MICROECONOMICS TOPIC 3 Economics

SUPPLY

NATURE OF PRODUCTION

SPECIALISATION  Modern production is based on the principle of specialisation.  Specialisation is using a resource in the productive capacity for which it is best suited.  Helps to use scarce resources efficiently.

BENEFITS OF SPECIALISATION  Increases the amount produced  Reduces the cost per unit produced  Efficient use of scarce resources.

APPLYING SPECIALISATION  Can be seen a number of different levels:  National – countries specialising eg coffee  Regional – different areas of one country eg farming  Industry eg whisky  Firm eg whisky distilling, bottling  Worker – called DIVISION OF LABOUR

DIVISION OF LABOUR  ADVANTAGES FOR THE WORKER  Increased productivity leading to increased income  More skills acquired  Gain more job satisfaction

 DISADVANTAGES FOR THE WORKER  Increased risk of unemployment – too specialised and can’t do anything else  Interdependence of workers  Monotony of tasks – gets boring!!!

PRODUCTION DECISIONS  Producers want to maximise their profits.  One way to do this is to use the most efficient method of production in order to keep cost per unit low.  In the short run, the capacity of the firm is fixed and so the firm will only be able to produce a maximum number of products  In the long run, the capacity of the firm can be increased or decreased, which can change the level of production.

PRODUCTION IN THE SHORT RUN: LAW OF DIMINISHING RETURNS  Factors of production – land, labour, capital and enterprise.  Returns are what a producer gets back in output when they employ more of a variable factor of production.  Example – returns to labour means the output gained when more labour is employed.

 In the short run when deciding what output will be the most efficient to produce the firm must take into consideration the LAW OF DIMINISHING RETURNS  This states that as a producer uses more of a factor of production the returns to begin with will increase but diminishing returns will eventually happen.

TYPES OF OUTPUT  Total Output – the total amount produced  Marginal Output – the extra output produced when an extra factor of production is employed  Average Output – the average amount produced. Normally TOTAL OUTPUT divided by NUMBER OF WORKERS

EXAMPLE  LOOK AT PAGE 27 IN THE CORE NOTES Workers Total output (meals per hour) Marginal output* (meals per hour) Average output** (meals per hour) –

 Increasing Marginal Returns – occurs when marginal output is growing.  Diminishing Marginal Returns – occurs when marginal output is decreasing.

PRODUCTION IN THE LONG RUN  in the long run all factors of production are variable.  The firm can change its capacity which is also called changing the scale of its operations.

RETURNS TO SCALE  Increasing Returns to Scale – output grows faster than the size of the firm. Also called ECONOMIES OF SCALE  Constant Returns to Scale – output rises at the same rate as the size of the firm.  Decreasing Returns to Scale – output rises slower than the size of the firm – also called DISECONOMIES OF SCALE

Economies of Scale  The advantages of large scale production that result in lower unit (average) costs (cost per unit)  AC = TC / Q  Economies of Scale – spreads total costs over a greater range of output

ECONOMIES OF SCALE  Often referred to as the ADVANTAGES OF BEING A BIG COMPANY  Two types:  Internal – improvements in output (productivity) as the firm grows in size  External – improvements in output which a firm gains from growth of its industry.

INTERNAL ECONOMIES OF SCALE  Technical  Financial  Purchasing  Managerial  Marketing  Research and development (R&D)  Risk bearing  Welfare

INTERNAL ECONOMIES OF SCALE 1. Technical  Increased division of labour and specialisation  Increased dimensions  Indivisibility  Principle of multiples

2. Financial  Easier to attract investors due to low risk  Borrow money at lower rates of interest

3. Purchasing  Gain large discounts for buying in bulk  Dictate to suppliers price, quality and delivery date they want

4. Managerial  Can afford to employ specialist staff e.g. an accountant

5. Marketing  Costs can be spread over a larger volume of sales  Transport costs per unit are lowered as ships, lorries etc are full.

6. Research and Development  Can afford to research  Can gain a competitive advantage through innovation  Maintain market share through product development

7. Risk Bearing  Diversify products to reduce risk from demand fluctuations  Diversify markets  Have different sources of supplies to reduce risk of fluctuating prices and availability.

8. Welfare  Can afford to offer benefits to employees that will increase motivation and efficiency. Pensions Medical services Fringe benefits Recreational facilities

Economies of Scale CapitalLandLabourOutputTCAC Scale A Scale B Assume each unit of capital = £5, Land = £8 and Labour = £2 Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility What happens and why?

Economies of Scale CapitalLandLabourOutputTCAC Scale A Scale B Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production PER UNIT has fallen Don’t get confused between Total Cost and Average Cost, Overall ‘costs’ will rise but unit costs can fall. Why?

EXTERNAL ECONOMIES OF SCALE  Normally happens when firms in an industry are focused in a particular area.  They can gain the following advantages:  Lower training costs  Ancillary services provided by specialist suppliers  Co-operation of firms

DISECONOMIES OF SCALE  These are the disadvantages of being a big company.  INTERNAL DISECONOMIES  Management problems – difficult to control  Waste is difficult to control or detect.

 EXTERNAL DISECONOMIES  Shortages of skilled labour and high wages  Shortage of raw materials  Congestion and high transport costs

COSTS OF PRODUCTION

 These are the money values of resources used in producing a good or service.  Wages to labour  Rent for land  Interest on capital  The owner of the firm provides enterprise. If revenue earned is equal to cost of production this is called NORMAL PROFIT, if revenue is greater than costs, it is called SUPERNORMAL PROFITS

TYPES OF COSTS  Fixed Costs  Costs which do not change with output.  If nothing is made fixed costs still need to be paid  Examples include rent and insurance.

 Variable Costs  These are costs which do change with output.  If output is zero then VC is zero  Examples include raw materials and wages

 Total Costs  This is fixed costs plus variable costs  Average (Total) Cost  Total Costs divided by Output  Can also be called UNIT COST

 Average Fixed Cost  Fixed cost divided by Output  Average Variable Cost  Variable cost divided by Output

 Marginal Cost  The extra cost of producing one additional unit of output.  E.g. The MC of the 50 th unit is the Total Cost of the 50 th unit minus the Total Cost of the 49 th Unit.  MC = TC n – TC n-1

SHORT RUN AND LONG RUN  In the short run the firm will have fixed capacity.  Some costs will be fixed and some variable  In the long run all costs are variable.

SHORT RUN COSTS  LOOK AT TABLE ON PAGE 35 OF CORE NOTES  DRAW THE GRAPHS

COST CURVES Output Cost FC TC VC

Output Cost AFC AVC AC

Output Cost AC MC AVC

OBSERVATIONS  When output increases in the short run:  Fixed costs do not change  Variable costs increase, not always at a constant rate  Total costs increase at the same rate as variable costs

 Average fixed costs fall, This is because fixed cost do not change but is being spread over a larger volume  Average variable costs fall until a certain point but then increase. Falls due to improved efficiency and increasing returns. Rises due to inefficiency and diminishing returns.  Average costs fall while average variable costs and average fixed costs are falling. When the increase in AVC exceeds the falls in AFC then AC will rise.

Combining the Factors of Production  In the short run a firm cannot change its fixed factors of production (eg land) but it can change its variable factors (eg labour)

Law of Diminishing Returns  As successive units of one factor are added to fixed amounts of other factors the increments in total output at first rise and then decline.

 Marginal costs fall and then rise as output increases  Marginal cost is less than AVC and AC when AVC and AC are falling  Marginal cost is greater than AVC and AC when AVC and AC are rising  MC will cut both the AVC and AC at their lowest point.

OPTIMUM OUTPUT  This is the output where the firm would be technically efficient.  At this point AC is at its lowest.

DIMINISHING RETURNS AND COSTS IN THE SHORT RUN  When a firm has increasing marginal returns it will have falling marginal costs  Diminishing marginal returns means rising marginal costs  Increasing average returns means falling average cost  Diminishing average returns means rising average cost

OUTPUT DECISION IN THE SHORT RUN  Firms want to maximise profits.  Any decision on how much to produce is based on the relationship between their sales revenue and their costs.

REVENUE  Total Revenue – total amount earned from selling output;  quantity sold X price per unit  Average Revenue – total revenue divided output. If only one product is sold then AR will be the same as price.

 Marginal Revenue is the extra revenue from selling an extra unit of output.  MC = TR n – TR n-1  When a firm sells all its output at the same price, price and MR will be the same.

PROFIT MAXIMISING  This can be determined in two ways. 1. Maximum profit is where the difference between total revenue and total cost is greatest. 2. Where MC = MR

SHUT DOWN POSITION IN THE SHORT RUN  As long as a firm’s TR covers VC then the firm will stay open.  Any money left over from paying VC can be used to pay towards TC and reduce the loss the firm will make.  Shut down would be where TR is less than VC or when price is less than AVC  In the long run the firm must make at least normal profit.

COSTS IN THE LONG RUN  In the long run all costs and factors of production are variable.  Average cost in the long run fall because of economies of scale and rise due to diseconomies of scale.

 The AC curve in the long run is U-shaped and has a series of interlinking Short Run AC curves.  The point where LRAC is at its lowest is the optimum size of the firm.

REMEMBER!!!  Short Run Average Costs fall due to increasing average returns to the variable factor  They rise due to diminishing average returns to the variable factor  Short Run Marginal Costs fall due to increasing marginal returns to the variable factor  They rise due to diminishing marginal returns to the variable factor  In the long run Average Costs falls due to economies of scale and rises due to diseconomies of scale.

SUPPLY UNIT 1 TOPIC 3

DEFINITION  Supply is the quantity of a good or service that firms are able and willing to supply at a certain price.  Individual supply is the supply of one firm  Market supply is the supply of all firms in the market.

EFFECT OF PRICE ON SUPPLY  As the price of a product increases the supply of that product will rise.  Represented by a MOVEMENT along the supply curve.  This is due to:-  Existing producers will to supply more to earn more profit  New firms entering the market to earn higher profits

SUPPLY CURVE Qty Price S S Supply Curve for Product A P P1 QQ1

CONDITIONS OF SUPPLY  A condition of supply will cause the supply curve to either:  shift to the left (a decrease in supply)  or  shift to the right (an increase in supply)

 Prices of other commodities  Competitive Supply – where a supplier will switch resources from the production of one product to another as a result of an increase in price.  Example – price of beef increases so there would be a shift to the right of the beef supply curve.  Joint Supply – a rise in the price could lead to an increase in supply of another commodity  Example – increase in price of petrol leads to the increase in supply of other oil products e.g. bitumen.

 Costs of Production  A fall in the cost of any resource will lead to an increase in supply This would be a shift to the right of the supply curve  A rise in the cost of a resource would lead to an decrease in supply This would be a shift to the left of the supply curve

 Change in availability of resources  If more resources are available then supply curve would shift to the right.  Example – new oil field discovered in the North Sea  If less resources are available then supply curve would shift to the left.  Example – bad harvest resulting in less wheat

SHIFT IN SUPPLY Qty Price SHIFT TO THE RIGHT OF SUPPLY S S S1

ELASTICITY OF SUPPLY UNIT 1 TOPIC 3

DEFINTION  Price elasticity of supply measures the responsiveness of supply to a change in price.  How do suppliers react when there is a change in the price of their product?

 Formula % change in supply % change in price  Answers  Greater than 1 – supply is price elastic and very responsive to a change in price  Less than 1 – supply is price inelastic and not responsive to a change in price  Equals 0 – supply did not or could not change in response to price – PERFECTLY INELASTIC

FACTOR AFFECTING ELASTICITY OF SUPPLY  The only factor that affects supply is TIME  In the short run a firm that is at full capacity cannot change its supply in response to a change in price.  Supply would be perfectly inelastic and the supply curve would be a vertical straight line.

PERFECTLY INELASTIC SUPPLY CURVE Qty Price S

 If the firm has spare capacity and stocks then it will be able to increase supply  The more spare capacity or more stock the firm has then the more elastic supply will be.

A LITTLE SPARE CAPACITY SOME SPARE STOCKS PLENTY SPARE CAPACITY, PLENTY STOCKS Qty Price

 In the long run, supply will be elastic.  Firms will have time to increase their capacity and new firms can enter the market.