IBEconomics

Econ 2.3Theory of the Firm (HL only)

Extract from Powerpoint NotesISS International School SingaporeAndrew McCarthy ©

Diminishing returns for a producer

The short run is defined as period of time in which some resources used in the production process are fixed and cannot be changed.

In the long run all factors are variable including level of capital employed.

Law of Diminishing Marginal ReturnsConcepts

Total product This is the quantity of output produced by a given number of workers over a given period of time. Remember the amount of capital (or machines) is fixed.

Average product This is the quantity of output per unit of input. In this model, the input is labour. In other words, we are dealing with the output per worker, on average.

Marginal product The addition to total output produced by one extra unit of input (again, labour). It is the extra output produced at the margin (i.e. by adding a marginal unit of labour).

Law of Diminishing ReturnsExample

Law of Diminishing ReturnsExample

Law of increasing costs Any situation where the law of diminishing returns

operates so does law of increasing costs. To gain an extra unit of output will require a greater

increase in the amount of inputs As a greater number of inputs are required you will have to pay for them.

Diminishing Marginal ReturnsLaw of Diminishing Costs

The returns from extra inputs are falling The costs of gaining extra output are increasing

Add one more worker | gain less marginal output

Gain extra output | will cost more workers

For each increase in output| the marginal cost will increase

Law of increasing costsDefinitions

Total cost (TC). This is the total cost to the firm of producing a given number of units. This can be sub-divided. Total cost = total fixed costs + total variable costs (or TC = TFC + TVC). A cost is either fixed or variable. There is no third group. If a cost is not fixed, then, by definition, it must vary with output.

Average cost (AC). This is the cost, on average, per unit of output produced. If a firm made 100 bars of chocolate at a total cost of £10, then the cost, on average, per bar of chocolate produced, is 10p. So, algebraically: It also follows that average cost = average fixed cost + average variable cost (AC = AFC + AVC). This is derived by simply dividing both sides of the total cost equation by Q. Average cost is often called average total cost so as to distinguish it from AFC and AVC.

Marginal cost (MC). This is the additional cost incurred by a firm as a result of producing one more unit of output. It is the extra cost at the margin (i.e. by producing the marginal unit of output).

Graphing output and costs

COSTS PRODUCT

Data and Graphs and Definitions – sourced from http://www.s-cool.co.uk/alevel/economics.html

Cost Curves Bob the Builder example

Total Costs To employ Bob to work the firm needs to pay $420 Every additional worker also cost $420

Cost Curves Bob the Builder example

Total Product When Bob begins laying bricks he adds 70 to the wall When a second friend begins the total product increases to

210 bricks. Worker 6 adds less bricks

Cost Curves Bob the Builder example

Average Costs Because Bob is not very productive by himself the cost per

brick is very high at $6 By adding extra workers the average cost per brick falls due

to increased efficiencies. Division of labour, specialisation etc.

Cost Curves Bob the Builder example

Marginal Costs If Bob’s boss wants to add one more brick to the fence he has

to pay a small amount. This is called the marginal cost.

MC per brick $ = (Total Cost now – Total Cost previous) / Marginal ProductMC (2) = (840 - 420) / 140 = $3 per brick

This is the cost of adding one more brick in dollars, at two workers

Cost Curves Bob the Builder example

Marginal Costs If Bob’s boss wants to add one more brick to the fence he has

to pay a small amount. This is called the marginal cost.

MC per brick $ = (Total Cost now – Total Cost previous) / Marginal ProductMC (2) = (840/420) / 140 = $3 per brick

This is the cost of adding one more brick in dollars, at two workers

Fixed Costs The firm where Bob works

needs to pay some costs regardless of the level of building that is occurring.

This are sometimes called sunk costs

Bobs firm must pay these fixed costs.

• General Managers salary• Lease the digger and crane• Pay insurance• Pay for a phone rental

Cost Curves Bob the Builder example

Average Fixed Costs These are calculated by dividing fixed costs by the

output of the firm. If Bobs firm makes two fences the AFC is $60

Cost Curves Bob the Builder example

Average Variable Costs These are the costs that increase as output increases. As quantity produced increases ….variable costs

increase Bills that relate directly to level of output Eg. Cost of raw materials, wages, electricity bills, petrol Output / Variable Cost = Average Variable Cost

Average Total Costs This is the sum of Variable Costs and Fixed Costs TC = FC + VC ATC = AFC + AVC ATC = TC / Output

Cost Curves Bob the Builder example

Cost Curves Bob the Builder example

Bringing it all together… what do costs look like?

FC = constantVC = increases with outputTC = increases with outputAFC = decreases with outputAVC = u shaped ATC = u shapedMC = u shaped but very steep at end

Cost Curves Bob the Builder example

Bringing it all together… what do costs look like?

Cost Curves Bob the Builder example

Marginal Cost curves… !!

Where does MC cross?

Cuts AVC at minimumCuts ATC at minimum

Increasing returns from 0 – 4 mean that MC must fall

Decreasing returns after 4 mean than MC must rise

Data and Graphs – sources from Geoff Evans (NZ Economics Textbook)