1. The Production Function II
1. Costs - short run
measures
relationship - production & costs
2. Costs - long run
scale expansion path
long run costs
3. Returns to scale & economies of scale

2. 1. Costs - short run Fixed & variable costs
fixed = unavoidable
variable = avoidable
Costs rise as output increases
e.g. As L, TPP   TC 
given PK and PL
inverse relationship MP & MC, AC & AP
Measures of cost - Table 1

3. Measures of cost Total costs: TC = TFC + TVC
Average costs: ATC = TC \ TPP
or TC \ Q
ATC = AFC + AVC
Marginal costs: MC =TC \ TPP
‘…the extra cost of producing one more unit.’
Shape - Figures 1 to 3

4. Total costs for firm X Output (Q) 1 2 3 4 5 6 7 TFC (£) 12 TVC (£) 101 2 3 4 5 6 7
TFC
(£) 12
TVC
(£) 10 16 21 28 40 60 91 TC
(£) 12 22 28 33 40 52 72
103 TC
TVC
TFC
fig

5. Average and marginal physical productb c
Output
APP
MPP
Quantity of the variable factor
fig

6. Average and marginal costsMC
Costs (£) x
fig
Output (Q)

7. 2. Costs - long run K & L are variable
Profit maximisation requires cost minimisation
Choice of technique: if
MPK \ PK > MPL \ PL
20 \ 2 > 32 \ 8
10 > 4

8. Cost minimisation i.e. last pound spent on K adds 10 units Therefore
spend 1 extra pound on K, TPP rises by 10
spend 2.50 less on L, TPP falls by 10
output is unchanged, but costs fall 1.50
Cost minimisation
MPK \ PK = MPL \ PL
tangency of isocost & isoquant

9. Scale expansion path & long run costs
Vary K & L  TPP rises (no. of factories)
See Figure - scale expansion path
Long run average costs
Returns to scale
Scale economies

10. Deriving an LRAC curve from an isoquant map
At an output of 100
LRAC = TC1 / 100
Units of capital (K)
100 O
TC1
fig
Units of labour (L)

11. Deriving an LRAC curve from an isoquant map
Expansion path
Units of capital (K)
700
600
500
400
300
200
100 O
TC1
TC2
TC3
TC4
TC5
TC6
TC7
fig
Units of labour (L)

12. A typical long-run average cost curve
LRAC
Costs O
Output
fig

13. Returns to scale (i) Increasing returns (ii) Constant returns LRAC
a % increase in inputs leads to a larger % increase in output
economies of scale
(ii) Constant returns
LRAC constant
a given % increase in inputs leads to the same % increase in output

14. Returns to scale (iii) Decreasing returns Economies of scale
LRAC
a % increase in inputs leads to a smaller % increase in output
diseconomies of scale
Economies of scale
plant level economies
multi-plant economies
Diseconomies of scale

15. Conclusion Cost minimisation - long run Profit = Revenue - Cost
Profit maximisation - level?
Market structure:
Perfect competition
Monopolistic competition
Oligopoly
Monopoly