Production Cost Theory

Think of each firm is a unit of the market supply curve. In a more competitive market (price comparison websites) each firm is a small chunk, and a very large chunk in a concentrated(e.g software) market.

It is important in the A2 section that we know how firms behave, and the dilemmas, costs and choices they make, as what they do as a whole defines supply. We will do so here:). There are lots of diagrams used in this section, production theory is used to explain each costs curve.

Short and Long Run Production

Here, the short and long run has a special definition. Remember factors of production we talked about earlier.

The Short Run: Time in which at least one factor cannot be varied.

Usually ‘land’ or ‘capital’, and the long run is where all factors can be changed to best suit the amount made.

Costs… Those factors that can be can be changed for output have costs, which are variable costs(important, and vary with output). Fixed costs are the costs of the factors which do not change with output.

Short Run Production

In production theory only the short run is where at least one factor is fixed. This means that where how much is made is subject to sudden change, there are only certain things that can be changed in amount employed soonafter.

Short run in Practice….You cannot instantly change youre storage warehouse if there is a sudden boom in output, but more quickly may you buy more machines and employ more labour(variable costs), hence youre ‘land’ and some ‘capital’ is fixed(a fixed cost). Until enough time has passed that you can upgrade youre warehouse by waiting until contracts are changed etc, then within that time is the short run.

The Law of Diminishing Returns

The reason why we must scale up all factors if we suddenly produce more. Marginal and average costs will increase as extra labour and other factors bring less and less return. The short run average total cost curve is below, with Q1 achieving productive efficiency.

Q1 in the short run optimum output. We have a constant fixed cost(as 1 FOP fixed). If we increase output from Q1, we get less productivity.

Diminishing returns, an example…Use an easy example and say we have an Ice cream van at a fate, which is fixed, just one. But we have queues outside, so we open the other window and increase 1 staff to 3 staff. Also we will need more freezers. There is only a certain level we can go before our staff start to get in each others way. Also, the staff may find getting to the ices are difficult because the van become so crammed of equipment. The staff are not able to work so quickly and productivity decreases. Output from the van(consumers satisfied) will increase, but at a decreasing rate for one extra worker or fridge used, hence diminishing marginal returns.

Short Run Increasing Returns.

Note the curve again, however, and we see that from output equals zero to Q1, average total cost decreases, with a fixed factor. This is because the fixed cost is spread among more output, bringing down average cost. As variable cost is introduced(which will be much less than the avfixed cost per unit), the Average Total Cost tends to decrease.

Increasing returns in practice…Use our example again and say van hire is £100 per day, and Variable cost per ice cream is 50p. Now, with only 10 per day sold, average total is £10.50p, V expensive. But say we sell 2000 per day, average total, adding this up is only 55p per unit, showing ATC decreases greatly with output increase. Also, up to a point factors such as labour will be more productive when more are used with a fixed factor. They may specialise and communicate well orders etc without getting in each others way. These two examples show increasing marginal returns happen up to that ideal output.

Relation Between SRATC and Marginal Cost

Important relation, used a lot when modelling profits/output etc in market structures(again, a typical average Joe firm example). Short run diminishing and increasing returns is shown here………The reasons for the latter cause both SRATC and MC to fall to Q1.

Provided marginal cost is lower than average, the sratc will keep falling. Its like me buying 10 sweets costing 50p on average, if my 11th costs only 10p, my average will fall.

The short run optimum output level is realised when marginal equals average cost.

Here, the spreading of the fixed costs among more output(reducing av) is exactly offset by a decreasing productivity of staff, which has started before this point. When MC>SRATC, SRATC rises, like me buying my 20th sweet for 90p when 19 cost 60p causes average to rise.

Long Run Production Theory.

In the long run, all factors of production can change, the firm will, when its having diminishing returns, change its scale of production(the previously fixed factor changes to suit), which will decrease its average cost again, as factors are combined more suitably.

Scaling Factors Reduces Average Costs Say a shop is packed with customers, stock control and cashiers are employed in greater number but get in each others way. The short run diminishing returns will be offset where a bigger shop is built(more tills, more storage etc), which can happen in the long run. Staff productivity increases back.

For long run production, we need to consider the long run average cost a firm faces.

LRATC is long run average total cost, which, like SRATC, curves to an OPTIMUM LEVEL before increasing again. SRATC sits on LRATC. We have here, different SRATCs for different combos of the fixed factor. When a firm increases its scale, its SRATC shifts. Minimum SRATC is now on a greater output level as scale of production increases, as the firm can make more with good productivity with enough machinery and space. Long run average cost decreasing when output increases is due to ECONOMIES OF SCALE. LRATC increasing with output is due to DISECONOMIES OF SCALE. I will explain how this works on the next page:).

Minimum Efficient Scale….You will sometimes see the term. Simply enough this is just the smallest scale of production needed for LRATC to be a minimum(shown where LRATC bottoms flat, no further EOS exploited). Large scale industry firms such as Anglo American will have a greater MES than, say, an ice cream distributor:).


Revenues….Aswell as the cost curves we have talked about, there are also revenue curves a firm faces. These will be seen in more detail with market structures as they can vary extremely depending on you’re level of competition. Such curves are also very important in explaining behaviors of consumers and firms in different markets, more of that later:). Anyways……

Marginal Cost: The cost to the firm of one more unit of output(this will be a variable cost)

Marginal Revenue: The change in revenue come from selling one more whatever it is. This can be negative, as to get one more buyer, the price may need reducing, eating into would be revenues which the sale doesnt make up.

Average Revenue: ‘Average’ price, simply enough, presuming no price discrimination(prices equal). Or the total revenue divided by output.

Typical showing of all 3, this is what you will see when this is explained. Note the similarity between AR and the demand curve, well this curve is the FIRM’S demand curve, and thinking this way will certainly help you(as AR is price, shows relation between that and output sold for the firm).  This example above will be a firm with control over their own price(monopoly power), in an ‘imperfect’ market.


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