Cost Theory

IB Economics
Long run and Short run
 When we talk about production costs we Short run – the period
have to distinguish between short run and of time in which at least
long run one factor of production
 When a firm is producing some of its factors is fixed. All production
of production will be fixed in the short run takes place in the short
 The firm will not be able to quickly increase run
the quantity of them that it has
 In the short run a firm that makes furniture
will only have a limited amount of factory
space
 In the long run it could plan to build another
factory but in the short term it has to make Long run – the period
do with what it has of time in which all
 Often the fixed factor is some element of factors of production
capital or land are variable, but the
 It could also be a a type of highly skilled state of technology is
labour such as a specialist machine worker fixed. All planning
 If a firm wants to produce more in the short takes place in the long
run it can only apply more units of its run
variable factors to the fixed factors while it
plans ahead
Long run and short run
 The length of the short run for the firm will
be determined by the time it takes to
increase the quantity of the fixed factor
 The furniture factory’s short run may be as
long as it takes to build another factory
(perhaps a year)
 A small firm involved in gardening’s fixed
factor may be the number of lawn mowers it
has
 Its short run will be the time it takes to order
and take delivery of a new lawn mower
which may only be a week
 The firm is in the long-run when it is
planning (all the factors of production are
variable)
 As soon as it makes the change the firm is
once again in the short run but with a
different number of fixed factors
 Once again the only way they can increase
output is by applying more units of variable
factors
 Complete Student workpoint 6.1
Total, average and marginal Average product (AP)
– the output produced,
product on average, by each
 A firm has four machines (fixed factors) and unit of variable factor
increases its output by using more operators to
work the machines (variable factors) Marginal product
 Make a note of the AP and MP definitions and (MP) – the extra output
then complete the table on the next slide that is produced by
 Once you have completed the table you need using an extra unit of
the variable factor
to plot 2 graphs
 The total product curve (total product on the
Y axis and quantity of variable factor on the
X axis)
 The AP and MP curve (same axes but scale
will be different)
 Plot the MP on the mid points just as
you drew the table e.g. you would plot
10 between 0 and 1
 Now look at the curves and think about what
we can deduce
Quantity of Labour Total product (TP) Average Product Marginal Product
(V) (AP) (MP)

0 0
10

1 10 10

15

2 25 12.5

20

3 45

4 70

5 90

6 105

7 115

8 120
The Tennis Ball Game

What is your
product?
What are you fixed
factors?
What are your
variable factors?
Now plot your AP and MP curves
What is happening?
Total, average and marginal
product
 Watch the mjm foodie video
 Producer Theory
 https://www.youtube.com/watch?
v=rnEFtyMzjOo
The law of diminishing returns

The hypothesis of The hypothesis of

eventually diminishing eventually
marginal returns – As diminishing average
extra units of a variable returns – As extra
factor are added to a units of a variable
given quantity of a fixed factor are added to a
factor, the output from given quantity of a
each additional unit of the fixed factor, the output
variable factor will per unit of the variable
eventually diminish factor will eventually
diminish
Economic costs / profit
 Watch the mjm foodie video
 Accounting vs Economics Profit
 https://www.youtube.com/watch?
v=BE5MBKtSA6w
Time for you to do some work!!
Read through pages 77-82 / make notes
Complete the student workpoint P82
Short run costs
 Firm’s have many different costs when
producing whatever good or service
they provide
 We need to understand the different
types and where they originate
 There are 3 main types
 Fixed
 Variable
 Marginal
Short run fixed costs
 Fixed costs (in the short run) are costs of
production that do not vary as output
changes
 It makes no difference how much the factory
makes the fixed costs will be the same
 e.g. payment for buildings, rent, salaries
(not wages), depreciation, machinery etc
 Fixed costs have to be paid for regardless of
whether the firm produces nothing or works
24 hours
 Fixed costs are never zero
 Drawn as a horizontal line
 If there are high fixed to variable costs there
is an opportunity for economies of scale
because the fixed costs are spread over the
output to give average fixed costs and
these will reduce as output increases
Variable costs
 Variable costs are costs of production that
vary with output
 the more that is produced the more the
variable costs
 Examples - raw materials, power, labour
 When there is no output the variable costs
are zero
 Semi variable costs are costs that have a
fixed and variable element e.g. telephone –
there will be a fixed rental cost and a
variable usage cost
 We add the variable costs to the fixed
costs to get the total costs (TC)
 Average variable costs (AVC) are the total
variable costs divided by the amount of
output
Cost Activity
 Using the same scenario that
we used to create the MP and
AP curves we are going to work
out the costs and plot the
curves (on excel)
 We are going to assume that
there are 4 machines that cost
$100 each per week (fixed
costs)
 Each worker costs $200 per
week (variable costs)
 For this scenario there are no
other costs
Fill in the spreadsheet and then use excel to create the curves
Use 2 separate diagrams and include the following on each
1. TFC,TVC, TC and
2. AFC, AVC, ATC, ATC, MC
3. Output should be on the x axis and costs on the y axis
What do you
notice about the
TC curve?

The TC curve is
just the TVC
curve shifted up
by the fixed
cost amount
 What do you
notice about the
marginal cost
curve?

It cuts through the

ATC and the AVC
at their lowest
points (always!!)
Average total costs (ATC) /
Marginal Costs
 ATC is the total cost divided by the number
of units produced
 These will decline as the fixed costs are
spread over more unit
 It will then increase as the growth in
variable costs is greater than the fall in
fixed costs
 Marginal costs are the cost of producing
one extra unit of output
 The average fixed costs fall as output rises
 The fall is very rapid as the fixed cost is
spread over more units
 This will reduce the cost of producing the
extra unit
 The falling AFC pull the marginal cost
curve down
 But..the firm will be taking on more labour
 At some point the falling fixed costs will be
unable to compensate for the increased
labour costs
 Marginal costs will start to increase
 Whenever the marginal
cost is below the
average total costs then
the average must be
falling

Note that the MC

intersects the AC
curve at the lowest
point of the AC
curve
Even if the MC is
Extra units of increasing if it is less
Extra units of
labour raise than the AC it will mean
labour reduce
marginal that AC are falling.
marginal
product product
(increasing When the MC is higher
(decreasing
returns) than the AC the AC will
returns)
start to rise
 If there is a room full of people
that are all 2m tall the average
height will be 2m. If someone
else comes into the room (the
marginal person) that is 1.5m tall
the average will fall (because
they are lower than the average).

Note that the MC

intersects the AC
curve at the lowest
point of the AC
curve

Extra units of Extra units of If the next marginal person is

labour raise labour reduce 1.8m the average will still fall
marginal marginal (still lower than the average). It
product product is only when the next marginal
(increasing (decreasing person who is 2.2m tall that
returns) returns) the average starts to increase
(because the marginal person
is taller than the average).
These are the curves you need to remember
Watch Pajholden’s video on costs
• http://www.youtube.com/watch?v=jNL9PNf
rKZI
Long Run Costs
 This diagram shows what happens in theory in the long run
(in the planning stage)
 The LRAC is an envelope curve (it envelops an infinite
number of short run average cost curves)
 Any point on the SRAC curve that is tangential to the LRAC
is the lowest possible cost of producing the output (in the
short run)
Long Run Costs
 Say a firm is operating at C3 on SRAC1
 Demand increases and the firm wants to produce q2
 They can employ more variable factors and move along the SRACs
 They are producing even more cheaply
 The firm knows that it can produce this output even more cheaply if it
alters all of its factors of production
 They will plan to make the change and move onto SRAC2
Long Run Costs
 Say a firm is operating at C3 on SRAC1
 Demand increases and the firm wants to produce q2
 They can employ more variable factors and move along the SRACs
 They are producing even more cheaply
 The firm knows that it can produce this output even more cheaply if it alters all
of its factors of production
 They will plan to make the change and move onto SRAC2
 They will now be producing Q2 at C2 (an even lower cost), again at the lowest
point on the SRAC2 because it its tangential to the LRAC
Long Run Costs
 The whole LRAC curve is made up of an infinite numbr of single points from
SRAC curves
 These curves represent all of the possible combinations of fixed and variable
factors that could be used to produce different levels of output
 The LRAC is the boundary between unit cost levels that are attainable and
those that are unattainable
 If possible the firm would wish to produce different output levels at points on the
LRAC curve in order to minimise their cost per unit of output
 This may not always be possible in the short run
Long Run Costs
 When the long run average costs are falling as output increases we say that the
firm is experiencing increasing returns to scale
 This means that a given percentage increase in all factors of production will lead to a
greater percentage increase in output
 When the LRAC are constant as output increases we call it constant returns to
scale
 This means that a given percentage increase in all factors of production will lead to
the same percentage increase in output
 When the LRAC are increasing with increased output we call it decreasing
returns to scale
 This means that a given percentage increase in all factors of production will lead to a
lower percentage increase in output thus increasing long run average costs
 Don’t confuse this with the law of diminishing returns; that is always the short
run. This is the long run
Long Run Costs
 There are two factors that make long run average costs
Economies of
increase or decrease
scale – any
 Economies of scale and
decreases in
 Diseconomies of scale long run
 There are a number of different economies of scale average costs
 Specialisation – as the firm grows managers can that come
concentrate on areas that they specialise in e.g. about when a
finance, marketing etc and become more efficient firm alters all of
 Division of Labour – breaking the production process its factors of
down into small jobs and sometimes replacing people production in
with machinery order to
 Bulk buying – getting discount for buying larger increase its
supplies scale of output
 Financial economies – getting a better rate of interest
on loans because the company is less of a risk
 Transport economies – have their own transport fleet
 Large machines – when a firm is small they may not
be able to afford large machinery and may have to
hire it but as they grow they can buy it
 Promotional economies – the costs of promotion do
not tend to increase in the same proportion as output
– the cost of promotion per unit of output falls
Long Run Costs
 There are 2 main diseconomies of scale
 Control and communication problems – as firms grow the Diseconomies
management will find it harder to control and coordinate of scale – any
the activities of the firm increases in
 This may lead to inefficiency and increases in unit costs of long run
production average costs
 Alienation and loss of identity – as firms grow workers and
that come about
managers may begin to feel that they are only a very small
part of the organisation when a firm
 They may be less motivated and therefore work less hard alters all of its
and become less productive factors of
 All of these economies and diseconomies of scale relate production in
to the unit cost decreases or increases that may be order to
encountered by a single firm – they are internal increase its
economies and diseconomies of scale scale of output
 When the whole industry size increases and it effects
the unit costs these are known as external economies
and diseconomies of scale
 Growth of industry leads to local universities with courses
related to the industry – graduates will leave ready trained
so there is less cost to the firms
 Rapid growth of the industry may lead to more competition
for raw materials, capital and qualified labour which forces
up the pries of these factors
Final note on cost
theory
 Short run cost curves are U
shaped because of the
hypothesis of diminishing
returns
 Long run cost curves are U
shaped because of the
existence of economies
and diseconomies of scale
 In reality, economists have
not yet found evidence of a
firm becoming so large that
the diseconomies of scale
start to outweigh the
economies of scale in the
long run
 Actual long run cost
curves may be drawn
like this
Time for you to do some work!!
Read through pages 83-88 / make notes
Complete exam questions 1, 2, 3 and 5 on P100
and the example paper 3 question on P101