Topic: Production in the short run and long run

We have learnt that there are 4 types of factors of production which

would be used for producing goods or services. In fact, factors of
production can be classified into the following two types according to
their nature:

1 Variable factors

• Input that varies in quantity as output changes.

• If the output level is zero, the quantities of variable factors will
also be zero.

For example, in a restaurant, electricity, town gas and foodstuffs are the
examples of variable factors, as their quantities will increase when more
dishes are produced.

2 Fixed factors

• Input that remains unchanged in quantity when output changes.

• If the output level is zero, the quantities of fixed factors should
be positive.

For example, the rented property is a fixed factor, as the quantity of

rented property would probably remain unchanged when more dishes are
produced.

Example 1:
What inputs would be needed in operating a restaurant?

__________________________________

__________________________________

__________________________________

__________________________________

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Fixed factors: Input that remains unchanged when output changes

Variable factors: Input that will change when output changes

Try to classify the above inputs (The “STEW” restaurant) into the
following two categories:

Fixed Factors Variable Factors

3 Short run and long run

Production period can be classified into the short run and long run

3.1 The short run

• A production period with fixed factors and variable factors

For example, in the short run, a restaurant can produce more dishes by
using more variable factors such as water and foodstuffs, but cannot use
more fixed factor such as rented property.

3.2 The long run

• A production period with variable factors only

For example, in the long run, the restaurant can produce more dishes by
increasing the use of all factors of production, including the rented
property.

Remarks:

The above example 1 assumed that the restaurant operates in the short
run as there are fixed factors and variable factors. However, if the

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restaurant is now operating in the long run, then all the inputs would
become variable factors

Example 2:

IKEA Store at MegaBox

Founded in Sweden, 1943, IKEA currently has 313 stores all over the world. The
newest store at MegaBox in Kowloon Bay was officially opened yesterday, being
the largest store in its Hong Kong branch. In order to expand its business, IKEA has
started to employ extra employees for 200 job places such as marketing assistant
and management probationer.

IKEA's business is booming in Hong Kong. But Ms Caroline Mak, Regional

Director, North Asia and CEO, Dairy Farm China (the parent company of IKEA),
said that they do not intent to have new branch in these one to two years.

1. In the coming one to two years, are the following items fixed or
variable factors to IKEA? Explain.

a) Employee

_______________________________________________________

_______________________________________________________

_______________________________________________________

b) Branch

_______________________________________________________

_______________________________________________________

_______________________________________________________

2. In the coming one to two years, is IKEA in short run or long run
production? Explain.

_______________________________________________________

_______________________________________________________

_______________________________________________________

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4 The input-output relationship in the short run

a) Total product (TP)

It refers to the total output produced by a firm in a time period

b) Average product (AP)

It refers to the output per unit of variable factor on average in a

time period
Total product
Average product =
Units of variable factor

For example, if a firm employs 10 units of labour and produces 1000 units
of output, the average product of labour would be 100 units of output.

c) Marginal product (MP)

The marginal product is the increase in the quantity of products

resulted from an additional unit of variable factor in a time period

Example 3:

Suppose the factory is in the short run, machinery is the fixed factor
and labour is the variable factor. The following table shows the factory’s
production data:

Machinery Labour Total output Average Marginal

(Units) (Units) (Units) product of product of
labour labour

2 0 0 0 -----
2 1 130
2 2 280
2 3 438
2 4 588
2 5 720

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5 The law of diminishing marginal returns

This law states that when more units of a variable factor are added
successively to a given quantity of fixed factors, the marginal products
of this factor will eventually diminish, holding technology constant.

The following figure shows the law of diminishing marginal returns:

Marginal Product

Variable factors

Example 4:

Number of Land Total Marginal

Farmers (units) product product
1 100 500

2 100 900

3 100 1200

4 100 1400

5 100 1500

6 100 1550

7 100 1560

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Remarks:

• As the number of farmers increases, the marginal product will

eventually decrease. This is confirmed with the law of diminishing
marginal returns

• When there are only a few farmers, they can adopt the division of
labour and work efficiently so MP will increase first

• However, when the number of farmers keeps increasing, an

additional farmer has to work in a more crowded area. Therefore,
each additional farmer will contribute less to the production

6 The cost-output relationship

Production cost refers to the expenses of using factors of production.

a. Total cost (TC)

In short run, since we have fixed factors and variable factors,

therefore, the total cost is:

Total cost = Total fixed cost + Total Variable cost

However, all factors of production are variable in the long run.

Therefore, the total cost is:

Total cost = Total Variable cost

b. Average Cost (AC)

It is the cost per unit of output in a time period.

Total Cost
Average cost =
Total Product

For example, the total cost for producing 5 apples is $200. The
average cost will be $40.

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 c. Marginal Cost (MC)

It is the change in total cost as a result of producing one extra

unit of output in a time period.

Example 5:

The following table shows the production data of a factory:

Total product Total Cost Average cost Marginal cost

1 $10

2 $16

3 $18

4 $36

5 $60

The following figure shows the average cost curve (Long Run):

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7 Economies and diseconomies of scale in the long run

• In the long run, individual firm or the whole industry can expand
the production scale

• Scale of production in Long run can be enlarged when more variable

factors are employed

When the firm enlarges the scale of production (increase the production
level), it can enjoy some advantages, leading to lower average cost of
production. Economies of scale exists for the firm.

However, if the firm excessively enlarges its scale of production (produce

too much), the firm may need to face a number of problems, leading to
the increase in average production cost. Diseconomies of scale exists for
the firm.

8 Types of economies of scale

• Internal economies of scale: Average cost decreases as a firm

expands its production scale

• External economies of scale: Average cost decreases as the

whole industry expands its production scale

9 The causes of internal economies of scale

I. Technology:

When a firm is producing on a large scale, the firm is able to

better utilize its machines. Thus, its average cost drops.

Example: Suppose the daily operating cost of a publisher is

$100,000,

The average cost of producing 50,000 units of textbook =

The average cost of producing 100,000 units of textbook =

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 II. Management:

• Higher production levels allow a firm to practice a higher

degree of division of labour, it makes workers work more
efficiently in their assigned tasks.

• It can enjoy the benefits of division of labour and a lower

average cost of production.

III. Finance:

• A large firm is able to provide adequate collateral.

• It can apply loan at a lower interest rate from bank so that

its average cost will be lower.

IV. Purchasing and sales

• A large firm can afford to launch advertising campaigns to

attract customers. The firm can spread the promotion cost
over a larger output. Thus, its average cost will be lower

• A large firm can enjoy more discounts when purchasing raw

materials in large quantities. Thus, its average cost will be
lower.

V. Research and development

A large firm can afford expenditures on research and development.

Therefore, it can enhance the production efficiency and enable the
firm to produce with a more cost-saving method.

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10 The causes of external economies of scale

1) Recruitment

• Expansion of whole industry can attract more experienced

and skilled workers

• The cost of training workers is thus lower

2) Flow of information

• Firms choose to provide goods and

services in the same location

• Cost of obtaining information of the

competitors and firm’s promotion
costs can be saved

3) Supporting Service

• The whole industry’s demand for supporting services (e.g

Transportation) will increase so more suppliers will enter the
market

• Competition of those supporting services will lower firm’s

average cost

11 Types of diseconomies of scale

• Internal diseconomies of scale: Average cost increases as a firm

over-expands its production scale

• External diseconomies of scale: Average cost increases as the

whole industry over-expands its production scale

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12 The causes of internal diseconomies of scale

1. Management

• When a firm has an excessive scale of production, its

management structure becomes too complicated.

• The problems of communication and coordination arise

• The production efficiency decreases and average cost will

increase

2. Purchasing and sales

• Product market may become saturated. More promotion may

not increase sales but only increase average cost

• Increasing demand for limited raw materials may cause the

price of those resources to increase. Therefore, average
cost increases

3. Finance

• Banks will charge a higher interest rate to lower the risk if a

firm over-expands its scale

• Average cost will then increase

13 The causes of external diseconomies of scale

(i) Sales and logistics

• A cluster of firms in one location may lead to unhealthy

competition
→ Firms may need to increase promotion activities so
average cost increases

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 • Traffic congestion may also result if too many firms
engaging in the same industry cluster in a place
→ Average cost of transportation will then increase

(ii) Factors of production

• The demand for factors of

production will increase
when whole industry
expands

• Prices of factors of
production and average
cost will increase

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