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Production and Costs

In this note we consider some of the background to the theory of supply in markets by considering the concepts of production and productivity and how they relate to the costs that all businesses must face.ProductionProduction refers to the output of goods and services produced by businesses within a market. This production creates the supply that allows our needs and wants to be satisfied. To simplify the idea of theproduction function, economists create a number of time periods for analysis.

  1. Short run production

The short run is a period of time when there is at least one fixed factor input. This is usually the capital input such as plant and machinery and the stock of buildings and technology. In the short run, the output of a business expands when more variable factors of production (e.g. labour, raw materials and components) are employed.

  1. Long run production

In the long run, all of the factors of production can change giving a business the opportunity to increase thescale of its operations. For example a business may grow by adding extra labour and capital to the production process and introducing new technology into their operations.


The point is that for some businesses the long run can be a matter of weeks! Whereas for industries that requires very expensive capital equipment which may take several months or perhaps years to become available, then the long run can be a sizeable period of time.
The length of time between the short and the long run will vary from industry to industry. For example, how long would it take a newly created business delivering sandwiches around a local town to move from the short to the long run? Let us assume that the business starts off with leased premises to make the sandwiches; two leased vehicles for deliveries and five full-time and part-time staff. In the short run, they can increase production by using more raw materials and by bringing in extra staff as required. But if demand grows, it wont take the business long to perhaps lease another larger building, buy in some more capital equipment and also lease some extra delivery vans – by the time it has done this, it has already moved into the long run.

The meaning of productivity

When economists and government ministers talk about productivity they are referring to how productive labour is. But productivity is also about other inputs. So, for example, a company could increase productivity by investing in new machinery which embodies the latest technological progress, and which reduces the number of workers required to produce the same amount of output. The government’s objective is to improve labour and capital productivity in the economy in order to improve the supply-side potential of the country.

Productivity of the variable factor labour and the law of diminishing returns

In the example of productivity in a bakery given below, the labour input is assumed to be the only variable factor by the bakery. Other factor inputs such as capital are assumed to be fixed in supply. The “returns” to adding more labour to the production process are measured in two ways:

Marginal product (MP)             =          Change in total output from adding one extra unit of labour

Average product (AP) =          Total Output divided by the total units of labour employed

In the example below, a business hires extra units of labour to produce a higher number of bread. The table below tracks the output that results from each level of employment.

Units of Labour Employed

Total Physical Product (number of bread)

Marginal Product (number of bread)

Average Product (number of bread)

0

0

1

3

3

3

2

10

7

5

3

24

14

8

4

36

12

9

5

40

4

8

6

42

2

7

7

42

0

6

Diminishing returns is said to occur when the marginal product of labour starts to fall. In the example above, extra labour is added to a fixed supply of capital like number of oven. The marginal product of extra workers is maximized when the 4th worker is employed. Thereafter the output from new workers is falling although total output continues to rise until the seventh worker is employed.

Notice that once marginal product falls below average product we have reached the point where average product is maximized – i.e. we have reached the point of productive efficiency.

Explaining the law of diminishing returns

The law of diminishing returns occurs because factors of production such as labour and capital inputs are not perfect substitutes for each other. This means that resources used in producing one type of product are not necessarily as efficient (or productive) when switched to the production of another good or service. For example, workers employed in producing glass for use in the construction industry may not be as efficient if they have to be re-employed in producing cement or kitchen units. Likewise many items of capital equipment are specific to one type of production. They would be much less efficient in generating output if they were to be switched to other uses. We say that factors of production such as labour and capital can be “occupationally immobile”; they can be switched from one use to another, but with a consequent loss of productivity.

There is normally an inverse relationship between the productivity of the factors of production and the unit costs of production for a business. When productivity is low, the unit costs of supplying a good or service will be higher. It follows that if a business can achieve higher levels of efficiency among its workforce, there may well be a benefit from lower costs and higher profits.

Costs of production

Costs are defined as those expenses faced by a business when producing a good or service for a market. Every business faces costs and these must be recouped from selling goods and services at different prices if a business is to make a profit from its activities. In the short run a firm will have fixed and variable costs of production. Total cost is made up of fixed costs and variable costs

Fixed Costs

These costs relate do not vary directly with the level of output. Examples of fixed costs include:

  1. Rent paid on buildings and business rates charged by local authorities.
  2. The depreciation in the value of capital equipment due to age.
  3. Insurance charges.
  4. The costs of staff salaries e.g. for people employed on permanent contracts.
  5. Interest charges on borrowed money.
  6. The costs of purchasing new capital equipment.
  7. Marketing and advertising costs.

Variable Costs

Variable costs vary directly with output. I.e. as production rises, a firm will face higher total variable costs because it needs to purchase extra resources to achieve an expansion of supply. Examples of variable costs for a business include the costs of raw materials, labour costs and other consumables and components used directly in the production process.

We can illustrate the concept of fixed cost curves using the table below. The greater the total volume of units produced, the lower will be the fixed cost per unit as the fixed costs are spread over a higher number of units. This is one reason why mass-production can bring down significantly the unit costs for consumers – because the fixed costs are being reduced continuously as output expands.

In our example below, a business is assumed to have fixed costs of $30,000 per month regardless of the level of output produced. The table shows total fixed costs and average fixed costs (calculated by dividing total fixed costs by output).

Output 

Total Fixed Costs 

Average Fixed Cost (AFC)

0

30k

1000

30k

30k

2000

30k

15k

3000

30k

10k

4000

30k

7.5k

5000

30k

6k

6000

30k

5k

7000

30k

4.3

When we add variable costs into the equation we can see the total costs of a business.

The table below gives another example of the short run costs of a firm

Output
Units

Total Fixed Cost
TFC 

Total Variable Cost
TVC 

Total Cost
TC 

Average Total Cost
ATC 

Marginal Cost
MC 

0

100

0

100

20

100

40

140

7.0

2.0

40

100

60

160

4.0

1.0

60

100

74

174

2.9

0.7

80

100

84

184

2.3

0.5

100

100

90

190

1.9

0.3

120

100

104

204

1.7

0.7

140

100

138

238

1.7

1.7

160

100

188

288

1.8

2.5

180

100

260

360

2.0

3.6

200

100

360

460

2.3

5.0

Average Total Cost (ATC) is the cost per unit of output produced. ATC = TC divided by output

Marginal cost (MC) is defined as the change in total costs resulting from the production of one extra unit of output. In other words, it is the cost of expanding production by a very small amount.

Long run costs of production

The long run is a period of time in which all factor inputs can be changed. The firm can therefore alter the scale of production. If as a result of such an expansion, the firm experiences a fall in long run average total cost, it is experiencing economies of scale. Conversely, if average total cost rises as the firm expands,diseconomies of scale are happening.

The table below shows a simple example of the long run average cost of a business in the long run when average costs are falling, then economies of scale are being exploited by the business.

Long Run Output (units per month)

Total Costs 

Long Run Average Cost (per unit)

1,000

8,500

8.5

2,000

15,000

7.5

5,000

36,000

7.2

10,000

65,000

6.5

20,000

120,000

6.0

50,000

280,000

5.6

100,000

490,000

4.9

500,000

2,300,000

4.6

Economies & diseconomies of scale

Introduction

Here we focus on long run costs, the effect of economies of scale on unit costs, prices and competition in markets.

What are economies of scale?

  • Economies of scale are the cost advantages that a business can exploit by expanding the scale of production
  • The effect is to reduce the long run average (unit) costs of production.
  • These lower costs are an improvement in productive efficiency and can benefit consumers in the form of lower prices. But they give a business a competitive advantage too!

Numerical example of economies of scale – falling long run average cost as output increases

Long Run Output (units per month)

Total Costs ($s)

Long Run Average Cost ($s per unit)

1,000

8,500

8.5

2,000

15,000

7.5

5,000

36,000

7.2

10,000

65,000

6.5

20,000

120,000

6.0

50,000

280,000

5.6

100,000

490,000

4.9

500,000

2,300,000

4.6

There are many different types of economy of scale and depending on the particular characteristics of an industry, some are more important than others.

The answer is that scale economies have brought down the unit costs of production and feeding through to lower prices for consumers.

Internal Economies of Scale

Internal economies of scale arise from the growth of the business itself. Examples include:

Technical economies of scale:

    1. Large-scale businesses can afford to invest in expensive and specialist capital machinery. For example, a supermarket chain such as Tesco or Sainsbury can invest in technology that improves stock control. It might not, however, be viable or cost-efficient for a small corner shop to buy this technology.
    2. Specialization of the workforce: Larger businesses split complex production processes into separate tasks to boost productivity. The division of labour in mass production of motor vehicles and in manufacturing electronic products is an example.
    3. The law of increased dimensions. This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – this is an important scale economy in distribution and transport industries and also in travel and leisure sectors.

Marketing economies of scale: A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. The big food retailers have monopsony power when purchasing supplies from farmers.

Managerial economies of scale: This is a form of division of labour. Large-scale manufacturers employ specialists to supervise production systems and oversee human resources.

Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities, with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (i.e. extra financial capital) more cheaply through the issue of equities. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets.

Network economies of scaleThis is a demand-side economy of scale. Some networks and services have huge potential for economies of scale. That is, as they are more widely used they become more valuable to the business that provides them. The classic examples are the expansion of a common language and a common currency. We can identify networks economies in areas such as online auctions,air transport networks. Network economies are best explained by saying that the marginal cost of adding one more user to the network is close to zero, but the resulting benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The expansion of e-commerce is a great example of network economies of scale – how many of you are devotees of the EBay web site or Facebook?

Illustrating Economies of Scale – the long run average cost curve

The diagram below shows what might happen to the average costs as a business expands from one scale of production to another. Each short run average cost curve assumes a given quantity of capital inputs. As we move from SRAC1 to SRAC2 to SRAC3, the scale of production is increasing. The long run average cost curve (drawn as the dotted line below) is derived from the path of these short run average cost curves.

Economies of Scale – the long run average cost curve

External economies of scale

  • External economies of scale occur within an industry and from the expansion of it
  • Examples include the development of research and development facilities in local universities that several businesses in an area can benefit from and spending by a local authority on improving the transport network for a local town or city.
  • Likewise, the relocation of component suppliers and other support businesses close to the main centre of manufacturing are also an external cost saving.

Diseconomies of scale

A firm may eventually experience a rise in average costs caused by diseconomies of scale.

Diseconomies of scale a firm might be caused by:

  1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly.
  2. Co-operation – workers in large firms may feel a sense of alienation and subsequent loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs. A fall in productivity means that workers may be less productively efficient in larger firms.
  3. Loss of control over costs – big businesses may lose control over fixed costs such as expensive head offices, management expenses and marketing costs. There is also a risk that very expensive capital projects involving new technology may prove ineffective and leave the business with too much under-utilized capital.

Evaluation: Do economies of scale always improve the welfare of consumers?

  • Standardization of products: Mass production might lead to a standardization of products – limiting the amount of consumer choice.
  • Lack of market demand: Market demand may be insufficient for economies of scale to be fully exploited leaving businesses with a lot of spare capacity.
  • Developing monopoly power: Businesses may use economies of scale to build up monopoly power and this might lead to higher prices, a reduction in consumer welfare and a loss of allocative efficiency.
  • Protecting monopoly power: Economies of scale might be used as a barrier to entry – whereby existing firms can drive prices down if there is a threat of the entry of new suppliers