4.1.4 – Production, Costs and Revenue

    88– Production and Productivity

    Production – producing something in order to sell it
    • production involves turning inputs (raw materials, labour) into outputs (things to sell )
    • inputs can be any factor of production and are tangible

    Productivity is Output per Factor Employed

    • productivity is measured by output per unit of input employed
    o therefore improved/ more advanced inputs increase output
    Labour productivity – output per worker/ output per hour worked
    • labour productivity is an example of measuring productivity allowing
    workers to be compared to other against other workers
    • the way to calculate productivity for a factor of production is:
    • improvements in productivity are caused by training, better education and better technology
    • specialisation can also improve productivity if each worker does the tasks they are skilled at – Specialisation, Division of Labour and Exchange

    Specialisation – leads to division of labour
    • people could make everything they want e.g. food,
    computers and clothes. However, what happens is people
    and firms specialise in a particular thing
    • division of labour – type of specialisation where productions split into different tasks and specific people are
    allocated to each task

    Trade – people buy stuff they are no longer making
    • swapping goods and services with other countries is one way a country can get what it needs its known as a
    barter system and is very inefficient
    • the most efficient way of exchanging goods and services is money as both buyers and sellers’ value it
    • money has three other functions:
    o measure of value – value given to good e.g. oil can be measured in US dollars
    o store of value – waiting before buying due to uncertainty in exchange rates
    o standard of deferred payment – money can be paid at a later date for something consumed – Law of diminishing Returns and Returns to Scale

    Increases in Output are Limited by Diminishing Returns
    in Short Run
    • The law of diminishing returns explains what occurs
    when a variable factor of production increases while other factors stay fixed
    • When you increase one factor of production by one unit but keep others fixed the extra output received is
    known as the marginal product
    ▪ Marginal product = additional output produced by adding one more unit of a factor input

    1) As you add more of a factor of production the marginal product with increase, so
    each unit of input added will raise output more than before
    2) Eventually as you keep adding units of one factor of production, the other fixed
    factors will begin to limit additional output you get.
    3) Therefore the marginal product will fall


    Law of Diminishing Returns = if one variable factor of production is increased
    while the others are fixed then eventually the marginal returns from the variable
    factor will begin to decrease


    Diminishing Marginal Returns Increase Marginal Cost
    1) Marginal Returns / Products are related to marginal cost
    • as marginal returns rise marginal costs fall
    • as marginal returns fall marginal costs rise
    2) marginal costs rise as marginal returns fall as if your getting less additional
    output from each unit of output then the cost per unit of output will be greater


    Diminishing Marginal Returns Eventually Causes Productivity Fall


    1) as the level of that factor input continues to increase, the average product will
    eventually start to fall too as shown on the right. The MP curve always meets the AP
    curve when the AP curve is at its maximum
    o average product = output produced per unit of factor input e.g. if one worker
    produces 7 toys then the AP is 7 but if 2 workers produce 10 the AP is 5
    2) the average product is also known as productivity
    o so if a firm employs more and more people they’ll find that productivity of
    employees fall
    3) if you then keep adding more of the variable factor you can reach a stage where adding further input results in a
    fall in the total product ( e.g. as workers get in each others way)
    o total product = total output produced using a particular combination of factor inputs

    Productivity Can Be Improved in Various Ways
    • Labour productivity can be improved by Better training and management
    • Improved technology
    Increased productivity reduces firms cost of production

    Returns to Scale
    Returning to Scale describe Effects of Increasing the Scale of Production
    • in the long run firms can increase all their factor inputs
    • returns to scale describe the effect on output of increasing all factor inputs by same proportion
    o increasing Returns to Scale – when an increase in all factor inputs leads to more than propotional
    increase in output. E.g. a double increase in input leads to triple increase in output
    o Decreasing Returns to Scale – when an increase in all factor inputs leads to a less than propotional
    increase in output. E.g. a triple increase in input leads to a double increase in output
    o Constant Returns to Scale – when an increase in all factor inputs leads to a propotional increase in output
    Increasing Returns to Scale Contribute to Economies of Scale
    • Returns to scale and economies of scale aren’t the same thing
    o Returns to scale shows how much output changes as input is increased
    o Economies of scale shows reductions in average cost as output increased
    • However, the two ideas do link
    o Increasing returns to scale contributes to economies of scale
    o Decreasing returns to scale contributes to diseconomies of scale

    1. When returns to scale are increasing, LRAC with fall.
    o An increase in input leads to a more than
    proportional increase in output, so more
    output is produced per unit of input
    2. When returns to scale are constant, LRAC will stay the
    o Costs increase proportionally to output
    3. When returns to scale are decreasing, LRAC will rise
    o Less output is being produced per unit of

    LRAC are Minimised at the MES – The Costs of a Firm

    Firms Generate Revenue and Incur Costs
    • a firm is a business organisation i.e. a dental practise
    • firms generate revenue by selling output
    ▪ producing this output uses the factors of production, which has a cost
    • the profit a firm makes is the total revenue – total production costs
    o profits needed in the long run for a firm to survive
    Economists Include Opportunity Cost in the Cost of Production
    • the costs of production is the economic cost of producing the output
    • economic cost includes:
    o costs of factors of production that have to be paid for
    o opportunity cost of factors that aren’t paid for e.g. (home office where business is run
    • opportunity cost of a factor of production is money you could’ve got by putting it to its next best use
    o e.g. in a self run business the money you could earn doing other work is the opportunity cost of your labour
    In the Short Run Some Costs are Fixed
    • the short run is the period where one factor of production is fixed usually capital
    • the long run is the period of time where all factors of production can change.
    • in the short run, costs can be fixed or variable but in the long run all costs are variable

    Total Cost and Average Cost Include Fixed and Variable Costs
    • Total cost = all the costs involved in producing particular level of output
    o Total cost = Total fixed Cost + Total Variable Cost
    • Average cost = cost per unit produced
    o Average cost = total costs / quantity produced
    o Average fixed cost = Total fixed Cost / quantity produced
    o Average variable cost = Total Variable Cost / quantity produced
    • Marginal Cost = Cost of producing one more unit of output
    Lowest Average cost is when MC=AC
    • MC decreases initially as output increases, then increases in short run due to law of diminishing returns .
    • So is always U-shaped – Economies and Diseconomies of Scale

    Economies of Scale can be Internal or External
    1) the average cost to a firm for making a product is high if
    not produced in bulk
    2) in the long run, the more products a firm makes, the more the average cost of making each one falls
    a. these falls are due to economies of scale
    economies of scale = the cost advantages of production on a large scale
    Internal Economies of Scale Involve Changes in A Firm

    ▪ Technical Economies of scale – Production lines used by large firms to make several things at low average cost
    – Large firms can also use specialist equipment to help reduce average costs
    – Workers can specialise so become more efficient
    o Another potential economy of scale arises from the law of increased dimensions. For e.g.
    – Bigger oil tankers can lower the cost of transporting each unit
    – Buying a small warehouse in comparison to a big one with larger volumes

    ▪ Purchasing Economies of scale – larger firms making several goods need more raw materials so can get discounts
    3 as they will put in the biggest orders

    ▪ Managerial Economies of scale – larger firms will hire specialist managers

    ▪ Financial Economies of scale – larger firms can borrow money at lower interest rates as its less riskier for banks
    ▪ Risk bearing Economies of scale- larger firms can diversify into different product areas and markets (sell abroad)
    – large firms more able to take risks (create products that may not be popular)
    – if product is unsuccessful larger firms other activity absorb cost of failure easily
    ▪ Marketing Economies of scale – Advertising is a fixed cost – spread over more units for larger firm
    – The Cost per product of advertising several products is lower than
    advertising just one
    – larger firms also benefit from brand awareness as it gains consumer trust

    External Economies of Scale Involve Changes Outside A Firm
    • Local colleges may start to offer qualification needed by big local employees, reducing training costs
    • Large companies locating in an area may lead to improvements in road networks or local public transport
    • If lots of firms do similar or related things locate near each other they might share resources
    o Supplies will also locate in same area reducing transport costs
    Extremely Successful Companies Can Gain Monopoly Power in Market
    • As firms’ average cost for making product falls, it can sell product at lower price, undercutting competition
    • This leads to a firm having a bigger and bigger market share
    • This allows a firm to force its competitors out of business and become the only supplier of the product
    Diseconomies of Scale – Disadvantages
    • Getting bigger isn’t always good as it can lead to diseconomies of scales
    • Diseconomies of scale cause average cost to rise as output rises and it can either be internal or external:
    ▪ Wastage and loss can increase as materials might seem in plentiful supply
    ▪ Communication may be more difficult as firm grows (affects staff morale)
    ▪ Managers less able to control what’s going on
    ▪ De-personalises the work environment
    ▪ As whole industry becomes bigger, price of raw materials may increase
    ▪ Buying larger amounts of materials may not make them less expensive per unit. If local suppliers aren’t
    sufficient, more expensive goods from further afield may have to be bought High Fixed Costs create Large Economies of Scale
    1. There are huge economies of scale in industries with high fixed costs but low variable costs
    a. For eg: robot based assembly lines are expensive to set up, but reduce labour required to produce each unit.
    This means fixed costs rise (loans to buy equipment need payment) while variable costs fall (labour)
    2. As a firm grows by taking advantage of its large diseconomies of scale, other firms in industry may be forced to do the
    same or shut down. This leaves an industry dominated by a few large firms
    Long Run Average Cost
    In the Long Run Firms can Move onto New Short Run Average Cost Curves
    • In the short run a firm has one fixed factor of production, so operates on a short run average cost curve (SRAC)
    • As firms increase output in short run by increasing variable costs of production
    o It moves along its short run average cost curve
    • In the long run a firm can change all factors of production


    1. SRAC curves can touch the LRAS curve, but not below it
    2. For a firm to operate on its LRAC curve, at a particular level of output, it has to use most appropriate mix of all
    the factors of production
    3. This means it may not be able to reduce costs to this minimum level in the short run (as some factors are fixed)
    4. But in the long run a firm can vary all factors of production and bring costs down to the level of LRAC curve

    External Changes Cause LRAC Curves to Shift
    • External economies of scale cause LRAC curve to shift downwards by reducing average
    costs at all output levels
    • External diseconomies of scale force LRAC curve to shift upwards
    • A change in taxation might cause LRAC curve to shift up or down e.g. increase in fuel duty would cause bus
    company’s LRAC to shift up
    • New technology would cause LRAC to shift down

    L-shaped LRAC
    1. Some economists argue LRAC curve is L-shaped. They believe average costs fall sharply
    as output increases, and then continue to fall slowly or level off
    2. this is based on the idea that while some internal diseconomies of scale will occur with increasing output, they’ll be offset by continued reductions in average cost due to things like production and technical economies of scale – so the curve wont curve upwards again – The Revenue of a Firm

    Revenue = Money Received From Selling Goods and Services
    • Total revenue – total amount of money received, in a time period, from a firm’s sales
    o Total revenue = total quantity sold x price
    • Average revenue – revenue per unit sold
    o Average Revenue = Total Revenue/ total quantity sold
    • Marginal revenue – the extra revenue received as a result of selling the final unit of output (one more unit)
    o Marginal Revenue is difference between Tr at
    new sales level (TRN) and TR at one unit less
    o MR = TRn – TRn-1

    Firms Demand Curve Determines How Revenue
    Relates to Output

    A Firm that’s a Price Taker Has Perfectly Elastic Demand Curve
    • a firm that’s a price taker has no power to control the price it sells at (have to accept price set by market)
    • a price takers demand curve will be flat (perfectly elastic)
    o If firm increases price then quantity sold drops to zero
    o Theres no reason to decrease the price as the same quantity would sell at the original higher price

    With a Perfectly Elastic Demand Curve AR = MR
    1. When demand is perfectly elastic the price is the same, no
    matter what the output level
    2. In this case marginal revenue = average revenue as extra unit
    sold bring in the same revenue as all the others
    3. When average revenue is constant, total revenue increases proportionally with sales, as shown on right
    A Firm That’s a Price Maker has a Downward Sloping Demand Curve
    • Price makers is a monopolists – have power to set price they sell at
    • Price makers demand curve will slope downwards – to increase sales the firm reduces price
    With a downward sloping Demand Curve TR is Maximised when PED = -1
    • if firms demand curve us straight line sloping downwards then PED will change depending on where firms
    operating on curve
    o at midpoint of demand curve PED = -1
    o to the left of the midpoint demand is elastic so decreasing price towards midpoint will cause a more
    than proportionate increase in sales and total revenue will rise
    o to the right of the midpoint demand is in elastic so decreasing price below price at midpoint will
    cause a less than proportionate increase in sales and total revenue will fall
    o total revenue is maximised when the firms are operating at midpoint of demand curve (PED = -1)
    And MR = 0 when TR is at its Maximum
    1. Demand curve is also average revenue curve, so maximum total revenue occurs at the midpoint of the AR curve
    2. The MR is always twice as steep as AR curve
    3. When total revenue is at its maximum, MR=0 – Profit

    Normal Profit and Supernormal Profit
    • Profit = Total revenue – Total Costs
    • Theres two kinds of profits in economics
    o Normal profit occurs when TR=TC
    ▪ Normal profit is when a firms total revenue equals its total costs
    ▪ So it is an economics profit of zero if all costs are taken into account
    ▪ This means normal profit occurs when the extra revenue left is equal to the opportunity
    costs of the factor of productions that aren’t paid for
    ▪ If the extra revenue is less than those opportunity costs, the firm would’ve been better off
    putting the factors of production to a different use
    ▪ normal profit = the minimum level of profit needed to keep resources in their current use in
    the long run
    o Supernormal profit
    ▪ Supernormal profit is when a firms total revenue is greater than its total costs
    ▪ This means revenue generated from using factors of production in this way is greater than
    using it in another way
    ▪ If firms in an industry are making supernormal profit, it will create incentives for other firms
    to try to enter the industry
    A Firm Must Make Normal Profit to Keep Operating in the Long Run
    • If a firm can’t make normal profit it will close in the long run, as revenue isn’t covering all its costs
    • Even if its making money profit the factors of production it’s using could be used better somewhere else
    • In the short run the firm has fixed costs it has to pay whether or not it produces any output
    • So a loss-making firm may not close immediately – it depends on its revenue to its variable costs

    in the long run the firm can be released from its fixed costs (e.g. no longer renting factory) and it will shut down
    • shut down points can be shown on a diagram
    o in long run if price remains below P (where normal profit is made) then firm should exit the market
    o in short run if price is between P and P1, then firm should
    continue producing
    o If price falls below P then the firm should cease production
    immediately as its variable costs aren’t being covered

    Profit is Maximised when Marginal Cost = Marginal Revenue
    • Economists assume firms aim to maximise their profits
    • To do this the optimum output level at which to operate must be found
    o If MR>MC then firm should increase output. As revenue gained by increasing output is greater than the
    cost of producing it. So increasing output adds to profit
    o If MR<MC then firm should decrease output. As the cost of producing the output is more than its
    revenue. So, decreasing output adds to profit
    • This means profit maximised output level occurs when MC = MR – Technological Change

    Technological Change Has Big Impact on Market Structure
    1. Technological change through innovation and
    invention can raise or lower barriers to entry
    2. Technological has an impact on:
    o Structure of market
    o Production methods
    o Consumption of goods and services
    3. Invention and innovation can lead to:
    o Improvements in capital equipment – leading to better quality products
    o Barriers to entry reduced or increased
    o Monopoly power to firm who invented innovation
    o Larger economies of scale
    New Technology Can Lead to Creative Destruction
    • Creative destruction is the idea markets are constantly changing due to innovation and invention of products
    and production methods
    o This causes job loses but new jobs will be made in new markets
    • Technological changes lead to creative destructive
    o As firms (even big ones) are put out of business due to innovation by new entrants seeking the profit
    o This also means large incumbent firms have incentive to invest so they can innovate keeping barriers to
    entry high






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