Analyse production
Distinguish the short run from the long run and calculate total, average and marginal product.
Types of Cost, Revenue and Profit, Short-run and Long-run Production
Firms combine factors of production to create output. Their decisions depend on how productivity, costs and revenue change as output changes. This chapter builds the core theory of the firm needed for the market-structure chapters that follow.
Short-run productionCostsReturns to scaleEconomies of scaleRevenueProfit
What this chapter prepares you to do
Work with costs
Calculate and interpret fixed, variable, average and marginal costs and explain their relationships.
Explain scale
Analyse returns to scale, economies and diseconomies of scale, MES and X-inefficiency.
Analyse profit
Calculate revenue and profit, distinguish profit concepts and apply the MR = MC rule.
High-grade habit: keep short-run diminishing returns separate from long-run returns to scale. The first changes one variable factor while at least one other factor is fixed; the second changes all factor inputs.
Chapter sections
17.1
Types of firm
A firm is an organisation that brings together factors of production to produce a good or service for a market. Firms differ greatly in size and organisation: a sole trader may serve one local area, while a multinational may produce and sell in many countries.
Local firms
Often small, with a limited customer base and relatively simple organisation.
National firms
Operate across a country and usually require more complex management and distribution.
International firms
Operate in global markets and may need a large scale to compete effectively.
A firm's preferred scale depends on its market, technology and cost structure. Some sectors can support small and large firms side by side, while others favour large-scale production.
17.2
Production in the short run
The short run and the production function
The short run is the period in which at least one factor of production is fixed. Labour can often be varied relatively quickly, while capital such as a factory, aircraft or major machine may take much longer to change.
A production function shows the technically efficient relationship between factor inputs and the physical quantity of output. It tells us how much output can be produced from particular combinations of labour, capital and other inputs.
Easy example: imagine a travel agency with 10 computers and 10 computer operators. Adding an 11th worker can still raise output because staff can share equipment or stagger breaks. But if the firm keeps adding workers without adding computers, each extra worker eventually contributes less because the fixed capital becomes increasingly scarce. This is why diminishing returns is a short-run idea.
Product measures
Average product (AP) = Total product ÷ Units of the variable factor
Marginal product (MP) = Change in total product ÷ Change in the variable factor
The law of diminishing returns
If a firm keeps increasing one variable factor while other factor inputs remain fixed, the additional output from extra units of the variable factor will eventually fall. This is the law of diminishing returns or law of variable proportions.
Example: if extra employees are added while the number of computers remains fixed, early additions may raise output strongly. Eventually workers must share the fixed equipment, so each extra worker adds less output than the one before.
A short-run production function
With capital and other inputs fixed, total physical product rises as more labour is employed. The curve becomes progressively flatter because each additional worker eventually adds less extra output: this is the law of diminishing returns.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
The effect of an increase in capital input
An increase in capital shifts the total product curve upward from TPPL0 to TPPL1. With more capital, the same labour input can produce more output.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Total, average and marginal product
The relationship between average and marginal values is important. When marginal product is above average product, average product rises. When marginal product is below average product, average product falls. Therefore, the marginal-product curve passes through the maximum point of the average-product curve.
Worked example
Output rises from 42 units with 3 workers to 54 units with 4 workers. The marginal product of the fourth worker is 54 − 42 = 12 units. Average product with 4 workers is 54 ÷ 4 = 13.5 units.
Do not confuse: diminishing marginal returns does not mean total output is falling. It means the additional output gained from another unit of the variable factor is falling.
17.3
The short-run cost function
Once the production relationship and factor prices are known, the firm can identify how costs change with output.
Total cost (TC)
All costs incurred in producing a given level of output, including opportunity cost.
Fixed cost (TFC)
A cost that does not vary with output in the short run.
Variable cost (TVC)
A cost that changes as output changes.
Sunk cost
A cost already incurred that cannot be recovered if the firm stops trading.
Average total cost (ATC)
Total cost per unit of output.
Marginal cost (MC)
The additional cost of producing an extra unit of output.
Core short-run cost formulae
TC = TFC + TVC
ATC = TC ÷ Q
AFC = TFC ÷ Q
AVC = TVC ÷ Q
MC = ΔTC ÷ ΔQ
Fixed costs do not change with output, so average fixed cost falls continuously as those costs are spread over more units. Average variable cost and average total cost are commonly shown as U-shaped because the cost effect of diminishing marginal returns eventually becomes important.
Total costs in the short run
Total fixed cost (TFC) is unchanged as output varies. Total variable cost (TVC) rises as more variable inputs are used, and short-run total cost (STC) is always the vertical sum of the two: STC = TFC + TVC.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
The firm's short-run average and marginal cost curves
SAFC falls continuously as output rises, while SAVC and SATC are typically U-shaped. SMC cuts both average curves at their minimum points.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Worked cost calculation
If fixed cost is $300, output is 50 units and variable cost is $200: TC = 300 + 200 = $500; ATC = 500 ÷ 50 = $10; AVC = 200 ÷ 50 = $4; AFC = 300 ÷ 50 = $6.
Exam technique: marginal cost can be calculated from the change in total cost. Fixed cost does not affect MC because fixed cost does not change when output changes.
17.4
Production and costs in the long run
Returns to scale
The long run is the period in which the firm can vary all factor inputs. When all inputs change together, the relevant concept is returns to scale.
| Type | Relationship between inputs and output |
|---|---|
| Increasing returns to scale | Output rises by a larger percentage than inputs. |
| Constant returns to scale | Output rises by the same percentage as inputs. |
| Decreasing returns to scale | Output rises by a smaller percentage than inputs. |
Do not confuse two different ideas: diminishing marginal returns occurs in the short run when one variable input increases while at least one other input is fixed. Returns to scale is a long-run concept in which all factor inputs change together.
Important: returns to scale is a long-run concept because all factor inputs can vary. Diminishing marginal returns is a short-run concept because at least one factor remains fixed.
Long-run average cost
In the long run the firm can choose the amount of capital best suited to its intended output. Each possible capital stock generates a different short-run average-cost curve. The long-run average cost (LAC) curve is the lower-cost envelope of these short-run curves.
Short-run cost curves with different levels of capital input
Each SATC curve represents a different fixed amount of capital. In the long run the firm can change plant size, so it chooses the lowest-cost SATC available for each output. The LAC curve therefore forms the lower envelope of the short-run cost curves.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Economies of scale
Economies of scale occur when a larger scale of production lowers long-run average cost. Important internal sources include:
Technology
Large equipment, indivisibilities and high overheads can make high-volume production cheaper per unit.
Specialisation
Division of labour and specialist managers or support staff can raise efficiency.
Marketing
Advertising and research expenditure can be spread across a larger volume of sales.
Finance
Large, established firms may obtain borrowing on more favourable terms.
Purchasing
Bulk buying can allow stronger firms to negotiate lower input prices.
Management
Some management and administrative functions need not grow proportionately with output.
Internal and external economies
Internal economies of scale arise because the individual firm expands. External economies of scale arise because the industry expands. Examples of external economies include better transport links, a deeper pool of skilled labour and specialised suppliers developing around an industry cluster.
Economies of scope: a multi-product firm may also lower costs by sharing functions across several products. For example, one finance, human-resources or marketing department can serve several product lines instead of each product needing a separate department. This is different from economies of scale, which arise from producing a larger quantity of output.
Extension insight — economies of scope: a multi-product firm may share finance, human-resource, marketing or other functions across several products, reducing costs across the wider organisation.
Diseconomies of scale
Diseconomies of scale occur when expansion raises long-run average cost. Internally, large organisations may suffer communication, coordination and motivation problems. Externally, an expanding industry can create congestion, pollution, pressure on mineral resources and higher input prices such as wages.
Minimum efficient scale
The minimum efficient scale (MES) is the smallest output at which long-run average cost stops falling. The size of MES relative to total market demand affects how many firms can operate efficiently in the market.
Possible shapes of the LAC curve
Long-run average cost curves can take different shapes depending on the balance between economies of scale and diseconomies of scale. Some are U-shaped, some flatten out, and some continue to fall over a wide range of output.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
X-inefficiency
X-inefficiency occurs when a firm fails to produce at the lowest attainable cost, for example because weak competitive pressure allows organisational slack or complacency. The firm therefore operates above its most efficient long-run cost position.
X-inefficiency
At output q₁, the firm operates on LAC₁ instead of the lower-cost curve LAC*. The vertical gap shows the extra cost caused by X-inefficiency.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Evaluation habit: economies of scale are not guaranteed simply because output rises. Their importance depends on the technology, organisation and industry. At sufficiently large scale, diseconomies may offset earlier cost advantages.
17.5
A firm's revenue
Total revenue (TR)
The revenue received from selling output.
Average revenue (AR)
Revenue per unit sold. When every unit is sold at the same price, AR equals price.
Marginal revenue (MR)
The additional revenue from selling an extra unit of output.
Revenue formulae
TR = P × Q
AR = TR ÷ Q = P
MR = ΔTR ÷ ΔQ
Along a downward-sloping demand curve, price and therefore AR fall as quantity sold rises. MR falls faster because lowering the price to sell an extra unit also reduces the revenue received on earlier units. For a straight-line demand curve, MR shares the same vertical intercept as AR and has twice its slope.
Elasticity and total revenue
Average revenue (AR) is the demand curve and marginal revenue (MR) falls twice as steeply for a straight-line demand curve. Total revenue reaches its maximum where MR = 0, which is also the point at which demand is unit elastic.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
The relationship with price elasticity of demand is also important. Total revenue rises as price falls over the elastic section of a demand curve, reaches its maximum where demand is unit elastic, and falls as price falls further over the inelastic section. At maximum total revenue, marginal revenue is zero.
Worked revenue calculation
If a firm sells 40 units at $8 each, TR = 40 × 8 = $320. If selling 60 units at $6 raises TR to $360, MR over that change = (360 − 320) ÷ (60 − 40) = $2 per extra unit.
17.6
Profit and loss
Profit
Profit = Total revenue − Total cost
Economic cost includes opportunity cost. For an entrepreneur, this includes the return that could have been earned in the next-best alternative activity. That required return is part of cost and is called normal profit.
| Profit position | Meaning |
|---|---|
| Normal profit | TR = TC, where TC includes the opportunity cost needed to keep the firm in the market. |
| Supernormal profit | TR exceeds economic TC; profit is above the level required to keep the firm in the market. |
| Subnormal profit | Profit is below normal profit. The firm is not fully covering its economic opportunity cost. |
| Accounting profit | Revenue minus explicit recorded costs; it excludes the entrepreneur's opportunity cost. |
Normal, supernormal, subnormal and accounting profit
| Profit concept | Meaning |
|---|---|
| Normal profit | Total revenue exactly covers total economic cost, including the entrepreneur's opportunity cost. It is the minimum return needed to keep the firm in the market in the long run. |
| Supernormal profit | Total revenue is greater than total economic cost. |
| Subnormal profit | The firm's return is below normal profit; if this persists in the long run, exit becomes rational. |
| Accounting profit | Revenue minus explicit, recorded business costs. It differs from economic profit because the economist also includes opportunity cost. |
Easy way to remember it: if a sole trader could earn the same return in their next-best occupation, that forgone return is part of the economic cost of running the business. Covering it means the firm is earning normal profit, not zero economic return.
The shutdown price
In the short run, fixed costs have already been incurred. A loss-making firm may therefore continue producing if revenue still covers variable cost and contributes something toward fixed cost. The short-run shutdown threshold is therefore linked to average variable cost. If price cannot cover AVC, remaining open makes the firm worse off.
In the long run all costs are variable. A firm must cover its long-run average total cost, including normal profit, to remain in the market.
Short run
Continue while revenue covers variable costs; the relevant shutdown threshold is minimum AVC.
Long run
The firm must cover all economic costs. If it cannot earn normal profit, exit becomes rational.
Profit maximisation
The marginal principle gives the firm's profit-maximising rule. If MR is greater than MC, producing an additional unit adds more to revenue than to cost, so profit rises. If MC is greater than MR, reducing output improves profit. Profit is therefore maximised at the output where MR = MC.
Profit maximisation in the short run
This rule applies whenever a firm is assumed to maximise profit; the following market-structure chapters use it repeatedly.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Exam technique: do not confuse profit maximisation with revenue maximisation. Revenue is maximised where MR = 0; profit is maximised where MR = MC.
Chapter 17 revision checklist
Define a firm and explain why firms differ in scale.
Define the short run and the long run.
Explain the production function.
Explain the law of diminishing returns.
Calculate total, average and marginal product.
Explain the AP–MP relationship.
Distinguish fixed, variable and sunk costs.
Calculate TC, ATC, AVC, AFC and MC.
Explain why MC cuts average cost at its minimum.
Distinguish diminishing returns from returns to scale.
Explain increasing, constant and decreasing returns to scale.
Explain the LAC envelope of short-run cost curves.
Explain internal economies of scale.
Explain external economies of scale.
Explain internal and external diseconomies of scale.
Define MES and X-inefficiency.
Calculate TR, AR and MR.
Explain the relationship between PED, TR and MR.
Distinguish normal, supernormal and subnormal profit and explain shutdown prices.
Apply MR = MC to profit maximisation.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.