TR=PQ
• Average revenue
 AR=TR/Q
• Marginal revenue
 MR=∆TR / ∆Q
Revenue Curves and Output
1. AR remains constant as Q increases



PED = 
AR (D) horizontal
Firms are price takers
2. AR falls as Q increases




PED < 
AR (D) downward sloping
Firms have some influence over P&Q
Price makers
When PED = 
TR
TR
35
Where P=5
5
Q
1
7
The relationship between D, AR, MR, TR & PED for a
downward sloping linear demand curve
P
Q
Review of Revenue
• When PED > 1 firms revenue increases if
P falls
• When PED < 1 firms revenue increases if
P increases
• When PED = 1 firms revenue stays the
same as P changes, revenue is already
maximised
Profit Theory
• The economist versus the accountant
– Accountant: Profit = TR – TC
– Economist: Profit = TR – TC but;
• Where TC = FC + VC + Opportunity Cost
– An accountant may deduce that a firm is making a
profit whereas an economist may conclude that they
are making a loss
– 3 scenarios to consider;
• The shut down price
• The break even price
• The profit maximising level of output
The Shut Down Price
• Firms often continue to produce even if they are making
a loss
– During the six months to September 2009, the company (BA)
suffered a £292m ($485m) loss. BBC, 9th Nov 2009
• Firms may even shut down for a period and then re-open
later on
– 1,700 jobs to go as Corus mothballs plant BBC, 4th Dec 2009
– Jobs axed at Ford, Nearly a hundred jobs are being cut at Ford’s
plant in Dagenham as a result of the economic downturn The
company has introduced 14 "non production days" until the
new year in its stamping departments. It'll mean 520 staff
could have to work 3 day weeks. BBC Nov 2008
– An ice cream shop shuts for winter and then reopens when the
weather improves
Why are they still in business?
The Shut Down Price
• The shut down price is the level of price
that enables a firm to cover its variable
costs in the SR, i.e. it is the price where
P=AVC. If price does not cover AVC, then
the firm will shut down in the SR
The Shut Down Price (ATC, AVC and MC)
Price and Cost
Q (Units)
Breaking Even
• In the long run firms are able to cover ATC
• Remember ATC includes OC and is
different for an economists and an
accountant
• If the price does not cover all costs in the
LR the firm will shut down and stay shut
Where does the firm operate?
Price and Cost ($)
• Assumption: Firms seek to
maximise profit
• A firm will continue to produce
until MC=MR why?
• What if the MC curve crossed
the MR curve twice?
• A firm should produce at the
level of Q where MC cuts MR
from below
• Remember that the MC cuts
the AC at its lowest point
Output
Output
Price and Cost
Q (Units)
Price and Cost
Q (Units)
Alternatives to Profit Max
•
•
•
•
•
Revenue Maximisation (MR=0)
Sales (Volume) Maximisation (AR=AC)
Employment
Environment
Satisficing
Ideas Board 1