Production Costs and Revenue

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  • Created by: ekenny5
  • Created on: 17-10-21 17:04

Production and Productivity

Production is a measure of the value of outputs of goods and services, measured by national GDP.

Productivity is a measure of the efficiency of the factors of production (over a given period of time)

An increase in production does not mean an increase in factor productivity, there could just be more of one of the factors of production. 

Factors affecting productivity:

  • degree of competition
  • technology
  • investment in apprenticeships/ quality of management 
  • specialisation
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Specialisation and the Division of Labour

Specialisation occurs at all levels of economic activity, when factors of production focus on a certain task, eg mass manufacturing.

Bangladesh is a major producer and exporter of textiles; the USA is a leading shale oil and gas supplier. And Ghana is one of the biggest producers of cocoa in the world. For many years the West Midlands has been a centre for motor car assembly, there has been huge investment in recent years in the Mini plant at Oxford.

Agglomeration is a mass collection of things - for example many restaurants in one area, or firms setting up near universities to be attractive to competitive graduates. Silicone Valley is an example of this. 

Division of Labour occurs when production is broken down into many separate tasks. Output per person can increase (increasing labour productivity) as workers become better and faster at their separate tasks.

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Advantages of Specialisation

  • higher labour productivity and business profits - increasing output per hours worked, and higher productivity lowers costs of production, so higher profits 
  • allows for international trade as specialisation creates a surplus that can be traded. Specialising can gain firms/countries relative advantage 
  • lower prices, higher real incomes and GDP growth - increases purchasing power from lower prices, successful specialisation can lead growth

Disadvantages of specialisation:

  • repetative tasks can lower motivation and so productivity in the long run 
  • may lower quality
  • high labour turnover and absenteeism 
  • mass produced goods lower consumer choice 
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The Functions of Exchange

  • a medium of exchange 
  • a store of value 
  • a unit of account 
  • a standard of deferred payment 

A medium of exchange is necessary for trade to occur 

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The Short Run

The SHORT RUN is the time period in which a minimum of one factor of production is fixed. This occurs usually when land is a fixed factor (eg labour, capital and enterprise are all variable and can be increased). The short run looks at marginal product (or returns) of variable factors of production and production and productivity of a firm. 

In the short run, firms will stay in production as long as they are covering average variable costs as this can contribute to cover fixed costs.

In the short run, firms have sunk costs- costs the firm has already paid and are not recoverable if the firm wishes to leave the industry. An example is marketing - unlike assets, they cannot be sold. They are unavoidable. 

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The Long Run

The LONG RUN is a time period in which no factors of production are fixed. Therefore the scale of output can be increased. This involves returns to scale. Firms will leave the industry if they do not cover average total costs.

A firm faces prospective costs are costs that will take into account when making an investment decision and are avoidable as they are based on the future.

When looking at a new investment the firm should cover sunk costs, and base decisions on merit 

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Marginal, Average and Total Returns

Total returns is the actual rate of return of an investment over a time period 

Average returns is the total returns divided by output 

Marginal returns is the rate of return for an increase in investment - the additional output from one unit increase in a variable factor of production

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The Law of Diminishing Returns

states that if one factor of production is increased while another factor of production is fixed, the productivity of the variable factor will eventually decrease. This is a short run phenomenon (as in the long run all factors are variable). 

Firstly there is increasing marginal returns as marginal product (MP) increases. As more units of the variable factor is added, marginal product, average product and total product increase. MP will increase as specialisation occurs and more efficient use of factors of production is made.

At some point, MP, then AP and finally TP will start to decline as problems such as co-ordination and communication occur.

See the source image 

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Diminishing Marginal Returns

There is an inverse relationship between marginal returns and marginal costs 

  • increasing marginal returns lead to decreasing marginal costs 
  • decreasing marginal returns lead to increasing marginal costs 

Once diminishing returns set in, each subsequent worker becomes less productive 

  

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Returns to Scale

In the short run, output can only be increased by adding more of the variable factors of production to fixed capital. At some point, the law of diminishing returns set in and marginal costs begin to rise.

In the long run the firm is able to increase the scale of production leading to economies of scale - it is able to change all factor inputs.

Economies of scale will lead to increased productive efficiency.

When all factors of production increase, the scale of the firm has increased

Increasing returns to scale are when all factors of production increase, the returns (output) increase proportionally more eg 10% increase in factors of production causes a 15% increase in output

Constant returns to scale are when the increase is of the same proportion eg 10% increase in factors of production lead to 10% increase in output 

Decreasing returns to scale are when the increase is proportionatley less eg 10% increase in factors of production cause a 5% increase in output

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Costs of Production

Fixed costs: costs that do not vary with output eg the cost of a factory

Variable costs: costs that vary with output eg costs of raw materials 

Total costs: fixed + variable costs 

Marginal costs: the cost of producing one extra unit

Sunk costs: costs that are not recoverable eg advertising 

See the source image 

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Production Costs

 

Initially, as output increases, marginal cost falls - producing one extra unit costs less than producing the previous units. 

After the lowest point on the MC curve is reached, any additional units will cost more than previous units .

The MC curve always cuts the AC curve at its lowest point.

Every point up to Q1, the MC is below the AC. If MC<AC, AC will fall. Once MC>AC, AC rises. Costs increase as diminishing marginal returns start to set in

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Total Costs

See the source image 

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Long Run Average Costs

In the long run, all costs are assumed to be variable, meaning the scale of production can change. Economies of scale are the unit cost advantages from expanding the scale of production in the long run. The effect is to reduce average costs over a range of output. As output increases, costs fall.

  The SRAC curve creates tangents to the LRAC at their lowest points. The LRAC curve falls as the firm experiences economies of scale, but as average costs begin to rise, diseconomies set in. When LRAC is constant, returns to scale are constant.

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Economies of Scale

Internal Economies of Scale

Internal economies of scale involve expansion of the firm itself, lower LRAC as output increases, increasing returns from large scale production 

  • technical - eg containerisation in shipping and tourism 
  • purchasing - bulk buying purchases 
  • managerial - employing specialized staff to raise efficiency 
  • financial - lower interest rates on loans for larger firms (they're seen as a safer investment)
  • risk-bearing - product diversification means risk can be shared between different products 
  • network - networks of suppliers/consumers - low marginal costs of adding units 
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External Economies of Scale

is expansion of the industry as a whole, and benefits most/all firms within the market. This helps to explain how some cities experience rapid growth.

Agglomeration economies is when businesses in similar industries cluster together to make use and attract an influx of skilled labour. Eg:

  • university research departments 
  • transport networks lower logistic costs 
  • relocation of suppliers
  • influx of human capital

External economies of scale:

  • New production methods
  • Transportation modes
  • Government tax breaks
  • Increased tariffs against a foreign competitor
  • New off-label use of a prescription drug or other product
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Diseconomies of Scale

lead to a rise in the long run average costs of production - resulting from a business expanding beyond their optimum size and production.

Diseconomies of scale can be caused by:

  • lack of control and communication eg unable to monitor production and quality 
  • unable to co-operate 
  • internal politics and information overload 

Diseconomies of scale mean that

  • A business has moved beyond their optimum size
  • Businesses are suffering from productive inefficiency
  • Higher unit costs will reduce total profits
  • Businesses may then have to charge higher prices in order to cover their increased costs
  • Lost competitiveness could lead to lower market share and also a fall in their share price
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Minimum Efficient Scale

The MES occurs at the scale of production where the long run average cost curve is at its lowest point. If it occurs at low levels of output, there is likely to be a large number of firms in the market (eg perfect competition or monopolistic competition). As the MES increases there will be fewer firms in the market, as the lowest costs occur at a much larger scale of production. This acts as a barrier to entry, as economies of scale cannot be exploited until production is larger. Most businesses do not want to join a market where so much finance is needed up front and the gains will not be seen in the short run. 

 

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MES in Perfect Competition

The firm will always operate at its MES, where the LRAC curve is at its lowest.

If a firm is operating below its MES, firms will increase output as they can still experience economies of scale.

If a firm is operating above its MES, it is experiencing diseconomies of scale so will reduce output.

In perfect competition, MES occurs at a very low level of output, as there are no barriers to entry.

     

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MES Monopolistic Competition

  These firms will often operate below the minimum efficiency scale, and have spare capacity so under utilising its resources. Firms often have goals other than profit maximisation.Few firms operate above the level of Q1, as diseconomies of scale set in at low levels of output.

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MES Oligopoly/Monopoly

 Diseconomies of scale set in later (at a higher level of production) than in monopolistic markets. This is mainly because of high fixed costs, so higher ouputs lower average costs.

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Returns to Scale and Economies of Scale

L Shaped Cost Curve

Average and Marginal Cost Curves of a Firm in the Long-Run ... In a natural monopoly there are constant returns to scale, meaning average costs are always falling. Increasing output will keep lowering average costs. There are highly significant barriers to entry, as a natural monopoly is often regulated by the government. 

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Marginal Costs and Returns

Revenue

Revenue is the total income generated from the sales of goods and services in a market 

Average revenue is the total revenue divided by output     AR=TR/Q

Marginal revenue is the change in revenue from adding one additional unit 

Total revenue is price per unit x quantity sold      TR=ARxQ

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Revenue in Perfect Competition

Firms face a perfectly elastic demand curve, meaning it could not raise its price, or demand would fall to zero, and if they lower the price, they will no longer cover their costs.

The demand curve is also the AR curve as total revenue divided by price is always the same. It is also the MR curve as prices do not change so the additional revenue from selling one additional unit will not change. 

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Average and Marginal Revenue

 The MR curve falls twice as steeply as the AR, as when the MR curve is below the AR curve, it pulls the average down. The desire to sell one extra unit pulls down the price 

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Revenues in Imperfect Competition

  The total revenue curve peaks when the marginal revenue is zero. This is where TR is maximised. When MR is above zero, each extra unit adds to total revenue. After this point, there will be negative marginal revenue, so total revenue will fall.

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Profit

is the difference between total revenue and total costs. 

Normal profit is the minimum amount reward for a firm to remain in the industry. This is classed as an opportunity cost as staying in the industry is just better than the next best alternative. In the long run, a firm will leave the market if they cannot make normal profit. 

Supernormal (abnormal) profit is the any profit above normal profit. If firms are seen to be making supernormal profits this acts as a signal for other firms to join the market. This will compete supernormal profit away. The degree of competition in the market will influence the level of supernormal profit. Monopolies and oligopolies have the power to restrict the level of competition coming into the market. 

Sub-normal profit is anything below normal profits, and if a firm makes sub-normal profits in the long run, they will leave the market. 

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The Role of Profit

  • Finance for capital investment and research: Retained profits are a key source of finance for businesses undertaking capital investment + funds for acquisitions
  • Market entry: Rising supernormal profits send signals to other producers within a market
  • Demand for and flow of factor resources: Resources flow where the risk-adjusted rate of profit is highest
  • Signals about health of the economy: Rising profits might reflect improvements in supply side performance. They are also the result of higher levels of aggregate demand for example during an economic recovery
  • Corporation tax is paid on profits, creating significant revenues for governments

 

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Technological Change

describes the process of innovation,invention and the widespread use of technology in society.

Invention is the development of an idea into a new product of or process. Firms invest time and money to get money in return.

Innovation involves the creation of a market for the invention in order to make a profit. 

Technological process occurs when technological change increases the output for the same giving factor inputs.

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Technological Progress

Technology is constantly changing within all industries. Technological change and progress can increase the number of firms within a market:

  • reduces barriers to entry - eg the internet allows cheap access to global markets 
  • greater scope for competition 
  • reduces monopoly power, as more firms join the market 

Investment is expensive, high fixed costs:

  • lead to a requirement to produce significant output in some industries to cover research and development costs
  • required to increased scale of production in order to attain MES
  • creating barriers to entry and creating more of an oligopolistic market 
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Effects on Efficiency

A firm is productively efficient when producing at the level where its average production costs are minimised (the bottom of the ATC/LRAC curve). Technological change leads to lower costs; shifting the curves down. 

dynamic efficiency

This measures change in productive efficiency over time. A dynamically efficient firm is one that is able to innovate and improve productive efficiency not just as a one-off, but in a continual/sustained manner.

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The Production Process

Division of Labour and Specialisation in the human workforce increase labour productivity. These gains have been increased further by the application of new technology.

Mechanisation:   moving from labour-intensive to more capital-intensive methods of production (ie. More machinery, fewer employees)

Automation:  removing human operators from processes altogether, eg. computer controlled assembly- line robots

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Dynamic Efficiency

Dynamic efficiency

  • Dynamic efficiency occurs when businesses supplying a market successfully meet our changing needs and wants over time
  • Crucial to dynamic efficiency is whether the market generates sufficiently robust and rapid innovation both in the processes of supply and the range of products available
  • Most people associate dynamic efficiency with innovation:                                                                                                                                                                                                              Recent examples of dynamic efficiency in markets:
  • Dec 2015: Porsche to make electric sports car in €700m project - aimed at challenging Tesla's dominance of the battery-powered sports car market
  • Dec 2015: Ford says it will invest $4.5bn (£3bn) to expand its fleet of plug-in and hybrid electric vehicles, and will start selling 13 new electric models by 2020.
  • Nov 2015: Huawei reveals a new quick-charge battery
  • Nov 2015: The doctor will text you now: Will mobile devices change healthcare? – new app allows doctors to process their patients electronically and remotely
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Creative Destruction

innovation leads to the development of new products and processes that displace firms that currently dominate industries. This can lead to destruction of existing markets, at the same time, markets are developed.

Examples:

  • Music and book retailing (Amazon)
  • Grocery retailing (Ocado, Amazon, Tesco)
  • Holidays (Expedia, Trip Advisor) • Gambling (Bet365, FoxyBingo)
  • File storage and sharing (Dropbox)
  • Music streaming (Spotify & iMusic)
  • Sharing economy (Uber, Airbnb)
  • Media consumption (Netflix, YouTube)
  • Media sharing (Snapchat, Facebook)
  • News publishing (Twitter, Huffington Post, Buzz Feed)
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Creative Destruction

innovation leads to the development of new products and processes that displace firms that currently dominate industries. This can lead to destruction of existing markets, at the same time, markets are developed.

Examples:

  • Music and book retailing (Amazon)
  • Grocery retailing (Ocado, Amazon, Tesco)
  • Holidays (Expedia, Trip Advisor) • Gambling (Bet365, FoxyBingo)
  • File storage and sharing (Dropbox)
  • Music streaming (Spotify & iMusic)
  • Sharing economy (Uber, Airbnb)
  • Media consumption (Netflix, YouTube)
  • Media sharing (Snapchat, Facebook)
  • News publishing (Twitter, Huffington Post, Buzz Feed)
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