Chapter 7 Costs of Production

An Overview of Costs Explicit costs are costs incurred by a firm when it pays an amount of money for something. Implicit costs, on the other hand, do not involve the paying out of money. Opportunity cost is the cost of anything in terms of the alternatives foregone (or simply the cost of foregone alternatives). Fixed costs don’t change as output changes. Variable costs vary as output changes.

The Short Run Average Cost (SAC) Curve The SAC slopes downwards because of specialisation/division of labour and greater spread of fixed costs. The SAC slopes upwards because of the law of diminishing marginal returns. The minimum point of each SAC curve when joined together gives us the long run average cost curve.

Average Cost The maxim for all companies in the short run is to cover their variable costs and contribute to the reduction of their fixed costs. As more and more of a variable factor is added to a fixed factor, at some stage the increase in output caused by the last unit of the variable factor will begin to decline. Average cost is calculated by dividing total cost by quantity (TC/Q or AFC + AVC).

Average Cost (Continued) Average cost also includes normal profit. Normal profit is the return that sufficiently rewards the risk-taking of an entrepreneur and it be must earned to stay in business.

The Long Run Average Cost Curve (LRAC) In the long run, all factors of production (land, labour, capital and enterprise) are variable and the company may use the exact amount of each factor to achieve maximum efficiency. The long run average cost (LRAC) curve is made up of the minimum point of many SAC curves. The minimum point of each SAC will give us the quantity that a company can produce at the lowest possible cost.

What Determines the Shape of the LRAC Curve? The LRAC curve is generally shown as saucer-shaped. As the firm grows in size, it experiences cost savings (otherwise called economies of scale). These savings cause the LRAC to slope downwards and average costs decrease. The upward part of the LRAC is due to diseconomies of scale and average costs begin to increase. What Determines the Shape of the LRAC Curve?

What Determines the Shape of the LRAC Curve? (Continued) Both economies and diseconomies of scale are present at all levels of output. When economies are dominant, the curve slopes downwards. When diseconomies are more prevalent, the curve slopes back upwards. The minimum point shown on the LRAC is referred to as the optimum level of output.

Internal Economies of Scale Internal economies of scale are forces within a firm that cause the average/unit cost of that firm to decline as it grows in size. Internal economies of scale include: Increased use of machinery Specialisation/division of labour Construction savings Purchasing economies Internal Economies of Scale

Internal Economies of Scale (Continued) Economies in distribution Financial economies Marketing economies Management economies Problem of indivisibility reduced

External Economies of Scale External economies of scale are forces outside a firm that cause the average/unit cost of that firm to decline as the industry grows in size. External economies of scale include: Better infrastructure Specialist firms established Development of separate research and development units

External Economies of Scale (Continued) Subsidiary trades may set up Availability of training courses Supports from public bodies

Internal Diseconomies of Scale Internal diseconomies of scale are forces within a firm that cause the average/unit cost of that firm to increase as it grows in size. Internal diseconomies of scale include: Poor decision-making Fall in staff morale Communication problems Control problems Increase in administrative overheads

External Diseconomies of Scale External diseconomies of scale are forces outside a firm that cause the average/unit cost of that firm to increase as the industry grows in size. External diseconomies of scale include: Shortages of factors of production Raw material shortage Infrastructural problems

What Effect Do Returns to Scale Have on Costs? Increasing returns to scale refers to doubling inputs with output more than doubling. This would cause the LRAC to slope downwards. Decreasing returns to scale refers to doubling inputs with output less than doubling and it would cause the LRAC to slope upwards. Constant returns to scale refers to output changing at exactly the same rate as factors and this results in the LRAC being horizontal.

Why do small firms survive in the Irish market even though they don’t benefit from economies of scale? Small size of the market Consumer loyalty Personal services Traditional markets Nature of the good Membership of voluntary groups

Benefits of Small-scale Enterprises Quick response time Decision-making High output per head Fewer HR problems Lower overheads

Social Costs and Benefits Social cost is a price that society has to pay for the existence of a particular product or as a result of the production/consumption of a community. External diseconomies of production occur when a producer carries out an activity and imposes a cost on third parties for which they are not compensated. External economies of production happen when actions taken by producers result in benefits to third parties for which the producer is not compensated.

Social Costs and Benefits (Continued) External diseconomies of consumption refer to where an action is taken by a consumer and this imposes a cost on third parties for which they are not compensated. External economies of consumption refer to when a consumer undertakes an action and it benefits third parties, for which the consumer is not compensated.

Social Costs and Benefits (Continued) Externalities are unintended costs or benefits to third parties. The private cost of a good or service is the cost to the firm of making the good or providing the service.

Revenue Revenue = P x Q Average revenue (AR) is calculated by dividing total revenue by quantity (AR = TR/Q = P). Marginal revenue is the change in total revenue. A company should produce where MC = MR. MC cuts MR from below/MC is increasing at a faster rate than MR. If a firm is to continue trading in the long run, AR must be at least equal to AC.

Short run Long run MC = MR MC cuts MR from below AVC covered AC covered