Unit 2.11(1) Market power - Theory of production and costs (HL)

The costs of production faced by producers in the economy have a very important influence over the supply decisions they make. Along with consumer demand, costs are crucial in determining price and output in all markets. The theory of costs underpins the theory of supply covered in Unit 2.2.

  • Difference between the short run and long run in cost theory
  • Theory of product
  • Law of diminishing returns
  • Total cost, fixed cost and variable cost
  • Average total cost, average fixed cost and average variable cost
  • Long run average total cost
  • Increasing and decreasing returns to scale
  • Economies and diseconomies of scale

Revision material

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Uni 2.11(1) Market power - Theory of production and costs

The nature of costs

The costs of production faced by producers in the economy have a very important influence over the supply decisions they make. Along with consumer demand, costs are crucial in determining price and output in all markets. The theory of costs underpins the theory of supply covered in Unit 2.2. There are two ways of looking at costs, implicit costs and explicit costs.

Implicit costs

An implicit cost is the opportunity cost that exists in every business decision-making situation. For example, if Coca Cola open a new factory in Vietnam, they might have to give up a plan to open a new factory in the USA which was their highest value alternative. This is sometimes called an implicit cost of production because it is not stated in money terms but arises whenever a business makes a choice between alternatives.

Explicit costs

Explicit costs are business costs that firms incur in their operations.  These are known as explicit costs because they are a stated money value arising from the use of resources by firms. In Economics we can categorise explicit costs in terms of the factors of production:

  • Land cost is rent
  • Labour cost is wages
  • Capital cost is interest
  • Enterprise/entrepreneur cost is normal profits

Firms also incur costs such as: energy, administration, marketing, etc, in their normal course of trading.

Time period

The short run (production stage)

The short run is the time period where at least one factor of production is fixed (normally capital) while other factors such as labour can be varied. Firms operate in the short run which is why it is called the production stage. For example, a coffee shop will find it relatively easy to vary the number of workers and raw materials (coffee, milk, water, etc) in the short run. The buildings used by the coffee shop along with the coffee making machines are more difficult to change in the short run and are categorised as fixed factors.

The long run (planning stage)

The long-run is the time period where all factors of production are variable. Normally we would express this as a business being able to vary both labour and capital. Firms cannot operate in the long run which is why it is called the planning stage. In the long run a coffee shop business could increase the number of outlets it opens and employ more workers.

The US footwear company Timberland is one of the most established leisure and outdoor wear companies in the world. It was founded in 1928 in Boston, Massachusetts by Nathan Swartz and the firm’s head office is in New Hampshire. It is a successful company with total revenues of $3.1 billion last year. Whilst the company specialises in shoes it also sells clothing, watches and glasses. Timberland manufactures its products all over the world and aims to produce high quality products that are sold at premium prices.

The firm’s costs are affected by cost theory and Timberland’s management make decisions that are partly influenced by the costs of production in its individual production plants and also across the business as a whole. For example, the cost of producing a pair of its shoes will vary depending on how many shoes are produced and the firm’s managers will make decisions to set production that earns them their target profit.

Questions

a. Outline the difference between Timberland's implicit costs and explicit costs. [4]

  • Implicit cost is the opportunity cost that exists in every business decision-making situation.
  • Explicit costs are business costs that firms incur in their operations: land, labour, capital and enterprise.

b. Explain two implicit costs associated with Timberland opening a new retail outlets. [4]

Implicit cost might include the opportunity cost of any two from:

  • Hiring more staff
  • Investing in new machinery
  • Paying profits to shareholders.
Investigation

Investigate another business and think about the cost factors that will affect the firm’s decision making.

Costs in the short run

The theory of product

The theory of product is the quantitative way the output of a firm can be expressed in the short run.

There are three ways of measuring a firm’s product:

  • Total product (TP): is the total output a firm can produce from a given quantity of labour and capital inputs
  • Marginal product (MP): is the change in TP when one extra unit of labour is added (ΔTP/Δ labour input).
  • Average product (AP): is the output per unit of labour input (TP/ labour input)

The table below sets out the product data for a shoe manufacturing business like Timberland. The data shows the number of pairs of shoes that can be produced in one hour by different numbers of workers working on two machines. The total product (TP), marginal product (MP) and average product (AP) of the firm that manufactures the shoes are set out in the table.

The law of diminishing returns

The law of diminish return states that when a variable factor such as labour, is added to a given set of fixed factors, such as capital there is a point where the marginal product of the extra unit of variable factor added falls (diminishes).

In this shoe manufacturing example, the point of diminishing returns sets in when the fourth worker is added, marginal product and average products are both lower than is the case with 3 workers. This means that as output is increased the most efficient combination of labour and capital is passed when the fourth worker is employed in production. Diagram 2.56 sets out marginal and average product when more unit of labour is employed and how marginal and average product are affected by the law of diminishing returns.

Classifying costs

In the theory of cost it is possible to classify the different types of costs that affect businesses. The table sets out how a firm’s explicit costs are categorised.

The effect of the law of diminishing returns on short run cost

The law of diminishing returns only affects variable costs because these are the only costs that change with output.  When a firm starts producing the marginal product and average product increase at first which means that marginal cost and average variable cost fall initially, but once the law of diminishing returns sets in both marginal product and average product fall which makes average variable cost and marginal costs rise. Diagram 2.57 shows the link between the law of diminishing returns and marginal cost and average total cost.

In the shoe firm example set out in the table below, the variable cost is labour which can be hired at $10 per hour and the fixed cost is the machine which can be hired for $20 per hour.  The table sets out the link between the shoe firm’s unit costs and diminishing returns.

Short run cost curve diagram

The short run average total cost, average fixed cost, average variable cost and marginal cost curves are set out in diagram 2.58. The ATC, AVC and MC curves are U-shaped because of the law of diminishing returns.

Marginal costs and supply

The supply curve in a market it determined by the marginal cost curves of all the firms in the market. This is called horizontal summing, which means the market supply curve is derived by adding together all the marginal cost curves of the firms in the market. This means the upward slowing nature of the market supply curve is determined by the law of diminishing returns.

Evaluation of short run cost theory

  • The law of diminishing returns exists, but its importance to many firms is arguable. In large manufacturing organisations where labour is such a small proportion of total cost, diminishing returns does not really have an important effect on unit costs.
  • Product theory assumes that all labour is equally productive, but this is not the case in reality.  A firm might see marginal product fall when a less motivated, unproductive worker is added to production but rise when a more motivated worker is employed.
  • Costs such as maintenance are semi-variable and vary with output in an unpredictable way. If a firm increases output machines will breakdown more often and incur maintenance costs, but it is difficult to predict how often this will happen.
  • Economic theory looks at labour as a variable cost, but in some situations labour is a fixed cost.  Once workers are hired and under contract, they have to be paid whatever the level of output.

Inquiry case example - Manufacturing coffee tables

Boca do Lobo is a Portuguese based luxury furniture maker. The business was started in 2005 with the aim of producing home furnishings of the very highest quality based on a combination of fine craftsmanship and contemporary design. Boco do lobo  sets premium prices for its products with the coffee table in the picture costing $7,000.

Questions

The data in the table is production and cost data based on the production of coffee tables by a similar furniture manufacturer to Boca do Lobo.

*Total product is the total number of high quality coffee tables that can be produced in an 12 hours with a fixed amount of capital and with different quantities of labour.

a. Outline the difference between fixed and variable costs. [2]

Fixed costs do not change with a firm’s output. Variable costs do change with a firm’s output.

b. (i) Using the data in the table, calculate the marginal product for the different quantities of labour employed. [2]

(ii) Using the data in the table, outline the relationship between marginal product and the quantity of labour employed. [2]

As the quantity of labour employed increases marginal product increases to the point when two workers are employed, but as the third worker is added marginal product falls and this continues when the fourth and fifth workers are added.

b. (i) Define term the law of diminishing returns. [2] 

The law of diminish return states that when a variable factor such as labour is added to a given set of fixed factors such as capital there is a point where the marginal product of the extra unit of variable factor added falls (diminishes).

 (ii) Using the marginal product data in the table, identify the point where diminishing returns set in. [1]

When the third worker is employed.

c. (i) Using the data in the table, determine the marginal cost and average cost figures for the different quantities of total product and complete the average and marginal cost columns in the table. [4]                                      


(ii) Draw a cost curve diagram that represents the relationship shown by the marginal cost and average total cost data in the table.  [2]     *You do not need to plot the data, just use a sketch diagram.                                                                                 

 (iii) Explain how the law of diminishing returns affects this firm’s marginal costs and average costs as output increases. [4]

The law of diminishing returns means to marginal product of producing a coffee table falls when the third worker is added in the example. This means the firm's marginal and average cost curves will fall initially as the firm's marginal product increases and then the firm’s marginal and average total costs will rise as output increases because the firm's marginal product is falling.                        

Long run costs

The long run is the period where all factors of production are variable. This means it is possible to vary capital as well as labour. Our shoe manufacturing firm can expand by increasing its factory space as well as its workforce.

The long run average total cost curve (LRATC)

Firms do not actually produce in the long run, but they can plan to produce at different scales of output. In diagram 2.58 a shoe manufacturing firm produces on SRATC1 and minimises unit costs cost at £25 for producing 20 pairs of shoes per hour.  It can increase output to 30 pairs, but ATC rises to £40 per pair.  Alternatively, the firm could purchase new machinery, move to SRATC2 and increase output to 50 pairs of shoes and see ATC fall to £15.  This process continues each time the shoe manufacturer increases the scale of production and moves to a new SRATC curve. 

If a curve is drawn tangential to the SRATC curves (envelopes them) this gives us the LRATC curve.

Returns to scale

Increasing returns to scale

Increasing returns to scale is where increasing the level of production (employing more labour and capital) in the long run leads to a fall in LRATC.  This means an increase in labour and capital input leads to a greater proportionate increase in output and LRATC falls. Increasing returns to scale occur because of economies of scale.

Constant returns to scale

Constant returns to scale occur when an increase in labour and capital input leads to the same proportionate increase in output and the LRATC curve stays constant as output increases.

Decreasing returns to scale

Decreasing returns to scale occurs on the upward sloping portion of the LRATC curve. This means that an increase in labour and capital input leads to a smaller proportionate increase in output and LRATC rises. Over this range of output the firm is experiencing diseconomies of scale.

Economies of scale

Economies are the cost advantages firms benefit from as they increase the scale of production.

 Types of economy of scale
  • Commercial economies (or marketing economies) arise from the ability of large firms to buy and sell in bulk.  Walmart, for example, has huge buying power and can negotiate very low purchase prices from their suppliers.  They are also able to sell in bulk which reduces their unit cost of selling.
  • Technical economies occur because large firms are able to use large scale machinery that reduces unit costs.  Walmart move their goods in large HGV lorries which are lower cost per unit shipped than moving goods in small vans.
  • Financial economies benefit large firms when they raise funds.  Banks are willing to offer firms like Walmart low rates of interest because they represent a lower risk than smaller retailers, and Walmart borrows larger amounts of money which reduces the cost per $ borrowed.
  • Labour or managerial economies (specialisation economies) arise because workers in large firms are able to specialise in particular tasks.  Workers at Walmart will be put into departments like fruit and vegetables or the bakery, and this allows them to be more efficient than workers in small firms who have to divide their time between functions.
Wal-Mart is one of the largest businesses in the world employing 2.2 million people worldwide. Last year its total revenue was $524Bn and it made a profit of $14Bn. Walmart’s size allows it to benefit from significant economies of scale and achieve unit costs its competitors struggle to compete with. Operating 5,000 large stores worldwide gives the business tremendous bargaining power with its suppliers and it buys in goods at the very lowest prices.

This does not just apply to the goods it sells but also services like energy, IT and finance. Walmart’s size also allows it to reduce average costs in distribution and logistics throughout it supply chains.

Questions

a. Define the term increasing returns to scale. [2]

Increasing returns to scale is where increasing the level of production (employing more labour and capital) in the long run leads to a fall in LRATC. 

b. Explain how Walmart benefits from commercial and technical economies of scale. [4]

  • Walmart benefits from commercial economies because it buys stock in very large quantities which reduces its purchasing unit costs and it sells in very large quantities which reduces its cost per unit of selling goods.
  • Walmart benefits from technical economies because of large scale and technologically advanced machinery it can afford as a large business. The use of this machinery in its operations can reduces its unit costs.

c. Explain how economies of scale can lead to decreasing average costs in the long run. [10]

Answers might include:

  • Definitions of economies of scale, average costs and long run.
  • Diagram to showing the LRATC curve with decreasing average costs.
  • Explanation of how technical, commercial, labour and financial economies of scale lead to fall in average costs as a firm increases the scale of production.
  • Examples of  technical, commercial, labour and financial economies of scale such as the buying and selling in bulk Walmart can use as such a large business.
Investigation

Research into another large retail business to see whether it benefits from similar economies of scale compared to Walmart.

Diseconomies of scale

Diseconomies of scale are the cost disadvantages that result from the increase in the size of a firm and its scale of production.

Types of diseconomy of scale
  • Communication diseconomies occur when firms become too big and it becomes more difficult for managers to communicate with workers as the number of employees, departments and offices increases. Walmart has outlets and offices all over the world which makes communication challenging for managers.
  • Motivation diseconomies arise as large firms find it more difficult to manage workers in organisations that they find more difficult to identify with. A person who works for a small independent retailer may feel more motivated than someone who works for Walmart.
  • Administrative diseconomies are more likely in large organisations where the level of bureaucracy increases which hinders the decision-making process. Imagine the administrative difficulties that Walmart might experience when it tries to change the goods it stocks.
 

A recent study using a sample of large multinational companies found that employees were wasting, on average, 26% their day on avoidable activities at work that dramatically reduce their efficiency.  These unnecessary tasks included:

  • 42 minutes spent on needless administration tasks
  • 36 minutes involved in unproductive work conversations
  • 28 minutes having to attend unnecessary meetings
  • 26 minutes devoted to outdated technology tasks

This inefficiency can mean higher average costs, reduced customer satisfaction and lower profits. If you add to this, other costs in terms of employee welfare you might question the benefits of being a big business. But perhaps these issues are worse in small businesses.

Question

Explain how diseconomies of scale might reduce business efficiency and cause long run average costs to rise. [10]

Answers should include:

  • Definitions of diseconomies of scale, effciency, long run and average costs.
  • Diagram to show the LRATC curve where average costs rise at high level of output because of diseconomies of scale.
  • Explanation of how communication, motivation and administrative diseconomies reduce business efficiency and increase average costs in the long run.
  • Example of how communication, motivation and administrative diseconomies reduce business efficiency such as the time workers might spend on their emails and in meetings in a large business like Walmart.
Investigation

Find out from someone you know what it is like to work in a large organisation. Are the observations in the case example something the people you have spoken to can identify with?

Thinking about a key concept - Interdependence

The law of diminishing returns shows how business costs are affected by the marginal product of labour as it is added to a fixed amount of capital in the short run. As marginal product rises and then falls when successive units of labour are employed this causes marginal cost to fall and and then rise. But business costs are affected by so many other factors as well such as the cost of capital, wages rates, administrative costs, etc. It is the interdependence of so many factors that affect business costs that makes the of the supply side of the economy so complex.

Investigate different factors that affect the costs of production in a particular business. Think about the interdependence of the different costs.

Which of the following is the best definition of the short run in cost theory?

 

 

Consider the product data in the table. Which of the following is not true from the information given by the data?

 

The law of diminishing returns sets in when MP starts to fall which is when the third worker is added not the fifth.

 

Which of the following is the best description of variable costs?

 

 

Which of the following is not a fixed cost

The cost of production line workers is a variable cost because their costs change with output.

 

Which of the following equations would you use to calculate marginal cost ?
 

 

 

Using the cost data below, which of the following is not correct?

AFC = $30; output = 200 units; TVC = $8,000

TFC: 200 x $30 = $6000

 

Which of the following is least likely to be an economy of scale?

An extra worker being employed is more likely to be a short-run activity and based on the theory of product.


 

Using the diagram, which of the following is true?

 

 

Total Score:

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