7.5 Types of Cost, Revenue and Profit, Short-Run and Long-Run Production

7.5 Types of Cost, Revenue and Profit; Short-Run and Long-Run Production

7.5.1 Short-Run Production Function

Fixed and Variable Factors of Production

• Fixed Factors: These cannot be changed in the short run, e.g., factory buildings, heavy machinery. They remain constant regardless of the level of output.

• Variable Factors: Inputs like labor, raw materials, and fuel that change with the level of output.

Productivity Measures

• Total Product (TP): Total output produced using given inputs.

• Average Product (AP): Output per unit of input.
  Formula: AP = TP / Units of input.

• Marginal Product (MP): Additional output from using one more unit of input.
  Formula: MP = Change in TP / Change in input.

Law of Diminishing Returns (Law of Variable Proportions)

• When more units of a variable input are added to fixed inputs, marginal product initially rises but eventually falls.

• Occurs only in the short run due to presence of fixed inputs.

• Stages:

1. Increasing returns

2. Diminishing returns

3. Negative returns

7.5.2 Short-Run Cost Function

Cost Types

• Fixed Costs (FC): Do not vary with output (e.g., rent, salaries).

• Variable Costs (VC): Vary directly with output (e.g., wages, materials).

• Total Cost (TC) = FC + VC

Cost Calculations

• Average Fixed Cost (AFC) = FC / Output

• Average Variable Cost (AVC) = VC / Output

• Average Total Cost (ATC) = TC / Output or AFC + AVC

• Marginal Cost (MC) = Change in TC / Change in Output

Cost Curve Behavior

• AFC falls as output increases.

• AVC and ATC typically U-shaped due to increasing and then diminishing returns.

• MC intersects AVC and ATC at their lowest points.

7.5.3 Long-Run Production Function

All Factors Are Variable

• Firms can adjust both capital and labor.

• No distinction between fixed and variable inputs.

Returns to Scale

• Describes how output responds to proportional increases in all inputs.

• Increasing Returns to Scale: Output increases more than input.

• Constant Returns to Scale: Output increases equally with input.

• Decreasing Returns to Scale: Output increases less than input.

7.5.4 Long-Run Cost Function

Long-Run Average Cost (LRAC) Curve

• U-shaped due to economies and diseconomies of scale.

• LRAC is formed by the envelope of various short-run ATC curves.

Minimum Efficient Scale (MES)

• The lowest point on the LRAC curve.

• Represents the scale of production with the lowest per-unit cost.

7.5.5 Relationship Between Economies of Scale and Decreasing Average Costs

• As a firm grows and scales up production:

• Internal Economies of Scale reduce average costs.

• Beyond MES, Diseconomies of Scale can occur, increasing average costs.

7.5.6 Internal and External Economies of Scale

Internal Economies of Scale (within the firm)

1. Technical: Efficient machinery, mass production.
2. Managerial: Specialized management.
3. Marketing: Bulk advertising, branding.
4. Purchasing: Bulk buying discounts.
5. Financial: Better credit terms.
6. Risk-bearing: Diversified product lines.
7. Network: Value from user growth (e.g., social networks).

External Economies of Scale (industry-wide)

• Improvements in infrastructure, availability of skilled labor, or suppliers clustering nearby.

7.5.7 Internal and External Diseconomies of Scale

Internal Diseconomies of Scale

• Coordination problems in large firms.

• Poor communication due to hierarchy.

• Low worker motivation.

• X-inefficiency: Complacency in large firms.

External Diseconomies of Scale

• Increased industry costs:

• Traffic congestion

• Rising input prices

• Labor shortages

7.5.8 Revenue Calculations

Total Revenue (TR)

• TR = Price × Quantity sold.

Average Revenue (AR)

• AR = TR / Quantity = Price.

• AR curve represents the firm’s demand curve.

Marginal Revenue (MR)

• MR = Change in TR / Change in Quantity.

• Shows additional revenue from one extra unit sold.

7.5.9 Types of Profit

Normal Profit

• When Total Revenue = Total Costs (including opportunity costs).

• It is the minimum profit required to stay in business.

Supernormal Profit

• TR > TC.

• Indicates strong market power or innovation.

Subnormal Profit

• TR < TC.

• Firm is making a loss, unsustainable in the long term.

7.5.10 Profit Calculations

Profit = Total Revenue – Total Cost

• Supernormal Profit: Positive economic profit.

• Subnormal Profit: Negative economic profit (loss).

• Can also be shown through:

• Area between TR and TC curves, or

• Area between AR and AC in diagrams (when quantity is multiplied).

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