Business Economics Topic 6.pdf

# Distinguishing short run and long run production The distinction between the short run and the long run in economics is defined by the variability of production inputs. ## 1. Distinguishing short run and long run production In economics, a firm's primary objective is profit maximization. To achieve this, firms make various decisions that can be categorized into two distinct time frames: the short run and the long run. The fundamental difference between these two periods lies in the nature of the inputs used in production [2](#page=2) [3](#page=3). ### 1.1 The short run In the short run, at least one input into the production process is fixed. These fixed inputs cannot be easily changed or are very costly to reverse, making them critical to the firm's survival. For production purposes, it is typically assumed that labor is the variable input, while capital (such as machinery, plant, and equipment) is the fixed input [2](#page=2) [3](#page=3) [5](#page=5). > **Tip:** Think of the short run as a period where some commitments are already in place and cannot be immediately altered, influencing the firm's flexibility in adjusting its output levels. ### 1.2 The long run In contrast to the short run, the long run is a period where all inputs into production are changeable or variable. This means that a firm has the flexibility to adjust all factors of production, including both labor and capital [3](#page=3) [5](#page=5). > **Example:** If a company needs to increase its production significantly, in the short run it might hire more workers to operate existing machinery. In the long run, it could choose to build a new factory and purchase additional machinery, making both labor and capital variable inputs. ### 1.3 Factors of production and their variability Production involves various factors, often categorized as capital (including machinery, plant, and equipment), labor (workers), land, and natural resources. The distinction between the short run and the long run is determined by which of these factors can be adjusted [5](#page=5). * **Short run:** Labor is considered a variable input, while capital is considered a fixed input [5](#page=5). * **Long run:** Both labor and capital are considered variable inputs [5](#page=5). --- # Production in the short run and the law of diminishing marginal returns This section explores the fundamental concepts of short-run production, focusing on total, marginal, and average product, and introduces the law of diminishing marginal returns. ### 2.1 Defining key production concepts In the short run, production is analyzed by examining the relationship between inputs and outputs, particularly when at least one input is fixed. #### 2.1.1 Total product (TP) Total product refers to the total quantity or total output produced in a production process [6](#page=6). #### 2.1.2 Marginal product (MP) Marginal product is the additional output gained from employing one more unit of a variable input. It is calculated as the change in total product divided by the change in the quantity of labor. The formula for marginal product of labor ($MP_L$) is: $$MP_L = \frac{\Delta TP}{\Delta L}$$ #### 2.1.3 Average product (AP) Average product is the total product divided by the quantity of the variable input used. It is also known as labor productivity. The formula for average product of labor ($AP_L$) is: $$AP_L = \frac{TP}{L}$$ > **Tip:** Understanding these three measures (TP, MP, AP) is crucial for analyzing how changes in variable inputs affect a firm's output in the short run. ### 2.2 Visualizing production curves The relationship between total product, marginal product, and average product can be visualized through curves. * **Panel A** typically shows the Total Product (TP) curve, which illustrates the total output as labor increases. It often exhibits an initial increasing slope, followed by a decreasing slope [7](#page=7). * **Panel B** usually displays both the Average Product (AP) and Marginal Product (MP) curves. The MP curve typically rises and then falls, intersecting the AP curve at its maximum point. The AP curve also rises and then falls [7](#page=7). > **Example:** At low levels of labor, adding more workers might lead to a large increase in total output because of specialization and better utilization of fixed resources. However, as more workers are added, the additional output from each new worker might start to decrease. ### 2.3 The law of diminishing marginal returns The law of diminishing marginal returns is a fundamental principle governing short-run production. #### 2.3.1 Statement of the law The law of diminishing marginal returns states that if a variable input is added to a production process that has at least one fixed input, the total output may initially increase at an increasing rate, but this rate of increase will eventually decline after a certain level of input is reached. This means that beyond a certain point, each additional unit of the variable input will contribute less to total output than the previous unit [8](#page=8). #### 2.3.2 Stages of production based on returns The law of diminishing marginal returns leads to distinct stages of production: * **Increasing Marginal Returns:** In this initial stage, marginal product increases as more variable input is added. Total product rises at an increasing rate [9](#page=9). * **Diminishing Marginal Returns:** This is the stage where marginal product begins to decrease but remains positive. Total product continues to rise, but at a decreasing rate. This is the most common and relevant stage for economic decision-making [9](#page=9). * **Negative Marginal Returns:** In this stage, marginal product becomes negative, meaning adding more variable input actually reduces total product. Total product starts to fall [9](#page=9). #### 2.3.3 Illustrative data for short-run production A typical table illustrating short-run production would show units of labor, total product, average product, and marginal product. | Units of variable resource (labour) | Total product (TP) | Average product (AP) | Marginal product (MP) | | :---------------------------------- | :----------------- | :------------------- | :-------------------- | | 0 | 0 | | | | 1 | 10 | 10 | 10 | | 2 | 25 | 12.5 | 15 | | 3 | 45 | 15 | 20 | | 4 | 60 | 15 | 15 | | 5 | 70 | 14 | 10 | | 6 | 75 | 12.5 | 5 | | 7 | 75 | 10.71 | 0 | | 8 | 70 | 8.75 | -5 | > **Tip:** Observe how MP rises initially (from 0 to 3 units of labor), then stays constant or falls (from 4 to 6 units), and finally becomes negative (at 8 units). AP also follows a similar but lagging pattern, reaching its peak where it is intersected by the MP curve. The point where MP becomes zero (at 7 units of labor) is where TP reaches its maximum. > **Example:** Imagine a bakery with a fixed oven. Adding one baker might significantly increase the number of loaves produced. Adding a second and third baker could lead to even greater increases as they can specialize tasks. However, if you add a fifth or sixth baker to the same fixed oven and limited workspace, they might start getting in each other's way, leading to smaller increases in production per additional baker, and potentially even a decrease if they cause too much congestion. This illustrates the law of diminishing marginal returns. --- # Economic costs and their classification Economic costs represent the total opportunity costs incurred by a firm when utilizing resources, encompassing both explicitly paid-for resources and those owned by the firm [12](#page=12). ### 3.1 Understanding economic costs Economic costs are comprised of two main components: explicit costs and implicit costs [12](#page=12). #### 3.1.1 Explicit costs Explicit costs are the direct monetary payments made by a firm to resource owners outside of the firm. These are the out-of-pocket expenses that an accountant would typically track [12](#page=12). #### 3.1.2 Implicit costs Implicit costs, also known as the economic costs of owner-supplied resources, represent the returns forgone by not selling or employing the owners' resources in their next best alternative market use. These are often opportunity costs that do not involve a direct monetary transaction [12](#page=12). #### 3.1.3 Total economic cost The total economic cost is the sum of both explicit and implicit costs, representing the complete opportunity cost of using all resources, whether market-supplied or owner-supplied [12](#page=12). $$ \text{Total Economic Cost} = \text{Explicit Costs} + \text{Implicit Costs} $$ ### 3.2 Economic costs in the short run In the short run, economic costs are typically classified into fixed costs and variable costs, which together form the total cost [13](#page=13). #### 3.2.1 Fixed costs Fixed costs are expenses that do not vary directly with the level of output produced. These costs are associated with the very existence of a firm's plant or capital and must be paid even if the output is zero. Examples include rent, property taxes, insurance, and administrative salaries. While the total fixed cost remains constant regardless of output, the average fixed cost per unit of output decreases as output increases [13](#page=13) [15](#page=15) [16](#page=16). * **Total Fixed Cost (TFC):** The sum of all fixed costs, which remains constant as output changes [15](#page=15). * **Average Fixed Cost (AFC):** Total fixed cost divided by the quantity of output ($ \text{AFC} = \frac{\text{FC}}{\text{Q}} $) [16](#page=16). > **Tip:** Fixed costs are sunk costs in the short run; they cannot be recovered or altered by changing production levels. #### 3.2.2 Variable costs Variable costs are expenses that change directly with the level of output. These costs include payments for raw materials, fuel, power, transportation, and direct labor wages. As output increases, total variable costs increase, and as output decreases, total variable costs decrease. The average variable cost is the total variable cost per unit of output [13](#page=13) [15](#page=15) [16](#page=16). * **Total Variable Cost (TVC):** Costs that vary directly with the level of output [15](#page=15). * **Average Variable Cost (AVC):** Total variable cost divided by the quantity of output ($ \text{AVC} = \frac{\text{VC}}{\text{Q}} $) [16](#page=16). #### 3.2.3 Total cost Total cost (TC) is the sum of total fixed costs and total variable costs at any given level of output [15](#page=15). $$ \text{TC} = \text{TFC} + \text{TVC} $$ * **Total Cost (TC):** The total expense incurred in producing a given level of output [15](#page=15). * **Average Total Cost (ATC or AC):** Total cost per unit of output ($ \text{ATC} = \frac{\text{TC}}{\text{Q}} $) [16](#page=16). #### 3.2.4 Marginal cost Marginal cost (MC) is the additional cost incurred when producing one more unit of output. It represents the change in total cost divided by the change in quantity [16](#page=16) [18](#page=18). $$ \text{MC} = \frac{\text{Change in TC}}{\text{Change in Q}} $$ > **Tip:** Understanding the relationship between marginal cost and average costs is crucial for production decisions. The marginal cost curve intersects both the average total cost and average variable cost curves at their minimum points [19](#page=19). ### 3.3 Summary of cost types and relationships The following table and definitions summarize the various cost concepts discussed: | Cost Category | Definition | Formula (if applicable) | | :--------------------- | :--------------------------------------------- | :------------------------------------------------------ | | Total Fixed Cost (TFC) | Costs that do not vary with output | Constant | | Total Variable Cost (TVC)| Costs that vary directly with output | Varies with Q | | Total Cost (TC) | Sum of fixed and variable costs | $ \text{TC} = \text{TFC} + \text{TVC} $ | | Marginal Cost (MC) | Increase in total cost from one more unit | $ \frac{\Delta \text{TC}}{\Delta \text{Q}} $ | | Average Fixed Cost (AFC)| Total fixed cost per unit of output | $ \text{AFC} = \frac{\text{FC}}{\text{Q}} $ | | Average Variable Cost (AVC)| Total variable cost per unit of output | $ \text{AVC} = \frac{\text{VC}}{\text{Q}} $ | | Average Total Cost (ATC)| Total cost per unit of output | $ \text{ATC} = \frac{\text{TC}}{\text{Q}} $ | #### 3.3.1 Sketching cost curves When graphing cost curves: * The marginal cost (MC) curve intersects the average total cost (ATC) and average variable cost (AVC) curves at their lowest points [19](#page=19). * The ATC and AVC curves converge as the quantity of output increases, as the gap between them is the average fixed cost, which diminishes with higher output [19](#page=19). * The average fixed cost (AFC) curve slopes downwards continuously [20](#page=20). > **Example:** Consider a firm with fixed costs of $300 dollars. If output is zero, total cost is $300 dollars. If output increases to 10 units, and variable costs are $200 dollars, then total cost is $500 dollars. The marginal cost of producing the 10th unit would be the change in total cost divided by the change in quantity. If producing 9 units cost $480 dollars, then the marginal cost of the 10th unit is $500 - 480 = 20 dollarsUSD [18](#page=18). --- # Long-run production costs and economies of scale In the long run, firms can adjust all their resources, leading to all production costs being variable and the absence of fixed factors. This allows for the examination of economies and diseconomies of scale, which explains the U-shaped nature of the long-run average total cost (LATC) curve [22](#page=22) [23](#page=23). ### 4.1 The long-run perspective on production In the long run, a firm has the flexibility to change its plant capacity by building a larger or smaller plant. Furthermore, the industry itself can adjust its plant size, and there is sufficient time for new firms to enter or existing firms to exit. A key characteristic of the long run is the absence of fixed factors of production, meaning all production costs are variable [22](#page=22). ### 4.2 Economies and diseconomies of scale The long-run average total cost (LATC) curve is typically U-shaped because, initially, larger plant sizes lead to lower unit costs, but beyond a certain point, larger plants result in higher average total costs. This phenomenon is explained by economies and diseconomies of large-scale production [23](#page=23). The LATC curve illustrates three distinct phases: economies of scale, constant returns to scale, and diseconomies of scale [24](#page=24). * **Economies of scale** occur when the LATC declines as output increases [25](#page=25). * **Constant returns to scale** occur when the LATC remains flat as output increases [25](#page=25). * **Diseconomies of scale** occur when the LATC increases as output increases [25](#page=25). > **Tip:** Visualizing the LATC curve helps understand how a firm's average costs change with its scale of operations in the long run. #### 4.2.1 Reasons for economies of scale Several factors contribute to economies of scale: 1. **Labor specialization:** As a plant grows, it becomes more feasible to divide and subdivide tasks among workers. This allows workers to specialize in specific tasks, leading to increased efficiency and lower unit costs [26](#page=26). 2. **Managerial specialization:** Larger firms can achieve greater specialization in management, leading to improved efficiency and reduced unit costs [26](#page=26). 3. **Efficient capital:** The effective use of advanced machinery and equipment often requires a high volume of production, making large-scale producers more efficient [26](#page=26). 4. **Other factors:** Costs associated with product design, development, and advertising can be spread over a larger output. For example, advertising costs per unit decline as the number of units produced and sold increases, lowering the average total cost (ATC) [26](#page=26). > **Example:** A car manufacturer can reduce the advertising cost per car by selling a million cars compared to selling only a thousand cars. #### 4.2.2 Reasons for diseconomies of scale As a firm expands, it may encounter diseconomies of scale, leading to higher average total costs. These can arise from [27](#page=27): * **Management problems:** Increased complexity in coordinating operations within a very large organization can lead to inefficiencies [27](#page=27). * **Worker isolation and morale:** Workers may feel isolated in large operations, especially if their jobs are repetitive and boring, potentially impacting productivity [27](#page=27). * **Declining industrial relations:** Large-scale operations can sometimes strain relationships between management and employees or among employee groups [27](#page=27). * **Disruption from mass production:** The very nature of mass production can sometimes lead to significant disruptions that increase costs [27](#page=27). --- # Revenue and profit maximization for a firm This section outlines how a firm determines the optimal output level to maximize its profits by analyzing revenue and cost components [30](#page=30). ### 5.1 Understanding revenue Revenue represents the total income a firm generates from selling its products or services. There are several key measures of revenue [29](#page=29): #### 5.1.1 Total revenue (TR) Total revenue is the aggregate amount of money a firm receives from selling a specific quantity of output. It is calculated by multiplying the price per unit by the number of units sold [29](#page=29). $$TR = P \times Q$$ where: - $TR$ is Total Revenue - $P$ is the Price per unit - $Q$ is the Quantity sold [29](#page=29). #### 5.1.2 Average revenue (AR) Average revenue is the revenue earned per unit of output sold. It is calculated by dividing total revenue by the quantity sold. In most market structures, average revenue is equivalent to the market price [29](#page=29). $$AR = \frac{TR}{Q}$$ where: - $AR$ is Average Revenue - $TR$ is Total Revenue - $Q$ is the Quantity sold [29](#page=29). #### 5.1.3 Marginal revenue (MR) Marginal revenue is the additional revenue gained from selling one more unit of output. It is calculated as the change in total revenue divided by the change in quantity [29](#page=29). $$MR = \frac{\Delta TR}{\Delta Q}$$ where: - $MR$ is Marginal Revenue - $\Delta TR$ is the change in Total Revenue - $\Delta Q$ is the change in Quantity [29](#page=29). ### 5.2 The profit maximization objective The fundamental assumption in this analysis is that a firm's primary goal is to maximize its profit. Profit is the difference between a firm's total revenue and its total cost [30](#page=30). $$Profit = TR - TC$$ where: - $Profit$ is the firm's profit - $TR$ is Total Revenue - $TC$ is Total Cost [30](#page=30). ### 5.3 Determining total costs, total revenue, and profits graphically Firms can visually determine their profit-maximizing level of production using cost and revenue curves [31](#page=31). To find total costs ($TC$) for a given quantity ($Q$), one can multiply the Average Total Cost ($ATC$) by the quantity produced, as $ATC = \frac{TC}{Q}$. This product ($ATC \times Q$) represents the area of a rectangle on a cost graph [31](#page=31). Similarly, total revenue ($TR$) is calculated by multiplying the market price ($P$) by the quantity produced ($Q$), and this also forms the area of a rectangle on the graph ($P \times Q$) [31](#page=31). Profits (or losses) are then represented by the difference between the areas of these two rectangles: the total revenue rectangle and the total cost rectangle [31](#page=31). > **Tip:** When analyzing graphs, look for the quantity ($Q$) where the vertical distance between the total revenue line and the total cost line is greatest. This visually identifies the profit-maximizing output. #### 5.3.1 Graphical representation of profit maximization On a standard cost and revenue graph, where the vertical axis represents cost or price and the horizontal axis represents quantity produced ($Q$): - The **market price ($P$)** is a horizontal line (assuming perfect competition or a price-taker). - **Total Revenue ($TR$)** is represented by the area of a rectangle formed by $P \times Q$. - **Average Total Cost ($ATC$)** is a curve. - **Total Cost ($TC$)** is represented by the area of a rectangle formed by $ATC \times Q$ [32](#page=32). **Calculating profit at a specific quantity:** - Identify the quantity $Q$ on the horizontal axis [32](#page=32). - Find the corresponding market price $P$ on the vertical axis [32](#page=32). - Find the corresponding Average Total Cost ($ATC$) at that quantity $Q$ on the vertical axis [32](#page=32). - Total Revenue is the rectangle $P \times Q$ [32](#page=32). - Total Cost is the rectangle $ATC \times Q$ [32](#page=32). - Profit is the difference between the TR rectangle and the TC rectangle. If $TR > TC$, the firm makes a profit. If $TC > TR$, the firm incurs a loss [32](#page=32) [33](#page=33). > **Example:** Consider a firm producing quantity $Q_1$. If the market price is $P$ and the average total cost at $Q_1$ is $ATC_1$. > - Total Revenue = $P \times Q_1$ (the area of the rectangle with height $P$ and width $Q_1$). > - Total Cost = $ATC_1 \times Q_1$ (the area of the rectangle with height $ATC_1$ and width $Q_1$). > - If $P > ATC_1$, the firm earns a profit equal to $(P - ATC_1) \times Q_1$. This profit is represented by the area of the rectangle between the price line and the ATC curve, up to quantity $Q_1$ [32](#page=32). #### 5.3.2 Graphical representation of a loss When a firm produces at a level where total cost exceeds total revenue, it incurs a loss. Graphically, this is shown when the area of the total cost rectangle ($ATC \times Q$) is larger than the area of the total revenue rectangle ($P \times Q$) [33](#page=33). > **Example:** If a firm produces quantity $Q_2$, and the market price $P$ is below the average total cost ($ATC_2$) at that quantity ($P < ATC_2$), the firm will experience a loss. The loss is calculated as $(ATC_2 - P) \times Q_2$, and it is represented by the area of the rectangle between the ATC curve and the price line, up to quantity $Q_2$ [33](#page=33). --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Short run | A period during which at least one input into production is fixed, meaning it cannot be easily changed. | | Long run | A period of time in which all inputs into production are variable and can be adjusted by the firm. | | Fixed input | A factor of production that does not change with the level of output in the short run, such as a factory building or machinery. | | Variable input | A factor of production that can be easily changed with the level of output, such as labor or raw materials. | | Production function | A relationship showing the maximum output that can be produced from a given combination of inputs. | | Total product (TP) | The total quantity of goods or services produced from a given amount of inputs. | | Marginal product (MP) | The additional output produced as a result of increasing the variable input by one unit. Mathematically, $MP_L = \frac{\Delta TP}{\Delta L}$. | | Average product (AP) | The total product divided by the quantity of the variable input. It is a measure of labor productivity. Mathematically, $AP_L = \frac{TP}{L}$. | | Law of diminishing marginal returns | A principle stating that as more units of a variable input are added to a fixed input, the marginal product of the variable input will eventually decrease. | | Explicit costs | Monetary payments made by a firm to owners of resources that are not owned by the firm. These are direct payments for resources. | | Implicit costs | The opportunity costs of using resources that are already owned by the firm. These represent the returns forgone by not selling or renting out the owned resources. | | Total Economic Cost | The sum of explicit and implicit costs, representing the total opportunity cost of all resources used in production. | | Fixed costs (FC) | Costs that do not vary directly with the level of output in the short run, such as rent or salaries of administrative staff. | | Variable Costs (VC) | Costs that change directly in proportion to the level of output produced. Examples include raw materials and direct labor wages. | | Total Fixed Cost (TFC) | The sum of all fixed costs, which remains constant regardless of the output level. | | Total Variable Cost (TVC) | The sum of all variable costs, which increases as output increases. | | Total Cost (TC) | The sum of total fixed cost and total variable cost at any given level of output. Mathematically, $TC = TFC + TVC$. | | Marginal Cost (MC) | The additional cost incurred by a firm from producing one more unit of output. Mathematically, $MC = \frac{\Delta TC}{\Delta Q}$. | | Average Fixed Cost (AFC) | Total fixed cost per unit of output. Mathematically, $AFC = \frac{TFC}{Q}$. | | Average Variable Cost (AVC) | Total variable cost per unit of output. Mathematically, $AVC = \frac{TVC}{Q}$. | | Average Total Cost (ATC) | Total cost per unit of output. Mathematically, $ATC = \frac{TC}{Q}$. Also referred to as Average Cost (AC). | | Economies of Scale | Situations where the average total cost decreases as the scale of production increases, due to factors like specialization and efficient use of capital. | | Diseconomies of Scale | Situations where the average total cost increases as the scale of production increases, often due to management complexities and coordination issues. | | Constant Returns To Scale | A situation where doubling inputs leads to a doubling of output, and average costs remain constant as the scale of production changes. | | Total Revenue (TR) | The total income a firm receives from selling a given quantity of output. Mathematically, $TR = P \times Q$. | | Average Revenue (AR) | The average amount of revenue received per unit of output sold. Mathematically, $AR = \frac{TR}{Q}$. | | Marginal Revenue (MR) | The additional revenue generated from selling one extra unit of output. Mathematically, $MR = \frac{\Delta TR}{\Delta Q}$. | | Profit | The difference between a firm's total revenue and its total cost. It is the financial gain. Mathematically, $Profit = TR - TC$. |