Revising Production and Costs
At A2 level there is a hefty chunk of analysis to do with production and short run costs – this revision note takes you through the key points. Check through your notes and make sure you understand the ideas. You can then check your understanding by using the revision multiple choice tests on the Economics VLE.
Fixed and variable factor inputs
Variable inputs: Energy, raw materials, components, workers on flexible contracts, leased capital equipment
Fixed inputs: Fixed plant and machinery, staff on fixed contracts
Law of Diminishing Returns
This relates only to the short run
Occurs when marginal product is falling as extra units of labour are employed
Falling MP eventually leads to falling average product (AP)
Important: Inverse relationship between productivity and cost
When MP is declining ► rise in marginal cost
Diminishing returns diagram
Evaluation: Realism of diminishing returns can be questioned
Globalisation – ability to outsource production to control costs
Multi plant businesses – able to switch production easily between different factories
Long run production
The scale of production can change because all factor inputs are variable
Leads us on to looking at economies and diseconomies of scale
- Increasing returns to scalewhen the % change in output > % change in inputs► falling LRAC
- Decreasing returns to scalewhen the % change in output < % change in inputs ► rising LRAC
- Constant returns to scalewhen the % change in output = % change in inputs ► constant LRAC
Take a revision multiple choice test here
Fixed and Variable Costs
Fixed costsdo not vary directly output – also known as the overhead costs of a business
Examples:
Rental costs of buildings
Costs of purchasing plant and machinery
Costs of full-time contracted salaried staff
Interest payments on loans
Depreciation of fixed capital (due solely to age)
Total fixed costs remain constant as output changes
Average fixed costs must fall as output increases (in the short run)
A change in fixed costs has no effect on marginal cost
Variable costs
Variable costs vary directly with output.
Examples:
Costs of intermediate raw materials and components
Wages of part-time staff or employees paid by the hour
Costs of electricity and gas
Depreciation of capital inputs due to wear and tear.
Sunk costs: Costs that cannot be recovered if a business opts to leave a market or industry
Cost measures
- Total cost = total fixed cost + total variable cost
- Average cost = total cost / output
- Marginal cost = change in total cost from producing an extra unit of output
- Average fixed cost = total fixed cost / output
- Average variable cost = total variable cost / output
The next diagram shows the conventional shape of short run cost curves – note in particular the relationship between marginal and average cost – practice drawing these cost curves so that you can always do them accurately in an exam.
Important:
- A change in variable costs (e.g. higher oil prices, rising foodstuff prices or an increase in the national minimum wage) causes an upward shift in both average and marginal cost
- A change in fixed costs (e.g. a rise in interest rates or perhaps a fall in the rate of capital depreciation) has no effect on the variable costs of production. This means that only the average total cost curve shifts. There is no change in the marginal cost curve
In the next revision note we will look at revenues and profits and how changes in short run costs and demand affects the price and output decisions of businesses.
Take a revision multiple choice test on short run costs here