microeconomics topic 3
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Microeconomics topic 3. Economics 2013-14. SUPPLY. NATURE OF PRODUCTION. SPECIALISATION. Modern production is based on the principle of specialisation. Specialisation is using a resource in the productive capacity for which it is best suited. Helps to use scarce resources efficiently. - PowerPoint PPT PresentationTRANSCRIPT
MICROECONOMICS
TOPIC 3Economics 2013-14
SUPPLY
NATURE OF PRODUCTION
SPECIALISATION Modern production is based on the
principle of specialisation.
Specialisation is using a resource in the productive capacity for which it is best suited.
Helps to use scarce resources efficiently.
BENEFITS OF SPECIALISATION Increases the amount produced
Reduces the cost per unit produced
Efficient use of scarce resources.
APPLYING SPECIALISATION Can be seen a number of different
levels:
National – countries specialising eg coffee Regional – different areas of one country eg
farming Industry eg whisky Firm eg whisky distilling, bottling Worker – called DIVISION OF LABOUR
DIVISION OF LABOUR ADVANTAGES FOR THE WORKER
Increased productivity leading to increased income
More skills acquired
Gain more job satisfaction
DISADVANTAGES FOR THE WORKER
Increased risk of unemployment – too specialised and can’t do anything else
Interdependence of workers
Monotony of tasks – gets boring!!!
PRODUCTION DECISIONS Producers want to maximise their profits.
One way to do this is to use the most efficient method of production in order to keep cost per unit low.
In the short run, the capacity of the firm is fixed and so the firm will only be able to produce a maximum number of products
In the long run, the capacity of the firm can be increased or decreased, which can change the level of production.
PRODUCTION IN THE SHORT RUN:LAW OF DIMINISHING RETURNS
Factors of production – land, labour, capital and enterprise.
Returns are what a producer gets back in output when they employ more of a variable factor of production.
Example – returns to labour means the output gained when more labour is employed.
In the short run when deciding what output will be the most efficient to produce the firm must take into consideration the LAW OF DIMINISHING RETURNS
This states that as a producer uses more of a factor of production the returns to begin with will increase but diminishing returns will eventually happen.
TYPES OF OUTPUT Total Output – the total amount
produced
Marginal Output – the extra output produced when an extra factor of production is employed
Average Output – the average amount produced. Normally TOTAL OUTPUT divided by NUMBER OF WORKERS
EXAMPLE LOOK AT PAGE 27 IN THE CORE NOTES
Workers Total output(meals per hour)
Marginal output*(meals per hour)
Average output**(meals per hour)
0 0 0 0
1 20 20 20
2 54 34 27
3 100 46 33.3
4 151 51 37.75
5 197 46 39.4
6 230 33 38.3
7 251 21 35.9
8 234 –17 29.25
Increasing Marginal Returns – occurs when marginal output is growing.
Diminishing Marginal Returns – occurs when marginal output is decreasing.
PRODUCTION IN THE LONG RUN in the long run all factors of production
are variable.
The firm can change its capacity which is also called changing the scale of its operations.
RETURNS TO SCALE Increasing Returns to Scale – output
grows faster than the size of the firm. Also called ECONOMIES OF SCALE
Constant Returns to Scale – output rises at the same rate as the size of the firm.
Decreasing Returns to Scale – output rises slower than the size of the firm – also called DISECONOMIES OF SCALE
Economies of Scale The advantages of large scale production
that result in lower unit (average) costs (cost per unit)
AC = TC / Q Economies of Scale – spreads total costs
over a greater range of output
ECONOMIES OF SCALE Often referred to as the ADVANTAGES OF
BEING A BIG COMPANY
Two types:
Internal – improvements in output (productivity) as the firm grows in size
External – improvements in output which a firm gains from growth of its industry.
INTERNAL ECONOMIES OF SCALE Technical Financial Purchasing Managerial
Marketing Research and
development (R&D)
Risk bearing Welfare
INTERNAL ECONOMIES OF SCALE1. Technical
Increased division of labour and specialisation
Increased dimensions Indivisibility Principle of multiples
2. Financial
Easier to attract investors due to low risk
Borrow money at lower rates of interest
3. Purchasing
Gain large discounts for buying in bulk
Dictate to suppliers price, quality and delivery date they want
4. Managerial
Can afford to employ specialist staff e.g. an accountant
5. Marketing
Costs can be spread over a larger volume of sales
Transport costs per unit are lowered as ships, lorries etc are full.
6. Research and Development
Can afford to research
Can gain a competitive advantage through innovation
Maintain market share through product development
7. Risk Bearing
Diversify products to reduce risk from demand fluctuations
Diversify markets
Have different sources of supplies to reduce risk of fluctuating prices and availability.
8. Welfare
Can afford to offer benefits to employees that will increase motivation and efficiency.
Pensions Medical services Fringe benefits Recreational facilities
Economies of ScaleCapital Land Labour Output TC AC
Scale A 5 3 4 100
Scale B 10 6 8 300
Assume each unit of capital = £5, Land = £8 and Labour = £2Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facilityWhat happens and why?
Economies of ScaleCapital Land Labour Output TC AC
Scale A 5 3 4 100 57 0.57
Scale B 10 6 8 300 114 0.38
Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production PER UNIT has fallenDon’t get confused between Total Cost and Average Cost, Overall ‘costs’ will rise but unit costs can fall.Why?
EXTERNAL ECONOMIES OF SCALE Normally happens when firms in an
industry are focused in a particular area.
They can gain the following advantages:
Lower training costs Ancillary services provided by specialist
suppliers Co-operation of firms
DISECONOMIES OF SCALE These are the disadvantages of being a
big company.
INTERNAL DISECONOMIES
Management problems – difficult to control
Waste is difficult to control or detect.
EXTERNAL DISECONOMIES
Shortages of skilled labour and high wages
Shortage of raw materials
Congestion and high transport costs
COSTS OF PRODUCTION
These are the money values of resources used in producing a good or service.
Wages to labour Rent for land Interest on capital
The owner of the firm provides enterprise. If revenue earned is equal to cost of production this is called NORMAL PROFIT, if revenue is greater than costs, it is called SUPERNORMAL PROFITS
TYPES OF COSTS Fixed Costs
Costs which do not change with output.
If nothing is made fixed costs still need to be paid
Examples include rent and insurance.
Variable Costs
These are costs which do change with output.
If output is zero then VC is zero
Examples include raw materials and wages
Total Costs
This is fixed costs plus variable costs
Average (Total) Cost
Total Costs divided by Output
Can also be called UNIT COST
Average Fixed Cost
Fixed cost divided by Output
Average Variable Cost
Variable cost divided by Output
Marginal Cost
The extra cost of producing one additional unit of output.
E.g. The MC of the 50th unit is the Total Cost of the 50th unit minus the Total Cost of the 49th Unit.
MC = TC n – TCn-1
SHORT RUN AND LONG RUN In the short run the firm will have fixed
capacity.
Some costs will be fixed and some variable
In the long run all costs are variable.
SHORT RUN COSTS LOOK AT TABLE ON PAGE 35 OF CORE
NOTES
DRAW THE GRAPHS
COST CURVES
Output
Cost
FC
TC
VC
Output
Cost
AFC
AVC
AC
Output
Cost ACMC
AVC
OBSERVATIONS When output increases in the short run:
Fixed costs do not change
Variable costs increase, not always at a constant rate
Total costs increase at the same rate as variable costs
Average fixed costs fall, This is because fixed cost do not change but is being spread over a larger volume
Average variable costs fall until a certain point but then increase. Falls due to improved efficiency and increasing returns. Rises due to inefficiency and diminishing returns.
Average costs fall while average variable costs and average fixed costs are falling. When the increase in AVC exceeds the falls in AFC then AC will rise.
Combining the Factors of Production
In the short run a firm cannot change its fixed factors of production (eg land) but it can change its variable factors (eg labour)
Law of Diminishing Returns As successive units of one factor
are added to fixed amounts of other factors the increments in total output at first rise and then decline.
Marginal costs fall and then rise as output increases
Marginal cost is less than AVC and AC when AVC and AC are falling
Marginal cost is greater than AVC and AC when AVC and AC are rising
MC will cut both the AVC and AC at their lowest point.
OPTIMUM OUTPUT This is the output where the firm would
be technically efficient.
At this point AC is at its lowest.
DIMINISHING RETURNS AND COSTS IN THE SHORT RUN
When a firm has increasing marginal returns it will have falling marginal costs
Diminishing marginal returns means rising marginal costs
Increasing average returns means falling average cost
Diminishing average returns means rising average cost
OUTPUT DECISION IN THE SHORT RUN
Firms want to maximise profits.
Any decision on how much to produce is based on the relationship between their sales revenue and their costs.
REVENUE Total Revenue – total amount earned
from selling output;
quantity sold X price per unit
Average Revenue – total revenue divided output. If only one product is sold then AR will be the same as price.
Marginal Revenue is the extra revenue from selling an extra unit of output.
MC = TR n – TRn-1
When a firm sells all its output at the same price, price and MR will be the same.
PROFIT MAXIMISING This can be determined in two ways.
1. Maximum profit is where the difference between total revenue and total cost is greatest.
2. Where MC = MR
SHUT DOWN POSITION IN THE SHORT RUN
As long as a firm’s TR covers VC then the firm will stay open.
Any money left over from paying VC can be used to pay towards TC and reduce the loss the firm will make.
Shut down would be where TR is less than VC or when price is less than AVC
In the long run the firm must make at least normal profit.
COSTS IN THE LONG RUN In the long run all costs and factors of
production are variable.
Average cost in the long run fall because of economies of scale and rise due to diseconomies of scale.
The AC curve in the long run is U-shaped and has a series of interlinking Short Run AC curves.
The point where LRAC is at its lowest is the optimum size of the firm.
REMEMBER!!! Short Run Average Costs fall due to increasing
average returns to the variable factor
They rise due to diminishing average returns to the variable factor
Short Run Marginal Costs fall due to increasing marginal returns to the variable factor
They rise due to diminishing marginal returns to the variable factor
In the long run Average Costs falls due to economies of scale and rises due to diseconomies of scale.
SUPPLYUNIT 1TOPIC 3
DEFINITION Supply is the quantity of a good or
service that firms are able and willing to supply at a certain price.
Individual supply is the supply of one firm
Market supply is the supply of all firms in the market.
EFFECT OF PRICE ON SUPPLY As the price of a product increases the
supply of that product will rise.
Represented by a MOVEMENT along the supply curve.
This is due to:-
Existing producers will to supply more to earn more profit
New firms entering the market to earn higher profits
SUPPLY CURVE
Qty
PriceS
S
Supply Curve for Product A
P
P1
Q Q1
CONDITIONS OF SUPPLY A condition of supply will cause the
supply curve to either:
shift to the left (a decrease in supply)
or
shift to the right (an increase in supply)
Prices of other commodities
Competitive Supply – where a supplier will switch resources from the production of one product to another as a result of an increase in price.
Example – price of beef increases so there would be a shift to the right of the beef supply curve.
Joint Supply – a rise in the price could lead to an increase in supply of another commodity
Example – increase in price of petrol leads to the increase in supply of other oil products e.g. bitumen.
Costs of Production
A fall in the cost of any resource will lead to an increase in supply
This would be a shift to the right of the supply curve
A rise in the cost of a resource would lead to an decrease in supply
This would be a shift to the left of the supply curve
Change in availability of resources
If more resources are available then supply curve would shift to the right.
Example – new oil field discovered in the North Sea
If less resources are available then supply curve would shift to the left.
Example – bad harvest resulting in less wheat
SHIFT IN SUPPLY
Qty
PriceSHIFT TO THE RIGHT OF SUPPLY
S
S
S1
S1
ELASTICITY OF SUPPLYUNIT 1TOPIC 3
DEFINTION Price elasticity of supply measures the
responsiveness of supply to a change in price.
How do suppliers react when there is a change in the price of their product?
Formula
% change in supply % change in price
Answers
Greater than 1 – supply is price elastic and very responsive to a change in price
Less than 1 – supply is price inelastic and not responsive to a change in price
Equals 0 – supply did not or could not change in response to price – PERFECTLY INELASTIC
FACTOR AFFECTING ELASTICITY OF SUPPLY The only factor that affects supply is TIME
In the short run a firm that is at full capacity cannot change its supply in response to a change in price.
Supply would be perfectly inelastic and the supply curve would be a vertical straight line.
PERFECTLY INELASTIC SUPPLY CURVE
Qty
Price S
If the firm has spare capacity and stocks then it will be able to increase supply
The more spare capacity or more stock the firm has then the more elastic supply will be.
A LITTLE SPARE CAPACITY SOME SPARE STOCKS
PLENTY SPARE CAPACITY, PLENTY STOCKS
Qty Qty
PricePrice
In the long run, supply will be elastic.
Firms will have time to increase their capacity and new firms can enter the market.