Michael Loh

COST AND PRODUCTION

Cost and Production

Definitions needed for this Topic
1. A Firm: is a producer of goods and services.
2. A plant: Is a factory where production of goods and services takes
place.
3. An industry: is a group of firms that produces similar goods or services.
4. Profits: is one of the factor payments paid to entrepreneurs for the
effort pt. in and the risk taken by them in carrying out
entrepreneurship.
5. Total Revenue: is a firms total earnings from a sale of its output for a
specific period of time.
6. Total cost: is the addition of implicit and explicit costs.
7. Implicit cost: is the opportunity cost of using resources that are owned
and do not involve a direct payment of money; they are costs of selfowned and self-employed resources.
8. Explicit cost: is the opportunity cost of using resources that arise when
a firm makes actual payments for the resources purchased in the factor
market.
9. Marginal Revenue: is the extra total revenue that affirm earns by
selling one more unit of output.
10.
Marginal cost: is the extra cost that a firm incurs by producing
one more unit of output.
11.
Total revenue: is a firms total earnings from a sale of its output
for a specific period of time.
12.
Average revenue: is the amount of a firm earns per unit of output
sold.
13.
The Law of Diminishing Returns: states that when an increasing
amount of a variable factor is used in combination with a given amount
of a fixed factor, there will be a point when each extra unit of the
variable factor will produce less extra output than the previous unit.
14.
Total Fixed Cost: is the total costs of fixed factors of production
that do not vary with the level of output.
15.
Average Fixed Cost: is found by dividing the total fixed cost by
the level of output.
16.
Total variable cost: is the total costs of variable factors of
production that vary with the level of output.
17.
Average variable cost: is found by dividing total variable cost by
level of output.
18.
Total cost: is the total cost of factor of production at a given level
of output; sum of fixed and variable cost at that level of output.
19.
Short-run Average Cost: is the amount of costs incurred per unit
of output produced.
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20.
Marginal cost: is the extra cost a firm incurs by producing one
more unit of output.
21.
Returns to scale: is the behaviour of production or returns when
all the factors of production are increased or decreased simultaneously
in the same ratio.
22.
The law of Returns to Scale: states that the change in output
when all factors of production are changed is in the same proportion.
23.
Long-run average cost: is the least costly way to produce any
given level of output.
24.
Minimum efficient scale: is the lowest level lf output at which the
long-run average cost is at the minimum indicates possible size of
the firm and the type of market structure.
25.
Internal economies of scale: is the reduction in long-run average
costs of production as a result of expansion of the scale of production
of a particular output for an individual firms.
26.
Internal diseconomies of scale: is the rise in unit cost of
production as a result of expansion of the scale of production of a
particular output for an individual firm.
27.
External economies of scale: is the cost savings individual firms
enjoy as a result of expansion of the whole industry; they are
independent of the firms output.
28.
External diseconomies of scale: is the rise in unit cost of
production as a result of over-expansion of other firms in the industry.

Objective of Firms: Profit Maximisation

Approaches
1. Total approach
a. The firm aims to maximise the difference between total revenue
and total cost so as to profit maximise Total Revenue Total
Cost.
2. Marginalist Approach
a. Profit maximisation condition Marginal Revenue = Marginal
Cost.

Approaches
Firms aim to maximise revenue Produce at MR =0.
Objectives of firms: Satisficing Behaviour
Owners of firms not involved in running businesses business decisions
made by managers managers salaries related to turnover instead of

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profits mangers do not aim to profit maximise only aim to achieve

profits that satisfy stakeholders (owners, consumers).

Objectives of Firms: Expansion of Market Share

When a firm wants to expand its business to a new country market, it lowers
the price of goods or services in the short run, increases consumer base in
the long run and gains market share.

Production
Factors of production
1. Fixed
a. Factor of production that cannot be changed in the quantity
within a given period of time.
2. Variable
a. Factor of production that can be changed in the quantity within a
given period of time.
3. Short Run
a. A time period with at least on fixed factor of production.
4. Long run
a. A time period in which all factors of production are variable.

Short-run costs of production: law of Diminishing

Returns
Assumptions:
1. The firms uses only capital as the fixed factor of production and labour
as the variable factor of production.
2. Factors of production are homogeneous i.e. quality of labour is equal.
3. The level of technology is constant.

Long-run costs of production: Long-run Average

Cost (LRAC) curve
Assumptions
1. The factor prices are provided.
2. The quality of factor of production and the level of technology
provided.
3. The firm choses the least cost combination of factors of production for
each output.

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Types of Returns to Scale on LRAC

1. Increasing
a. Occurs when a given increase in output leads to a large increase
in output internal economies of scale.
2. Decreasing
a. Occurs when a given increase in output leads to a smaller
increase in output internal diseconomies of scale.
3. Constant
a. Occurs when a given increase in output leads to the same
increase in output at MES no additional economies of scale
can be achieved.

Internal Economies of Scale

Types
1. Technical economies of scale
a. It refers to the cost saving gained directly from expansion in
scale of production,
2. Indivisibilities
a. Big firms can optimally utilise machines that only have large
output fixed cost is spread over large output lowering costs.
3. Specialisation
a. Expansion of production provides greater scope of specialisation
for labour and capital raises productivity and lowers costs.
b. Labour repetitive tasks labour becomes very skilled
performs with deftness less time lost.
4. Capital
a. Use of dedicated machines instead of multi-purpose machines
saves tie.

Firm economies of scale

It refers to benefits of large-scale organisations and management.
1. Financial economies large firms have greater collateral (assets)
more credit worthy than smaller firms banking and financial
institutions more willing to offer loans and lower interest rates when
borrowing large sums alternatively to borrowing from bank, large
firms can raise funds by issuing shares to the public where no interest
is incurred.
2. Risk-bearing economies Large firms have the capabilities of market
diversification offset loss in one market with gains in another
minimise loss and lowers risks.
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3. Administrative and managerial economies large firms can have

centralised administration (e.g. one human resource department)
cost spread over large output higher productivity and lower costs.

Internal Diseconomies of Scale

Types
1. Management difficulties
a. Coordination problems with expansion, the number of
departments increases increasingly difficult to coordinate
activities affects speed and efficiency increases average
cost.
b. Communication problems with expansion, communication
lines are longer increased probability of miscommunication
and communication breakdowns resulting in costly delays.
c. Moral problems large firms tend to have hierarchy o authority
results in bureaucracy distancing leadership and individuals
creating alienation dissatisfaction low morale at worker
increased absenteeism lower productivity.

External Economies of Scale

Types
1. It refers to cost savings due to sharing of resources between firms in
the industry, i.e. clustering of firms in the same industry, they are
independent of the firms output.
2. Training training centres set up to cater to the growing size of
workforce acquiring the necessary skills pool of skilled workforce
available
3. Infrastructure with clustering of firms industry concentrated in
one region Infrastructure such as transport and telecommunication
set up shared by firms lowering costs
4. Economies of Information
a. It refers to common information services provided by research
centres or trade associations for the entire industry through
newsletters or journals shares cost of research obtains
information more cheaply as compared to carrying out
independent research.
5. Economies of Disintegration
a. It refers to firms splitting up production process and specialising
in a single production process as firms expand and industries
localise, components can be mass produced by auxiliary firms

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and supplied to the entire industry improves efficiency and

lowers costs.

External Diseconomies of Scale

1. Types
a. Higher factor prices
i. The industry expands greater demand for factor input +
supply for factor input is price inelastic bids higher
prices more powerful large firms bid higher higher
cost of production
b. Strain on infrastructure
i. The concentration of industry in one region
infrastructure strained over-crowding, congestion
pollution

Growth of Firms
1. Internal expansion
a. It refers to the expansion of firms by increasing productive
capacity using capital raised to invest in new building,
equipment, etc. the firm enjoys internal economies of scale
and large market share.
2. External expansion
a. It refers to merger resulting from mutual agreement or
acquisition
i. Horizontal merger two firms in the same industry and
the same stage of production merge.
ii. Vertical merger Two firms in the same industry but
different stage or production merge categorised into
backward integration (merge with firm at earlier stage of
production secure raw materials and forward integration
(merge with firm at later stage of production control
distribution lines.)
iii. Conglomerate merger two firms in the different
industries merge the aim is to diversify risks.

Size of Firms
1. Classification
a. Legal Formation
i. The larger the legal formation, the larger is the firm i.e.
sole proprietor, partnership, partner limited company,
publicly listed company, etc.
b. Number of share holders
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i. The larger the number of shareholders, the larger is the

firm.
c. Size of capital assets
i. The larger the size of capital assets, the larger in the firm.
2. Factors (Why firms remain small)
a. Demand-side factors
i. Some firms chose to remain small due to the small
demand, which makes large-scale production unjustifiable.
1. The nature of the product or service personalised
or exclusive by nature loses appeal if mass
produced caters to exclusive clientele e.g.
dental treatment.
2. Niche markets luxury goods limited market size
small demand.
3. Ancillary firms provide infrastructure support for
large firms small target market do not need to
capture bi market share e.g. windscreen
subcontractors for car-marker Honda.
b. Supply-side factors
i. Limited economies of scale expansion results in internal
diseconomies of scale MES attained at low output.
ii. The co-existence of big and small firms MES attained at
lo output big firms do not enjoy significant cost
advantage over small firms.
iii. Oligopoly Large firms operate with similar cost
structures as natural monopoly industry can only
support few large firms.
iv. Barriers to entry limited control over raw materials +
legal barriers e.g. intellectual property rights.

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