A LEVEL UNIT 7

TOPIC 5 - Types of cost, revenue and profit,

short-run and long-run production
By the end of these topics, you should be able to…
7.5.1 Short-run production function:
• fixed and variable factors of production
• definition and calculation of total product, average product and marginal
product
• law of diminishing returns (law of variable proportions)

7.5.2 Short-run cost function:

• definition and calculation of fixed costs (FC) and variable costs (VC)
• definition and calculation of total, average and marginal costs (TC, AC,
MC), including average total cost (ATC), total and average fixed costs
(TFC, AFC) and total and average variable costs (TVC, AVC)
• explanation of shape of short-run average cost and marginal cost curves

7.5.3 Long-run production function:

• no fixed factors of production
• returns to scale
7.5.4 Long-run cost function:
• explanation of shape of long-run average cost curve
• concept of minimum efficient scale

7.5.5 Relationship between economies of scale and decreasing average

costs
7.5.6 Internal and external economies of scale
7.5.7 Internal and external diseconomies of scale
7.5.8 Definition and calculation of revenue: total, average and
marginal revenue (TR, AR, MR)
7.5.9 Definition of normal, subnormal and supernormal profit
7.5.10 Calculation of supernormal and subnormal profit
Law of Diminishing Marginal
Returns Simulation
7.5.1 Short-run cost function
Production: the physical transformation of inputs into output.

Short run production: a period of time when there is at least one

fixed factor input. (usually factory / machinery)

Fixed input: input whose quantity cannot be altered in short run.

Variable input: input whose quantity can be changed in short run as

well as the long run (usually labour)

Long run production: a time period in which all of the factors of

production can change.
Length of time between the short and the long run will vary from industry to
industry.

BISHOPS BURGERS

Long run = +/- 1 week Long run = +/- 5 years

Assumptions when analysing production in the short run

• The firm produces only one product.

• Units of input are identical/homogeneous.
• Inputs can be used in infinitely divisible amounts.
• Prices of the product and of inputs are given.
• Firm uses fixed inputs and one variable input.
 Total, Marginal, and Average Product
Maize Farm Example
Fixed quantity of land = 20 units (acres/hectares…)
Variable input = labour
 Production schedule for maize farmer
Total Product
Units of land Units of Labour
(tons of maize)
20 0 0
20 1 5
20 2 16
20 3 30
20 4 56
20 5 85
20 6 114
20 7 140
20 8 160
20 9 171
20 10 180
To investigate law of diminishing returns further we also need to
look at…

Marginal product: the number of additional units of output

produced by adding one additional unit of the variable
input.

Average product: the average number of total output

produced by each unit of variable input.
 Total
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7.5.2 Short-run cost function
Costs: expenses faced by a business when producing a good or
service for a market.

Short run - fixed and variable costs.

Fixed Costs

Fixed costs: cost that remains constant irrespective of the

quantity of output produced.

Examples :
• Rent, Insurance charges, Salaries, Interest on borrowed money,
Marketing & advertising costs.
Variable Costs

Variable costs: costs that vary directly with output.

As production rises - higher total variable costs as extra resources

purchased.

Examples of variable costs for a business include:

• The costs of raw materials
• Labour costs
• Consumables and components used directly in the production process.
Total, average and marginal costs

There are five types of short-run costs:

Total product
Average and marginal cost curves
Shape of short-run average cost and marginal cost curves

• Short-run ATC shape results from interaction between AFC + AVC =

ATC.
• As output rises, AFC falls (TFC spread over increased output).
• At the same time, AVC rises (diminishing returns to variable factor).
• Eventually, AVC rising > AFC falling causing ATC to rise.
• Results in ‘U’ shape to the ATC curve because of the law of
diminishing returns
Output
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7.5.3 Long-run production function
Short run: a period of time in economics when at least one of the factors of
production is fixed.

Long run: a period of time when all factors of production are variable.

I.e. enough time to build a new factory, install new machines, use new techniques
of production etc…

In the long run…

• Law of diminishing returns does not apply - all the costs are variable.

• Marginal product has no meaning - can only be calculated if all the other inputs
are held constant.
Returns to scale
Returns to scale: long-run relationship between inputs and output.
• Measured by varying all inputs by a certain % and comparing resulting percentage in
production.

Three possible situations can result…

Constant returns to scale

Given % increase in inputs = same % increase in output

Increasing returns to scale

Given % increase in inputs = larger % increase in output

Decreasing returns to scale

Given % increase in inputs = smaller % increase in output
 Decreasing Returns to Scale
vs
Diminishing Marginal Returns

Decreasing returns to scale (long run concept) – ALL inputs increase by

the same proportion.

Diminishing marginal returns (short-run concept) - only the variable

input increases.
7.5.4 Long-Run Cost Function
7.5.5 Relationship between economies of scale and
decreasing average costs

Economies of scale: occur when costs per unit (average costs) of output
fall as the scale of production increases.
7.5.6 Internal and external economies of scale

Internal: reduction in LRAC as a result of the firm itself increasing the

scale of production.
Specific to a firm – can be controlled.

External: reductions in LRAC from a firm as a result of the whole

industry growing in size.
Outside the firm’s control – affects entire industry/economy.
Internal economies of scale

Technical economies
Economies of increased dimensions
Technical economies (cont.)
Internal economies of scale

Managerial, organisational or administrative economies: specialisation

and division of labour

Marketing economies: bulk discounts & cost per thousand (CPT)

decreases

Financial economies: easier/cheaper to raise finance with more collateral.

By spreading overheads, average fixed charges decline.

Risk bearing economies: firms can move into other product/service areas
and markets as they grow, thus diversifying risk.
Economies of scope: reduction in average costs resulting from
producing two or more similar products. Benefits from purchasing EOS
as a result of similar component parts.
External economies of scale

Industry economies: Specialised markets – benefits raw materials,

selling finished product; specialised labour skills

General economies: general infrastructural development & better

workers and may lower the effective cost of labour.
7.5.7 Internal and external diseconomies of scale

Diseconomies of scale: occur when unit costs rise as output increases.

Internal diseconomies of scale

Managerial diseconomies: longer lines of communication, management

less directly involved.

Worker alienation: specialised, boring and repetitive jobs – motivation &

productivity affected.

Deteriorating industrial relations: increased work stoppages and strikes.

External diseconomies of scale
Shortage: raw materials, skilled labour – unit costs rise

Congestion: land prices, traffic, pollution.

Kahoot: Long Run Cost Structure
7.5.8 Definition and calculation of revenue: total, average
and marginal revenue (TR, AR, MR)
Revenue is the payment firms receive when they sell the goods and services that
they have produced.

3 revenue concepts:
Total revenue (TR) = P × Q
Revenue received by the sale of a product

Average revenue (AR) = TR/Q

Revenue/unit

Marginal revenue (MR) = ΔTR/ΔQ

Addition to total revenue when with sale of ONE additional unit
Revenue curves - constant price (price-taker)
Revenue curves - falling price (price-maker)
Example: MR < AR due to prices falling for
extra quantity to be sold.
Relationship between PED, AR, MR and TR for downward
sloping demand curve.
• As a price maker, if the firm chooses
to increase output, price will fall; if it
decides to reduce output, price is
expected to increase.
• As output changes so does price and
revenue. Extent of Δ revenue depends
on PED.
• Demand curve = AR curve.
• MR always below AR since firm only
sells more goods by reducing price.
7.5.9/10 Definition & calculation of normal,
subnormal and supernormal profit
Profit: revenue – cost of producing it

Total (accounting) profit: total revenue – total explicit costs

Economic profit: total revenue - total explicit and implicit

costs

Normal profit: equal to the best return that the firm’s

resources could earn elsewhere
Economic and Accounting Costs
Economic cost: total cost of choosing one action over another.
(Explicit + Implicit costs)

Accounting costs: the actual expenses incurred in the production

process (explicit costs ONLY).

Explicit costs: the monetary payments for the factors of

production and other inputs bought or hired by the firm.
Eg. – rent, raw materials, wages, electricity.

Implicit costs: those opportunity costs which are not reflected in

monetary payments.
Eg. – salary that could have been earned.
A quick story to explain accounting and economic costs…
Bob is a teacher who earns R100 000 a year (this includes his
salary, medical aid and pension benefits). He also has R50 000 in
a savings account. Bob decides to retire from teaching and start
his own business making bean bags. He uses R50 000 from his
savings account to purchase the machinery and equipment
required to start his business.

 What are the accounting (explicit) costs involved in this

decision?
 What are the economic (explicit + implicit) costs involved in
this decision?
Summary of two types of profit…

Normal profit refers to the minimum payment required to keep an

entrepreneur in a particular line of business. It is regarded as a cost of
production because, if this is not earned, the entrepreneur will leave the
industry.

Supernormal profit is any profit in excess of normal profit.

By the end of these topics, you should be able to…
7.5.1 Short-run production function:
• fixed and variable factors of production
• definition and calculation of total product, average product and marginal
product
• law of diminishing returns (law of variable proportions)

7.5.2 Short-run cost function:

• definition and calculation of fixed costs (FC) and variable costs (VC)
• definition and calculation of total, average and marginal costs (TC, AC,
MC), including average total cost (ATC), total and average fixed costs
(TFC, AFC) and total and average variable costs (TVC, AVC)
• explanation of shape of short-run average cost and marginal cost curves

7.5.3 Long-run production function:

• no fixed factors of production
• returns to scale
7.5.4 Long-run cost function:
• explanation of shape of long-run average cost curve
• concept of minimum efficient scale
7.5.5 Relationship between economies of scale and decreasing average
costs
7.5.6 Internal and external economies of scale
7.5.7 Internal and external diseconomies of scale
7.5.8 Definition and calculation of revenue: total, average and
marginal revenue (TR, AR, MR)
7.5.9 Definition of normal, subnormal and supernormal profit
7.5.10 Calculation of supernormal and subnormal profit