Land S3/econ/chapter4/p1

Capital fixed factors

Inputs/factors Labour True Light Girls
variable College
factors
Entrepreneurship S4 Economics
Chapter 4
Production and Supply
5.1 Basic concepts
A. Fixed factors (factors = inputs)
A factor of production that remains _unchanged/constant_ in _quantity as
___output___ changes. [in a given period of time] (fixed factor 使用量不變當生产
量 (output)改变)

Variable factors
A factor of production that __varies__ in __quantity__ as output changes.
(variable factor 使用量變 當生产量改变)

Example

In a hair salon, factor/ inputs include:_ scissor, labour, shampoo,

water, premises, business registration licence.
The variable factors are:_ scissor, labour, shampoo, water_
premises, business
The fixed factors are ___

registration licence.

B. Short run
It refers to a production _period__ in which there are __variable__________ and
___fixed__ factors. [In short run, if a firm wants to increase its output, it can do so
only by using more __variable________ factors.]

Long run
It refers to a production _period__ in which there are only __variable_ factors
[In long run, a firm can increase __ALL__its factors in order to increase its output.]

Notes:
a. In both the _____SR____ and ___LR_______run, the production
____technology________ is assumed to be fixed or unchanged. (assumption)
b. In short run, even if the firm does not produce anything (i.e. output
=__0___), she still has to keep using __fixed_____ factors (as she may not be
able to stop_using them)
c. In long run, if output level =0, the firm will use __no____factors or inputs. It
is possible to reduce the use of ANY factor to zero.
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5.2 Production in the short run

Suppose a firm uses labour and capital only to produce goods. The following
table shows its input-output relationship.

Capital (units) Labour (units) Total Marginal Average

Machines = =variable product/output product of product of
fixed factor factor (units) labour (units) labour (units)
2 0 0 - -
2 1st 10 10 - 0 =10 10/1=10
2 2nd 18 18 - 10 = 8 18/2=9
2 3rd 24 24- 18 = 6 24/3=8
2 4th 28 28-24 =4 28/4=7
2 5th 30 30-28 = 2 30/5=6
2 6th 30 30 -30 =0 30/6=5
2 7th 28 28-30 = -2 28/7 =4
Table 5.1.
[The above table shows that the firm is in ____short_______ run because there is
__fi
TP = sum of MP xed
Example ___
TP of 3 workers = the sum of MP of the first 3 workers = the MP of the 1 st + the ___
MP of the 2nd + the MP of the 3rd = 10+8+6 =24 or ___
Or fact
= TP of 2 workers + the MP of the 3rd worker or
= 18+6 =24 = total product of 3 workers i.e.
___
capi
tal_
___
.]

A.
The relationship between total, marginal and average products

I. Total product (TP) = total output

The total product is the total ___output______ from production within a certain
period of time.

Refer to table 5.1. The firm’s total output is ____24_____ units if it employs
____2____ units of capital and 3 units of labour.

II. Average product (AP)

It refers to the product or output produced by ____each______ unit of a certain
(variable) (labour) factor of production.
 S3/econ/chapter4/p3

AP = Total product/ total variable factors (labor) used

In table 5.1, the total product of employing 5 labour is _30__________ units of

output and the AP produced by the 5 labour is __30/5=6__ units of output (per
labour)
III. Marginal product (MP) [of an additional variable factor employed]
MP refers to the ___CHANGE_(rise or fall)_______ in total output brought by a
change in one unit of a certain (variable) factor. (laour) / MP = the extra/additional
output of employing ONE more variable factor (labor).
In table 5.1, the total product of employing 4 labour
The marginal is (MP)
product ___28________ units =ofthe
of the 3rd worker
output and the TP of employing 5 labour
total is _______30____
product units
of 3 workers of total
– the output. The MP
product of 2
of employing the 5th labour is ____30-28=2___
workers. units of output.
As the total product of 2 workers is NOT given, the
MP of the 3rd worker cannot be calculated.
Exercises
Study the following table about a firm’s input-output relationship.
Units of labour (variable factor) 3 4 5 6 7
Units of machine (fixed factor) 2 2 2 2 2
Total product =______(units) 12 39 50 54 56
Average product (units) [TP/VF] 4 39/4= 10 9 8
9.75
Marginal product (units) / 39-12 11 4 2
=27

a. Is the firm in short run or long run? Why? SR because there is fixed factor
(machine)
b. Fill in the blanks. [We can’t find the MP of the 3rd labour because the TP of 2
labour is NOT given]
MP may go down all the way
B. The law of diminishing marginal returns (products)
Study the following table about the input-output relationship in a factory.
No. of machines Units. of labour Total product Marginal product
1 1 10 10
1 2 25 15
1 3 45 20
The total 1 4 60 15
output of 1 5 70 10
2 workers 1 6 75 5 The
output of
When more and more variable factors are added to a given quantity of _fixed_ the 2nd
factors, the marginal product (or marginal output) will (eventually) fall, holding worker
production technology _constant__. only

Notes 1. the law applies in the __short__ run only

2. the law is an __ empirical __law i.e. obtained from _observation_
logical/deductive law_.
 SR: variable factor (e.g. electricity) Fixed factor (e.g. factory)
Cost of using variable factor = variable cost (e.g. electricity fee) i.e.
S3/econ/chapter4/p4
when output changes, variable cost changes.
5.3 Costs in the short run Cost of using fixed factor = fixed cost (e.g. rent) when output changes,
fixed
A. Basic concepts of production cost does NOT change.
costs
In short run, when a factory decides to increase or decrease her output level, she can
do so only by employing more or fewer _variable_ factors (e.g. labour) but not
_fixed__ factors (e.g. premises). So, in short run, there are some production
_COST__ that will change____ with the output level while some production costs
will not i.e. fixed.
We can classify the short run production costs into two types: variable__ and
fixed__ costs.
I. Fixed costs, variable costs and total cost
Variable costs [Labour=variable factor/input; wage payment = variable cost]
Variable costs are the costs of using __variable_____ factors. They will increase or
Short run decrease as __output__ increases or decreases. Variable costs would be __0____ if
--- both a firm does not produce anything.
fixed & Fixed costs
variable Fixed costs are the costs of using __fixed_ factors. They remain ___unchanged___
factors as output increases or decreases. Fixed costs would be _positive_ even if output
exists ---- level is zero.
both fixed Take a clinic as an example. Suppose the clinic rents its premises. When its output
& variable level (i.e. the number of patients) changes, its rent will _NOT_ be affected. That’s
costs exist because its premises are a _fixed___ factor in short run. Therefore, rent is a fixed
Long cost. However, a change in output level will affect the quantity of medicine used.
run –only Hence, the cost of medicine is a __ variable _ cost.
variable
factors---o Total cost
nly Total cost = the total _fixed_ cost (TFC) + the total _variable_ cost (TVC).
variable [In long run, TC = __TVC_______]
costs Increasing output
exists Revision exercise
Mr Li has accepted an extra order for producing additional toys. The following table
shows some of his costs of production.
Type of cost Amount before Amount after
1. rental cost of factory $80,000 $80,000
2. cost of raw material $15,000 $20,000
3. cost of electricity $3000 $5000
4. workers' overtime pay $10,000 $30,000

1. Classify the factor costs into fixed cost or variable cost

Fixed cost Variable cost
______1_______________ _________2,3,4_____________
_____________________ ______________________
_____________________ ______________________
_____________________ ______________________
2. Calculate the followings:
Total fixed costs = $______80000 (even if output =0, TFC still exists)_
Total variable costs = $__2+3+4 = 55000
Total production costs = $135000
 S3/econ/chapter4/p5

II. Total cost, marginal cost and average cost

Total Total fixed Total Total costs Marginal Average
output costs ($) variable costs ($) cost ($) costs ($)
(unit) ($)
0 10 0 10 / /
1 10 10 20 10 20/1=20
2 10 18 28 28-20=8 28/2=14
3 10 _33-10=23___ 33 33-28=5 33/3=11
4 10 34 44 44-33=11 44/4=11
5 10 50 60 60-44=16 60/5=12
6 10 70 80 80-60=20 80/6=13.3
Table 5.3
[The firm is in __short___ run i.e. fixed cost __>__0 even if output level =_0____
i.e. even if the firm does not produce anything, she still has to use some
___fixed____ factors and so needs to pay ___fixed__ cost.]

1. Total cost (TC)

TC = Total ___fixed______ cost + Total __variable________ cost
When total output is zero, the firm will not use any variable factor but its
quantity of fixed factors employed will not change. So, the total cost = the total
fixed cost = $__10_____ when the total output is zero.
The total fixed cost does _NOT_change (i.e. = $_10______) when the output
level changes. [Fixed cost >0 even if output =0]

2. Marginal cost (MC) [The extra cost from producing ONE more unit]
It is the __change____ in the total cost (TC) when the total output changes by 1
unit. Refer to table 5.3. When the output level is 3 units, the TC = $_33______.
When the output level is 4 units, the TC = $_34+10=44_______. Therefore, the
MC of producing the 4th unit of output is $__44-33=11 i.e. TC of 4 units – TC of
3 units_ i.e. the total cost will increase by $__11____ if the 4th output is
produced. [Marginal cost is a _variable_ cost. TVC = sum of MC e.g. TVC of 3
units = MC of the 1st unit + MC of the 2nd unit + the MC of the 3rd unit =
10+8+5=$23 or the TVC of 2 units + the MC of the 3rd unit = 18+5=$23]

3. Average cost (AC)

AC = TC/Q, where Q refers to the total quantity of output_. If Q = 5 unit, TC =
$___60_____ and AC = $__60/5=$12________.

Notes:
$ SRAC
The relationship between MC & AC in the SR
MC
When output rise, MC & AC fall initially but rise eventually.
$2
[When MC falls, AC must fall.
Q (output)
When MC =AC, AC is at the minimum]
Q*
At Q*, MC=AC =$2. AC is
at the minimum.
 S3/econ/chapter4/p6

5.4 Production and costs in the long run Can only be changed in the LONG run

A. I. Production scale (生产规模) and long run average cost

A firm’s production scale is larger when the quantities of __ALL__ factors of

production _increases___(e.g. factories, machines, workers, raw materials)___.
In the short run, as there are _fixed_______ factors, the production scale
___cannot_____be changed. Yet, in the long run, all factors are ___variable_______
$ and so the scale of production can be changed.
LRAC II. The long run average cost (LRAC)
When the production scale keeps expanding initially, its LRAC will
___FALL_______ at first as the firm enjoys ____economies of scale. However,
Q when the firm continues to expand its production scale, she may suffer diseconomies
0 Q* of scale (maybe the firm is becoming too big). Its LRAC will ___rise___.
When a firm operates at a production scale in which its LRAC is the _lowest___, the
From 0 to Q*, Q firm is said to operate at the _optimal__ scale.
rises but AC [However, producing at the optimal scale does NOT necessarily mean earning the
falls—enjoy greatest profit (Total revenue – total cost). So, a firm may not choose to produce at
(internal) EOS; the optimal scale.]
B. Internal economies of scale (EOS) and internal diseconomies of scale (DOS)
From Q* onward, Internal economies of scale (EOS) i.e. why a firm enjoys lower AC when she
AC rises when Q increases her output in the long run?
rises ---suffer In long run, if a firm increases its __scale___of production (by employing ___more_
DOS. factors e.g. opening more branches), it will enjoy _economies________ of scale i.e.
its _average__ cost will decrease. The firm is said to enjoy _internal___EOS.
At Q*, LRAC is [opening more branches producing more output enjoy internal EOS
at the min. It is average cost falls]
called the Examples of internal EOS (= the advantages of being a larger company= the
optimal scale of advantages of a firm that becomes bigger by increasing its scale of production):
production. a. It is easier to obtain bank __loan_____ at a _lower_____ interest rate.
b. The advertisement_ cost ($100) can be shared by a _large__ quantity of
output. Hence, average advertisement or promotion_-- cost per output will _fall_.
c. The firm may enjoy discount_ on bulk_ purchase of inputs.
Pls refer d. It is easier to hire better experts__ or professionals to manage the company.
to re ex 4 Internal diseconomies of scale (DOS) Examples of internal EOS i.e. why a firm
for more faces a higher AC when she produces “too many” in the long run or the
updated disadvantages of being “too big”?
& In long run, when a firm keeps on increasing its production scale, its _average_ cost
complete will increase eventually.
content. Its average cost will eventually rise because the size of the firm becomes too
__big_______. The firm is said to suffer __internal__________ DOS.
Examples of internal DOS:
a. When a firm expands too much, the bank may charge a __higher__ interest rate on
its loans as it may have already __borrowed___ a lot from banks.
b. A larger firm incurs huge management__ costs, which are greater than the
possible_benefits_ from EOS. [AC rises]
c. Employees may have low __working__ incentive as the relationship between
employer & employees is not __close_, resulting in lower productivity _& higher
cost of supervising workers.
Internal EOS: open more branches
---more output---AC falls
S3/econ/chapter4/p7

C. External economies of scale (EOS) and external diseconomies of scale (DOS)

However, a firm may still be able to reduce its AC even it does __NOT_______
increase production scale. It can decrease its average cost because of some
_favourable__external_______ factors.
Usually, we will use the external EOS to explain why firms selling similar product
concentrate in one place:

Examples of external EOS: why firms selling similar product concentrating in one
place may enjoy lower AC?
- when firms selling similar product _concentrate_ in one place, the place will become
__famous_______ for selling the product and attract___ many customers. This
reduces firms’ promotion__________ or advertisement____________ costs.

- when firms selling similar product concentrate in one place, this will attract_____
many skilled labour_ to go there to seek work. This reduces firms’ labour_ cost.

- when firms selling similar product concentrate in one place, this may attract_ many
raw material suppliers to set up companies there. This reduces firms’ procurement (_
Internal 採購) cost (of inputs).
DOS: open
more
branches - when firms selling similar product concentrate in one place, information about the
---more product can be shared __quickly_. This reduces firms ____information____ cost.
output---A
C rises - when firms selling similar product concentrate in one place, they may order inputs___
together and therefore enjoy a bulk__ purchase discount__ from input sellers. This
reduces firms’ production__ cost.

External diseconomies of scale (DOS): why firms selling similar product

concentrating in one place may face higher AC?

- when more and more firms selling similar product concentrate in one place, this will
increase the demand_ for skilled labour in the area. The wage of skilled labour will
____rise_____. This increases firms’ labour_ cost.

- when more and more firms concentrate in one place, the competition among firms
will become very __keen/fierce _________. Firms may have to spend a _lot_____ on
advertisement to survive. This increases firms’ ___ advertisement __________ cost.

- when more and more firms selling similar product concentrate in one place, this may
cause serious traffic ___congestion_________. This may increase firms’
transportation_____________ cost.

External EOS: a fall in AC caused by factors unrelated to a rise in production scale

(e.g. the govt offers a subsidy 補貼 to the firm)
External DOS: a rise in AC caused by factors unrelated to a rise in production scale
(e.g. the govt imposes a sales tax on the firm/the price of inputs rises etc)
 S3/econ/chapter4/p8

Summary

Increase ALL factors of production =

Increase production scale (only possible
in long run)

Increase production scale increase output level

average cost falls initially but rise eventually

Internal economies of scale (EOS) = AC falls when production

scale increases

Internal diseconomies of scale (DOS) = AC rises when production

scale increases

External economies of scale (EOS) = AC falls when favorable

external factors appear [scale of production does NOT increases]

External diseconomies of scale (DOS) = AC falls when

unfavorable external factors appear

 S3/econ/chapter4/p9

Chapter 4: Production in long run (LR) and short run (SR)

Variable factors Variable costs

Costs in SR Fixed costs
Fixed factors
Output: SRTC
AP/TP/MP SRAC
In SR SRMC
LDMR

Production i.e. turn

inputs/factors into
output

In LR Costs in LR Variable costs

Variable factors LRTC (long run total cost = total
only variable cost)
LRAC (long run average cost)
Scale of Production
EOS affect
DOS LRAC