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1 ExamLearn.ie Costs of Production

2 Costs of Production Fixed Costs = Costs that don't change as you increase output in the short, e.g. Rent Variable Costs = Costs that change as your output increases e.g. Wages, Raw Materials Total Costs = Fixed + Variable Average Costs = Total Costs divided by Output (Cost per unit). Or Average variable costs (VC/Q) + Average Fixed Costs (FC/Q). Marginal Costs = The Cost of Employing an Extra Unit Factor of Production (Land, Labour, Capital, Enterprise)

3 Law of Diminishing Marginal Returns: (LDMR) Def: As more and more units of a variable factor of production are employed the extra output/ returns of the variable factor will eventually diminish/decline. Why does this happen? Machines begin to over-heat and breakdown Workers getting in each other's way = reduced productivity. Relationship between Marginal Cost and Average Cost curve: When MC is greater than AC, then AC is rising.

4 When MC is less than AC, then AC is falling. When MC = AC, the AC is at its minimum point. Shape of Short-run Average Cost (SAC)/(SRAC) curve:

5 Downward sloping between Q1 and Q2: Specialisation Workers become more efficient or specialists are employed resulting in lower unit costs. Larger spread of fixed costs - As the number of units produced increases the fixed costs will stay the same, so the unit cost falls as fixed costs are spread out over more units. Upward sloping between Q2 and Q3: LDMR This law will apply after a certain point which results in an increase in the amount of variable factors used per unit produced, resulting in higher unit costs. Long-run Average Cost curve (LRAC):

6 LRAC slopes downwards because economies of scale are dominant over this range of output. LRAC slopes upwards because diseconomies of scale are dominant over this range of output. Relationship between Long-run and Short-run Average Costs:

7 The Long run average cost curve (LRAC) consists of several short run average cost curves, each of which refers to a particular scale of operation. The lowest cost of production for that quantity is at the minimum point of each SAC curve. Q2 could be produced in Factories 1 and 2 (SRAC 1 and 2) but as we can see diminishing returns have begun in SRAC1 and so the firm opts for the larger factory 2 with the lower cost of production at that quantity. The LRAC must comprise of all the lowest points of each of the SRAC's because no firm will operate at a level of higher costs in the long run than in the short run. Economies of Scale These result in a reduction in the unit price of a good as the firm/industry increases its size of the operation. Internal Economies of Scale = Forces within a firm which cause the average/unit cost of that firm to decline as it grows in size.. Increases use of specialised machinery: As a firm grows they can buy bigger and more specialised machinery resulting in a decrease in unit cost. Specialisation of labour: Dividing a job into separate components may result in a reduction in costs as greater efficiency is allowed. Construction savings: Larger buildings cause less per square meter than smaller ones, so as the firm grows the unit cost will drop. Financial Economies: Larger and more established may be able to negotiate lower interest rates as they are seen as being more reliable. Purchasing economies: if firms buy in large quantities from suppliers they can get discounts.

8 Management economies: Large companies can employ management in specific areas which would increase productivity. External economies of scale Forces outside a firm that cause the average/unit cost of that firm to incline as the industry grows. Better infrastructure: As roads/communications improve they will benefit all firms. Suppliers of machinery: As an industry grows, manufacturers of machinery are encouraged to develop machines for expanding industry. These advanced machines help reduce costs. Development of training courses: Workers in expanding industries may be provided with training courses which would make them more efficient. Supports from public bodies: Some public help particular industries. Eg. Bord Fáilte helps the tourism industry. Subsidiary trades may develop: As industries grow, subsidiary trades can develop to assist them. Eg.s Hotels locating near airports. Diseconomies of Scale These result in an increase in the unit cost of production as the firm/industry increases its size of operation. Internal diseconomies of scale Forces within a firm that causes the unit cost of the firm to increase as it grows in size. Poor decision making: Can lead to decreased efficiency. - Fall in staff morale: Increased specialisation and repetitive work may lead to boredom and low productivity. - Communication: As the firm grows communication problems can occur due to increased layers in the hierarchy of the company. - Control problems: Amount of waste and stolen stock becomes harder to control. External diseconomies of scale Forces outside a firm that cause the unit cost of that firm to increase as the industry grows. Shortages of factors of production: As the industry increases, demand for specialised workers can become greater than supply which results in an increase in their price/wage rate, and sometimes less qualified staff have to be hired. Raw material shortage: Raw materials may run out as the industry expands. Infrastructural problems: As the industry expands, infrastructure may not be efficient which will lead to greater costs. Externalities = Unintended costs/benefits to third parties.

9 External economies/diseconomies of consumption When an action is taken by a consumer which benefits/imposes a cost on third parties for which the consumer is not compensated. - External economies/diseconomies of production When a producer carries out an activity and benefits/imposes a cost on third parties for which the producer is not compensated. Social cost = The price that society has to pay for the existence of a particular product. Private cost = The cost to the firm of making a good or providing a service. Social benefit = The benefit on society as a whole as a result of an individual firm producing a commodity that is not measured by the price system. Returns to Scale = It explains the behaviour of the rate of increase in output (production) relative to the associated increase in the inputs (the factors of production) in the long run. Increasing returns to scale refers to doubling inputs with outputs more than doubling as a result. Causes the LRAC to slope downwards. Decreasing returns to scale refers to doubling inputs with output less than doubling. Causes LRAC to slope upwards. Constant returns to scale refers to output changing at the same rate as input. Causes a horizontal LRAC. How do small firms who don't benefit from economies of scale survive? Because of consumer loyalty, the personal service they offer compared to larger firms, and the fact that some markets/areas are too small for large firms to set up. Benefits of small scale enterprises? They can respond quicker to economic changes and make decisions quicker as there is less people to consult with. There is a higher output per head as workers must multitask etc. and smaller plants means

10 verheads are lower. Fewer HR problems exist as staff have more of a say in what goes on in the business etc. Average Cost (AC) = The cost of producing one unit of output. Marginal Cost = The extra cost of producing one extra unit of output. Average revenue (AR)/price of the good = Total revenue (TR) divided by quantity (Q). Marginal revenue (MR) = The extra revenue received when an extra unit of output is sold. When MR = MC, Profit is Maximised (The Revenue you make selling extra output = the cost of making the extra output) After this point, any extra output made will begin to make a loss. AR must at least equal AC for a company to stay in business in the long run. If AC > AR then the company is making a loss and will shut down. Key Terms: Law of Diminishing Marginal Returns = States that as more and more units of a variable factor of production are employed the extra output/ returns of the variable factor will eventually diminish/decline. Economies of Scale These result in a reduction in the unit price of a good as the firm/industry increases its size of the operation. Diseconomies of Scale These result in an increase in the unit cost of production as the firm/industry increases its size of operation. Social cost = The price that society has to pay for the existence of a particular product. Private cost = The cost to the firm of making a good or providing a service. Social benefit = The benefit on society as a whole as a result of an individual firm producing a commodity that is not measured by the price system. Returns to Scale = It explains the behaviour of the rate of increase in output (production) relative to the associated increase in the inputs (the factors of production) in the long run.

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