Production and Costs
Production and costs
Setting up a business is not an easy task. Whether you want to make laptops, bracelets or bread, there are some key decisions you need to make as an entrepreneur: what are you going to produce? How much of it? How many people will you employ? How much is it going to cost you?
Similar issues of production and costs take place in a classroom. If your school pays your best teacher to teach a class of only 3 students, it is wasting money: output (the number of students learning Economics) could be increased e.g. to 10 and the lesson would still be good! However, with 25 students, the teacher is being overburdened and each student will learn proportionately less. Should the school pay for a second teacher and form another class? These are very similar questions to those you will encounter in this section.
Production and output
Let’s start from the concepts of output (or product) in the short run.
The short run in microeconomics is defined as the period of time when at least one of the factors of production (land, labour, capital, entrepreneurship) is fixed.
Imagine that you have a small bakery. On your own, you manage to bake 100 loaves of bread per day – your total output (TO). You would however be able to bake more, had it not been for the fact that you also have to sell them and do the dishes. You therefore decide to hire your friend Adam. Adam is very charismatic and friendly, and you therefore let him do the selling. Now, you are in fact able to bake and sell 250 loaves of bread every day. Your average output (AO) is 125. The dishes are still yours to do though, and you therefore decide to hire Beatrice, another friend. Because the three of you divide the chores between yourselves so as to maximise efficiency, you are able to bake 500 loaves of bread per day!
Feeling the need to increase output even further, you hire a third friend to help you with the baking. Output now increases to 600 loaves of bread per day. The marginal output (MO) of your third friend is 100. You realise that you and your friend run in each other’s way every now and then – after all, it is a rather small bakery. When you hire yet another friend, output increases to 650, and when you hire another person still, you, in fact, find that this person has to remain in the corner the whole day so as not to block anyone else.
The situation you are experiencing in your bakery can be shown on the following table:
|Number of workers||Total Output||Marginal Output||Average Output
|1||100||100 – 0 = 100||100 / 1 = 100|
|2||250||250 – 100 = 150||250 / 2 = 125|
|3||500||500 – 250 = 250||500 / 3 = 167|
|4||600||600 – 500 = 100||600 / 4 = 150|
|5||650||650 – 600 = 50||650 / 5 = 130|
|6||650||650 – 650 = 0||650 / 6 = 108|
The law of diminishing marginal returns
What you experience in your bakery is the law of diminishing marginal returns. While you can add more employees, the fact that one of the factors of production is fixed, in this case capital (i.e. the size of the shop), means that you will experience a drop in marginal output. That is, you will experience a drop in the output added by the extra worker, as we move from 3 to 4 workers.
It is at this point that marginal output starts to decrease: the factors of production are no longer in perfect proportions to each other, and the result is that we do not make full use of each worker’s capacity. In order to do so, we need to change another factor of production as well (e.g. capital: if we expand our shop so that workers do not step on each other’s feet!).
The data from our bakery example has also been plotted in the diagram to the right. An important point to remember when drawing these diagrams is that AO will continue to increase when MO>AO. Only when MO<AO will average output start to fall. It follows then that the MO curve always cuts the AO curve at the latter’s point of inflexion (i.e. at the highest point of AO).
So, to sum up:
- Average outputis the total output divided by the number of workers employed.
- Marginal outputis the extra output that an additional worker produces. The MO curve intersects the AO curve at its highest point.
- The law of diminishing marginal returnssays that as a firm adds more and more units of a variable factor (e.g. labour) to a fixed factor (e.g. capital) in the short run, there is a point beyond which the total output will continue to rise but at a diminishing rate (i.e. the marginal output begins to decline).
Implicit and explicit costs
We now examine the other side of the same coin: economic costs. When you know both your output and cost curves, you can run your bakery more efficiently!
The term economic cost includes both the explicit and implicit costs of firms. Explicit costs such as raw materials, wages, rent and interest are known as accounting costs. Implicit costs such as entrepreneurship are costs which do not require real payments to someone. However, they involve using up scarce resources like time and ideas (you are in the bakery, while you could be doing something else to earn money). Implicit costs is the same as opportunity cost.
Economic cost is the sum of accounting costs and the opportunity cost.
Different types of costs
We can use the same example as above in order to better understand how costs work. You are still in the bakery, and you have figured out that you should hire 4 workers to produce efficiently. You are now interested in costs. The rent you pay to the landlord is a fixed cost (FC): it is always the same for example, € 200, every month.
Fixed costs are costs that are independent of the number of units produced.
In addition to fixed costs, you have to pay for other bills as they come through: electricity bills, flour for the bread, wages paid to the staff who works in the bakery etc. These are variable costs (VC). Variable costs increase as your production increases.
Revisiting the table of costs from the section above, For example, if you double the production of bread from 250 to 500 loaves of bread, your VC will increase from € 150 to € 200. However, when you try to increase production from 500 to 600 loaves of bread, your VC would go up from € 200 to € 400. This is because your old oven is not big enough to bake 600 loafs and it needs to be fixed constantly by the technician.
Variable costs are costs that change with the number of units produced.
The sum of fixed and variable costs at each level of output gives you the total cost (TC = FC + VC). When we divide the total cost by the quantity produced, we find the average total cost (ATC) for producing X loaves of bread.
Finally, we want to know what the cost of producing an extra loaf of bread is. You can simply calculate this by seeing how much is your total cost going up for every extra loaf you make. For example, when you increase production from 100 to 250 loaves (150 more), your total cost goes up by 50. Hence the cost of producing an extra loaf of bread is €50150 = € 0.33. This is themarginal cost (MC).
The costs of your bakery can be written in a table to summarise our example as follows:
|Output, q (loaves of bread)||Fixed Cost, FC (€)||Variable Cost, VC (€)||Total Cost, TC (€) [FC + VC]||Average Cost (€) [TC / q]||Marginal Cost (€)|
We can plot the following diagrams to represent cost curves in the short run.
In the first one, we show how total cost is the sum of variable costs and fixed costs. As in our example, variable costs increase at a slower rate as production increases, but then start increasing at a faster rate again. This will happen when you make more bread from the same oven, but then it will break down very often if it never rests! Because total costs are the sum of fixed and variable costs, they will follow the same pattern: grow slowly up to € 400, and then increase rapidly beyond that cost.
In the second diagram, we plot average and marginal cost curves from our example. We now know from the table above that the MC represents the cost of producing an additional unit. Thus our initial cost per loaf of bread is € 1. However, when we manage our workers and our oven more efficiently, we can lower the cost of producing bread to €0.2 per loaf. However, when we try to produce more, each additional loaf will start becoming more expensive to make – even as high as € 6!
Another important point to remember when drawing these diagrams is that ATC will continue to decrease when MC < ATC. But when MC > ATC average costs will begin to rise. It follows then that the MC curve always cuts the ATC curve at the lowest point!
You will have realised that the cost curves mirror the output curves, for a simple reason: it is, again, because of the law of diminishing returns! We saw that bread per worker starts decreasing when diminishing returns kicks in. Then it is only logical that costs per loaf of bread should also start rising beyond a certain point. The rise in costs per unit of output is, in our case, a consequence of overusing our oven.
Economies and diseconomies of scale
However, the law of diminishing returns only applies in the short run, when a factor of production is fixed. We can now see what happens in the long-run.
The long-run is defined as the period of time when all factors of production are variable.
The definition tells us that in the long run we can overcome diminishing returns, for example by buying a new oven. This way, the average output per unit of input will continue to rise as output rises. This also means then that the average cost will fall as total output increases. When this happens, we are enjoying economies of scale in our bakery.
Economies of scale is defined as the long run decrease in average total cost when total output increases. It is explained by increasing returns to scale – when the percentage increase in output is greater than the percentage increase in all inputs.
Economies of scale is yet another very important economic concept. It is one of the main reasons why firms wish to grow and expand production. This is, partly because the fixed costs are distributed over a greater output and partly because of increasing returns to scale. For example, rather than having one worker in the bakery producing 100 loaves of bread, two workers can produce 250 loaves of bread in the same shop; likewise, we can produce 500 loaves in our oven, instead of 250, using the same amount of energy.
In general, the most common reasons for economies of scale to occur are:
- Specialisation – workers learn a specific task and perform it more efficiently; if you only have to focus on placing fresh loaves in the window of your shop, you will become very good at it.
- Efficiency – machines are used at their full potential; we should fill up our oven before turning it on.
- Marketing – brands are established and customers become loyal; the more people appreciate your bakery, the more they will tell their friends how good it is. Without having to change production styles, we can sell more with a bit of marketing.
- Indivisibilities – large plants can only work if large volumes of output are produced; while this is not the case of our bakery, there are many examples of indivisibilities in bigger factories: would you set up a factory only to produce 2 cars per day? No, because the process of car production is indivisible from large-scale production processes.
It is however also possible that a firm might experience diseconomies of scale, i.e. that average total cost increases as output increases. This is the case of our bakery too. Look at the cost table again. As we increase production from 600 to 650 loaves, total costs rise sharply to € 900. This may occur due to a lack of coordination between workers in the bakery: there is so much to do, that you and your friends start panicking! Also, communication may become difficult as too many customers are placing their orders for bread. Some of your workers could feel frustrated by the whole situations and start working less efficiently.
We say that diseconomies of scale take place because of decreasing returns to scale – when the percentage increase in output is less than the percentage increase in all inputs.
Short-run vs. Long-run distinction
When comparing and discussing short-run and long-run costs in an exam situation, it is often very useful to make use of the diagrams below.
The first diagram shows the standard short-run situation one more time: average cost (in red) first declines and then starts rising again because of diminishing returns. Marginal cost (in blue) also declines as we increase production, but then starts rising and cuts the ATC curve at its lowest point.
The second diagram shows that there are a number of short-run average cost curves (SRAC1, SRAC2 etc) on the single long-run average cost curve (LRAC). In the short-run, at least one factor of production is fixed (e.g. capital, so we can’t expand our shop, or we can’t buy a new oven).
As soon as we change the factor of production that was previously fixed, we move on to a new short-run average cost curve – that is, when we change a previously fixed factor of production, we start another short run! When we do this, long-run average cost will first fall (economies of scale) and, after reaching a minimum point, will start to rise again (diseconomies of scale).
You should now be able to distinguish between the law of diminishing returns (which models the shape of the cost curves in the short run) and economies/diseconomies of scale (which model the shape of the cost curves in the long-run).
What you should know
- The short run is defined as the period of time when at least one of the factors of production is fixed.
- Total costis the sum of total fixed costs and total variable costs.
- Average costis total cost divided by output.
- Marginal costis the cost of an additional unit of output. The MC curve intersects the AC curve at its lowest point.
- The long run is defined as the period of time when all factors of production are variable.
- Firms experienceeconomies of scale due to increasing returns – that is, as production increases, average cost decreases as firms gain efficiency.
- However, after a certain level of output,diseconomies of scale kick in – the more it is produced, the higher the average cost, because certain inefficiencies (e.g. coordination) cannot be overcome.
- This behaviour is shown by the U-shaped curve of the short-run average cost.