3.14 Operational Strategies: location Costs

Candidates should be able to: Syllabus Candidates should be able to: Define total cost, total fixed cost, total variable cost, average total cost, average fixed cost, average variable cost and marginal cost Draw and interpret cost curves Distinguish between short run and long run costs and derive short-run cost curves from the assumption of diminishing marginal productivity Explain the relationship between short-run and long-run average cost curves

Definitions – factors of production, economic cost versus imputed cost 3.14 Operational Strategies: location Definitions – factors of production, economic cost versus imputed cost Firms combine factors of production (_______________ ____________________________________________) in order to produce goods or services. Economists differ in their use of the word “cost” and “normal profit” from accountants, tax inspectors, businesses and others. The opportunity cost refers to the __________________ _____________________________________________ Jacob leaves his job as an accountant earning £30,000 to start his own business. What’s the opportunity cost?

Examples of imputed cost - Labour A market trader working on her own may say that she has made £50 profit on a day’s trading but this figure may not include the value of her own time. If she could earn £40 working in another job for the day then what is her opportunity cost and hence her economic profit?

Definitions – variable versus fixed costs Costs can be classified in two ways. Variable costs vary in direct proportion to output e.g. if Anna makes twice as many sandwiches she will need twice as much ________ Fixed costs don’t change in relation to output. They remain the same whether 500 or 501 sandwiches are sold e.g. ________________ Fixed costs are often capital goods. Variable costs are often raw materials

Short run versus long run In the short run at least one factor of production cannot be changed. For example the size of the factory is fixed although more workers could be employed. So in the short run, some costs are fixed whilst others are ____________________ In the long run, all factor inputs can vary, so all costs will be variable. For example, a new factory could be built. (Some textbooks refer to the very long run when technology can change as well.)

Total, average and marginal costs Total cost is found by adding total fixed cost and total variable cost Total cost = TC = Average cost = AC = Marginal cost is the cost of producing an _____ unit of output MC =

Worksheet 3: plot TC, TFC and TVC

Worksheet 3: plot ATC, AFC, AVC and MC You should find that the MC curve cuts the AC and AVC at their ________ points respectively. If it doesn’t that is because you’ve put the minimum in the wrong place!

Explanation why MC cuts ATC and AVC at minimum If MC < ATC then ATC is If MC > ATC then ATC is Therefore if MC = ATC this must be the ________ point

In the short run at least one factor is fixed. The short run and diminishing marginal productivity (diminishing returns) In the short run at least one factor is fixed. Assume a firm has a factory with machines and 10 staff. What will happen as more staff are employed? Initially output per worker should ____________ until it reaches a maximum. There is an optimum level of production which is productively efficient; eventually output per worker will start to __________ This is known as the law of diminishing marginal returns (or the law of diminishing productivity).

Short run cost schedules – what can you say about the diagram? TFC is a ________________ line showing that TFC is _____________ whatever the output. TC and TVC are _____________ because the vertical distance between them is _______ The inflections in the TC and TVC are caused by the change from increasing returns to diminishing returns.

Short run cost schedules – what can you say about the diagram? AFC ____ as output increases because FC represent an ever decreasing proportion of TC as output rises ATC and AVC ___ and then ___ as diminishing average returns set in, MC falls but then rises as diminishing marginal returns set in. The vertical distance between ATC and AVC is the value of _____

Key points with short run cost curves MC, ATC and AVC curves are U shaped because of the law of diminishing returns. The lowest points on the MC and AC curves show where diminishing marginal returns and diminishing average returns set in respectively. MC cuts the ATC and AVC curves at their _____ points ATC curve is ______ MC curve when ATC is falling ATC curve is _______ MC curve when ATC is rising ATC = MC when ATC is constant. Hence MC = ATC at its lowest point. Points (3 – 5) are also true for AVC and MC

Average costs and marginal costs Complete the tables, what do you notice about TC, AC and MC? Quantity TC (£) AC (£) MC (£) 1 20 2 28 3 35 4 41 Quantity TC (£) AC (£) MC (£) 1 20 2 26 3 33 4 42

In the long run all factor inputs are __________ A producer can vary the amount of land, labour and capital. How might this happen?

There is no standard length of time for the short or long run. In the chemical industry a plant may last 20 years before it needs replacing and so the short run might last 20 years. In an industry with little or no permanent physical capital, the short run may be measured in months or even weeks.

What does the LRAC curve show? The LRAC curve shows the minimum level of average costs attainable at a given level of output. It is a boundary between attainable and unattainable costs. If a firm is producing on the LRAC curve, then it is producing at long run minimum cost. If long run production is inefficient, costs will be within the boundary (shaded)

Points on, above and below the LRAC curve So, the curve shows the minimum average costs at any output. If a firm was producing at point __ this would be less efficient than producing at point __ (since the costs are ____________). Points above the LRAC are not _____________ Points below the LRAC are _________________ B A

Movement along the LRAC curve Sketch a LRAC diagram showing an increase in output which leads to a fall in costs. Assume the firm is originally producing at the minimum cost

Change in costs and LRAC curve LRAC curves are drawn given a set of costs. If the costs fell (e.g. a fall in the wage rate in the whole industry) then the LRAC curve would shift downwards.

Movements along the LRAC curve versus a shift An increase in output which leads to a fall in costs is shown by a ________________ the LRAC curve. External economies of scale will __________ the LRAC curve downwards. New technology, which is more efficient, will shift the LRAC _______________ If the government imposed a tax on the industry then the LRAC would shift ____

Short run average cost curve and LRAC curve In the short run at least one factor is _______ SRAC fall at first and then begin to _________ because of diminishing returns. In the long run all costs are ___________ LRAC change because of economies and diseconomies of scale. In the _________ run, a company will choose a scale of production that will maximise its __________ fixed, long, profits, rise, variable

Short run average cost curve and LRAC curve We can combine SRAC curves with the LRAC curve