Chapter 10: Production in the Short Run and Long Run

Question 1

What are ‘fixed factors’?

Answer 1

Fixed factors refer to inputs whose quantity remains unchanged even the amount of output changes.

Question 2

What are ‘variable factors’?

Answer 2

Variable factors refer to inputs whose quantity increases (decreases) as output increases (decreases).

Question 3

How to define whether an output is fixed or variable?

Answer 3

Fixed and variable factors are defined in terms of whether they vary with output.

Question 4

How does a firm decide which factors to vary so as to meet output changes?

Answer 4

It may consider whether the change in output is temporary or persistent.

To meet a temporary increases in demand …

• The firm may not need to increase all the factors, only the quantities of some factors would vary but some would not.

To meet a persistent increases in demand …

• The firm may have to increase the employment of all factors to raise production capacity. Thus, all factors now become variable factors.

Question 5

What does it mean when a production period is in short run?

Answer 5

Definition:

• Production is in short run if both fixed factors and variable factors are present.

Elaboration:

• That means in the short run, a firm will increase output by using more variable factors. They will keep the quantity of fixed factors constant even when they raise output.

Question 6

What does it mean when a production period is in long run?

Answer 6

Definition:

• Production is in long run if all factors are variable. There are no fixed factors.

Elaboration:

• That means in the long run, a firm will increase all factors to increase output.

Question 7

How to define whether a production period is in short run or long run?

Answer 7

Short run and long run are defined in terms of whether there are fixed factors in the production (not defined by the length of time).

Question 8

What is ‘total product’?

Answer 8

Definition:

• Total product is the total amount of output produced at a certain amount of inputs used.

Calculation formula:
Total product (of A)

• = Average product x Quantity of variable factor
• = Total product of the previous unit of A + Marginal product of A

Question 9

What is ‘average product’?

Answer 9

Definition:

• Average product is the amount of output produced per unit of variable factor.

Calculation formula:

• Average product
  = Total product / Quantity of variable factor

Question 10

What is ‘marginal product’?

Answer 10

Definition:

• Marginal product is the Δ in total product as a result of changing the employment of the variable factor by one unit.

Calculation formula:

• Marginal product of A (any unit of variable factor)
  = Total product of A - Total product of the previous unit of A

Question 11

What is the relationship between marginal product and total product?

Answer 11

When marginal product is +ve

• Total product is ↑ing

When marginal product is -ve

• Total product is ↓ing

When marginal product is 0

• No Δ in total product (TP is at maximum)

Question 12

State the Law of diminishing marginal returns.

What if it reverse??????

Answer 12

The Law of diminishing marginal returns:

• When variable factor is added continuously to a given quantity of fixed factor, the marginal product or marginal return will eventually decrease, ceteris paribus.

Note: This Law only apply in short run, because there will be fixed factors only in short run (not long run).

Question 13

When does the Law set in?

Answer 13

The law sets in at the unit when MP begins to fall.

Examples (Refer to notes p.7):

• The law sets in when the 3rd unit of labour is employed.
• The law sets in after the 2nd unit of labour is employed.

Question 14

What are ‘fixed costs’?

Answer 14

Fixed costs refer to the costs of employing fixed factors. These costs do not change when output changes.

Question 15

What are ‘variable costs’?

Answer 15

Variable costs refer to the costs of employing variable factors. These costs increases (decreases) when output increases (decreases).

Question 16

How are fixed costs and variable costs related to short run and long run (when total output > 0, total product = 0)?

Answer 16

(Refer to notes p.13)

In the Short Run,

• There are fixed costs and variable costs when output is produced (total output > 0).
• There are fixed costs, but the variable cost is 0 when output is not produced (total output = 0).

In the Long Run,

• There are variable costs, but no fixed costs when output is produced (total output > 0).
• There is no fixed cost, and the variable cost is 0 when output is not produced (total output = 0).

Question 17

What is ‘total cost’ (TC)?

Answer 17

Definition:

• Total cost is the cost of producing a total amount of output.

Calculation formula:

• Total cost = Total fixed costs + Total variable costs

Question 18

What is ‘average cost’ (AC)?

Answer 18

Definition:

• Average cost is the cost incurred per unit of output produced.

Calculation formula:

• Average cost
  = Total cost / Quantity of output

1. Average variable cost
   = Total variable cost / Quantity of output
2. Average fixed cost
   = Total fixed cost / Quantity of output

Question 19

What is ‘marginal cost’ (MC)?

Answer 19

Definiton:

• Marginal cost is the Δ in total variable cost that results from producing an additional one more unit of output.

Calculation formula:

• Marginal cost of A
  = Total cost of A - Total cost of the previous unit of A
  = Total variable cost of A - Total variable cost of the previous unit of A

Key concept:

• Marginal cost can be calculated by the Δ in total cost or the Δ in total variable cost.
• Δ in fixed cost will not affect marginal cost.

Question 20

What is ‘total profit’?

Answer 20

Definition:

• Profit is the difference between total revenue and total cost.

Calculation formula:
Total profit = Total revenue - Total cost

• Total revenue = Profit x Quantity
• Total cost = The cost of producing the total amount of output

Question 21

How to find the total profit at the profit maximizing output level?

Answer 21

Total profit = Total revenue - Total cost

• Where TR = Price x Q; TC = TVC + fixed cost

Total profit = Sum of marginal profit of each unit - Fixed cost

• Can only use when data start with one unit of output

Question 22

What does it mean by ‘the seller is in a price-taking market’?

^as an assumption

Answer 22

In a price-taking market, the market price is determined by the market demand and supply. Individual seller cannot have the power to influence the market price by himself.

In other words, the seller just take the market price as given and sell at this market price with all the other sellers in the market. The seller can choose the amounts he wants to sell at the given market price.

Question 23

When does maximum profit occur?

Answer 23

Maximum profit occurs when the difference between total revenue and total cost is the largest.

Question 24

What is ‘profix-maximizing output’?

Answer 24

In maximizing profit, a seller needs to decide on the best quantity of output to sell. The output or quantity supplied at which a seller can maximize his or her profit is called the profit-maximizing output.

It is obtained by comparing marginal revenue and marginal cost, i.e. the profit maximizing output is the output at which MR = MC.

Question 25

What is ‘marginal revenue’ (MR)?

Answer 25

Definition:

• Marginal revenue is the Δ in total revenue obtained from selling an additional unit of output.

Calculation formula:
It is assumed that an individual seller cannot affect the market price. Every unit is sold at the same per unit price. Therefore:

• Marginal revenue = Per-unit price

Question 26

What is ‘marginal cost’ (MC)?

Answer 26

Definition:

• Marginal cost is the Δ in total cost for producing an additional unit of output.

Question 27

What is ‘marginal profit’?

Answer 27

Definition:

• Marginal cost is the Δ in total profit for producing an additional unit of output.

Calculation formula:

• Marginal profit = Marginal revenue - Marginal cost

Question 28

How to find the profit maximizing output with the help of MR and MC?

Answer 28

If MR > MC → Marginal profit +ve

• A firm should increase output to gain more profit.

If MR < MC → Marginal profit -ve

• A firm should increase profit by decreasing output.

If MR = MC (equilibrium state, no tendency to change) → Marginal profit = 0

• Profit is already the maximum at the current output level.

Question 29

How to derive the supply schedule with the MC schedule?

Answer 29

MC schedule VS Supply schedue: Refer to notes p.22

• The individual schedule is equal to the firm’s marginal cost (MC) schedule.

Question 30

What are other possible objectives that an enterprise may adopt (other than profit-maximizing)?

Answer 30

Market share maximization, Corporate social responsibility, Provision of non-profit making goods and services

Question 31

What does ‘market share maximization’ mean?

Answer 31

Definition:

• The market share of a firm in an industry refers to the % of its product sales to the total product sales of that industry.
• Sales can be measured in terms of either dollar sales or unit sales.

Market share (%)

• = Sales of the firm / Sales of the whole economy

Elaboration:

• Some firms want to maximize market share so that they can have greater influence on the market, e.g. the market price.
• However, the firm with the largest market share may not be the one making the most money in the industry.

Examples:

• DHC cosmetics offer excessive price discounts when it tries to increase their market share in HK.

Question 32

What does ‘corporate social responsibility’ mean?

Answer 32

Definition:

• Try to hold responsibilities to the society and its stakeholders (i.e. people who affect or are affected by the behaviour of the firm, e.g. shareholders, employee, customers, the community, etc).

Elaboration:

• Firms have to meet the desires and ethical standards of their stakeholders.

Examples:

• Being environmentally friendly, treat employees fairly, etc.

Question 33

What does ‘provision of non-profit making goods and services’ mean?

Answer 33

Definition:

• Provides essential goods and services to the public at low prices / free of change.
• To serve the needs of some targeted groups.

Examples:

• Most non-government organisation (NGO) have objectives of serving the community other than maximizing profits.
• Public enterprises and subsidized school

Question 34

What does it mean by ‘the scale of production is enlarged’?

Answer 34

When the employment of all inputs increases together (in long run only), we may say the scale of production is enlarged, and vice versa.

Note:

• Due to the presence of fixed factor in the short run, the production scale in short run cannot be increased.

Question 35

What are ‘economies of scale’?

Answer 35

The possible benefits from expansion are called economies of scale.

Question 36

What are ‘diseconomies of scale’?

Answer 36

The possible disadvantages due to expansion are called diseconomies of scale.

Question 37

How do we know whether there is economies or diseconomies of scale?

Answer 37

Economies of scale: When the average cost is negatively related to output level (the scale)

• Firm expand its scale (increases output)
  → Average cost falls
• Firm contract its scale (decreases output)
  → Average cost rises

Diseconomies of scale: When the average cost is positively related to output level (the scale)

• Firm expand its scale (increases output)
  → Average cost rises
• Firm contract its scale (decreases output)
  → Average cost falls

Graphical representation:
Refer to notes p.28

• The point where AC is the lowest → Optimal scale (i.e. MR = MC)

Question 38

Bonus question: If the firm doubles its inputs and production cost and finds that its output increases by more than double, is it operating at economies or diseconomies of scale?

Answer 38

AC = TC (↑100%) / Q of output (↑>100%)
∴ Economies of scale
(AC ↓ when output level ↑)

Question 39

What are the two types of ‘economies of scale’?

Answer 39

1. Internal economies of scale
   Advantages enjoyed by a firm when the firm itself enlarges the scale of production.
2. External economies of scale
   Advantages enjoyed by a firm when the other firms or the industry enlarges the scale of production.

Question 40

What are the possible sources of internal economies of scale (+ Explanation)?
(p.s. Why do larger firms often enjoys more advantages internally than a smaller firm?)

^Expansion of the scale of production

Answer 40

1. Technical economies
   When the output is larger, machines can be utilized more fully and efficiently and reduce average cost.
2. Managerial economies
   A larger firm can have wider scope of specialization and thus improves efficiency and lower average cost.
3. Financial economies
   A larger firm can obtain capital at a lower average cost, e.g. borrow funds from banks at a lower interest rate.
4. Purchasing economies
   Buying raw materials in bulk helps obtain discounts in the purchase and result in a decrease in average cost.
5. Marketing economies
   Spreading the advertising cost and the cost of providing extra service to customers over a larger output can reduce average cost.
6. Risk diversification economies
   A larger firm can spread risk by diversification of its input sources, products and markets.
   Risk is reduced by market diversification and source diversification.
7. Research and development economies
   A larger firm can afford huge expenses on research and development. Spreading research expenses over a larger output can reduce average cost.

Question 41

What are the possible sources of external economies of scale (+ Explanation)?

^Expansion of the scale of production

Answer 41

1. More workers would be attracted to the industry.
   → Lowers firm’s average cost of recuiting workers.
2. As the demand for back-up, transport and communication services increases, corresponding services would be developed.
   → Lowers firm’s average cost of using these services.
3. More firms advertise the products of the industry or when the firms cluster together.
   → Lowers firm’s average cost of marketing.

Question 42

What are the two types of ‘diseconomies of scale’?

Answer 42

1. Internal diseconomies of scale
   Disdvantages arise when the firm becomes too large.
2. External diseconomies of scale
   Disdvantages arise when the other firms or the industry enlarges the scale of production.

Question 43

What are the possible sources of internal diseconomies of scale (+ Explanation)?

Answer 43

1. Managerial diseconomies
   When a firm becomes too big, its internal structure becomes too complicated and it creates problems of communication and coordination. These increase average cost of production.
2. Financial diseconomies
   When a firm is already very big and is still in need of borrowing huge amount of capital to expand, banks may regard the risk of making additional loans very high and charge a higher interest rate. Average cost of obtaining capital will increase.
3. Marketing diseconomies
   If the market share of a large company is already huge or the market has become saturated, further sales promotion will not be effective in increasing sales of the firm. Further promotion only increases average cost of marketing its product.

Question 44

What are the possible sources of external diseconomies of scale (+ Explanation)?

Answer 44

1. Excessive expansion of industry causes a drastic increase in the demand for factor inputs like labour, raw materials, etc
   → Greatly raise input prices like wages, rent, prices of raw materials.
2. Increasing concentration of business activities in a district leads to a substantial increase in traffic in that area.
   → The resulting congestion raises transport costs.