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7/27/2019 Avarage Cost and Marginal Cost
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States the relationship between inputs and outputs
Inputs the factors of production classified as: Land all natural resources of the earth not just terra
firma!
Price paid to acquire land = Rent
Labour all physical and mental human effort involved inproduction
Price paid to labour = Wages
Capital buildings, machinery and equipment
not used for its own sake but for the contributionit makes to production
Price paid for capital = Interest
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Inputs Process Output
Land
Labour
Capital
Product orservice
generated
value added
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In the short run at least one factor fixed in supply but all
other factors capable of being changed Reflects ways in which firms respond to changes
in output (demand)
Can increase or decrease output using more or less of
some factors but some likely to be easier
to change than others
Increase in total capacity only possible
in the long run
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In times of risingsales (demand)firms can increaselabour and capitalbut only up to acertain level theywill be limited bythe amount ofspace. In thisexample, land is
the fixed factorwhich cannot bealtered in the shortrun.
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Analysis of Production Function:Short Run
If demand slows
down, the firm canreduce its variablefactors in thisexample it reducesits labour andcapital but again,land is the factorwhich stays fixed.
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Analysis of Production Function:Short Run
If demand slows
down, the firm canreduce its variablefactors in thisexample, itreduces its labourand capital butagain, land is thefactor which staysfixed.
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The long run is defined as the period of time taken to vary all factors
of production
By doing this, the firm is able to increase its total capacity notjust short term capacity
Associated with a change in the scale of production
The period of time varies according to the firm
and the industry
In electricity supply, the time taken to build new capacity could bemany years; for a market stall holder, the long run could be as
little as a few weeks or months!
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Analysis of Production Function:Long Run
In the long run, the firm can change all its factors of production thusincreasing its total capacity. In this example it has doubled its capacity.
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Mathematical representation
of the relationship:
Q = f (K, L, La)
Output (Q) is dependent upon the amount ofcapital (K), Land (L) and Labour (La) used
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In buying factor inputs, the firmwill incur costs
Costs are classified as: Fixed costs costs that are not related directly to
production rent, rates, insurance costs, admincosts. They can change but not in relation tooutput
Variable Costs costs directly relatedto variations in output. Raw materials primarily
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Total Cost -the sum of all costs incurredin production
TC = FC + VC
Average Cost the cost per unitof output
AC = TC/Output
Marginal Cost the cost of one more or
one fewer units of productionMC= TCn TCn-1 units
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Short run Diminishing marginal returnsresults from adding successive quantities of
variable factors to a fixed factor
Long run Increases in capacity can lead toincreasing, decreasing or constant returns toscale
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Total revenue the total amount receivedfrom selling a given output
TR = P x QAverage Revenue the average amount
received from selling each unitAR = TR / Q
Marginal revenue the amount receivedfrom selling one extra unit
of outputMR = TRn TRn-1 units
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Profit = TR TC
The reward for enterprise
Profits help in the process of directing
resources to alternative uses in free markets Relating price to costs helps a firm to assess
profitability in production
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Normal Profit the minimum amountrequired to keep a firm in its current line ofproduction
Abnormal or Supernormal profit profit
made over and above normal profit Abnormal profit may exist in situations where firms
have market power Abnormal profits may indicate the existence of
welfare losses
Could be taxed away without altering resourceallocation
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Sub-normal Profit profit below normalprofit
Firms may not exit the market even if sub-normal
profits made if they are able to cover variable
costs
Cost of exit may be high
Sub-normal profit may be temporary (or
perceived as such!)
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Assumption that firms aim to maximise profit
May not always hold true
there are other objectives
Profit maximising output would be where MC= MR
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Why?Cost/Revenue
Output
MR
MR the additionto total revenue asa result ofproducing one
more unit ofoutput the pricereceived fromselling that extraunit.
MCMC The costof producingONE extra unit
of production
100
Assume output is at100 units. The MC ofproducing the 100thunit is 20.
The MR received from
selling that 100th unitis 150. The firm canadd the difference ofthe cost and therevenue received fromthat 100th unit to
profit (130)20
150
Totaladded
toprofit
If the firm decides toproduce one more unit the 101st the additionto total cost is now 18,the addition to total
revenue is 140
the firmwill add 128 to profit. it is worth expandingoutput.
101
18
140
Added tototalprofit
30
120
Addedto totalprofit
The process continuesfor each successiveunit produced.Provided the MC isless than the MR it
will be worthexpanding output asthe differencebetween the two isADDED to total profit
102
40
145
104103
Reducestotalprofit bythisamount
If the firm were toproduce the 104th unit,this last unit would costmore to produce than itearns in revenue (-105)this would reduce totalprofit and so would notbe worth producing.
The profit maximisingoutput is where MR =MC