a) Formulae to calculate and understand the relationship between:
Cost – opportunity cost of the factors of production used
Total cost
How much it costs to produce a given level of output – an increase in output results in an increase in total costs. Total costs = total variable costs + total fixed costs.
Total fixed cost
In the short run, at least one factor of production cannot change
This means there are some fixed costs and they don’t vary with output.
E.g. rents, advertising and capital goods are fixed goods – indirect costs
Total variable cost
In the long run, all factor inputs can change
This means all costs are variable
E.g. the production process might move to a new factory or premises – not possible in the short run – variable costs change
Average (total) cost
Average (total) cost (ATC) = total costs / quantity produced.
ATC = AVC + AFC
Average fixed cost
Average fixed costs (AFC) = total fixed costs/ quantity
AFC = TFC/ Q
Average variable cost
Average variable costs (AVC) = total variable costs/ quantity
AVC = TVC/ Q
Marginal cost
This is how much it costs to produce one extra unit of output – calculated by ∆TC/ ∆Q
Economic Cost:
Full economic cost of production – includes a sum to represent opportunity cost of factors of production for which no money payment is made – imputed cost
Economic cost = money cost + imputed cost
Accountant’s measure of profit takes into account only money costs like wages, raw materials and power
His measure of profit exceeds the economists
When economic profit is 0 – accounting profit is positive
Situation in which normal profit is made
If revenue were to fall further – wouldn’t be sufficient to cover opportunity costs of factor of production
Normal profit is the minimum accounting profit to keep factors of production in their current use
Any profit above this is supernormal or economic profit
Unlike accounting profit, economic profit (and, thus, normal profit as well) takes into account the opportunity cost of a particular enterprise
Summary:
• Accounting profits = Sales Revenue – Accounting Cost (money cost) • Economic costs = Accounting Cost (money cost) + Opportunity Cost of the factors of production • Economic profit (supernormal profit) = Sales Revenue – Economic Cost
Example:
• 2 firms would like to hire a machine – Firm A would generate £400 revenue per week, Firm B £300 revenue per week • if rent rises about £300 per week, Firm B drop out • Firm A are expected to hire the machine at a rent of marginally about £300 per week • £300 per week represents the opportunity cost of the machine, as it would generate this sum in its next best use (with firm B)
b) Derivation of short-run cost curves from the assumption of diminishing marginal productivity
Measure of the short run varies with industry – no standard
• E.g. the short run for the pharmaceutical industry is likely to be significantly longer than the short run for the retail industry
In the short run – some fixed costs
In the long run – all costs are variable
In the very long run, the state of technology can change, such as electronics.
The law of diminishing marginal productivity – adding more units of variable input to a fixed input, increases output at first but after a certain number of inputs are added, the marginal increase of output becomes constant – then, when there is an even greater input, the marginal increase in output starts to fall
At some point in the production process, adding more inputs leads to a fall in marginal output
Could be due to labour becoming less efficient and less productive
At this point, total costs start to increase.
c) Relationship between short-run and long-run average cost curves
The LRAC curve is shown in the diagram below
The point of lowest LRAC is the minimum efficient scale – where the optimum level of output is since costs are lowest.
If SRAC = LRAC, the firm operates where it can vary all factor inputs.