Production & Costs
Production & Costs in the Short Run and Long Run
Understanding production and costs is essential for analysing firm behaviour, pricing decisions, and market structures. The distinction between the short run and long run is central.
Time Periods in Economics
- Short run: at least one factor of production is fixed (typically capital — buildings, machinery). Firms can only vary labour and raw materials.
- Long run: all factors are variable. Firms can change the scale of production (build new factories, invest in technology).
- Very long run: the state of technology changes.
Short-Run Production
Total, Average, and Marginal Product
| Concept | Definition |
|---|---|
| Total Product (TP) | Total output produced by all units of the variable factor |
| Average Product (AP) | TP ÷ number of workers (output per worker) |
| Marginal Product (MP) | Additional output from employing one more worker |
The Law of Diminishing Marginal Returns
In the short run, as successive units of a variable factor (labour) are added to a fixed factor (capital), the marginal product of the variable factor will eventually decline.
Example: In a restaurant kitchen with 3 ovens (fixed capital):
- 1st cook: MP = 20 meals
- 2nd cook: MP = 25 meals (increasing returns — specialisation benefits)
- 3rd cook: MP = 22 meals (diminishing returns begin)
- 4th cook: MP = 15 meals (workers getting in each other's way)
- 5th cook: MP = 5 meals (severe overcrowding)
Key relationships:
- When MP > AP, AP is rising
- When MP < AP, AP is falling
- When MP = AP, AP is at its maximum
- MP curve crosses AP curve at AP's peak
Short-Run Costs
Fixed Costs (FC)
Costs that do not vary with output in the short run:
- Rent, insurance, loan repayments, salaries of permanent staff
- Total Fixed Cost (TFC) is a horizontal line
- Average Fixed Cost (AFC) = TFC ÷ Q — falls continuously as output rises (spreading the overhead)
Variable Costs (VC)
Costs that vary directly with output:
- Raw materials, energy, hourly wages
- Total Variable Cost (TVC) rises with output
- Average Variable Cost (AVC) = TVC ÷ Q
Total Cost (TC)
TC = TFC + TVC
Average Total Cost (ATC)
ATC = TC ÷ Q = AFC + AVC
The ATC curve is U-shaped in the short run:
- Initially falls (spreading fixed costs + increasing returns)
- Reaches a minimum (productive efficiency)
- Then rises (diminishing returns cause variable costs to rise faster)
Marginal Cost (MC)
MC = change in TC from producing one more unit.
Key relationships:
- MC curve is also U-shaped (reflects diminishing returns)
- MC intersects AVC at AVC's minimum
- MC intersects ATC at ATC's minimum
- When MC < ATC, ATC is falling
- When MC > ATC, ATC is rising
Long-Run Costs
In the long run, firms choose the optimal scale of production. The Long-Run Average Cost (LRAC) curve is an envelope of all possible short-run ATC curves.
Economies of Scale
Economies of scale occur when increasing the scale of production leads to a fall in long-run average cost.
Internal Economies of Scale (within the firm):
| Type | Explanation |
|---|---|
| Technical | Large firms use specialised machinery; indivisibilities (a blast furnace needs minimum scale) |
| Managerial | Employ specialist managers (HR, finance, marketing) |
| Financial | Borrow at lower interest rates; access capital markets |
| Purchasing/Bulk-buying | Negotiate discounts on large orders |
| Marketing | Spread advertising costs over larger output |
| Risk-bearing | Diversify products and markets |
External Economies of Scale (benefit all firms in an industry/area):
- Skilled labour pool (e.g., tech workers in Silicon Valley)
- Specialist suppliers locate nearby
- Knowledge spillovers and shared R&D
- Improved infrastructure
Diseconomies of Scale
Diseconomies of scale occur when expansion leads to a rise in LRAC:
- Communication problems: messages distorted in large hierarchies
- Coordination difficulties: harder to manage complex operations
- Motivation and morale: workers feel like "a cog in a machine"
- Principal-agent problem: managers (agents) may not act in owners' (principals) interests
The LRAC Curve Shape
- Falling section: economies of scale dominate
- Flat section: constant returns to scale
- Rising section: diseconomies of scale dominate
The Minimum Efficient Scale (MES) is the lowest output at which LRAC is minimised. Industries with a high MES relative to market demand tend to be oligopolistic or monopolistic (e.g., car manufacturing, aircraft).
Returns to Scale
In the long run, when all factors are increased proportionally:
| Type | Output Change | LRAC |
|---|---|---|
| Increasing returns to scale | Output rises more than proportionally | Falls |
| Constant returns to scale | Output rises proportionally | Constant |
| Decreasing returns to scale | Output rises less than proportionally | Rises |
Note: Diminishing returns is a short-run concept (one factor fixed). Returns to scale is a long-run concept (all factors variable). Do not confuse them.
Revenue Concepts
| Concept | Formula | Meaning |
|---|---|---|
| Total Revenue (TR) | P × Q | Total income from sales |
| Average Revenue (AR) | TR ÷ Q = P | Revenue per unit = demand curve |
| Marginal Revenue (MR) | Change in TR from selling one more unit | Below AR for a downward-sloping demand curve |
Profit Maximisation
Firms maximise profit where MC = MR (provided MC is rising through MR).
- Normal profit: TR = TC (AR = ATC). The minimum return needed to keep the firm in the industry. It is an economic cost (the opportunity cost of the entrepreneur's capital and time).
- Supernormal (abnormal) profit: TR > TC (AR > ATC). Profit above normal profit.
- Subnormal profit (loss): TR < TC.
Shutdown Condition
- Short run: the firm shuts down if AR < AVC (cannot cover variable costs; losses exceed fixed costs)
- Long run: the firm exits if AR < ATC (cannot cover all costs, including normal profit)
Evaluation
- Cost curves assume smooth, continuous production — in reality, costs may change in steps (hiring a whole new shift)
- Economies of scale are not guaranteed — they depend on effective management
- The MES varies enormously by industry, affecting market structure
- Firms may not actually seek to minimise costs — satisficing behaviour (Simon), or X-inefficiency (Leibenstein) where lack of competition leads to waste
- Technological change (very long run) can dramatically shift cost curves (e.g., cloud computing reducing IT infrastructure costs)
- Firms increasingly outsource to exploit external economies while staying small
Exam Technique
- Draw cost curves accurately — MC must cross AVC and ATC at their minimum points
- Clearly distinguish short-run diminishing returns from long-run diseconomies of scale
- Use real-world examples of economies of scale (Amazon's distribution, Tesco's bulk buying)
- Link cost analysis to market structure (MES determines whether markets tend towards competition or monopoly)