Transcript SHORT-RUN AND LONG

COSTS AND PROFITS
• Efficiency in the private sector is usually measured by the making of
profits
• Profits represent the difference between sales revenue and total costs
i.e. P = TR – TC
• Therefore the making of profits requires focusing on two important
related areas
(i) increasing revenue
(ii) reducing cost
• Costs relate to the inputs used in production e.g. labour and raw
materials
• Revenue relates to sale of the output generated as product or service
SHORT-RUN AND LONG-RUN COSTS
• In economics, costs are classified as being short-run or long-run
• In the short-run some costs are fixed and some costs variable. In the
long-run all costs are variable
• Examples of fixed costs would be plant and machinery and fixed
(annual) payments such as insurance, depreciation, interest
repayments etc.
• Variable costs would include items such as raw materials, labour,
electricity, delivery charges etc.
• Sometimes costs are hard to clearly classify
e.g. maintenance could have both a fixed and variable element
• Also the length of short run can vary considerably depending on cost
elements involved so that there can be a whole series of short runs
associated with different costs
PRODUCTION IN THE SHORT-RUN
The Law of Diminishing Returns:
• Here - because we are dealing with short-run - we keep adding variable
factors while keeping the fixed costs constant
Then when increasing amounts of a variable factor (such as labour) are
combined with a fixed factor (such as land), returns to each unit of the
variable factor will eventually diminish (though initially may increase).
This is known as the law of diminishing returns
For example, if we put people to work in a field - say picking
strawberries - eventually the amount that each will individually pick
will diminish (as pickers eventually get in each other's way).
However initially - with a plentiful supply of strawberries available returns to each worker could increase (due to being organised in a
more effective manner)
Wheat production per year from a particular
farm (tonnes)
(a)
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
0
0
-
MPP
(= TPP/ Lb)
3
1
3
3
7
2
10
5
(b)
14
3
24
8
12
(c)
4
36
9
4
5
40
8
2
6
42
7
(d)
0
7
42
6
-2
8
40
5
Wheat production per year from a particular farm
Tonnes of wheat per year
40
d
Slope = TPP / L
= APP
30
c
TPP
20
b
10
0
0
1
2
3
4
5
6
7
8
Number of
farm workers (L)
Tonnes of wheat per year
b
14
12
c
10
8
6
APP
4
2
d
0
-2
0
1
2
3
4
5
6
7
8
MPP
Number of
farm workers (L)
Wheat production per year from a particular farm
Number of
workers
0
1
2
3
4
5
6
7
8
Tonnes of wheat produced per year
40
30
20
TPP
0
3
10
24
36
40
42
42
40
10
0
0
1
2
3
4
5
Number of farm workers
6
7
8
SPECIALISATION AND DIVISION OF LABOUR
• Normally increasing returns apply over the earlier stages of production
due to the benefits of increasing division of labour in the work place
- famous passage by Adam Smith in “Wealth of Nations” describing a
visit to a pin factory
• Advantages of division of labour
- greater specialisation of skills leading to greater efficiency
- loss in time in moving from job to job
- provides opportunities for increased mechanisation (and automation)
• Disadvantages of division of labour
- work can become boring and repetitive leading to demotivation of
workers
- can lead to x-inefficiency
- workers can become increasingly vulnerable to replacement by
machines
Average cost
Costs (£)
AC
Diminishing marginal
returns set in here
x
Output (Q)
COST RELATIONSHIPS
• Costs and Inputs
- a firm’s costs depends on two factors
(i) the productivity of factors
(ii) their prices
• Total Cost
The total cost is made up of two factors - fixed and variable
Total Cost = Total Variable Cost + Total Fixed Cost
TC = TVC + TFC
Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
Total costs for firm X
TC
(£)
0
10
16
21
28
40
60
91
TC
12
22
28
33
40
52
72
103
TVC
40
20
TFC
0
0
1
2
3
4
5
6
7
8
AVERAGE AND MARGINAL COST
• We get average cost by dividing total cost by the number of units
produced
Thus if the total cost of producing 10 units is €100, then the average
cost is €100/10
AC = TC/Q;
AVC = TVC/Q
AFC = TFC/Q
Thus AC = AVC + AFC
• Marginal cost (MC) is the additional cost of producing one more unit
of output.
Thus if 10 units cost €100 and 11 units cost €112, then the marginal
cost of the 11th unit is €12 (i.e. €112 - €100).
If 12 units now cost €125, then the marginal cost of the 12th unit is €13
(i.e. €125 - €112)
MARGINAL COST (con)
• MC is always equal to AC (and AVC) at their lowest points
• AC can only fall if MC is less than it. Thus if a footballer has scored an
average of 30 goals in the previous two seasons, this can only fall, if
the average is less than 30 for the current season
• Likewise AC can only rise if MC is greater than it. Thus the average of
30 goals per season (in the previous example) can only rise if the
footballer scores more than 30 in this present season)
• Thus AC falls when MC < AC; AC rises when MC>AC. So AC
neither falls nor rises (i.e. is at its lowest point) when MC = AC.
Average and marginal costs
MC
AC
Costs (£)
AVC
z
y
x
AFC
Output (Q)
PRICING DECISIONS AND SHORT RUN COSTS
• In the short run pricing decisions are made on the basis of variable rather than
total costs
Thus if price is sufficient to cover average variable cost (AVC) - though not
average total cost (ATC) - it still makes sense to produce in the short run,
though obviously this position cannot be sustained in the long run.
The argument here is that once a business remains in production (in the short
run) fixed costs will have to be incurred in any case. Therefore if price covers
the variable cost element some contribution can be made to cover fixed costs
• The practice is evident in wide variety of circumstances e.g.
- magazine pricing on subscription rates
- hotel pricing during the off season
- sale clearances
- building tenders during a recession
- discount selling of seats by airlines
OTHER COST NOTIONS
•
Accountants measure explicit costs i.e. where money is paid out by a firm
•
However implicit costs may also arise where a firm loses the opportunity to make
additional revenue
•
Implicit costs apply to factors of production
- in small businesses where owner is principal worker, labour may not
be properly costed.
- land such as unused office space also has an opportunity cost
- owner capital has an opportunity cost as the interest rate foregone on
investment: from this perspective internal funds used for investment are not
costless
- enterprise has an opportunity cost which in economics is measured
as normal profits
So from this perspective normal profits represents a legitimate cost of business
•
Sunk costs relate to historic costs of an asset
Isoquant–isocost analysis
• Isoquants are the equivalent in production to indifference curves in
consumer theory
– Each isoquant represents varying combinations of two factors (e.g.
capital and labour) that give the same level of output
– A diminishing marginal rate of substitution attaches to each factor
in that as one becomes more scarce a greater amount of the other is
required to compensate in production
• Isocosts are the equivalent of the budget lines and represent the
varying combinations of the two factors which can be bought with the
same cost outlay
• Production can be capital intensive or labour intensive. As the price of
capital falls relative to labour progressively more will be used in
production
An isoquant
45
a
40
Units
of K
40
20
10
6
4
Units of capital (K)
35
30
25
Units
of L
5
12
20
30
50
Point on
diagram
a
b
c
d
e
b
20
15
c
10
d
e
5
0
0
5
10
15
20
25
30
Units of labour (L)
35
40
45
50
Diminishing marginal rate of factor substitution
14
g
Units of capital (K)
12
K = 2
MRS = K / L
MRS = 2
h
10
L = 1
8
j
MRS = 1
k
K = 1
6
L = 1
4
2
isoquant
0
0
2
4
6
8
10
12
Units of labour (L)
14
16
18
20
An isocost
30
Assumptions
Units of capital (K)
25
PK = £20 000
W = £10 000
TC = £300 000
20
a
15
b
10
c
5
TC = £300 000
d
0
0
5
10
15
20
25
Units of labour (L)
30
35
40
Finding the least-cost method of production
35
Assumptions
Units of capital (K)
30
PK = £20 000
W = £10 000
25
TC = £200 000
20
TC = £300 000
15
TC = £400 000
10
TC = £500 000
5
0
0
10
20
30
Units of labour (L)
40
50
Finding the least-cost method of production
35
Units of capital (K)
30
25
s
TC = £500 000
20
15
TC = £400 000
r
10
t
5
TPP1
0
0
10
20
30
Units of labour (L)
40
50
Finding the maximum output for a given total cost
r
Output is highest
along the isocost
at point t.
Units of capital (K)
s
K1
t
u
v
TPP5
TPP4
TPP3
TPP2
TPP1
O
L1
Units of labour (L)
Deriving a long-run average cost curve:
choice of factory size
Costs
LRAC
O
Output
ECONOMIES OF SCALE
• Production in the long-run: the scale of production
• In the long-run all factors are variable. Thus a firm now can
change all of its costs
This is known as the scale of production
There are three possibilities here.
• If a firm increases all its inputs by a certain percentage and
output increases by more than the same percentage then we
have economies of scale (i.e. increasing returns to scale)
• If however a firm increases all its inputs by a certain percentage
and output increases by less than the same percentage then we
have diseconomies of scale (i.e. decreasing returns to scale)
• Finally if a firm increases all its inputs by a certain percentage
and output increases by the same percentage then there is
neither economies nor diseconomies (i.e. constant returns to
scale).
ECONOMIES OF SCALE (con)
Another way of expressing this relationship is as follows
•
If the average cost of production falls (in the long run) then we have
economies of scale; if the average cost rises then we have diseconomies
and if average cost stays the same, then we have neither economies nor
diseconomies
•
Economies of scale are very important in many industries. For example
the cost of producing a car will generally be less when production takes
place on a large scale. Thus it is uneconomic to produces cars (for the
mass market) in a small sized plant. This explains why we have no
major car plants in Ireland (as the size of the market here is too small).
•
Economies of scale are often less important in service type operations
where flexibility of response and personal interaction with the
consumer are necessary e.g. the professions, convenience shops,
plumbing etc.
Costs
A typical long-run average cost curve
O
Economies
of scale
Constant
costs
Output
Diseconomies
of scale
LRAC
MINIMUM EFFICIENT SCALE (MES)
• The minimum efficient scale is the level of production that a firm must
reach in order to attain the lowest average cost per unit
• The MES can be expressed either in terms of an individual factory
(minimum efficient plant size) or the whole firm.
- expressing MES as a percentage of total output gives an indication of
how competitive the industry could be with in many cases only firm in
a country arising e.g. cars, computers and aircraft.
- in other cases such as bricks and shoes a very small size is required to
achieve economies. So here economies of scale can be fully
compatible with competition
• The second way of measuring economies of scale is to see how much
costs would increase if production were reduced to a certain fraction of
MES (normally 1/2 or 1/3 of MES). In some studies this suggests that
for cars it would lead to a 9% cost increase. However for bricks it
would be 25%!
REASONS FOR ECONOMIES OF SCALE
Technical (Classical Economies of Scale)
•
Indivisibilities
Some capital equipment can only be efficiently used at a large level of
output
•
Container principle
Plant and machinery is cheaper to provide at larger sizes of output as
capacity grows faster than material required
•
More efficient use of larger machines
Machines can be employed more fully at large size thus enhancing
efficiency
•
By-products
With larger output by-products can be used for creation of additional
products
•
Multi-stage production
Becomes more feasible with larger level of output
REASONS FOR ECONOMIES OF SCALE (con)
Other Reasons for Economies
• Financial Economies
Finance is more easily acquired and at cheaper rates at larger
scales
• Managerial Economies
Managerial ability can often be more effectively employed at
larger scales of output
• Marketing Economies
Bulk discounts can be obtained more effectively at larger scales
of output as for example with major supermarkets
REASONS FOR DISECONOMIES OF SCALE
• Management Problems
Large companies can be come unduly rigid and bureaucratic
• Industrial Problems
The opportunities for disruption in pursuit of worker claims is
greater with large companies (especially monopolies)
• Low worker morale
Too much specialisation can lead to boredom and loss of work
incentive
• In practice, economies can be important up at lower levels of
production after which they generally become fairly constant
over a considerable range of output.
The minimum output required to achieve these economies is
known as the minimum efficient scale (MES)
ECONOMIES OF SCOPE
• Economies of scope relate to the cost savings that can be made by
producing two or more products jointly rather than separately.
• In this way it is distinguished from (internal) economies of scale which
relates to the long run cost savings that can be made by increasing
production of the same product
• Economies of scope are very import in the IT sector where for example
the efficient introduction of broadband requires development with
respect to a number of related activities i.e. the provision of cabling
network, availability of service providers, technological improvement
with respect to band width, computer and software usage etc.
• A different type of example would relate to the provision of major hub
networks for the airline carriers which again enhances the efficiency of
carrying passengers. Here regular flights to regional destinations - as at
a large airport - become more cost effective
COSTS IN INFORMATION SECTOR
Information sector distinguished by three distinctive features
• Network effects characterised by a high degree of
complementarity as between component elements (nodes)
giving rise to significant externalities
• Cost structure subject to unusually high fixed costs (of a
sunk nature) and extremely low marginal costs of
production. Competitive advantage and ultimate survival
thereby depends on obtaining a high volume of output
• Switching costs and lock-in effects can be especially high
for information type products
EXTERNAL ECONOMIES AND EXTERNAL
DISECONOMIES (EXTERNALITIES)
• External economies and diseconomies of scale (externalities)
relate to the effects of a firm's activities outside the confines of
the firm in question
• Positive externalities (i.e. external economies of scale) arise
when a benefit is provided by a firm's activities for other firms
or the wider economy
For example the opening of a new rail line could provide
benefits for road users who now might travel with less
congestion
• Negative externalities (i.e. external diseconomies of scale) arise
when a cost is imposed by a firm's activities on the wider
environment.
For example pollution caused by a firm could impose problems
for others e.g. people working in the tourist industry (affected
by the pollution)
LEGAL STRUCTURE OF FIRM
Small firms are usually of two types:
• Sole proprietorships
• Partnerships
Larger firms are usually limited and can be public and private
• Public limited companies - that are quoted on the stock exchange
• Private limited companies - that cannot offer shares publicly
We can also have state-owned companies and co-operatives
Also there are numerous possible business arrangements such as franchising,
strategic alliances, joint ventures, integration, diversification etc.
Also the organisational structure (e.g. unitary or multi-divisional) can be very
important with respect to the efficiency of a firm
REVENUE
• TP (Total Profit) = TR (Total Revenue) – TC (Total Cost)
• TR = P X Q
If a firm sells 1000 units (Q) per month at a price of €5 each (P) then
its total monthly revenue will be €5,000.
• Average revenue is the amount that the firm earns per unit sold.
Thus AR = TR/Q
So if the firm earns €5,000 (TR) from selling 1000 units (Q) it will
earn €5 per unit (which is the price).
• Marginal revenue is the extra revenue gained by selling one more
unit (per time period). So if a firm sells an extra 20 units this month
for €100 then it is getting an extra €5 for each extra unit
MR = ∆TR/∆Q
REVENUE CURVES
• Revenue curves when price is not affected by the firm’s output
Quantity
0
200
400
600
800
1000
1200
Price = AR = MR (€)
5
5
5
5
5
5
5
TR
0
1000
2000
3000
4000
5000
6000
S
AR, MR (£)
Price (£)
Deriving a firm’s AR and MR: price-taking firm
D = AR
= MR
Pe
D
O
Q (millions)
(a) The market
O
Q (hundreds)
(b) The firm
REVENUE CURVES (con)
Revenue curves when price is affected by the firm’s output
Q (units)
P = AR (€)
TR(€)
MR
1
8
8
6
2
7
14
4
3
6
18
2
4
5
20
0
5
4
20
-2
6
3
18
-4
7
2
14
AR and MR curves for a firm facing a downward-sloping D curve
Q P =AR
(units) (£)
8
1
7
2
6
3
5
4
4
5
3
6
2
7
8
AR, MR (£)
6
4
2
TR MR
(£) (£)
8
6
14
4
18
2
20
0
20
-2
18
-4
14
AR
0
1
2
3
4
5
6
7
-2
-4
MR
Quantity
MAXIMISING PROFIT
• The easy way to see how profit is maximised is to use total cost and total
revenue curves
Q (units)
TR (€)
0
1
2
3
4
5
6
7
0
8
14
18
20
20
18
14
TC (€)
6
10
12
14
18
25
36
56
TP (€)
-6
-2
2
4
2
-5
- 18
- 42
TR, TC, TP (£)
24
22
20
18
16
14
12
10
8
6
4
2
0
-2
-4
-6
-8
Finding maximum profit using total curves
TC
d
TR
e
f
1
2
3
4
5
6
TP
7
Quantity
MAXIMISING PROFIT (con)
Short-run profit maximisation: using average and marginal curves
Profit maximised where MR = MC
Q
P = AR
(units) (€)
0
1
2
3
4
5
6
7
9
8
7
6
5
4
3
2
TR
(€)
0
8
14
18
20
20
18
14
MR
(€)
TC
(€)
8
6
4
2
0
-2
-4
6
10
12
14
18
25
36
56
AC
(€)
10
6
4.7
4.5
5
6
8
MC
(€)
4
2
2
4
7
11
20
TP
(€)
-6
-2
2
4
2
-5
-18
- 42
AP
(€)
-2
1
1.3
.5
-1
-3
-6
Measuring the maximum profit using average curves
16
MC
Total profit =
£1.50 x 3 = £4.50
Costs and revenue (£)
12
AC
8
a
6.00
TOTAL PROFIT b
4.50
4
AR
0
1
-4
2
3
4
5
6
7
MR
Quantity
PROFIT
• The meaning of profit can vary depending on the accountancy or
economics perspective.
• In the main accountants recognise solely explicit costs (i.e. what are
directly paid out by the firm)
• However economists recognise both explicit and implicit costs
Implicit costs (or opportunity costs) arise when through the action of a
firms the opportunity to make additional revenue is lost.
e.g. if a person sets up a business and total revenue exceeds total costs for
the year by €30,000 this will be measured as (accountancy) profits
However if it transpires that that person could alternatively have obtained a
job with payment of €40,000 p.a. then there is an additional implicit cost of
€40,000 which means that the true profit (economics) is - €10,000.
In other words the person would have been better off in monetary terms by
€10,000 through taking a job (rather than running the business)
PROFIT (con)
• Implicit costs can apply to any of the factors of production
In practice such costs associated with capital are most important in large
businesses.
For example if a firm uses its own reserves of €10,000,000 to fund a major
expansion, then the opportunity cost could be measured by the loss of
interest it could have made if the money was safely invested.
Thus if the interest rate obtainable is 5% pa then the implicit cost of this
money for a year would be €500,000
• Implicit costs also apply to enterprise
In economics there is a distinction as between normal and supernormal
profits
Normal profits actually measure the implicit cost of enterprise.
Thus a firm earning normal profits is just breaking even in economics terms
Supernormal profits (which would be the excess over normal) thus
measures true economics profits.
Thus a firm making a profit in accountancy terms could be making a less
from an economics perspective