Business Organisation and Production Costs

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Business Organisation and Production Costs
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Todays Lecture Structure

• Definitions of cost and profit
• Short run and long run
• Different components of costs
• Economies and diseconomies of scale

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Costs and Profits

• A basic assumption in economics is that the
  driving motive of business decisions is profit
  maximisation.
• Profits total revenue - total costs
• Economists and accountants measure profits in
  different ways

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Costs and Profits

• Total revenue price x quantity
• Costs are treated differently
• Explicit costs payments to non-owners of a firm
  for the supply of their resources (wages paid to
  labour, costs of electricity, etc.)
• Implicit costs the opportunity costs of using
  the resources already owned by the firm, where no
  payment is made to outsiders (use of the factory,
  input of the owner / manager,)

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Economic Profits

• Profit total revenue - total opportunity cost
• or
• Profit total revenue - (total explicit costs
  total implicit costs)
• Economists refer to a zero economic profit as
  normalprofit (minimum necessary to keep a firm
  in operation)

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The short and the long run a formal definition

• The distinction between SR and LR depends on the
  ability to vary the quantity of inputs /
  resources used in production
• Distinction between fixed variable inputs
• fixed inputs cannot be changed during the period
  of time under consideration (e.g. physical
  capital assets)
• a variable inputs can be changed during the
  period of time under consideration (e.g. labour)
• So
• Short run a period of time when there is at
  least one fixed input
• Long run a period of time when all inputs are
  variable

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The production function

• A production function is a technical relationship
  between the maximum amount of output a firm can
  produce with their inputs

This is a short run production function since
the capital stock is being held fixed
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Fig. 8.1 A short run production function
Output per day
Quantity of labour

• The relationship between the change in total
  output and labour is the marginal product of
  labour (i.e. by how much output goes up with an
  extra unit of labour - holding all other factors
  constant)
• Hiring more workers increases output but not at
  a constant rate
• The law of diminishing marginal returns states
  that beyond some point the marginal product
  decreases as additional units of a variable
  factor are added to a fixed factor.

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Relation Between the Production Function and the
Marginal Product of Labour
Output per day
Quantity of labour
MPL
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Short run costs

• Total costs total fixed costs total variable
  costs
• TC TFC TVC
• Total fixed cost costs that do not vary with
  output
• Total variable cost costs that vary as output
  changes

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Fig. 8.3 Total Cost Curves
Cost
Output
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Average Costs

• Average costs costs per unit of output
• Average fixed cost TFC divided by quantity
  produced AFC TFC / Q
• as output rises AFC falls continuously
• Average variable cost TVC divided by quantity
  produced AVC TVC / Q
• usually average variable cost is U-shaped, with
  AVC falling initially and then rising as it
  becomes more costly to produce additional units
  of output.
• Average total costs AFC AVC TC/Q

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Fig. 8.4 Average Costs
Cost
Output
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Marginal Cost

• Change in total costs due to a unit change in
  output

Crucial!
If the MC is less than the ATC, then the ATC
must be falling. If the MC is more than the ATC,
then the ATC must be increasing
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Fig 8.5 Average and Marginal Costs
Cost
ATC
Output
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Fig 8.6 Average and Marginal Costs
Cost
ATC
AVC
Output
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Long Run Production Costs

• A firm operates in the short run when there is
  insufficient time to alter some fixed inputs
• Butthe firm plans in the long run, when all
  inputs are variable
• The long run average cost (LRAC) traces the
  lowest cost per unit at which a firm can produce
  any level of output, after the firm builds any
  desired plant size

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Fig. 8.7 The LRAC or The Firms Planning Curve
Cost
SRATCl
SRATCs
SRATCm
40
30
Output
6
12
The plant size selected in the LR depends on the
expected level of production
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Fig. 8.8 The LRAC with unlimited plant size
Cost
Output
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Fig. 8.9 Scale economies
Cost
Economies of scale
Constant returns to scale
Diseconomies of scale
Output

• LRAC varies from industry to industry
• Usually economies of scale dominate diseconomies
  of scale