3.1 Short-run costs
 
 

Short-run and long-run changes in production

In economics, costs are classified as being short-run or long-run.

In the short-run some costs are fixed and some costs variable. In the long-run all costs are variable.

Examples of fixed costs would be plant and machinery and fixed (annual) payments such as insurance, depreciation, interest repayments etc.

Variable costs would include, raw materials, labour, electricity, delivery charges etc.
 
 

Production in short run: the law of diminishing returns

When increasing amounts of a variable factor (such as labour) are combined with a fixed factor such as land, returns to each unit of the variable factor will eventually diminish (though initially may increase). This is known as the law of diminishing returns.

In other words if we put people to work in a field - say picking strawberries - eventually the amount that each will pick will diminish (as pickers eventually get in each other's way).
 
 

Costs and Inputs

A firm's costs depends on two factors - the productivity of the factors and their prices.
 
 

Total cost

The total cost is made up of two factors - fixed and variable

Total Cost = Total Variable Cost + Total Fixed Cost

TC = TVC + TFC
 
 

Average and marginal cost

We get average cost by dividing total cost by the number of units produced.

Thus if the total cost of producing 10 units is €100, then the average cost is €100/10.

AC = TC/Q;

AVC = TVC/Q

AFC = TFC/Q

Thus AC = AVC + AFC

Marginal cost (MC) is the additional cost of producing one more unit of output.

Thus if 10 units cost €100 and 11 units cost €112, then the marginal cost of the 11^th unit is €12 (i.e. €112 - €100).

If 12 units now cost €125, then the marginal cost of the 12^th unit is €13 (i.e. €125 - €112).

MC is always equal to AC (and AVC) at their lowest points.

AC can only fall if MC is less than it. Thus if a footballer has scored an average of 30 goals in the previous two seasons, this can only fall, if the average is less than 30 for the current season.

Likewise AC can only rise if MC is greater than it. Thus the average of 30 goals per season (in the previous example) can only rise if the footballer scores more than 30 in this present season).

Thus AC falls when MC < AC; AC rises when MC>AC. So AC neither falls nor rises (i.e. is at its lowest point) when MC = AC.
 
 

3.2 Long-run costs

Production in the long-run: the scale of production

In the long-run all factors are variable. Thus a firm now can change all of its costs.

Thus is known as the scale of production.

There are three possibilities here.

If - for example - a firm doubles all its inputs and output more than doubles then we have economies of scale (i.e. increasing returns to scale).

If however a firm doubles all inputs and output less than doubles then we have diseconomies of scale (i.e. decreasing returns to scale).

Finally if a firm doubles all inputs and output exactly doubles then there is neither economies nor diseconomies (i.e. constant returns to scale).

Another way of expressing this relationship is as follows.

If the average cost of production falls (in the long run) then we have economies of scale; if the average cost rises then we have diseconomies and if average cost stays the same, then we have neither economies nor diseconomies.

Economies of scale are very important in many industries. For example the cost of producing a car will be less if production takes place on a large scale. In other words it is uneconomic to produces cars (for the mass market) in a small sized plant. This explains why we have no major car plants in Ireland (as the size of the market here is too small).
 
 

Reasons for economies of scale
 

Indivisibilties

Some capital equipment can only be efficiently used at a large level of output

Container principle

Plant and machinery is cheaper to provide at larger sizes of output as capacity grows faster than material required

More efficient use of larger machines

Machines can be employed more fully at large size thus enhancing efficiency

By-products

With larger output by-products can be used for creation of additional products

Multi-stage production

Becomes more feasible with larger level of output

Financial Economies

Finance is more easily acquired and at cheaper rates at larger scales

Managerial Economies

Managerial ability can often be more effectively employed at larger scales of output

Marketing Economies

Bulk discounts can be obtained more effectively at larger scales of output as for example with major supermarkets
 
 

Reasons for diseconomies of scale
 

Management Problems

Large companies can be come unduly rigid and bureaucratic

Industrial Problems

The opportunities for disruption in pursuit of worker claims is greater with large companies (especially monopolies)

Low worker morale

Too much specialisation can lead to boredom and loss of work incentive
 
 

In practice, economies can be important up at lower levels of production after which they generally become fairly constant over a considerable range of output.

The minimum output required to achieve these economies is known as the minimum efficient scale (MES).
 
 

External economies and diseconomies of scale

External economies and diseconomies of scale (externalities) relate to the effects of a firm's activities outside the confines of the firm in question.

Positive externalities (i.e. external economies of scale) arise when a benefit is provided by a firm's activities for other firms or the wider economy.
For example the opening of a new rail line could provide benefits for road users who now might travel with less congestion.

Negative externalities (i.e. external diseconomies of scale) arise when a cost is imposed by a firm's activities on the wider environment.
For example pollution caused by a firm could impose problems for others e.g. people working in the tourist industry (affected by the pollution).
 
 

3.3. Marginal Revenue (MR)
 

Marginal revenue is the additional revenue obtained from the sale of one more unit of a product i.e. the change in TR resulting from the change (one unit) in output.

The marginal revenue curve is horizontal (in perfect competition) where a firm can sell additional units of its product at the same price. In such cases MR = AR.

However it slopes down from left to right in other forms of competition as the firm must lower price in order to sell additional units.

In such cases MR < AR (as the average revenue can only fall if the additional units sold are less than the previous average).

Profits are maximised when MC = MR