Micro 5: Production and Cost

Micro 5: Production and Cost

At the end of this set of notes, you should be able to explain:

1. Short-run theory of production ..................................................................................2

2. Short-run theory: Law of Diminishing Marginal Returns ....................................4
3. Short-run average costs and marginal costs curves ...........................................8
4. Long-run theory: Returns to scale ............................................................................9
5. Long-run average cost curve (LRAC) ....................................................................10
6. Constructing the LRAC curve ..................................................................................11
7. Long-run theory: Internal economies/diseconomies of scale .........................12
8. Long-run theory: External economies/diseconomies of scale .......................15
9. Factors influencing size of firm ...............................................................................16
10. Methods of growth for a firm ................................................................................17

Note: This set of notes is meant to concise with just enough information for “A” level
students. It is best used as a cheat sheet, complementary with official school notes.

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Micro 5: Production and Cost

1. Short-run theory of production

1.1 Factors of production are inputs used for production.

1.2 Factors of production can be:

a. Fixed: i.e. cannot be increased or decreased in quantity within a
given time period (e.g. land and machines).
b. Variable: i.e. can be increased or decreased in quantity within a
given time period (e.g. labour and raw materials).

1.3 The short-run is a time period during which there is at least one fixed factor.

1.4 In the short-run, output can only be increased by using more variable factors.

1.5 For example, a firm can only increase output the short-run by hiring more
workers (variable factors), because building a new factory (fixed factor) is not
possible as the time period is too short to allow the fixed factor to change.

1.6 The long-run is a time period long enough for all factors to be varied,
except for technology.

1.7 Therefore, a firm can now increase output by both increasing the number
of workers and building a new factory, over the long-run.

1.8 The Total Product (TP) is the total output per period of time that is
obtained from a given amount of factors.

1.9 The Average Product (AP) is the total output per unit of the variable
factor:

𝑻𝑷
𝑨𝑷 =
𝑸𝒕𝒚 𝒐𝒇 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒇𝒂𝒄𝒕𝒐𝒓

1.10 The Marginal Product (MP) is the extra output gained by the
employment of one more unit of the variable factor, keeping the quantity
of the other factors unchanged:

∆𝑻𝑷
𝑴𝑷 =
∆ 𝑸𝒕𝒚 𝒐𝒇 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒇𝒂𝒄𝒕𝒐𝒓

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1.11 Explicit costs are actual payments made for using resources not owned
by the firm (e.g. wages of workers and cost of raw materials).

1.12 Implicit costs are opportunity costs of using resources or factors

already owned by the firm itself as well as the cost of bearing
uncertainty.

1.13 Total Cost (TC) is the sum of explicit costs and implicit costs.

1.14 Total Fixed Cost (TFC) is the total cost of the fixed factors.

1.15 Since the quantity of the fixed factor is unchanged, therefore, the TFC
is constant and does not vary with the level of output.

1.16 Total Variable Cost (TVC) is the cost of acquiring the variable factors.

1.17 In the short-run, output can only be increased by increasing variable

factors, and therefore TVC will increase with the increase in output.

1.18 Average Cost (AC) is the cost per unit of output.

1.19 TC can also be expressed as the sum of TFC and TVC:

TC = TFC + TVC

1.20 Therefore, AC can also be expressed as the sum of AFC and AVC:

AC = AFC + AVC

𝑻𝑭𝑪 𝑻𝑽𝑪
where AFC = and AVC =
𝑻𝒐𝒕𝒂𝒍 𝑶𝒖𝒕𝒑𝒖𝒕 𝑻𝒐𝒕𝒂𝒍 𝑶𝒖𝒕𝒑𝒖𝒕

1.21 Average Fixed Cost (AFC) is the fixed cost per unit of output, and it
falls continuously as output increases as it gets spread over a larger
output.

1.22 Average Variable Cost (AVC) is the variable cost per unit of output,
and it falls then rises as output increases due to the LDMR (elaborated
on below).

1.23 Marginal Cost (MC) is the change in TC as a result of producing an

additional unit of output.

1.24 In the short-run, output can only be increased by increasing the quantity
of the variable factor.

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1.25 Thus, the change in TC in the short-run is due to the change in the
total variable cost only.

2. Short-run theory: Law of Diminishing Marginal Returns

2.1 In the short-run, production is subject to the Law of Diminishing Marginal

Returns (LDMR).

2.2 The LDMR states that when increasing amounts of a variable factor are added
to a given amount of a fixed factor, eventually the marginal product of that
variable factor will decline.

2.3 To understand the LDMR, let’s first assume that:

a. There are two factors of production: one is the fixed factor (e.g.
land) and the other is the variable factor (e.g. labour).
b. All units of the variable factors are homogeneous.
c. The level of technology is constant.

2.4 The short-run production function is given in the table below:

2.5 Plotting the MP, AP and TP on one graph, and the TC, MC and AC on
another graph, yields the following diagrams:

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Figure 1: LDMR illustrated by MP, AP and TP

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Micro 5: Production and Cost

Figure 2: LDMR illustrated by MC, AC and TC

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Micro 5: Production and Cost

Figure 3: LDMR illustrated by MC, AC (zoomed in)

2.6 In the above Figures (1 – 3), there are 4 stages explained by the LDMR:
a. Increasing returns (green);
b. Constant returns (yellow);
c. Diminishing returns (red);
d. Negative returns (red).

a. Increasing returns

2.7 In the initial stage, as the firm begins to hire more workers, the total
output of wheat increases at an increasing rate (i.e. MP is rising, MC is
decreasing).

2.8 The total output increases at an increasing rate because :

a. The fixed factor is more efficiently utilised as more workers
are made to work on it.
b. With more workers, the work can be divided and each worker can
specialise in a particular task.

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b. Constant returns

2.9 At this stage, when more of the variable factor is added to the fixed
factor, total output increases at a constant rate (i.e. MP and MC are both
constant).

2.10 The gains from hiring more workers have stopped increasing here.

c. Diminishing returns

2.11 At this stage, when more of the variable factor is added to the fixed
factor, total output increases at a decreasing rate (i.e. MP is
decreasing, MC is increasing).

2.12 Diminishing returns is due to over-utilisation of the fixed factor as more

workers are added to it.

d. Negative returns

2.13 At this stage, when more of the variable factor is added to the fixed
factor, total output begins to fall (i.e. MP is negative).

2.14 Over-utilisation of the fixed factor as more workers are added to it has
reached an extent where output decreases rather than increase .

3. Short-run average costs and marginal costs curves

Figure 4: Average and marginal cost curves

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a. Relationship between AC, AVC and MC

3.1 When MC is less than AVC, AVC will fall.

3.2 When MC is greater than AVC, AVC will rise.

3.3 MC is therefore equal to AVC when AVC is at minimum.

b. Shapes of AC, AVC, AFC and MC

3.4 AVC is U-shaped (i.e. it first fails then rises as output increases),
because of LDMR as explained in Section 2.

3.5 Recalling that AC = AFC + AVC, as the firm first increases its output,
both AFC and AVC fall, thus AC falls.

3.6 Referring to Figure 4, between Y and Z, AC continues to fall, because

the fall in AFC more than offsets the rise in AVC.

3.7 Beyond Z, AC will rise, as the rising AVC more than offsets the fall in
AFC.

3.8 MC first falls then rises as output increases due to the LDMR, because:
a. As the firm expands its output, it employs more units of variable
factors of production.
b. This will cause the combination of the fixed and variable inputs to
improve which, in turn, raises the MP.
c. Assuming that the price of the variable input is constant, the MC
will fall.
d. At higher output, the factor proportion becomes less efficient
and this in turn, lowers the MP.
e. Again, assuming that the price of the variable input is constant,
the MC will increase.

4. Long-run theory: Returns to scale

4.1 The long-run is a time period long enough for the firm to vary all its factors of
production.

4.2 Thus in the long-run, a firm can increase output by increasing the quantity of all
factors of production in a fixed proportion i.e. increase the scale of
production.

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4.3 In the long-run, when a firm increases its scale of production by

increasing all inputs by the same proportion, there are three possible
outcomes:
a. Increasing returns to scale occurs when a given increase in all
inputs results in a more than proportionate increase in output.
b. Constant returns to scale occurs when a given increase in all
inputs results in a proportionate increase in output.
c. Decreasing returns to scale occurs when a given increase in all
inputs results in a less than proportionate increase in output.

5. Long-run average cost curve (LRAC)

5.1 In the long-run, a firm can vary all its factors of production and so it does not
have to operate with a fixed plant size.

5.2 Since there are no fixed factors in the long-run, there are no fixed costs, and
therefore all costs in the long-run are variable.

5.3 The long run average cost curve (LRAC) shows the cheapest way to produce
various levels of output in the long-run.

Figure 5: LRAC and returns to scale

5.4 Referring to Figure 5: LRAC is generally `U' shaped as it is often assumed that
as a firm expands:
a. It will initially experience internal economies of scale as well as
increasing returns to scale and thus the LRAC will decrease.
b. After a point, all economies will have been achieved and the curve
will flatten out (Minimum efficient scale of production - MES).

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Micro 5: Production and Cost

c. If the firm continues to expand, it may get so large that it will

experience internal diseconomies of scale as well as
decreasing returns to scale and thus the LRAC will rise.

6. Constructing the LRAC curve

6.1 The LRAC curve is sometimes called the planning or envelope curve and the
long-run may be regarded as the planning horizon.

6.2 The LRAC tells the firm the plant size and the quantity of factors to use at
each output to minimize cost.

6.3 Assume that in the long-run, a firm has a choice of 3 plant sizes: small,
medium, large.

6.4 Figure 6 shows the SRAC curves associated with the three plant sizes:
a. SRAC 1 corresponds to the small plant size;
b. SRAC 2 corresponds to the medium plant size; and
c. SRAC 3 corresponds to the large plant size.

6.5 The aim of the firm is to minimise costs,
the firm decides to produce at:
a. Q 1 , then the form should build the
b. Q 2 , then the form should build the
c. Q 3 , then the form should build the
therefore based on Figure 6, if
small plant, since C 1 < C 2 .
medium plant, since C 3 < C 4 .
large plant, since C 5 < C 6 .

Figure 6: SRAC for different plants

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6.6 If we assume that the firm is faced with an infinite number of choices
regarding plant size in the long-run, then we will be able to derive an
infinite number of SRAC curves accordingly.

6.7 By drawing the envelope of all the SRACs (black lines) at the lowest cost
associated with each output level, we find the LRAC (red line) as shown
in Figure 7.

6.8 Hence, the LRAC indicates the cheapest way to produce various
levels of output.

Figure 6: Construction the LRAC curve

7. Long-run theory: Internal economies/diseconomies of scale

7.1 Economies of Scale are the reductions in unit cost enjoyed from the growth in
production of the firm or growth of the whole industry.

7.2 On the other hand, diseconomies of scale occurs due to the over-expansion of
the firm or the industry, causing unit costs to escalate.

7.3 Economies and diseconomies of scale may be:

a. Internal, when the average cost decreases due to the increase in
the scale of production of the firm itself.
b. External, when the average cost decreases due to the expansion
of the entire industry.

7.4 As shown in Figure 5, economies/diseconomies of scale are represented by

movements along the LRAC.

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a. Internal (technical) economies of scale

7.5 In a larger firm, it is possible to have specialisation and division of

labour, which increases the efficiency of labour, thus resulting in
lowering unit cost of production.

7.6 The indivisibility of plants means that some inputs can only be
employed efficiently in units of minimum size and this size may be too
large for a small firm (e.g. combine harvesters for large farms).

7.7 The principle of increased dimension means that an addition in input

may not require a proportionate increase in other factors of production
to yield higher production levels. (e.g. double decker bus can carry twice
as many passengers but doesn’t require an additional driver).

b. Internal (marketing) economies of scale

7.8 As a firm gets bigger, it buys its inputs, such as raw materials in bulk ,
which increases bargaining power with suppliers, driving down the
firm's unit cost of production.

7.9 Also, since a bigger firm produces more output, its total advertising
cost is spread over larger output, thus reducing its unit cost.
c. Internal (financial) economies of scale

7.10 Larger firms may be able to obtain financial loans at lower interest
rates due to better credit worthiness.

7.11 It can also raise funds more easily in the capital market by issuing
shares to members of the public.

d. Internal (risk-bearing) economies of scale

7.12 Large firms are more able to diversify their products, and therefore
able to enjoy lower unit cost because they are more able to deal with
risks arising from trading, compared to smaller firms.

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e. Internal (managerial) economies of scale

7.13 As a firm expands, it is also able to hire professionals to specialise in

different areas of work, increasing a firm's output through better
efficiency, thus lowering its unit cost of production.

f. Internal (managerial) diseconomies of scale

7.14 A firm can grow so large that it becomes more complex and
cumbersome to manage, and the resultant bureaucratic and decision-
making process results in low productivity and higher unit cost.

7.15 Difficulties in co-ordination within the firm may appear as the firm
becomes too big, and thus inefficiency may creep in, increasing unit cost.

7.16 As a firm becomes too large, workers may feel alienated as the firm
becomes impersonal to their needs, resulting in lower morale and
therefore productivity.

7.17 In addition, an employee in a large organization who gets a fixed salary

every month may not be too motivated about efficiency as he will not
gain more from working harder.

g. Internal (financial) diseconomies of scale

7.18 When firms become very big and borrow heavily, the firm's credit-
worthiness might be cut, causing creditors and banks to be reluctant
to offer generous loans and also begin to charge high interest rates.

h. Internal (risk-bearing) diseconomies of scale

7.19 The larger the output level and the bigger the scale of production, the
greater the risk involved.

7.20 As the firm expands excessively, the poor performance of one branch
in one area may have negative spill over effects on all the other
branches, causing higher unit costs.

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8. Long-run theory: External economies/diseconomies of scale

a. External economies of scale

8.1 External economies of scale occur when the average cost of a firm decreases
as the output of the whole industry increases.

8.2 This is represented by a downward shift in the LRAC curve, i.e. from LRAC1 to
LRAC2 as shown in Figure 8.

8.3 As the industry grows, industrial amenities such as water and power
supplies will be developed for the convenience of the industries by the
relevant authorities and suppliers, reducing costs for firms.
8.4 Also, a transport network will be developed by the government to
facilitate efficient movement of factor inputs and finished products within
the industry, reducing transport costs.

8.5 Firms may combine efforts to engage in research or the government

may set up a research centre to develop better methods and products of
higher quality, allowing every firm to enjoy better efficiencies.

b. External diseconomies of scale

8.6 External diseconomies of scale occur when the average cost of a firm
increases as the output of the whole industry increases.

8.7 This is represented by an upwnward shift in the LRAC curve, i.e. from LRAC1
to LRAC3 as shown in Figure 6.

8.8 As an industry grows, the increased demand for factors of production

can lead to a shortage of the factors that result in higher factor
prices, driving unit costs up.

8.9 Strong competition for customers as industry output increases may also
result in increased spending on advertising.

8.10 Over-crowding and traffic congestion could mean loss of man-hours

in business, reducing productivity of the individual firms.

8.11 Noise as well as air pollution arising from geographical concentration of

firms may also force government to impose taxes and fines.

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Figure 8: External (dis)/economies of scale

9. Factors influencing size of firm

a. Size of the demand

9.1 Large-scale production is not economically efficient unless justified by a large

market for its product.

9.2 Firms may remain small simply because the market for their product is relatively
small. (e.g. local demand for groceries).

9.3 Physical difficulties may also make it expensive to transport large amounts of
perishable goods such as vegetable over long distances.

9.4 In the case of luxury items, the market is limited by price. (e.g. sports car, large
luxury yachts, high quality jewellery and fur coats).

b. Consumer preference for personal touch

9.5 Large-scale production chums out mass-produced goods lacking individuality.

9.6 Many consumers prefer personal contact which is not available in large firms,
and which can be gotten at small firms (e.g. small provision store and the local
tailors).

c. Nature of the product

9.7 The optimum size for some firms is small.

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9.8 This is particularly true for highly personal services that require full
attention at hand and cannot be easily scaled up (e.g. private tutoring,
doctors).

d. Availability of funds and managerial expertise

9.9 Some firms remain small because they encounter difficulties in rais ing,
on reasonable terms, the necessary finance for further expansion.

9.10 This is because banks and other financial institutions generally prefer to
lend to big firms who have greater collateral security.

9.11 Other firms do well on small scale but fail on a larger scale owing to the
inability of management to handle the complexities of a big business .

e. Availability of raw materials

9.12 Shortage of raw materials would hinder the growth of the firm , as firms
would not be able to produce more even with higher prices.

f. Government policies

9.13 Governments' imposition of anti-trust regulations or policies that favour

large MNCs (e.g. extremely high requirements) may stifle the
development of small firms.

g. Diseconomies of scale

9.14 Some firms may experience internal diseconomies of scale fairly early in
the firm's growth.

9.15 If the LRAC of the firm rises very fast as output increases (i.e. the MES
occurs at relatively small output levels), its growth may then be limited
by higher unit costs.

10. Methods of growth for a firm

a. Internal growth

10.1 In this case, the firm increases its size by expanding its operation organically.

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b. External growth – Vertical integration

10.2 Vertical integration occurs when two firms at different stages of production in
the same industry come together.

10.3 A backward vertical integration occurs when a firm integrates with

another firm upstream in the supply chain (e.g. tea retailer integrating
with tea plantation owner) for reasons including:
a. Better quality control of supplies;
b. Restricting the availability of supplies to competitors.

10.4 A forward vertical integration occurs when a firm integrates with

another firm downstream in the supply chain (e.g. oil companies
integrating with petrol kiosks) for reasons including:
a. Increasing sales channels and therefore revenue;
b. Better control of product image portrayed by retail outlets.

c. External growth – Horizontal integration

10.5 Horizontal integration occurs when two or more firms which produce
the same good or service or which are engaged in the same stage of
production are integrated (e.g. DBS-POSB merger).

10.6 This allows the firm to exploit potential internal economies of scale
from a larger scale of production and also achieve greater monopoly
power by capturing a larger market share.

d. External growth – Conglomeration

10.7 A conglomerate merger refers to the combination of two or more

firms with no obvious common links between them.

10.8 For example, the Alphabet conglomerate operates life sciences

projects, driverless cars, start-up investing, fibre optics, and home
devices like Nest thermostats and Google Home.

10.9 A conglomerate merger helps the firm diversify into different product
areas and helps spread a firm's risks, allowing it to offset periodic
declines in sales in one of its products against the increase in sales
elsewhere (i.e. cross-subsidise).

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