IB Economics

Costs, Revenues and profit(HL ONLY)

Ford has commenced production on the all-new 2009 Ford Fiesta at the Cologne assembly plant in

Germany, with other Ford factories around the globe gearing up to produce the

automaker’s latest small car offering.

What are COSTS?

• COSTS OF PRODUCTION: These are the costs to the individual firm that it incurs as a result of production;– Total costs– Fixed costs– Variable costs

The Theory of Production Key Terms 1

• Total Costs – Fixed costs + variable costs

• Fixed Costs– Costs of production that do not vary as output changes

• Variable Costs– Costs of production which vary with output

• Short Run– Period of time during which fixed costs and the scale of

production remain constant• Long Run

– Period of time during which all factors become variable and the scale of production can change

• Marginal Product– The output added by the extra worker or unit of a factor

Adding more of the VARIABLE FACTOR when there are FIXED factors

(In SR)

1

2

Adding more of the VARIABLE FACTOR when there are FIXED factors

(In SR)

AP

1

Class Task using table 1.1 add in the MPP

curve

Class Task using table 1.1 add in the MPP

curve

The relationship between APP and MPP (In SR)Table 1.1.1

1

The relationship between AVERAGE, MARGINAL & TOTAL Physical Product

(in SR)

AP

APP &MPP

Number of workers

MP

TP

TPP

1

Class Task using table

1.1.1 to add detail

Class Task using table

1.1.1 to add detail

2

3

The Theory of Production Key Terms 2

• Increasing marginal returns – Where the addition of an extra variable factor adds more to output that

the previous variable factor• Average product

– The total product divided by the number of workers• Law of diminishing marginal returns

– Where increasing amounts of a variable factor are added to a fixed factor and the amount added to total product by each additional unit of the variable factor eventually decreases

• Optimal output– The ideal combination of fixed and variable factors to produce the

lowest average cost• Productive efficiency

– When a firm operates at minimum average total cost, producing the maximum possible output from inputs into the production process

• Depreciation– In relation to fixed assets, all fall in the value of an asset during its

working life

FIXED, VARIABLE & SEMI-VARIABLE (in SR)

Total Costs

Output

Class Task complete the diagram to include FC, VC and TC

Class Task complete the diagram to include FC, VC and TC

The Theory of Production Key Terms 3

• Semi-variable costs – Costs which have both a fixed and variable element e.g. landline

telephone usage• Average fixed costs

– TFC/Q• Average total costs

– TC/Q• Marginal costs

– The cost of the extra unit of output

Costs in more detail (SR)Table 1.2

Increasing and decreasing SHORT RUN COSTS

AC

Costs

Output

MC

1

2

Class Task Use table 1.2 to complete the diagram

Class Task Use table 1.2 to complete the diagram

MC, AC, AVC & AFC (in SR)

Costs £’s

Quantity

Class Task Use table 1.2 to complete the diagram

Class Task Use table 1.2 to complete the diagram

http://news.bbc.co.uk/2/hi/business/8062844.stm | 22nd May 2009

Questions for thought

1) How does a weak £GBP affect costs for UK businesses?

2) Are all firms affected by rising fuel costs in the same way?

3) How can firms protect themselves from the fluctuations in commodity and currency prices?

Task – The shape of costs

Production in the LR

• In the LR all factors become variable and hence firms can overcome diminishing returns by increasing the SCALE of production.

• However as the firm continues to increase output then diminishing returns will creep in again and the firm must look to increase it’s scale once more.

• Each size of operation forms a SRAC (or SRATC) curve each with it’s own optimal size of operation.

• In practice firms may choose or be unable to move to a new SRAC and may over work a fixed factor e.g. existing factory size is too small but the owners do not have the funds to build a new one or the increase in output is only expected to be temporary

• All planning takes place in the long run

Relationship between SR & LR AC

Class Task complete the diagram to

show a series of

SRAC and the eventual

LRAC

Class Task complete the diagram to

show a series of

SRAC and the eventual

LRAC

Costs £’s

Quantity

SRAC1

SRAC2

Which factory size would you choose if your firm needed to produce 100 units?

Costs £’s

Quantity

SRAC1

SRAC2

100

SRAC3

175

What about 175 units?

What will influence your

decision?

The Theory of Production (LR)Key Terms 4

• Increasing returns to scale– Where an increase in factor inputs leads to a more proportionate

increase in outputs• Decreasing returns to scale

– Where an increase in factor inputs leads to a less than proportionate increase in factor outputs

• Constant returns to scale– Where an increase in factor inputs leads to a proportionate

increase in factor outputs. • Minimum efficient scale (MES)

– This corresponds to the point at which average costs reach their lowest point for the first time, i.e. the lowest number of units a firm needs to produce to fully utilise all available economies of scale

What shape & why?

Co

sts

£’s

Quantity

LRAC2

MES

Co

sts

£’s

Quantity

LRAC4

MES

Co

sts

£’s

Quantity

LRAC3

Co

sts

£’s

Quantity

LRAC1

MES

The Minimum Efficient Scale (MES)

• The MES corresponds to the lowest point on the LRAC (or LRATC)

• MES defined as the first point at which all possible economies of scale are fully utilized

• There is unlikely to be one point rather a range of outputs which are all productively efficient

• During the range firms are said to be experiencing constant returns to scale

Co

sts

£’s

Quantity

LRAC4

MES

Economies of Scale

• Defined: Are any decrease in LRAC that come about when a firm alters all of its factors of production - Increasing returns to scale– Specialisation– Division of labour– Bulk buying– Financial economies– Transport economies– Large machines– Promotional economies

Diseconomies of scale

• Define: Any increase in LRAC when a firm alters all of its factors of production – decreasing returns to scale– Control and management problems– Alienation and loss of identity

• In reality there is little evidence to suggest that firms actually suffer from diseconomies of scale

External Factors

• Economies of scale– Local universities specialise due to high

concentration of firms

• Diseconomies of scale– Increase in size of industry pushes up the

price of raw materials

Example IB Question

• What are the distinctions between decreasing returns to scale and diminishing marginal returns? (10 marks)

Answer Essential to an understanding of this question is the

economist’s distinction between short run and long run. Decreasing returns to scale should be illustrated with a

Long Run Average Cost Curve, with the clear understanding that it operates over a period in which all factor inputs are variable.

Diminishing returns should be illustrated with a numerical or diagrammatic example which shows increasing application of a variable factor to at least one fixed factor.

Good answers might include short run average cost curves on a climbing envelope curve.

Allow up to [5 marks] if only one aspect of the question is answered.

10 Marks

Revenue Theory

• Total revenue TR=PQ

• Average revenue AR=TR/Q

• Marginal revenue MR=∆TR / ∆Q

Revenue Curves and Output

1. AR remains constant as Q increases PED = AR (D) horizontal Firms are price takers

2. AR falls as Q increases PED < AR (D) downward sloping Firms have some influence over P&Q Price makers

When PED = TR

Where P=5

5

1

TR

Q

35

7

P

Q

Class Task Use table 7.4 to complete the diagram

Class Task Use table 7.4 to complete the diagram

The relationship between D, AR, MR, TR & PED for a downward sloping linear demand curve

Review of Revenue

• When PED > 1 firms revenue increases if P falls

• When PED < 1 firms revenue increases if P increases

• When PED = 1 firms revenue stays the same as P changes, revenue is already maximised

Profit Theory

• The economist versus the accountant– Accountant: Profit = TR – TC– Economist: Profit = TR – TC but;

• Where TC = FC + VC + Opportunity Cost

– An accountant may deduce that a firm is making a profit whereas an economist may conclude that they are making a loss

– 3 scenarios to consider;• The shut down price• The break even price• The profit maximising level of output

The Shut Down Price

• Firms often continue to produce even if they are making a loss– During the six months to September 2009, the company (BA)

suffered a £292m ($485m) loss. BBC, 9th Nov 2009

• Firms may even shut down for a period and then re-open later on– 1,700 jobs to go as Corus mothballs plant BBC, 4th Dec 2009 – Jobs axed at Ford, Nearly a hundred jobs are being cut at Ford’s

plant in Dagenham as a result of the economic downturn The company has introduced 14 "non production days" until the new year in its stamping departments.  It'll mean 520  staff could have to work 3 day weeks. BBC Nov 2008

– An ice cream shop shuts for winter and then reopens when the weather improves

Why are they still in business?

The Shut Down Price

• The shut down price is the level of price that enables a firm to cover its variable costs in the SR, i.e. it is the price where P=AVC. If price does not cover AVC, then the firm will shut down in the SR

Q (Units)

Class Task complete the

diagram

Class Task complete the

diagram

The Shut Down Price (ATC, AVC and MC)

Price an

d

Co

st

Breaking Even

• In the long run firms are able to cover ATC

• Remember ATC includes OC and is different for an economists and an accountant

• If the price does not cover all costs in the LR the firm will shut down and stay shut

Where does the firm operate?

• Assumption: Firms seek to maximise profit

• A firm will continue to produce until MC=MR why?

• What if the MC curve crossed the MR curve twice?

• A firm should produce at the level of Q where MC cuts MR from below

• Remember that the MC cuts the AC at its lowest point

Price an

d C

ost

($)Output

Output

Q (Units)

Class Task complete the diagram to

show a firm maximising

profits in the production of

television sets

Class Task complete the diagram to

show a firm maximising

profits in the production of

television sets

Price an

d

Co

st

Q (Units)

Class Task Compare firms

making a profit, making

a loss and breaking even (normal profit): HINT shift the

AC

Class Task Compare firms

making a profit, making

a loss and breaking even (normal profit): HINT shift the

AC

Price an

d

Co

st

Alternatives to Profit Max

• Revenue Maximisation (MR=0)

• Sales (Volume) Maximisation (AR=AC)

• Employment

• Environment

• Satisficing

Ideas Board 1